Chapter 14
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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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Chapter 14

Chapter 14

Investing in bonds and other investments


Why consider bonds

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

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


Basic bond terminology and features cont d

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


Different types of bonds

Different Types of Bonds

  • Corporate bonds

  • Treasury and agency bonds

  • Municipal bonds

  • Special situation bonds


Corporate bonds

Corporate Bonds

  • Secured corporate debts are secured by collateral or real property liens

    • Secured bond

    • Mortgage bond


Corporate bonds cont d

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


Treasury and agency bonds

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


Treasury bills notes and bonds

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


Treasury bills notes bonds cont d

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


Agency bonds

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


Pass through certificates

Pass-through Certificates

  • Issued by government national mortgage association (GNMA)

  • Minimum $25,000 certificate for pool of mortgages

  • Principal and interest repaid monthly


Treasury inflation indexed bonds

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


U s series ee bonds

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


Municipal bonds muni s

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


Municipal bonds cont d

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


Special situation bonds

Special Situation Bonds

  • Zero-coupon bonds

  • Junk bonds


Zero coupon bonds

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


Junk bonds

Junk Bonds

  • Have very low ratings

  • Normally offer very high interest rates

  • Have a high default rate

  • Are almost always callable


Bond yield

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


Ways to measure bond yield

Ways to Measure Bond Yield

  • Current yield

  • Yield to maturity

  • Equivalent taxable yield on muni’s


Current yield

Current Yield

  • Ratio of annual interest payments to the bond’s market price

  • Current yield =

    Annual interest payments

    Market price of the bond


Yield to maturity

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


Equivalent taxable yield equation for muni s

Equivalent Taxable Yield Equation for Muni’s

  • Equivalent taxable yield =

    Tax-free yield on the municipal bond (1 - investor’s marginal tax bracket)


Bond ratings a measure of riskiness

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


Corporate bond quotes in the wall street journal

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


Corporate bond quotes cont d

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.


Reading treasury quotes in the wall street journal

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


Reading treasury quotes cont d

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


Bond valuation principles

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.


Valuation principles cont d

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.


Valuation principles continued

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.


Valuation principles cont d1

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.


Bond valuation relationships and the investor

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.


The pros of investing in bonds

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.


The cons of investing in bonds

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.


The cons of investing in bonds cont d

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.


Analyzing bond choices

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.


Analyzing bond choices cont d

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!


Preferred stock an alternative to bonds

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.


Preferred stock an alternative to bonds cont d

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


Features and characteristics of preferred stock

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


Features and characteristics of preferred stock cont d

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


The valuation of preferred stock

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


Risks associated with preferred stock

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.


Risks of preferred stock investing cont d

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.


Investing in real estate

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)


Real estate pros and cons

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


Investing speculating in metals gems collectibles

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.


Summary

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


Summary cont d

Summary (Cont’d)

  • Sources of bonds

    • Corporations

    • Treasury and other agencies

    • Municipalities

  • Bond ratings -- AAA to D

  • Bond valuation and the relationship with interest rates


Summary cont d1

Summary (Cont’d)

  • Features of preferred stock

  • Real estate investments

  • Speculative “investments” -- precious metals, gems, and collectibles


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