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the reduction in advertising, that ultimately led to the smaller percentage of smokers in society. The critics also
contend that the advertising ban may have slowed the rate at which low-tar cigarettes were introduced.
BONDS
By Clifford W. Smith
Bond markets are important components of capital markets. Bonds are fixed-income securities – securities
that promise the holder a specified set of payments. The value of a bond (like the value of any other asset) is the
present value of the income stream one expects to receive from holding the bond. This has several implications:
1. Bond prices vary inversely with market interest rates. Since the stream of payments usually is fixed no
matter what subsequently happens to interest rates, higher rates reduce the present value of the expected pay-
ments, and thus the price.
2. Bonds are generally adversely affected by inflation. The reason is that higher expected inflation raises
market interest rates and therefore reduces the present value of the stream of fixed payments. Some bonds (ones
issued by the Israeli government, for example) are indexed for inflation. If, for example, inflation is 10 per cent
per year, then the income from the bond rises to compensate for this inflation. With perfect indexation the
change in expected payments due to inflation exactly offsets the inflation-caused change in market interest
rates, so that the current price of the bond is unaffected.
3. The greater the uncertainty about whether the payment will be made (the risk that the issuer will default
on the promised payments), the lower the "expected" payment to bondholders and the lower the value of the
bond.
4. Bonds whose payments are subjected to lower taxation provide investors with higher expected after-tax
payments. Since investors are interested in after-tax income, such bonds sell for higher prices.
The major classes of bond issuers are the U.S. government, corporations, and municipal governments. The
default risk and tax status differ from one kind of bond to another.
The U.S. government is extremely unlikely to default on promised payments to its bondholders. Thus, vir-
tually all of the variation in the value of its bonds is due to changes in market interest rates. That is why ana-
lysts use changes in prices of U.S. government bonds to compute changes in market interest rates.
Because the U.S. government's tax revenues rarely cover expenditures nowadays, it relies heavily on debt
financing. Moreover, even if the government did not have a budget deficit now, it would have to sell new debt
to obtain the funds to repay old debt that matures. Most of the debt sold by the U.S. government is marketable,
meaning that it can be resold by its original purchaser. Marketable issues include Treasury bills, Treasury notes,
and Treasury bonds. The major non-marketable federal debt sold to individuals is U.S. Savings Bonds.
Treasury bills have maturities up to one year and are generally issued in denominations of $10,000. They
are sold in bearer form – possession of the T-bill itself constitutes proof of ownership. And they do not pay in-
terest in the sense that the government writes a check to the owner. Instead, the U.S. Treasury sells notes at a
discount to their redemption value. The size of the discount determines the interest rate on the bill. For instance,
a dealer might offer a bill with 120 days left until maturity at a yield of 7,48 per cent. To translate this quoted
yield into the price, one must "undo" this discount computation. Multiply the 7,48 by 120/360 (the fraction of
the 360-day year) to obtain 2,493, and subtract that from 100 to get 97,506. The dealer is offering to sell the
bond for $97,507 per $100 of face value.
Treasury notes and Treasury bonds differ from Treasury bills in several ways. First, their maturities gener-
ally are greater than one year. Notes have maturities of one to seven years. Bonds can be sold with any matur-
ity, but their maturities at issue typically exceed five years. Second, bonds and notes specify periodic interest
(coupon) payments as well as a principal repayment. Third, they are frequently registered, meaning that the
government records the name and address of the current owner. When Treasury notes or bonds are initially
sold, their coupon rate is typically set so that they will sell close to their face (par) value.
Yields on bills, notes, or bonds of different maturities usually differ. Because investors can invest either in
a long-term note or in a sequence of short-term bills, expectations about future short-term rates affect current
long-term rates. Thus, if the market expects future short-term rates to exceed current short-term rates, then cur-
rent long-term rates would exceed short-term rates. If, for example, the current short-term rate for a one-year T-
bill is 5 per cent, and the market expects the rate on a one-year T-bill sold one year from now to be 6 per cent,
then the current two-year rate must exceed 5 per cent. If it did not, investors would expect to do better by buy-
ing one-year bills today and rolling them over into new one-year bills a year from now.
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