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11B Investing Basics and Evaluating Bonds #2. Recall the concept of asset allocation. 11- 1. One Effect of Asset Allocation: A Weighted Total Return. Ultraconservative “Investors” Are Really Just “Savers”. People who invest very conservatively

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11b investing basics and evaluating bonds 2
11B Investing Basics and Evaluating Bonds #2

Recall the concept of asset allocation

11-1

ultraconservative investors are really just savers
Ultraconservative “Investors” Are Really Just “Savers”
  • People who invest very conservatively
  • They do not get ahead financially over the long term because taxes and inflation offset most of their interest earnings
  • Remember “The Rule of 72”?
    • 72/4% = 18 years
    • 72/8% = 9 years (money doubles much faster)
identify the types of investments you want to make
Identify the Types of Investments You Want to Make

Do You Want to Lend Your Money or Own an Asset?

  • Debts – “loanership” (lending) investments.
    • Fixed Maturity – the borrower agrees to repay the principal to the investor on a specific date.
    • Fixed Income – the borrower agrees to pay the investor a specific rate of return for use of the principal.
  • Equities – “ownership” investments.
    • Potential for a higher return by sharing in profits
inflation
Inflation
  • To beat inflation, one must invest money so that it earns a higher after-tax return than the inflation rate
  • Real Rate of Return – the return after subtracting the effects of both inflation and income taxes.

Example:

10% return, 7.5% after taxes (25% tax bracket), 4% inflation, real rate of return of 3.5% after taxes and inflation

objective 5 recognize why investors purchase c orporate bonds
Objective 5Recognize Why Investors Purchase Corporate Bonds

Corporate Bonds

  • A corporation’s written pledge to repay a specified amount of money with interest
  • An interest-only loan
  • Considered safer than co. stocks
  • A “fixed-income” security
  • A form of debt financing (bond owners repaid in future)

11-7

corporate bonds
Corporate Bonds
  • Face Value
    • Dollar amount bondholder receives at bond’s maturity date
    • Usually $1,000
  • Coupon rate
    • Stated interest rate
    • Interest payments made every six months
    • Example: $1,000 x 5.8% = $58 (in two $29 payments)
  • Maturity Date = date on which face value repaid; generally 1 to 30 years

11-8

corporate bonds1
Corporate Bonds
  • Bond Indenture
    • Legal document describing conditions of the bond issue
  • Trustee
    • Financially independent firm that acts as the bondholder’s representative
    • Usually a commercial bank or other financial institution

11-9

why corporations sell bonds
Why Corporations Sell Bonds
  • To raise funds for major purchases
  • To fund ongoing business activities
  • When difficult or impossible to sell stock
  • To improve financial leverage
  • Interest paid to bondholders is tax- deductible for the firm

11-10

types of corporate bonds
Types of Corporate Bonds
  • Debenture
    • Unsecured debt
    • Investors become “creditors” if company fails
    • Backed only by the reputation of the issuing company; most corporate bonds are this type
  • Mortgage Bond
    • Secured by various assets of the issuing firm, such as real estate and property
    • Lower interest (coupon) rate since debt is secured

11-11

types of corporate bonds1
Types of Corporate Bonds
  • Convertible Bond
    • Can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock
    • Generally, coupon rate on a convertible bond is 1% to 2% lower than the rate paid on traditional bonds
    • Would only want to convert when stock price gets higher than the bond’s equivalent value in stock

11-12

provisions for repayment
Provisions For Repayment

Call Feature of Bonds

  • Corporation can “call in” or buy back outstanding bonds before the maturity date
  • Most corporate bonds are callable
  • Call-protected for first 5 to 10 years after issue
  • A firm calls a bond issue if the coupon rate they are paying is much higher than the market rate
    • Like consumers refinancing to lower-rate mortgage

What is the effect of called back bonds on investors?

11-13

provisions for repayment1

Bond

Provisions For Repayment
  • Sinking Fund
    • Corporations deposit money annually
    • Trustee uses the money to retire the bond issue prior to maturity
  • Serial Bonds
    • Bonds of a single issue that mature on different dates
    • Example: After first 10 years, over the next 10 years, 10% of bonds mature each year

11-14

why investors purchase corporate bonds

Bond

Why Investors Purchase Corporate Bonds
  • Interest Income - “Fixed Income”
    • Registered Bond- tracked electronically
      • Coupon and principal paid to registered owner (check or direct deposit)
    • Registered Coupon Bond
      • Registered for principal only
      • Coupon must be presented to obtain payment
    • Zero-Coupon Bond
      • Pays no interest
      • Sold at a discount from face value
      • Redeemed at face value at maturity

11-15

why investors purchase corporate bonds1
Why Investors Purchase Corporate Bonds
  • Dollar Appreciation of Bond Value
    • Bond values change with market interest rates
      • Bond value vs. Interest rates = inverse relationship
      • If Market rate< Coupon rate  Price > Face value
      • If Market rate > Coupon rate ← Price < Face value
    • Bond values change with the financial condition of the issuing company or government unit
  • Bond Repayment at Maturity
    • Face value repaid on maturity date (will be worth less due to inflation)
    • Bondholders may keep till maturity or sell
  • Portfolio diversification beyond stock and cash assets

11-16

approximate bond value formula
Approximate Bond Value Formula
  • 5.875% interest on ($1,000 bond) = $58.75
  • New issues paying 5% (decrease in coupon rate)
  • Dollar amount of interest$58.75

Comparable interest rate = 5% (.05) = $1,175

  • Bond worth more than face value because it pays interest rate higher than current market rate
  • New issues paying 6.5% (increase in coupon rate)
  • Dollar amount of interest$58.75

Comparable interest rate = 6.5% (.065) = $903.85

  • Bond worth less than face value because it pays interest rate lower than current market rate
premiums and discounts
Premiums and Discounts

When a bond is first issued, it is sold in one of three ways:

  • at its face value
  • at a discount below its face value or
  • at a premium above its face value.
price changes for bonds
Price Changes for Bonds

What does this graph tell you?

objective 6 evaluate bonds when making an investment
Objective 6Evaluate Bonds When Making an Investment
  • Sources of Information – The Internet
    • The issuing firm’s website
    • www.bondsonline.com
    • http://bonds.yahoo.com
  • Financial coverage of bond transactions
    • Wall Street Journal, Barrons, Internet
  • Other Sources of Information
    • Business Periodicals
    • Federal Agencies
      • www.federalreserve.gov
      • www.treasury.gov
      • www.sec.gov

11-20

corporate bond quotes
Corporate Bond Quotes
  • The first bond in the list:
  • Matures in 2036
  • Current price = 93.51% of par (discount) = $935.10
  • Pays an annual coupon rate of 5.875% = $58.75
  • Yield-to-Maturity = 6.365% (considers bond maturity date)
  • Current yield = 6.283% = 5.875/93.51 (interest/price)

11-21

decisions bond investors must make
Decisions Bond Investors Must Make
  • Decide on risk level.
    • Investment grade bonds: top 4 grades (BBB, A, AA, AAA)
    • Junk bonds (a.k.a., high yield bonds): lower rated and higher risk
  • Decide on maturity.
    • Match to financial goals
  • Determine the after-tax return.
    • Taxable versus tax-exempt
wrap up
Wrap Up
  • Chapter Quiz
  • Concept Check 11-5- Calculate Semi-annual Interest and Reasons That Investors Buy Bonds
  • Concept Check 11-6- Current Value of Bonds; Explain Bond Ratings