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Module 4 Bonds

Module 4 Bonds. Module 4 - Learning Objectives. Define bond issuer, par or face value, coupon rate, maturity date and call date. Explain why entities issue bonds. Explain how an investor makes money from bonds.

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Module 4 Bonds

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  1. Module 4Bonds

  2. Module 4 - Learning Objectives • Define bond issuer, par or face value, coupon rate, maturity date and call date. • Explain why entities issue bonds. • Explain how an investor makes money from bonds. • Define and calculate nominal yield, current yield, yield to maturity and yield to call. • Define and differentiate Treasuries, municipal bonds, mortgage securities, and corporate bonds. • Differentiate short, medium, long and zero coupon bonds. • Explain what credit rating measures. • Define bond fund. • Explain how an investor purchases a bond. • Evaluate a bond using yield, maturity, issuer, credit rating, and interest rate environment. • Explain how to monitor bond investments with regards to interest rate, call and credit risk. • Select a bond based on financial goals.

  3. Income is not rising but debt is 3

  4. People are raiding the piggy bank 4

  5. Spending power? 5

  6. The big picture http://www.nytimes.com/interactive/2008/07/20/business/20debt-trap.html?scp=1&sq=debt%20trap%202008-07-%20interactive&st=cse 6

  7. Gender Age Childbearing plans Marital status Change in marital status Loans Public assistance Dependents How long you’ve lived at your house Alimony Race Color National origin People in the neighborhood where you want to buy How long you’ve had your job Salary Which of the following factors can a lender use to evaluate your credit? 7

  8. What does your credit report affect? • Interest rates • Job opportunities - Can your prospective employer check your credit report? • Insurance • Ability to assume debt 8

  9. Analyze a credit report

  10. Your credit score Source: www.myfico.com 10

  11. Credit Scores 11

  12. Credit ratings and cost of credit Source: www.myfico.com 3/21/07 12

  13. Credit Check-up • Get a free credit report every year www.annualcreditreport.com or call: 877-322-8228 • Correct any errors by contacting the company in writing – they must resolve the error in 30 days 13

  14. Debt as an Investment • Investors can get on the other side of the fence by lending money to people or entities who want to borrow • Bonds are usually the investments

  15. True or False? • You could go through your entire investing life without investing in bonds. • You should only invest in bonds when you’re older. • Stocks always return better than bonds. • Bonds are boring investments.

  16. It is January, 2001. You are analyzing a T-bond $1000 face value that matures in January 2011 and has a 6.125% coupon. • Who is the issuer of the bond? • How much will you get in interest per year? • How many years will you get the interest? • What will you get back when the bond matures?

  17. Why do companies, governments, etc. issue bonds?

  18. How have bonds done as investments?

  19. How do you make money from bonds?

  20. You can also have a gain or loss on a bond

  21. It boils down to two factor: coupon and maturity.

  22. Pop quiz • When interest rates go up, bond prices go where? • When interest rates go down, bond prices go where? • Shorter maturity bonds are more or less sensitive to interest rate changes than longer maturity bonds? • Smaller coupon bonds are more or less sensitive to interest rate changes than larger coupon bonds?

  23. Figure this out • On 2-22-01 you buy a Motorola $1000 face value bond with a maturity date of 10-01-2097 and a coupon of 5.22. The bond has a credit rating of A. Equivalent bonds are giving 7.895%. Calculate the price of this bond.

  24. Nominal Yield • What the issuer pays on the par value of the bond • It is the return you get if you buy the bond when it’s issued and hold it until it matures • In a bond quote, annual interest is not given, so you have to figure out annual interest by using nominal yield and multiplying by par value

  25. The following are $1000 par value bonds and their coupon rates. What is the annual interest on each? • Ford Motor (car company) 6.7% • Hewlett Packard (computers) 7.15% • Kroger (supermarkets) 6.8%

  26. Current Yield • Annual interest divided by price you paid • Let’s you know what you get every year • Might want to compare to other investments • Doesn’t consider what you sell for

  27. Calculate current yield • Alcoa (aluminum manufacturer) $1000 par value bonds with a coupon rate of 6.5% and maturity of 10 years traded at 104.075. Calculate the current yield.

  28. Yield to Maturity • May have bought a bond at a premium or discount • When the bond is redeemed, you will have a capital loss or gain • Yield to maturity takes this into consideration • More complete measure of return from the bond (includes interest and gain or loss)

  29. Calculate the yield to maturity • It's 2-22-01 and you're evaluating a University of North Carolina at Greenville $1000 par value bond with a coupon of 6.0 and a maturity date of 04-01-2021. The bond is quoted at 111.225. • What is the nominal yield? • What is the current yield? • What is the yield to maturity?

  30. Yield to Call • Certain bonds may be called (redeemed before the maturity date) by the issuer • This can change your return on the bond • Callable bonds are riskier and need to be assessed using yield to call • Similar to yield to maturity except earliest call date is used rather than maturity date • Yield to call is higher than yield to maturity when the bond is bought at a discount • Yield to call is lower than yield to maturity when the bond is bought at a premium

  31. Calculate nominal yield, current yield, yield to maturity and yield to call. You are buying 3-1-00.

  32. Answer sheet

  33. US Bond Choices

  34. Choices - Treasuries Deficit $9 T (12/06)

  35. Who do we owe?

  36. Choices - Municipal Bonds • Issued by state and local government • May have tax advantages (be careful--not all muni interest is tax free) • Not as safe as treasuries but still relatively safe • May be backed by tax revenues or revenues of facility

  37. Evaluating Munis • It is 02-22-2001. You're looking at two bonds given the same credit rating by Standard and Poor’s. Calcualte their yields and explain why the yields are different. • .Coca Cola with a maturity date of 09/15/2022 and a coupon of 8 is quoted at 117.325. • .Pennsylvania State Health Services with a maturity date of 01/01/2022 and a coupon of 5.75 is quoted at 101.812.

  38. Choices - Mortgage-backed Securities • Mortgage-backed securities are created when individual homeowner mortgages are bundled and sold to investors • May be guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac • Irregular payments because homeowners may prepay mortgage--based on average life rather than maturity • Highest risk of prepayment when interest rates fall--bad for bondholder

  39. Evaluate these

  40. Choices - Corporate Bonds • Issued by large corporations to finance their business. • Listed on the NYSE or sold over the counter. • Some corporations offer convertible bonds.

  41. Evaluate this • Amazon issued $681 million in convertible 10-year notes in 1999. The coupon rate was 6 7/8%. Each $1000 bond is convertible to 9.529 shares of Amazon stock. In early 2001, Amazon is selling at about $15 a share. If you are holding these bonds, would it be more profitable to convert to stock or hold the bond? Give your reasons why.

  42. Choices - Maturity • During normal economic expansion, the longer the term the higher the interest rate • This is because the longer the term, the higher the risk

  43. The date is 2-22-2001. You are evaluating three municipal bonds. Calculate the yield to maturity for each and discuss why they might be different. • New York Metropolitan Transit Authority bond quoted at 109.603 with a coupon of 5.4. Maturity date is 04-01-2011. Credit rating is AAA. • Philadelphia General Purpose bond quoted at 98.234 with a coupon of 4.9. Maturity date is 09-15-2021. Credit rating is AAA. • King County General Purpose bond quoted at 101.25 with a coupon of 5.25. Maturity date is 01-01-2034. Credit rating is AAA.

  44. Choices - Zero Coupon Bonds • Pros: • Can buy bond with little money upfront • Bigger gains if interest rates fall • Cons: • Bigger losses if interest rate rise • Don’t hear from borrower for a long time • Taxed even though you don’t have the cash

  45. The effect of interest rate changes on zeros • Last year. You bought a 30-year par value $1000 zero coupon bond that yielded 6%. Calculate the price you paid. • This year. Interest rates have fallen to 5%. Calculate the value of your zero coupon bond.

  46. Choices - Credit Ratings Investment Grade Junk

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