Chapter 14

1. Chapter 14 Investing in Bonds and Other Alternatives

2. 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 value to change.

3. Learning Objectives • Compare preferred stock to bonds as an investment option. • Understand the risks associated with investing in real estate. • Know why you shouldn’t invest in gold, silver, gems, or collectibles.

4. Introduction • Bonds carry less risk than stocks. • Bonds provide steady income. • But returns from bonds are not necessarily low.

5. Why Consider Bonds? • Bonds reduce risk through diversification. • Bonds produce steady income. • Bonds can be a safe investment if held to maturity.

6. Basic Bond Terminologyand Features • Par value • Maturity • Coupon Interest Rate • Indenture

7. Basic Bond Terminologyand Features • 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.

8. Basic Bond Terminologyand Features • Call Provision • Deferred call • Sinking Fund

9. Corporate Bonds • Corporate bonds • Secured corporate debt • Mortgage bond • Unsecured corporate debt • Debenture

10. Treasury and Agency Bonds • Risk-free • Not callable • Lower interest rate • Most interest payments are exempt from state and local taxes.

11. Treasury and Agency Bonds • Treasury-issued debt has maturities from 3 months to 10 years. • Bills, notes, and bonds differ by maturity and denomination. • Agency bonds

12. Treasury and Agency Bonds • Pass-through certificates issued by the Government National Mortgage Association “Ginnie Mae” • Treasury Inflation Protected Securities (TIPS)—par value changes with the consumer price index to guarantee investor a real rate of return

13. Treasury and Agency Bonds • U.S. Series EE Bonds • I Bonds

14. Municipal Bonds • “Munis”—issued by states, counties, cities, public agencies e.g. school districts • General obligation bond • Revenue Bonds • Serial maturities

15. Special Situation Bonds • Zero Coupon Bonds—don’t pay interest and are sold at a deep discount from their par value • Junk Bonds—also high-yield bonds, very risk, low-rated BB or below

16. 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. • The poorer the rating, the higher the rate of return demanded by investors. • Safest bonds receive AAA, D is extremely risky.

17. Table 14.1

18. Bond Yield • Current Yield—ratio of annual interest payment to the bond’s market price. • Yield to maturity—true yield or return that the bondholder receives if a bond is held to maturity—measure of expected return • Equivalent taxable yield on municipal bonds

19. Valuation Principles • Principle 3—time value of money • Principle 8—risk and return go hand in hand • Value in today’s dollars of the interest payments and principal payments, add them together.

20. Bond Valuation • The value of a bond is the present value of the interest payments plus the present value of the repayment of the bond’s par value at maturity

21. Bond Valuation • If the issuer becomes riskier, the required rate of return should rise. • A change in general interest rates, the required rate of return should increase. • When interest rates rise, the value of outstanding bonds falls.

22. Why Bonds Fluctuate in Value • Inverse relationship between interest rates and bond values in the secondary market. • When interest rates rise, bond values drop, and when interest rates drop, bond values rise • Longer-term bonds fluctuate in price more than shorter-term bonds.

23. Figure 14.1

24. Figure 14.2

25. Why Bonds Fluctuate in Value • As a bond approaches maturity, the market value approaches its 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.

26. Figure 14.3

27. Table 14.2

28. What Bond Valuation Relationships Mean to the Investor • If you expect interest rats to go up (bond prices to fall)—purchase very short-term bonds • If you expect interest rates to go down (bond prices to rise)—purchase bonds with long maturities and are not callable.

29. Reading Corporate Bond Quotes in the Wall Street Journal Online • Selling price is quoted as percentage of par. • Also expected to pay accrued interest • Invoice price—sum of the quoted or stated price of a bond and the bond’s accrued interest—price of bond on secondary market.

30. Figure 14.4

31. Preferred Stock—An Alternative to Bonds • A hybrid security with features of common stock and bonds. • Similar to common stock—no fixed maturity date, not paying dividends won’t bring bankruptcy. • Similar to bonds—dividends are fixed, paid before common and no voting rights.

32. Features and Characteristicsof Preferred Stock • Multiple Issues • Cumulative Feature • Adjustable Rate • Convertibility • Callability

33. Valuation of Preferred Stock • The value of a share of preferred stock is the present value of the perpetual stream of constant dividends. • Value of preferred stock = annual preferred stock dividend required rate of return • As market interest rates rise and fall, the value of preferred stock moves in an opposite manner

34. 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.

35. Risks Associated withPreferred Stock • 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.

36. Investing in Real Estate • Requires time, energy and sophistication. • Direct investments in real estate • Indirect investments in real estate • Investing in real estate: the bottom line

37. 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. • Don’t expect them to provide for your financial future.

38. Summary • Bonds reduce risk, produce steady income, and can be safe investment. • Hold bond until it matures—can get yield to maturity. • Value of bond is the present value of the stream of interest payments plus the present value of the repayment of the bond’s par value at maturity

39. Summary • Preferred stock is a security with no fixed maturity date and with dividends that are generally set in amount and don’t fluctuate. • You own property with direct real estate investment but with indirect real estate investment, you’re an investor in a group. • Gold, silver, gems or collectibles are not investments but speculation.