The Bond Market

Bonds are an important asset traded around the world everyday on many different trading platforms. You can buy and sell both corporate and government bonds through brokers who have connections to large trading exchanges (some of which are electronic). Americans can now open an account and buy US government bonds online through TreasuryDirect@.

This is the interface for buying government bonds with TreasuryDirect@

New Bonds Issued

Primary Market

Secondary Market(e.g. NYSE)

laterBuyer

Banks maintain large trading floors to help individuals and firms trade in bonds.

Massive UBS trading floor in Stamford, CT – 1400 seats with 2000 computers and 5000 monitors

Outside of the building housing the Bank of America Trading floor in Charlotte NC

The NYSE offers trading in many types of bonds.

But...what are bonds and how are they priced?

A Bond is merely a formal means of borrowing money.

In the past, bonds were paper and they were held by custodial banks, not engaged in commercial banking. These custodial banks continue to exist today, but paper bonds are being made largely irrelevant by digitization of bonds.

 A central securities depository (CSD) is a specialist financial organization holding securities so that ownership can be easily transferred through a book entry rather than the transfer of physical certificates. This allows brokers and financial companies to hold their securities at one location where they can be available for clearing and settlement. This is usually done electronically making it much faster and easier than was traditionally the case where physical certificates had to be exchanged after a trade had been completed.

Three Things cannot change on a bond --

FaceValue

Maturity Date

Couponspaid

semiannually

Each six months you can “clip off a coupon and get $25 in interest – fixed income

After one year...our 20 year bond (with 40 coupons) becomes a 19 year bond (with 38 coupons)

After two years...our 20 year bond (with 40 coupons originally) becomes an 18 year bond (with 36 coupons)... and so on

Finally, after 19 years...our 20 year bond (with 40 coupons originally) becomes an 1 year bond (with only 2 coupons). This one year bond must compete in the secondary market with all one year bonds...even ones that were issued for only one year.

The yield to maturity for all one year bonds will determine the price of this bond, as well ... it has become a one year bond, since there is only one year remaining before it matures.

Remember...it is 2033 now ...with just one more year to maturity !!! IT’S A ONE YEAR BOND.

The price of our 20 year bond can be computed as follows

1 2 40$25 $25 $1025(1 ') (1 ') (1 ')BP r r r

The yield to maturity here is the 6-month yield since the coupons are paid every six months ... to get the annual yield to maturity we use the formula

2r (1 ') 1r

This means hat we can substitute the formula into our bond price equation to get the relation between PB and r ... anyway, its all the same

1/2 2/2 40/2

$25 $25 $1025(1 ) (1 ) (1 )BP r r r

If it was a 20 year bond, but paid $4 coupons every month, we would have

1/12 2/12 240/12$4 $4 $1004

(1 ) (1 ) (1 )BP r r r

Here is the Excel command that returns the yield as given in the Wall Street Journal’s quotation page

Fidelity has its own little yield/price online calculator which rounds the yield up to 0.02%....very imprecise

Supply: BorrowersDemand: Lenders

Remember – Bond prices and interest rates must move inversely to each other. Always.

I discussed some cases for the bond market in class. This was to help you gain some intuition about bonds. What did we discover?

(1)If unforeseen inflation occurs, it can be bad for bonds.

(2)If there is a recession, usually long term government bonds do well. You can make money if you have good foresight.

(3)The US is often a safe haven for foreign investors that are having trouble in their own countries. This is good for the long term US bond market.

(4)Big government deficits can be bad for bonds. Large deficits means more bonds are issued....driving down prices in the bond market and raising interest rates.

(5)Interest rates have five important parts to them; namely

Please see class notes

l m KR r r r r r

See You in Class