These instruments are sometimes said to comprise the fixed-income capital market, because most of them promise either a fixed stream of income or stream of income that is determined according to a specified formula. In practice, these formulas can result in a flow of income that is far from fixed. Therefore, the term “fixed income” is probably not fully appropriate. It is simpler and more straightforward to call these securities either debt instruments or bonds.
Treasury Notes and Bonds
The U.S. government borrows funds in large part by selling Treasury notes and bonds. T-note maturities range up to 10 years, while T-bonds are issued with maturities ranging from 10 to 30 years. The Treasury announced in late 2001 that it would no longer issue bonds with maturities beyond 10 years. Nevertheless, investors often refer to all of these securities collectively as Treasury or T-bonds. They are issued in denominations of $1,000 or more. Both bonds and notes make semiannual interest payments called coupon payments, so named because in precomputer days, investors would literally clip a coupon attached to the bond and present it to an agent of the issuing firm to receive the interest payment. Aside from their differing
maturities at issuance, the only major distinction between T-notes and T-bonds is that Tbonds may be callable during a given period, usually the last five years of the bond’s life. The call provision gives the Treasury the right to repurchase the bond at par value. While callable T-bonds still are outstanding, the Treasury no longer issues callable bonds.
The yield to maturity reported in the last column is a measure of the annualized rate of return to an investor who buys the bond and holds it until maturity. It is calculated by determining the semiannual yield and then doubling it, rather than compounding it for two half-year periods. This use of a simple interest technique to annualize means that the yield is quoted on an annual percentage rate (APR) basis rather than as an effective annual yield. The APR method in this context is also called the bond equivalent yield.
Federal Agency Debt
Some government agencies issue their own securities to finance their activities. These agencies usually are formed for public policy reasons to channel credit to a particular sector of the economy that Congress believes is not receiving adequate credit through normal private sources.
The major mortgage-related agencies are the Federal Home Loan Bank (FHLB), the Federal National Mortgage Association (FNMA, or Fannie Mae), the Government National Mortgage Association (GNMA, or Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac).
Freddie Mac, Fannie Mae, and Ginnie Mae were organized to provide liquidity to the mortgage market. Until establishment of the pass-through securities sponsored by these government agencies, the lack of a secondary market in mortgages hampered the flow of investment funds into mortgages and made mortgage markets dependent on local, rather than national, credit availability. The pass-through financing initiated by these agencies represents one of the most important financial innovations of the 1980s.
Although the debt of federal agencies is not explicitly insured by the federal government, it is assumed the government will assist an agency nearing default. Thus, these securities are considered extremely safe assets, and their yield spread over Treasury securities is usually small.
International Bonds
Many firms borrow abroad and many investors buy bonds from foreign issuers. In addition to national capital markets, there is a thriving international capital market, largely centered in London, where banks of over 70 countries have offices.
A Eurobond is a bond denominated in a currency other than that of the country in which it is issued. For example, a dollar-denominated bond sold in Britain would be called a Eurodollar bond. Similarly, investors might speak of Euroyen bonds, yen-denominated bonds sold outside Japan. Since the new European currency is called the euro, the term Eurobond may be confusing. It is best to think of them simply as international bonds.
In contrast to bonds that are issued in foreign currencies, many firms issue bonds in foreign countries but in the currency of the investor. For example, a Yankee bond is a dollardenominated bond sold in the U.S. by a non-U.S. issuer. Similarly, Samurai bonds are yen-denominated bonds sold in Japan by non-Japanese issuers.
Municipal Bonds
Municipal bonds (“munis”) are issued by state and local governments. They are similar to Treasury and corporate bonds, except their interest income is exempt from federal income taxation. The interest income also is exempt from state and local taxation in the issuing state. Capital gains taxes, however, must be paid on munis if the bonds mature or are sold for more than the investor’s purchase price.
There are basically two types of municipal bonds. These are general obligation bonds, which are backed by the “full faith and credit” (i.e., the taxing power) of the issuer, and revenue bonds, which are issued to finance particular projects and are backed either by the revenues from that project or by the municipal agency operating the project. Typical issuers of revenue bonds are airports, hospitals, and turnpike or port authorities. Revenue bonds are riskier in terms of default than general obligation bonds.
Aparticular type of revenue bond is the industrial development bond, which is issued to finance commercial enterprises, such as the construction of a factory that can be operated by a private firm. In effect, this device gives the firm access to the municipality’s ability to borrow at tax-exempt rates.
Like Treasury bonds, municipal bonds vary widely in maturity. A good deal of the debt issued is in the form of short-term tax anticipation notes that raise funds to pay for expenses before actual collection of taxes. Other municipal debt may be long term and used to fund large capital investments. Maturities range up to 30 years.
The key feature of municipal bonds is their tax-exempt status. Because investors pay neither federal nor state taxes on the interest proceeds, they are willing to accept lower yields on these securities. This represents a huge savings to state and local governments. Correspondingly, exempting interest earned on these bonds from taxes results in a huge drain of potential tax revenue from the federal government, which has shown some dismay over the explosive increase in the use of industrial development bonds.
Because of concern that these bonds were being used to take advantage of the tax-exempt feature of municipal bonds rather than as a source of funds for publicly desirable investments, the Tax Reform Act of 1986 restricted their use. Astate is now allowed to issue mortgage revenue and private purpose tax-exempt bonds only up to a limit of $50 per capita or $150 million, whichever is larger. In fact, the outstanding amount of industrial revenue bonds stopped growing after 1986.
An investor choosing between taxable and tax-exempt bonds needs to compare after-tax returns on each bond. An exact comparison requires the computation of after-tax rates of return with explicit recognition of taxes on income and realized capital gains. In practice, there is a simpler rule of thumb. If we let t denote the investor’s federal plus local marginal tax rate and r denote the total before-tax rate of return available on taxable bonds, then r (1 t) is the after-tax rate available on those securities. If this value exceeds the rate on municipal bonds, rm, the investor does better holding the taxable bonds. Otherwise, the tax-exempt municipals provide higher after-tax returns.
One way of comparing bonds is to determine the interest rate on taxable bonds that would be necessary to provide an after-tax return equal to that of municipals. To derive this value, we set after-tax yields equal and solve for the equivalent taxable yield of the tax-exempt bond. This is the rate a taxable bond would need to offer in order to match the after-tax yield on the tax-free municipal.
Corporate Bonds
Corporate bonds are the means by which private firms borrow money directly from the public. These bonds are structured much like Treasury issues in that they typically pay semiannual coupons over their lives and return the face value to the bondholder at maturity. Where they differ most importantly from Treasury bonds is in risk.
Default risk is a real consideration in the purchase of corporate bonds. We treat this issue in considerable detail in Chapter 9. For now, we distinguish only among secured bonds, which have specific collateral backing them in the event of firm bankruptcy; unsecured bonds, called debentures, which have no collateral; and subordinated debentures, which have a lower priority claim to the firm’s assets in the event of bankruptcy.
Corporate bonds sometimes come with options attached. Callable bonds give the firm the option to repurchase the bond from the holder at a stipulated call price. Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock.
Mortgages and Mortgage-Backed Securities
Thirty years ago, your investments text probably would not have included a section on mortgage loans, for investors could not invest in these loans. Now, because of the explosion in mortgage-backed securities, almost anyone can invest in a portfolio of mortgage loans, and these securities have become a major component of the fixed-income market.
Until the 1970s, almost all home mortgages were written for a long term (15- to 30-year maturity), with a fixed interest rate over the life of the loan, and with equal, fixed monthly payments. These so-called conventional mortgages are still the most popular, but a diverse set of alternative mortgage designs have appeared. Fixed-rate mortgages can create considerable difficulties for banks in years of increasing interest rates. Because banks commonly issue short-term liabilities (the deposits of their customers) and hold long-term assets, such as fixed-rate mortgages, they suffer losses when interest rates increase. The rates they pay on deposits increase, while their mortgage income remains fixed.
A response to this problem is the adjustable-rate mortgage. These mortgages require the borrower to pay an interest rate that varies with some measure of the current market interest rate. The interest rate, for example, might be set at two points above the current rate on oneyear Treasury bills and might be adjusted once a year. Often, the maximum interest rate change within a year and over the life of the loan is limited. The adjustable-rate contract shifts the risk of fluctuations in interest rates from the bank to the borrower.
Because of the shifting of interest rate risk to their customers, lenders are willing to offer lower rates on adjustable-rate mortgages than on conventional fixed-rate mortgages. This has encouraged borrowers during periods of high interest rates, such as in the early 1980s. But as interest rates fall, conventional mortgages tend to regain popularity.
A mortgage-backed security is either an ownership claim in a pool of mortgages or an obligation that is secured by such a pool. These claims represent securitization of mortgage loans. Mortgage lenders originate loans and then sell packages of these loans in the secondary market. Specifically, they sell their claim to the cash inflows from the mortgages as those loans are paid off. The mortgage originator continues to service the loan, collecting principal and interest payments, and passes these payments along to the purchaser of the mortgage. For this reason, these mortgage-backed securities are called pass-throughs.
Mortgage-backed pass-through securities were introduced by the Government National Mortgage Association (GNMA, or Ginnie Mae) in 1970. GNMA pass-throughs carry a guarantee from the U.S. government that ensures timely payment of principal and interest, even if the borrower defaults on the mortgage. This guarantee increases the marketability of the passthrough.
Thus, investors can buy and sell GNMA securities like any other bond. Other mortgage pass-throughs have since become popular. These are sponsored by FNMA (Fannie Mae) and FHLMC (Freddie Mac). By 2001, more than $2.5 trillion of outstanding mortgages were securitized into mortgage-backed securities, making the mortgage-backed securities market larger than the $2.4 trillion corporate bond market and nearly the size of the $3 trillion market in Treasury securities.
The success of mortgage-backed pass-throughs has encouraged the introduction of passthrough securities backed by other assets. These “asset-backed” securities have grown rapidly, from a level of about $316 billion in 1995 to $1,202 billion in 2001.
Read More: THE BOND MARKET
