Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIII. Valuation of Future
Cash Flows- Interest Rates and Bond
Valuation
(^254) © The McGraw−Hill
Companies, 2002
How Bonds Are Bought and Sold
As we mentioned all the way back in Chapter 1, most trading in bonds takes place over
the counter, or OTC. Recall that this means that there is no particular place where buy-
ing and selling occur. Instead, dealers around the country (and around the world) stand
ready to buy and sell. The various dealers are connected electronically.
One reason the bond markets are so big is that the number of bond issues far exceeds
the number of stock issues. There are two reasons for this. First, a corporation would
typically have only one common stock issue outstanding (there are exceptions to this
that we discuss in our next chapter). However, a single large corporation could easily
have a dozen or more note and bond issues outstanding. Beyond this, federal, state, and
local borrowing is simply enormous. For example, even a small city would usually have
a wide variety of notes and bonds outstanding, representing money borrowed to pay for
things like roads, sewers, and schools. When you think about how many small cities
there are in the United States, you begin to get the picture!
Because the bond market is almost entirely OTC, it has little or no transparency.A
financial market is transparent if it is possible to easily observe its prices and trading
volume. On the New York Stock Exchange, for example, it is possible to see the price
and quantity for every single transaction. In contrast, in the bond market, it is usually not
possible to observe either. Transactions are privately negotiated between parties, and
there is little or no centralized reporting of transactions.
Although the total volume of trading in bonds far exceeds that in stocks, only a very
small fraction of the total bond issues that exist actually trade on a given day. This fact,
combined with the lack of transparency in the bond market, means that getting up-to-
date prices on individual bonds is often difficult or impossible, particularly for smaller
corporate or municipal issues. Instead, a variety of sources of estimated prices exist and
are very commonly used. Bond markets are moving to the Web. See our Work the Web
box on page 223 for more info.
Bond Price Reporting
Although most bond trading is OTC, there is a corporate bond market associated with
the New York Stock Exchange and other major exchanges. If you were to look in The
Wall Street Journal(or a similar financial newspaper), you would find price and volume
information from this market on a relatively small number of bonds issued by larger cor-
porations. This particular market represents only a sliver of the total market, however.
Mostly, it is a “retail” market, meaning that smaller orders from individual investors are
transacted here.
Figure 7.3 reproduces a section of the bond page from the May 11, 2001, issue of The
Wall Street Journal.If you look down the list, you will come to an entry marked “ATT
6s09.” This designation tells us that the bond was issued by AT&T, and that it will ma-
ture in 09, meaning the year 2009. The 6 is the bond’s coupon rate, so the coupon is
6 percent of the face value. Assuming the face value is $1,000, the annual coupon on
this bond is .06 $1,000 $60. The small “s” stands for “space” and is just used to
separate the coupon and maturity where it might otherwise be confusing.
The column marked “Close” gives us the last available price on the bond at close of
business the day before. As with the coupon, the price is quoted as a percentage of face
value; so, again assuming a face value of $1,000, this bond last sold for 93.875 percent
of $1,000, or $938.75. Because this bond is selling for about 94 percent of its par value,
it is trading at a discount. The last column, marked “Net Chg,” indicates that yesterday’s
closing price was .25%, or $2.5, higher than the previous day’s closing price.
224 PART THREE Valuation of Future Cash Flows