A Complete Guide to Bond Markets: Treasury, Municipal, and Corporate Bonds
Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2
Chapter 7 shifts from money markets (short-term) to bond markets (long-term). Bonds are how governments and corporations borrow money for years or even decades. This chapter covers the different types of bonds, how they work, and how the bond market has gone global.
What Bonds Are
A bond is a long-term debt security. The issuer promises to pay periodic interest (coupon payments) and return the principal (par value) at maturity. Most bonds have maturities between 10 and 30 years, though some companies like Disney and AT&T have issued 100-year bonds. Yes, really.
Bonds fall into four categories by issuer: Treasury bonds, federal agency bonds, municipal bonds, and corporate bonds. Each has different risk levels, tax treatment, and liquidity. That means yields vary across all of them.
Treasury and Federal Agency Bonds
Treasury bonds are issued by the U.S. government to finance the budget deficit. Because the government is not expected to default, these bonds are considered the risk-free benchmark. The minimum denomination is just $100. Treasury notes have maturities under 10 years; Treasury bonds are 10 years or more.
Interest on Treasury securities is exempt from state and local taxes but still subject to federal tax. Treasury bond auctions work similarly to T-bill auctions, with competitive and noncompetitive bidding.
Madura covers some interesting variations:
STRIPS (Separate Trading of Registered Interest and Principal of Securities) are stripped Treasury bonds. A securities firm takes a regular Treasury bond and separates the coupon payments from the principal payment, creating multiple zero-coupon securities. Each one represents a single future payment. These are useful for investors who want to match a specific future cash need.
TIPS (Treasury Inflation-Protected Securities) have their principal adjusted for inflation every six months. The coupon rate is lower than regular Treasury bonds, but the principal grows with the consumer price index. If prices double over the life of the bond, the par value doubles too.
Savings bonds are for small investors. You can buy Series EE or Series I bonds for as little as $25. No secondary market exists, but the Treasury allows redemption after 12 months with a small penalty.
Federal agency bonds are issued by Fannie Mae and Freddie Mac to fund mortgage purchases. Before 2008, these were not backed by the government. But when the credit crisis hit and both agencies nearly collapsed, the government stepped in and took them over.
Municipal Bonds
State and local governments issue municipal bonds to finance their spending. There are two types: general obligation bonds (backed by the government’s taxing ability) and revenue bonds (backed by revenue from a specific project like a toll road or dormitory).
The big selling point of municipal bonds is the tax advantage. Interest income is exempt from federal taxes. If you buy bonds issued in your own state, you may avoid state taxes too. This makes them especially attractive to investors in high tax brackets. Municipal yields are typically 20 to 30 percent lower than Treasury yields with similar maturities, and investors still come out ahead after taxes.
But municipals are not risk-free. Some cities and states run serious budget deficits. Ratings can be misleading. During the credit crisis, MBIA (the largest bond insurer) took massive losses. By 2010, fewer than 10 percent of new municipal bonds were insured, down from about 50 percent in 2006. Investors learned the hard way that bond insurance is only as good as the insurer.
Corporate Bonds
Corporate bonds are issued by companies that need long-term funding. Interest is tax-deductible for the company, which is a major reason corporations prefer bonds over equity financing. Maturities are typically 10 to 30 years, and the minimum denomination is $1,000.
How They Are Issued
Corporations issue bonds through public offerings or private placements. In a public offering, the company hires an underwriter (a securities firm) to price the bonds and sell them. The company files a prospectus with the SEC. The underwriter may guarantee a price (firm commitment) or simply try their best to sell them (best efforts).
Private placements skip the SEC registration and sell directly to a few institutional investors. They are less liquid but cheaper to issue, making them practical for smaller offerings.
Key Features
Madura covers several bond features that matter to investors:
Sinking-fund provisions require the issuer to retire a portion of the bonds each year, reducing the risk at maturity.
Protective covenants restrict what the company can do. They might limit dividend payments, executive salaries, or additional borrowing. These exist because bondholders and shareholders have different interests. Shareholders want risk (higher returns). Bondholders just want their money back.
Call provisions let the issuer buy back bonds early, usually at a premium. Companies use this when interest rates drop so they can refinance at a lower rate. Bondholders dislike call provisions because they can lose a good investment.
Convertible bonds can be exchanged for shares of the company’s stock. This gives bondholders upside potential if the stock price rises, so the company can offer a lower coupon rate.
Junk Bonds
Corporate bonds rated below investment grade are called junk bonds (or high-yield bonds). The risk premium over Treasury bonds is typically 3 to 7 percentage points. During the 2008 credit crisis, that spread exceeded 10 percent. Junk bonds valued at over $25 billion defaulted during that period.
The main investors in junk bonds are mutual funds, life insurance companies, and pension funds. High-yield mutual funds exist specifically for this purpose. When rates are low across the board, investors are more willing to reach for yield and buy junk bonds.
Global Bond Markets
Bond markets have become increasingly international. Pension funds, insurance companies, and banks regularly invest in foreign government bonds (sovereign bonds). The yields vary by country, and the credit risk does too. Argentina, Brazil, Russia, and others have defaulted on sovereign debt in the past.
The Greek debt crisis of 2010 is a key case study in Madura. Greece had a massive budget deficit and could not repay its debt. The eurozone and IMF provided $110 billion in loans with strict austerity conditions. The crisis spread to Portugal, Spain, and Ireland, with risk premiums rising sharply across the eurozone.
The Eurobond market allows corporations to issue bonds denominated in a currency of their choosing. A U.S. company might issue bonds in Swiss francs if the interest rate is lower, then use a Swiss subsidiary to cover the payments. This avoids exchange rate risk while getting cheaper financing.
Other Long-Term Debt
Madura closes with a few specialty instruments:
Structured notes tie interest and principal payments to specific market conditions, like a stock index or currency. They became popular in the 1990s. Orange County, California invested heavily in structured notes betting that interest rates would decline. They guessed wrong. Interest rates rose, the portfolio lost massive value, and Orange County filed for bankruptcy in 1994.
Exchange-traded notes (ETNs) promise returns based on a debt index. They are unsecured, so default risk is real. They can use leverage, which amplifies both gains and losses.
Auction-rate securities were supposed to offer long-term borrowing with short-term investor commitments. They fell apart in 2008 when financial institutions could no longer find buyers, effectively freezing investor money.
My Take
Bond markets are much bigger and more complex than most people realize. The corporate bond market alone exceeds $5 trillion. What stands out from this chapter is how much trust matters. Bonds are built on the promise of repayment. When that trust breaks down (Greece, Lehman Brothers, Orange County), the consequences are severe.
The rating agency problem also jumps out. Agencies are paid by the issuers they rate. That is a conflict of interest that the Financial Reform Act of 2010 tried to address, but the fundamental structure has not changed. If the company paying you also decides whether to hire you again, how honest will your ratings be?
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