PART 4: MANAGING YOUR MONEY Chapter 14 Investing in Bonds and Other Alternatives

PART 4:MANAGING YOUR MONEY

Chapter 14

Investing in Bonds and Other Alternatives

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Learning Objectives

Invest in the bond market. Understand basic bond terminology and compare the

various types of bonds. Calculate the value of a bond and understand the

factors that cause bond values to change. Understand the risks associated with investing in real

estate. Know why you shouldn’t invest in gold, silver, gems,

or collectibles.

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Why Consider Bonds?

Bonds reduce risk through diversification. Bonds produce steady income. Bonds can be a safe investment if held to

maturity.

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Basic Bond Terminologyand Features

Par value – the face value or amount returned at maturity.– Usually $1000 for corporate bonds.– Bonds selling at 99½% are selling for $995.

Coupon Interest Rate – the percentage of par value that will be paid out annually in the form of interest.– 8½% coupon pays $85 annually.

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Indenture – a legal document that provides specific terms of the loan agreement.

It includes:– A description of the bond.– The rights of bondholders.– The rights of the issuing firm. – The responsibilities of the bond trustees.

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Call Provision – entitles issuer to repurchase (“call”) back the bonds at stated prices.– If interest rates decline, the issuer will call the bonds

and replace with lower-cost debt.

Sinking Fund – issuer sets aside money on a regular basis to pay off bonds at maturity.– Firm calls or repurchases in the open market.

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Corporate Bonds

Corporate bonds - allow firms to borrow money, are a major source of funding.– Denominations in $1000.– Secured bond – backed by collateral.– Unsecured bond – a debenture.– Hierarchy of bonds – subordinated debentures

are low on the list.

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Treasury and Agency Bonds

U.S. government is the largest issuer of debt. Government spends more than it takes in. To finance an unbalanced budget, it can:

– Sell assets.– Raise taxes.– Borrow more money.

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Viewed as risk-free - given the government’s ability to tax and print money.

With no default risk and no call risk, they pay a lower interest rate.

Most government interest payments are exempt from state and local taxes.

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Treasury-issued debt has maturities from 3 months to 10 years.

– Until 2001, 30-year bonds were issued.– 70% of the debt has maturities of 5 years or less.

Government issues include bills, notes, and bonds.

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Government Debt Treasury Bills Treasury Notes Treasury Bonds

Maturity When Issued

3, 6, or 12 months 2, 3, 5, or 10 years Over 10 years

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Federal National Mortgage Association (FNMA) and the Federal Home Loan Banks (FHLB) issue agency bonds.– Not directly issued through the Treasury.– Considered to be virtually risk-free.– Interest rate higher than Treasuries.– Minimum denomination is $25,000.

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Government National Mortgage Association (GNMA) issues “pass-through certificates.”– Represents an interest in a pool of federally insured

mortgages. – GNMA packages a group of mortgages, guarantees

them, then sells certificates. – $25,000 minimum denomination.– Investor receives a monthly check of interest and

principal, but amount varies.

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Treasury Inflation Protected Securities (TIPS) is the newest Treasury bond.– Maturities of 5, 10, or 20 years.– Par value of $1,000.– Par value changes when CPI changes.– Investors guaranteed a real return – a return

above inflation.– Must pay taxes on adjustment although no cash is

received.

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U.S. Series EE Bonds – savings bonds aimed at small investor.– Face values from $50 to $10,000.– Purchased at half of face value.– Bond doubles in value after a specified period.– Liquid – can be cashed in at any time.

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Bonds are accrual-type bonds.– Interest added to the value of bond, paid when

cashed in.– Sold at face value, grow with inflation-indexed

earnings for up to 30 years.– Return includes a fixed return and a semiannual

inflation rate.– Invest from $50 to $30,000 per year.– Defer federal taxes up to 30 years.

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Municipal Bonds

Munis are issued by states, counties, cities, and other public agencies.

Over $1 trillion in outstanding value. Tax exempt from federal government and by

state (as long as you live where the bonds were issued).

Capital gains, from selling early, are taxed.

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Municipal Bonds

General Obligation Backed by the full faith

and credit of issuer. Taxes used to pay back

principal and interest. Example: School district

builds new school, taxes used to pay back the lenders.

Revenue Bonds

Derive funds to pay interest and repay principal from a designated project.

Example: Bond finances a new toll road, revenue from tolls pay back lenders.

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Municipal Bonds

Most munis have serial maturities – a portion of the debt matures each year.

Munis are not risk-free.– Although rare, issuers can default.

Rating agencies evaluate bonds.

Small issues may be illiquid.

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Special Situation Bonds

Zero Coupon Bonds – no interest payments.– Sold at a discount, returns par value at maturity.– Acts like a savings bond, appeals to those wanting a

lump sum payment in the future without concerns of reinvesting interest.

– Although interest is not received annually, the investor is taxed on interest income.

– Federal government issues STRIPS.

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Special Situation Bonds

Junk Bonds - low-rated bonds or high-yield bonds. – Have ratings of BB or below. – Major issuers of junk bonds are new firms that

have not yet established a performance record. – With a greater risk of default, they have interest

rates 3-5% above AAA long-term bonds. – Most are callable.

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Evaluating Bonds

Current Yield - refers to the ratio of interest payment to the bond’s market price.

Yield to Maturity – true yield received if bond is held to maturity.– Considers the annual interest payments as well

as the difference between the bond’s current market price and maturity value.

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Evaluating Bonds

Equivalent Taxable Yield on Municipal Bonds:– Appeal of munis is their tax-exempt status.– Make comparisons between munis and taxable

bonds.– Calculation refers to tax bracket – including

federal, state, and local taxes avoided by the muni.

– The higher the tax bracket, the more attractive the muni.

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Bond Ratings – A Measureof Riskiness

Moody’s and Standard & Poor’s provide ratings on corporate and municipal bonds.

Ratings involve a judgment about a bond’s future risk potential.

– Default risk – ability to repay principal.– Inability to meet interest obligations.

The lower the rating, the higher the rate of return demanded by investors.

Safest bonds receive AAA, D is extremely risky.

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Reading Corporate Bond Quotes in the Wall Street Journal

Selling price is quoted as a percent of par.– Price listed at 101 -- 101% x $1000 = $1010.

Include accrued interest. Invoice price is the sum of the quoted price

and accrued interest.

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Reading Treasury Quotes inthe Wall Street Journal

Treasury and agency securities trade in thirty-seconds (1/32).

Price listed as 102:31 = 102 31/32– If par value is $10,000 then price is $10,296.88.

Paper lists both bid and ask prices.

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Bond Valuation

Bond owners receive interest payments for a number of years, and then par value at maturity.

Value of a bond is the present value of the interest payments plus the present value of the repayment of par value at maturity.

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Bond Valuation

The value of a bond should be approximately the same as its price.

The interest payments come in the form of an annuity.

The repayment of par comes in the form of a single cash flow.

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Bond Valuation

What causes the required rate of return to change?– If the issuer becomes riskier, the required rate of

return should rise.– A change in general interest rates, increase in

expected inflation, the required rate of return should increase.

When interest rates rise, the value of outstanding bonds falls.

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Why Bonds Fluctuate in Value

Inverse relationship between interest rates and bond values.– When interest rates rise, investors demand a

higher return.– Because of the fixed coupon rate, the price must

drop.

Longer-term bonds fluctuate in price more than shorter-term bonds.

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Why Bonds Fluctuate in Value

Longer-term bonds fluctuate in price more than shorter-term bonds.

As a bond approaches maturity, the market value approaches par value.

When interest rates go down, bond prices go up, but upward price movement on bonds with a call provision is limited by the call price.

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Preferred Stock

A hybrid security with features of common stock and bonds.

Similar to common:– No fixed maturity date.– Not paying dividends won’t cause bankruptcy.

Similar to bonds:– Dividends are fixed, paid before common.– No voting rights.

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Features and Characteristicsof Preferred Stock

Multiple Issues – more than one issue. Cumulative Feature – all unpaid dividends must be paid

prior to declaring common dividends. Adjustable Rate – dividends fluctuate with interest rates. Convertibility – holder can, at any time, exchange for

predetermined number of common shares. Callability – if interest rates decline, preferred stock likely

to be called.

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Valuation of Preferred Stock

With a preferred stock, you receive a steady stream of dividends that go on forever.

The value of a share of preferred stock is the present value of the perpetual stream of constant dividends.

When interest rates rise, value decreases.

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Risks Associated withPreferred Stock

If interest rates rise, the value of preferred stock drops.

If interest rates drop, the value of preferred stock rises and it is called away.

Investor does not participate in the capital gains that common stockholders receive.

Investor doesn’t have the safety of bond interest payments, preferred dividends can be passed without the risk of bankruptcy.

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Investing in Real Estate

Investing in real estate requires time, energy and sophistication.

Investment real estate can be:– Direct – own the property

Vacation homes, commercial property, undeveloped land

– Indirect – invest in a group, hire a manager Real Estate Investment Trust (REIT), real estate

syndicates

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Investing – Speculating in Gold, Silver, Gems, and Collectibles

Don’t do it! This is not investing – it is speculation. Collectibles may only have entertainment value.

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PART 4: MANAGING YOUR MONEY Chapter 14 Investing in Bonds and Other Alternatives