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Chapter 14

Chapter 14. Investing in bonds and other investments. Why Consider Bonds?. Bonds reduce risk through diversification. Bonds produce steady current income. Bonds can be a safe investment if held to maturity. Basic Bond Terminology and Features.

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Chapter 14

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  1. Chapter 14 Investing in bonds and other investments

  2. Why Consider Bonds? • Bonds reduce risk through diversification. • Bonds produce steady current income. • Bonds can be a safe investment if held to maturity.

  3. Basic Bond Terminology and Features • Par value -- the amount returned to the holder at maturity • Coupon interest rate -- indicates the percentage of the face value that will be paid annually to the holder in the form of interest • Indenture -- a document that outlines the terms of the loan agreement

  4. Basic Bond Terminology and Features (Cont’d) • Call provision -- allows the issuer to repurchase the bonds before the maturity date • Deferred calls provide more protection. • Sinking fund -- money set aside annually to pay off the bonds at maturity

  5. Different Types of Bonds • Corporate bonds • Treasury and agency bonds • Municipal bonds • Special situation bonds

  6. Corporate Bonds • Secured corporate debts are secured by collateral or real property liens • Secured bond • Mortgage bond

  7. Corporate Bonds (Cont’d) • Unsecured corporate debts are not secured by collateral, and pay a higher return • Debenture -- long-term unsecured bond • Can have a hierarchy of payment, with unsubordinated and subordinated debentures

  8. Treasury and Agency Bonds • Treasury bonds • Bills, notes, and bonds • Treasury inflation-indexed bonds • Savings bonds • U.S. Series ee bonds • I bonds • Agency bonds • Pass-through certificates

  9. Treasury Bills, Notes, and Bonds • Considered risk free – no default or call risk • Pay a lower rate of interest than other bonds • Most interest is exempt from state and local taxes • Treasury direct avoids brokerage fees

  10. Treasury Bills, Notes, Bonds (Cont’d) • Bills mature in 3, 6, or 12 months • Notes mature in 2, 3, 5, or 10 years • Bonds mature in 10 to 30 years • All are sold in denominations of $1,000

  11. Agency Bonds • Issued by government agencies; authorized by congress • Federal national mortgage association (FNMA) • Federal home loan banks (FHLB) • Low risk, with interest rates slightly higher than treasury issues • Minimum denomination of $25,000 with maturities from 1 to 40 years

  12. Pass-through Certificates • Issued by government national mortgage association (GNMA) • Minimum $25,000 certificate for pool of mortgages • Principal and interest repaid monthly

  13. Treasury Inflation-indexed Bonds • Maturities of 10 years and a minimum par value of $1,000 • Inflation increases the face value of the bond, guaranteeing the investor a real return • Tax complication -- must pay taxes annually on par value adjustments

  14. U.S. Series Ee Bonds • Purchase price is one-half of the face value, ranging from $50 to $10,000 • Rate of return varies with the market rate • Have a guaranteed minimum interest rate based on treasury securities • High level of liquidity, but cashing in before maturity may reduce yield

  15. Municipal Bonds (Muni’s) • Issued by to fund public projects • Interest earnings are federal tax-exempt • Can be exempt from state taxes if you live in the state where bonds issued • Not very liquid, due to the lack of a secondary market

  16. Municipal Bonds (Cont’d) • Two basic types • General obligation • Revenue • Serial maturity -- a portion of the debt comes due each year for a set number of years • Not risk free; check the bond ratings

  17. Special Situation Bonds • Zero-coupon bonds • Junk bonds

  18. Zero-coupon Bonds • Issued by corporations, municipalities, and the treasury (e.G., STRIPS) • Do not pay interest • Are sold at a discount from face value • Annual appreciation is taxed although it is not realized • Fluctuate more with interest rate changes than traditional bonds

  19. Junk Bonds • Have very low ratings • Normally offer very high interest rates • Have a high default rate • Are almost always callable

  20. Bond Yield • Is the total return on a bond investment • Is not the same as the interest rate • Is affected by the bond price which may be more or less than face value

  21. Ways to Measure Bond Yield • Current yield • Yield to maturity • Equivalent taxable yield on muni’s

  22. Current Yield • Ratio of annual interest payments to the bond’s market price • Current yield = Annual interest payments Market price of the bond

  23. Yield to Maturity • True yield received if the bond is held to maturity • Approximate yield to maturity = Annual interest + par value - current price payments years to maturity par value + current price 2

  24. Equivalent Taxable Yield Equation for Muni’s • Equivalent taxable yield = Tax-free yield on the municipal bond (1 - investor’s marginal tax bracket)

  25. Bond Ratings – A Measure of Riskiness • Generally ratings run from AAA or aaa for the safest to D for the extremely risky • Ratings categorize bonds by default risk • Rating companies • Standard & Poor’s • Moody’s

  26. Corporate Bond Quotes in The Wall Street Journal • Bonds -- the name of the issuer • Cur yld -- the annual interest divided by the most current price • Vol -- the volume, or number, of bonds traded

  27. Corporate Bond Quotes (Cont’d) • Close -- the last price paid for that issue. Measured in 1/8s or $1.25. • Net chg -- the change in closing price from the prior day’s closing price. Measured in 1/8s or $1.25.

  28. Reading Treasury Quotes in The Wall Street Journal • Rate -- the original interest rate on the bond • Maturity mo/yr -- the year and month the issue will mature • Bid -- the previous day’s mid-afternoon bid price that treasury dealers were willing to buy the issue for. Measured in 32nds of a point; a point equals one-hundredth of par. • Asked -- the previous day’s mid-afternoon ask price the treasury dealers were willing to sell the issue for

  29. Reading Treasury Quotes (Cont’d) • Chg -- change from the prior day’s bid price • Ask yld -- is the effective rate of return on the investment • STRIPS -- refers to zero-coupon bonds • Days to mat -- listed for t-bills due to their short maturity lengths

  30. Bond Valuation Principles Value of a bond = Present value of + present value of repayment All interest payments of par at maturity • Bonds fluctuate in value, and the longer the time to maturity the greater the fluctuation.

  31. Valuation Principles (Cont’d) • Why would an investors required rate of return change? • Change in the risk associated with the firm issuing the bond. • Change in general interest rates in the market.

  32. Valuation Principles (Continued) • As the available rate of return increases, the value of a lower rated bond decreases and an investor would pay a discount. • As the available rate of return drops, the value of a higher rated bond increases and an investor would pay a premium.

  33. Valuation Principles (Cont’d) • Interest rates affect bond valuation by changing the demand, and price, for a bond. • Interest rates and bond values are inversely related in the secondary market. But the call price limits the upward price on a bond with a call provision. • As a bond approaches its maturity date, its market value approaches it par value.

  34. Bond Valuation Relationships and The Investor • If you expect interest rates to increase, buy short-term bonds. • If you expect interest rates to decrease, buy long-term non-callable bonds.

  35. The Pros of Investing in Bonds • If interest rates drop, bond prices will rise. • Bonds reduce risk through diversification. • Bonds produce steady current income. • Bonds can be a safe investment if held to maturity.

  36. The Cons of Investing in Bonds • If interest rates rise, bond prices will fall. • If the issuer experiences financial problems, the bondholder may lose. • If interest rates drop, rather than experiencing price appreciation, the bond may be called.

  37. The Cons of Investing in Bonds (Cont’d) • If you need to sell your bonds early, you may have a problem selling them at a reasonable price. • Finding a good investment outlet for the interest you receive may be difficult.

  38. Analyzing Bond Choices • Think about taxes. • Keep the inverse relationship between interest rates and bond price in mind. • Avoid losers, and don’t worry about picking winners. • Consider only high quality bonds. • Buy a bond when it is first issued, rather than in the secondary market.

  39. Analyzing Bond Choices (Cont’d) • Avoid bonds that might get called. • Match your bond’s maturity to your investment time horizon. • Stick to large issues. • When in doubt, go treasury!

  40. Preferred Stock -- An Alternative to Bonds • Hybrid security with characteristics of stocks and bonds. • Dividend payments can be skipped, without the company being bankrupt. • Dividends are a fixed amount – a fixed dollar amount or a percentage of the stock’s par value.

  41. Preferred Stock -- An Alternative to Bonds (Cont’d) • Dividends are paid before common stock dividends • Do not share in other profits with the common stockholders • No voting rights • No fixed maturity date • Rated like bonds, typically medium grade

  42. Features and Characteristics of Preferred Stock • Multiple issues – some companies have multiple issues of preferred stock, each with a different dividend • Cumulative feature – all past unpaid dividends must be paid before common stock dividends are paid • Adjustable rate – the dividend rate changes with the market interest rate rather than letting the value of the stock drop

  43. Features and Characteristics of Preferred Stock (Cont’d) • Convertibility – preferred stock can be exchanged for common stock at any time • Callability – issuer can repurchase the stock in case interest rates drop

  44. The Valuation of Preferred Stock • The value of preferred stock is the present value of the perpetuity of dividends • Value = annual dividend required rate of return

  45. Risks Associated With Preferred Stock • If interest rates rise, the value of the preferred stock drops. • If interest rates drop, the value rises, and the stock may be called.

  46. Risks of Preferred Stock Investing (Cont’d) • Investors don’t participate in the capital gains that common stockholders receive. • Preferred stock does not have the safety of a bond, because dividends can be passed without the risk of bankruptcy.

  47. Investing in Real Estate • Direct investments • Vacation homes • Commercial property (e.G., Apartment buildings, office buildings, etc.) • Undeveloped land • Indirect investments • Real estate syndicates • Real estate investment trusts (REIT)

  48. Real Estate: Pros and Cons • Income produced with an opportunity of capital appreciation • Few tax advantages • Direct investment is active – time, energy, and knowledge required • Illiquidity • Overbuilding can hurt prices

  49. Investing (Speculating) in Metals, Gems, Collectibles • Just don’t do it! • Speculation is not investing. • Collectibles are fine as entertainment, but not as savings vehicles. • Price depends on supply and demand.

  50. Summary • Reasons to invest in bonds • Determinants of a bond’s return • Annual interest payments • Return of the par value • Measures of bond returns • Current yield • Yield to maturity

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