Bonds and Mutual Funds

Finance Chapter 10 Bonds and Mutual Funds

Corporate Bonds • A corporations written pledge to repay a bondholder • The bonds interest rate, maturity date and face value are listed on the bond • Corporation pays annual interest at the rate specified on the bond (usually semiannually) • Face Value x Interest rate 10-1 Corporate and Government Bonds

Types of Corporate Bonds • Debentures (Most common) • A bond that is backed only by the reputation of the issuing corporation rather than its assets • Buy these because it is believed the corporation is on solid financial ground • Investors expect the company to repay the face value and make the interest payments. • Mortgage Bond (Secured Bond) • A bond backed by the assets of the company • Safer than a debenture bond, which means earning less interest Corporate and Government Bonds

Subordinated Debentures • An unsecured bond that gives you a claim to interest payments and assets of the corporation only after all bondholders have been paid • More risky, higher interest rates • Convertible Bonds • A bond that an investor can trade for shares of the corporations common stock. • Interest rates are about 1 to 2 percent lower because of it’s flexibility. Corporate and Government Bonds

Methods Corporations use to repay Bonds • Most bonds are callable: • They have a call feature that allows a corporation to buy back bonds from holders before the maturity date • Premiums • An additional amount above face value, if called • Sinking Funds • A corporation makes deposits for the purpose of paying back a bond • This means the company will be able to repay its bonds. • Serial Bonds • Bonds issued on the same date but which mature on different dates Corporate and Government Bonds

Why Corporations Sell bonds • They sell bonds to raise money when it is difficult or impossible to sell stock • Used to finance regular business activities • Why Investors Buy corporate Bonds • Interest Income • Registered Bonds – Bond registered in the owners name by the corporation • Only the owner can collect money Corporate and Government Bonds

Coupon Bonds • A bond registered in the owners name for only face value, not for the interest. • Coupons are given to receive the interest, anyone with the coupon can receive the interest. • Bearer Bonds • A bond that is not registered in an investors name • Anyone in physical possession of the bonds or their coupons can collect on them • Very few in circulation, but they are no longer issued by corporations • Zero-Coupon Bonds • Bond that does not produce interest payments • Sold below face value but is redeemed for full face value at maturity Corporate and Government Bonds

A Typical Bond Transaction • Purchasing Bonds • Primary Markets • You purchase financial securities from an investment banker representing the corporation or government agency that issues them • Secondary Markets • You trade bonds with other investors • Corporate Bonds issued by large companies are traded on the New York Bond Exchange and American Bond Exchange Corporate and Government Bonds

Government Bonds and Securities • Federal, State and Local governments issue bonds to raise money they need to operate. • Offer lower interest rates than corporate bonds • Treasury Bills (T-bills) • Discounted Securities – Purchase price is lower than face value • Sold in units of $1000 Corporate and Government Bonds

Treasury Notes • Issued in $1000 units, with maturity date between 1 – 10 years • Interests rates are a little higher than T-bills because investors must wait longer to get money back • Treasury Bonds • No longer issued, but some remain and can be purchased on the secondary market • Series EE Savings Bond • Purchase price is ½ of its face value • Can be redeemed anytime from 6 months to 30 years • You receive the amount you paid plus interest (up to 30 years) • Series I Bonds • Inflation indexed bond – Pay a fixed interest rate and a variable interest rate that adjusts with inflation. Corporate and Government Bonds

Bonds Issued by State and Local Governments • Municipal Bonds (muni) • A security issued by a state or local government to pay for ongoing activities • Major project: Airports, schools, and highways • Classified As: • General Obligation Bonds: Backed by the full faith and credit of the government that issued it • Revenue Bond: Repaid from the income generated by the project it is designed to finance ( Municipal Sports Arenas) • Insured Municipal Bonds • If there is a risk of default you can buy these • Less risk so less interest 10-1 Corporate and Government Bonds

Bond Price Quotations • Percentage of the face value of a bond • $1000 x price quotation (%) • You should know this before buying or selling bonds • Usually can be found in Barron’s or the Wall Street Journal • Source of Information on Bonds • You should always be aware of the financial stability of the issuer. Always Ask: • Will the bond be repaid at maturity? • Will you receive interest payments until maturity? 10-2 Investing in Bonds

To help answer the previous questions look at: • Annual Reports • Look for signs of financial strength or weaknesses & ask: • Is the firm profitable? • Are sales increasing? • Are long-term liabilities increasing? • How might the company’s current activities and future plans affect its ability to repay bonds? • The Internet • Business Magazines • Government Reports and Research Investing in Bonds

Bond Ratings • Each bond is rated by an independent rating company • Ratings are based on the financial stability of the issuer • Services: • Moody’s Bond Survey • Standard and Poor’s Stock and Bond Guide • The Internet • Categories (P. 322) • Moody’s: Aaa, Aa, A, Baa, Ba, B, Caa, Ca, C • S&P: AAA, AA, A, BBB, BB, B, CCC, CC, C, D • S&P Municipal Bond Ratings for Municipal bonds that have a maturity date of 3 years or less: • SP-1: Strong ability to pay face value and interest • SP-2: Satisfactory ability to pay face value and interest • SP-3: Doubtful ability to pay face value and interest Investing in Bonds

Yield of a Bond Investment • To determine the return that a particular bond may produce, investors calculate and track it’s yield. • Yield • The rate of return, usually stated as a percentage, earned by an investor holding a bond for a certain time period • Current Yield = $ amount of Annual Interest Income / Current Market Value • $1000 Bond @ 7.5% interest, Current market value $960 • $1000 x 7.5% = $75 • $75/$960 = 7.8% (current yield) Investing in Bonds

Investors pool their money to buy stocks, bonds, and other securities based on the selections of professional managers working for an investment company • Why Investors Buy Mutual Funds • Professional Management • Diversification • Reduce risk because money is spread out into a variety of securities • An occasional loss can be offset by a gain in another investment. 10-3 Mutual Funds

Types of Mutual Funds • Closed End Funds • A mutual fund with a fixed number of shares that are issued by an investment company when the fund is first organized • Open End Funds • A mutual fund with an unlimited number of shares that are issued and redeemed by an investment company at the investors request • Net Asset Value – Amount that one share of a mutual fund is worth • Services – You have access to many services • Payroll Deduction • Automatic reinvestment programs • Automatic withdrawal programs Mutual Funds

Load Funds (“A” funds) • A mutual fund for which you pay a commission every time you buy or sell shares • Account Executives offer advice and guidance • No Load Funds • A mutual fund with no commission fee • Management Fees and Other Charges • Management Fees – Fixed percentage of the funds asset value • Back-end load – charged for withdrawing money from the fund (to discourage early withdrawals) • 12b-1 fee – Investment company charge for marketing and advertising the mutual fund Mutual Funds

Mutual Funds • Categories of Mutual Funds • Stock Mutual Funds • Aggressive Growth Funds • Equity Income Funds • Global Stock Funds • Growth Funds • Growth and Income Funds • Index Funds • International Funds • Large Cap Funds • Mid Cap Funds • Small Cap Funds • Micro Cap Funds • Regional Funds • Sector Funds • Utility Funds

Mutual Funds • Bond Mutual Funds • High Yield (Junk)Bond Funds • Insured Municipal Bond Funds • Intermediate Corporate Bond Funds • Intermediate U.S. bond Funds • Long Term Corporate Bond Funds • Long Term U.S. Bond Funds • Municipal Bond Funds • Short Term Corporate Bond Funds • Short Term U.S. Bond Funds • Mixed Mutual Funds • Balanced Funds • Money Market Funds • Stock/Bond Blend Funds • Variety Funds

Making an Informed Decision • Considering Your Financial Goals • Consider several questions for investment goals: • How old are you? • What is your family situation? • How much risk do you want to take? • How much money do you now make? • How much money are you likely to make in the future? • Once you know your goals find mutual funds that match you investment objectives. 10-4 Investing In Mutual Funds

Information on Mutual Funds • Main sources of information • Newspaper Financial Publications • Quotations Professional Advice • Prospectuses Internet • Annual Reports • Return on Investments • Gain Income in one of three ways • Income Dividends – Earnings a fund pays the shareholder • Capital Gains Distribution – Payments made to shareholders that result from the sale of securities in the funds portfolio • Make a good return by buying shares at a low price and selling them when the price increases (Capital Gain) Investing In Mutual Funds

Taxes and Mutual Funds • Dividends, capital gain distributions, and capital gains are all taxable earnings • IRS form 1099DIV – shows all capital gains distributions and income dividends. • Guidelines on how mutual fund transactions are taxed: • Income dividends are reported along with all other dividend amounts you have received. They are taxed as regular income • Capital gain distributions are reported on your federal income tax return • Capital gains or losses are reported on your federal income tax return. Investing In Mutual Funds

Buying and Selling Mutual Funds • Purchase Options • Closed End Funds – Traded through Stock Exchanges • Open End Funds – Bought from a brokerage firm or investment company • Regular Account Transaction • Decide how much money to invest and when to invest it • Then you buy as many shares as possible • Voluntary Savings Plan • Make smaller purchases than minimum required • Once you make 1st purchase you commit to making regular minimum purchases of fund’s shares Investing In Mutual Funds

Payroll Deduction Plans • Deduct a certain amount of money from each paycheck to invest in mutual fund • Contracted Savings Plans • Require you to make regular purchases of shares over a specific period of time • You will pay penalty fees if you do not make the required purchases • Reinvestment Plans • Your income from dividends and capital gain distributions are automatically reinvested to buy more shares • Most allow you to reinvest without paying additional sales charges or commissions Investing In Mutual Funds

Withdrawal Options • Closed End Funds – Sell your shares to another investor anytime you want (Stock Exchange or Over-the-Counter) • Open End Funds – Sold to the investment company • If more than $5000: • Investment Period Withdrawals – Withdraw a certain amount each investment period until the fund has been exhausted (Usually 3 months) • Investment Period Liquidation – Sell off a certain amount of shares each investment period • Net asset value of shares vary from one period to another • Asset Growth Withdrawal – Withdrawal a prearranged % of your investment’s asset growth (the amount your portfolio has increased in value) • Principal is left untouched • Dividend and Distribution Withdrawal – Withdrawal all income from dividends and capital gains distributions earned during an investment period. Investing In Mutual Funds

Owning property • Direct Investment • Holds legal title to the property he/she has purchased • Examples: • Single Family homes • Duplexes • Apartments • Vacation Homes (tax deductions for 2nd home) • Commercial Property – Land and buildings that produce rental income • Land • Indirect investment • An investment in which a trustee is appointed to hold legal to the property on behalf of the investor or group of investors Real Estate

Real Estate • Advantages • Hedge against inflation • Easy entry • Limited financial Responsibility (indirect) • Financial Leverage – using borrowed funds for direct investment • Disadvantages • Illiquidity • Declining property values • Lack of diversification • Lack of tax shelter • Management problems (indirect)

Commodities • Precious Metals • Gold, silver, platinum • Precious Gems • Rough mineral deposits cut from the earth then cut and shaped into jewels • Diamonds, sapphires, rubies, emeralds • Collectibles • Items that are rare in number • Buy them and hope to sell them at a profit • Art, antiques, rare coins, sports memorabilia • Risky because there is such a small market Other investments

Bonds and Mutual Funds