Purpose of the capital market (lecture 11)

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Lecture 11. Capital Markets
Murodullo Bazarov
[email protected]
ATB205
office hours: Tues 11:00-13:00

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MEQ & RYL

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Lecture Outline
• Purpose of the Capital Market
• Capital Market Participants
• Capital Market Trading
• Types of Bonds
• Treasury Notes and Bonds
• Municipal Bonds
• Corporate Bonds
• Financial Guarantees for Bonds

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Purpose of the Capital Market
• Original maturity is greater than one year, typically for long-term financing
or investments
• Best known capital market securities:
─Stocks and bonds

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Capital Market Participants
• Primary issuers of securities:
─Federal and local governments: debt issuers
─Corporations: equity and debt issuers
• Largest purchasers of securities:
─You and me
─And other financial market players

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Capital Market Trading
1. Primary market for initial sale (IPO)
2. Secondary market
─ Over-the-counter
─ Organized exchanges (i.e., NYSE)

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Types of Bonds
• Bonds are securities that represent debt owed by the issuer to the
investor, and typically have specified payments on specific dates.
• Types of bonds we will examine include long-term government bonds
(T-bonds), municipal bonds, and corporate bonds.

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Treasury Notes and Bonds
• The U.S. Treasury issues notes and bonds to finance its operations.
• The following table summarizes the maturity differences among the
various Treasury securities.

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Treasury Bond Interest Rates
• No default risk since the Treasury can print money to payoff the debt
• Very low interest rates, often considered the risk-free rate (although inflation risk is
still present)
Interest Rate on Treasury Bonds and the Inflation Rate, 1973–2013
(January of each year)

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Money Market Instruments: Treasury Bills

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Municipal Bonds
• Issued by local, county, and state governments
• Used to finance public interest projects
• Tax-free municipal interest rate = taxable interest rate (1 marginal
tax rate)
Suppose the rate on a corporate bond is 9% and the rate on a municipal
bond is 6.75%. Which should you choose?
Answer: Find the marginal tax rate:
6.75% = 9% (1 – MTR), or MTR = 25%
If you are in a marginal tax rate above 25%, the municipal bond offers a
higher after-tax cash flow.

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Municipal Bonds
Suppose the rate on a corporate bond is 5% and the rate on a municipal
bond is 3.7%. Which should you choose? Your marginal tax rate is 28%.
Find the equivalent tax-free rate (ETFR):
ETFR = 5% (1 – MTR) = 5% (1 – 0.28)
The ETFR = 3.6%. If the actual muni-rate is above this (it is), choose the
municipal bond

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Municipal Bonds
• Two types
─General obligation bonds
─Revenue bonds
• NOT default-free (e.g., Orange County California)
─Defaults in 1990 amounted to $1.4 billion in this market
• Read more examples:
http://www.municipalbonds.com/news/the-biggest-municipal-bonddisasters-of-all-time/

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Municipal Bonds: Comparing Revenue
and General Obligation Bonds
Issuance of Revenue and General Obligation Bonds, 1984–2012 (End of year)

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Corporate Bonds
• Typically have a face value of $1,000, although some have a face value of
$5,000 or $10,000
• Pay interest semi-annually
• Cannot be redeemed anytime the issuer wishes, unless a specific
clause states this (call option).
• Degree of risk varies with each bond, even from the same issuer.
Following suite, the required interest rate varies with level
of risk.
• The degree of risk ranges from low-risk (AAA) to higher risk (BBB).
Any bonds rated below BBB are considered sub-investment grade debt.

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Corporate Bonds: Interest Rates
Corporate Bond Interest Rates, 1973–2012 (End of year)

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Characteristics of Corporate Bonds
• Registered Bonds
─ Replaced “bearer” bonds
─ Internal revenue service (IRS) can track interest income this way
• Restrictive Covenants
─ Mitigates conflicts with shareholder interests
─ May limit dividends, new debt, ratios, etc.
─ Usually includes a cross-default clause
• Call Provisions
─ Higher required yield
─ Mechanism to adhere to a sinking fund provision
─ Interest of the stockholders
─ Alternative opportunities
• Conversion
─ Some debt may be converted to equity
─ Similar to a stock option, but usually more limited

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Characteristics of Corporate Bonds
• Secured Bonds
─Mortgage bonds
─Equipment trust certificates
• Unsecured Bonds
─Debentures
─Subordinated debentures
─Variable-rate bonds
• Junk Bonds
─Debt that is rated below BBB
─Michael Milken developed this market in the mid-1980s, although he was
subsequently convicted of insider trading
(http://www.businessinsider.com/michael-milken-life-story-2017-5)

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Financial Guarantees for Bonds
• Some debt issuers purchase financial guarantees to lower the risk of
their debt.
• The guarantee provides for timely payment of interest and principal,
and are usually backed by large insurance companies.
• https://www.investopedia.com/terms/c/creditdefaultswap.asp
• As it turns out, not all guarantees actually make sense!
─In 1995, JP Morgan created the credit default swap (CDS), a type of insurance
on bonds.
─In 2000, Congress removed CDSs from any oversight.
─By 2008, the CDS market was over $62 trillion!
─2008 losses on mortgages lead to huge payouts on this insurance

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Investing in Bonds
• Bonds are the most popular alternative to stocks for long-term
investing.
• Even though the bonds of a corporation are less risky than its equity,
investors still have risk: price risk and interest rate risk,

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Investing in Bonds
Bonds and Stocks Issued, 1983–2012

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Investing in Stocks
1.
Represents ownership
in a firm
2. Earn a return in
two ways
─ Price of the stock rises
over time
─ Dividends are paid to the stockholder
3. Stockholders have claim on all assets
4. Right to vote for directors
and on certain issues
5. Two types
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Common stock
• Right to vote
• Receive dividends
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Preferred stock
• Receive a fixed dividend
• Do not usually vote

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Investing in Stocks: How Stocks are Sold
• Organized exchanges
─NYSE is best known, with daily volume around 4 billion shares, with peaks at 7
billion.
─“Organized” used to imply a specific trading location. But computer systems (ECNs)
have replaced this idea.
─Others include the ASE (US), and Nikkei, LSE, DAX (international)
─Listing requirements exclude small firms
• Over-the-counter markets
─Best example is NASDAQ in history
─Dealers stand ready to make a market
─Today, about 3,000 different securities are listed on NASDAQ.
─Important market for thinly-traded securities—securities that don’t trade very often.
Without a dealer ready to make a market, the equity would be difficult to trade.

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Investing in Stocks: Organized vs. OTC
• Organized exchanges (e.g., NYSE)
─Auction markets with floor specialists
─25% of trades are filled directly by specialist
─Remaining trades are filled through SuperDOT
• Over-the-counter markets
─Multiple market makers set bid and ask prices
─Multiple dealers for any given security
─Examples: The OTC Markets Group operates some of the most
well-known networks, such as the Best Market (OTCQX), the
Venture Market (OTCQB), and the Pink Open Market and
NASDAQ in history

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How the Market Sets Security Prices
• Generally speaking, prices are set in competitive markets as the price
set by the buyer willing to pay the most for an item.
• The buyer willing to pay the most for an asset is usually the buyer who
can make the best use of the asset.
• Superior information can play an important role.
• Consider the following three valuations for a stock with certain
dividends but different perceived risk:
• But, who perceives the lowest risk, is willing to pay the most and will
determine the “market” price.

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Errors in Valuation
Although the pricing models are useful, market participants frequently
encounter problems in using them. Any of these can have a significant
impact on price in the Gordon model.