FIN 200: Personal Finance

1. FIN 200: Personal Finance Topic 19–Bonds Lawrence Schrenk, Instructor

2. Learning Objectives • Explain the features basic common to all bonds. ▪ • Compare and contrast the bonds issued by different government levels and agencies. • Describe the various features found in corporate bonds. ▪

3. Bonds Basics

4. Bond Cash Flows • Bonds are loans. • Regular Interest Payments (Coupons) • Principle Repaid at End • Example: Three year annual bond with a principal or $1,000 and coupon rate of 10%. Year 1 Year 2 Year 3 Coupon $100 $100 $100 Principal $1,000 TOTAL $100 $100 $1,100

5. Bond Terminology • Principal, Par Value, Face Value • Coupon, Coupon Rate • Maturity • Discount Rate • Periods

6. Bond Valuation • Example: Three year annual bond with a principal of $1,000 and coupon rate of 10% (r = 8%). Year 1 Year 2 Year 3 Coupon $100 $100 $100 Principal $1,000 TOTAL $100 $100 $1,100

7. Bond Price Movement • Interest Rate Risk • Interest Rates and Bond Prices • Inversely Related Interest Rates ↑ Bond Prices ↓ Interest Rates ↓ Bond Prices ↑

8. More Complicated Bonds • ‘Straight’ Bond • Premium versus Discount Bonds • Features • Callable Bonds • Convertible Bonds • Sinking Funds • Debt Covenant • Financial Ratios • Technical Default

9. Federal Government Bonds

10. Government Bonds • US Treasury • Bills, Notes and Bonds • Savings Bonds • Inflation-Adjusted Bonds • TIPS • I-Bonds • Other Agencies

11. Why do Investors Purchase Government Bonds? • Government bonds are written pledge to repay a specified sum of money along with interest • Sold to obtain money to finance the national debt, and the ongoing costs of government.

12. U.S. Treasury Bills, Notes and Bonds • Treasury Bills (T-Bills) • 4, 13, or 26 weeks to maturity • Sold at a discount • Federal but no state tax on interest earned • Treasury Notes • Typical maturities are 2, 3, 5, and 10 years • Interest paid every six months, at a higher rate than T-bills • Federal but no state tax on interest earned • Treasury Bonds • 30 year maturity dates • Interest rates higher than the notes and bills • Interest paid every six month

13. U.S. Savings Bonds. • U.S. Savings Bonds. • Series EE sold at half of face value, with potential tax advantages if used to pay tuition and fees. • Series HH pays interest every six months. • I bonds which earns a fixed rate plus an inflation rate which changes twice a year • Seewww.savingsbonds.gov for rates. • Advantages • Exempt from state and local income taxes. • You don’t have to pay federal income tax on earnings until you redeem the bonds.

14. Treasury Inflation-Protected Securities (TIPS) • Treasury Inflation-Protected Securities (TIPS) started in 1997 • Provide protection against inflation • Principal increases with inflation (CPI) • When a TIPS matures, the investor is paid the inflation-adjusted principal or original principal, whichever is greater • Interest paid semiannually at a fixed rate • The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation

15. Payments in TIPS • Consider a 3-year TIPS, par value of $1,000, and a coupon rate of 4%. • Assume that the inflation turns out to be 2%, 3%, and 4% in the next 3 years • Returns in the first year

16. TIPS versus Regular Bonds

17. Historical Yields on TIPS

18. Federal Agency Debt Issues • Agencies, examples… • Government National Mortgage Association (GNMA) • Export-Import Bank • Farmers Housing Administration (FHA) • Higher interest than government securities issued by the treasury department. • Minimum investment may be as high as $25,000 • Maturities range from 15-30 years. • Average maturity is 15 years.

19. State and Local Bonds

20. State and Local Government Securities • Municipal Bonds (Muni’s) • Issued by a state or local government, including cities, counties, school districts, and special taxing districts. • Use funds for ongoing costs and to build major projects such as schools, airports, and bridges. • Tax Status • Two Types: • General obligation bonds are backed by the state or local government that issues them. • Revenue bonds are repaid from money generated by the project the funds finance, such as a toll bridge.

21. Corporate Bonds

22. Corporate Bonds • Corporation’s written pledge to repay a specified amount of money with interest. • The face value is the dollar amount that the bondholder will receive at the bond’s maturity date. • Bondholders receive interest payments every six months at the stated interest rate. • The legal conditions are described in a bond indenture (or covenant).

23. Major Classifications • Collateral • Secured Debt (Mortgage) versus • Unsecured Debt (Debenture) • Seniority • Senior Debt versus • Subordinated Debt

24. Why Corporations Sell Bonds • To get funds for major purchases. • To fund ongoing business activities. • As an alternate to selling stock. • Interest Payments are tax deductible • Versus dividend payments, which are not.

25. Types of Corporate Bonds • Unsecured (Debenture) Bond • Most corporate bonds are debenture bonds. • Unsecured - Backed only by the reputation of the issuing company. • Secured (Mortgage) Bond • A corporate bond that is secured by various assets of the issuing firm, usually real estate. • Interest rate is lower because it is secured.

26. Types of Corporate Bonds (cont’d) • Convertible Bond • A special kind of corporate bond that can be exchanged for a specified number of shares of the corporation’s common stock. • Generally, the interest rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds.

27. Provisions for Repayment • Call Feature of a Bond • Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date. • Most corporate bonds are callable. • Most agree not to call bonds for the first 5 to 10 years after they are issued. • They call bonds if the interest rate they are paying is much higher than the going rate.

28. Provisions for Repayment (cont’d) • Sinking Fund • Corporations deposit money in this fund annually or semiannually and use the money to pay off the bondholders when the bond issue comes due. • Serial Bonds • Bonds of a single issue that mature on different dates.

29. Bond Rating Agencies • Standard & Poor's (S&P) • Moody's • Fitch • NOTE: There are similar to the ratings given insurance companies.

30. Bond Rating Classifications

31. ‘Junk’ Bonds • Alternate Names/Different Spin • High Yield Bonds • Non-investment Grade Bonds • Speculative Grade Bonds • Junk Bonds • Higher Risk of Default, Higher Yield

32. Bonds Indices Lehman Aggregate Bond Index

33. Project Note

34. Ethical Dilemma