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 • A bond is a loan with a fixed maturity date • When you buy a bond, you become a lender • The issuer of the bond gets the use of your money and pays you interest for the life of the bond • At maturity, the issuer pays you the face value of the bond, which may be more or less than what you originally paid

5. Why Consider Bonds? • Bonds reduce risk through diversification • Bonds may move in price opposite of stocks • Bonds produce steady income • You get regular interest payments • Bonds can be a safe investment if held to maturity • Bond rating services will grade riskiness of bonds

6. Basic Bond Terminologyand Features • Par value – face value of the bond. Par value is usually $1,000. A bond is sold at a percentage of its par value, such as 95.125 • Maturity – the date the bond is due, or when the principal must be repaid • Coupon Interest Rate – annual interest rate to be paid to holders of the bond

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 – gives the issuer the right to repurchase the bonds at stated prices • Deferred call – states that the bond can’t be called until a set number of years after it is issued • Sinking Fund – a fund to which the bond issuer deposits money to pay off the bond • Since money is regularly deposited to pay off debt, it reduces the risk for the borrower

9. Corporate Bonds • Corporate bonds – debt issued by corporations – about half of bonds outstanding • Secured corporate debt – backed by collateral, less risky • Mortgage bond – secured by real property • Unsecured corporate debt • Debenture– any unsecured long-term bond

10. Treasury and Agency Bonds • These are bonds issued by the U.S. government • Generally regarded as being risk-free • Government doesn’t issue callable bonds • Lower interest rate • Most interest payments are exempt from state and local taxes

11. Treasury and Agency Bonds • Treasury debt – government-issued debt with maturities from 3 months to 30 years • Treasury Bills – 3, 6, or 12 months • Treasury Notes – 2, 3, 5, or 10 years • Treasury Bonds – 30 years • Agency bonds – issued by government agencies other than the Treasury

12. Treasury and Agency Bonds • Pass-through certificates issued by the Government National Mortgage Association “Ginnie Mae”, represents a portion of ownership in a pool of mortgages • Treasury Inflation Protected Securities (TIPS) – bonds in which the par value changes with the consumer price index to guarantee the investor a real rate of return

13. Treasury and Agency Bonds • U.S. Series EE Bonds – aimed at the small investor, sold for as little as $25 • When issued, its price is half the maturity value • At maturity, they pay the full face value • For example, a $50 bond is purchased for $25; when held to maturity, it can be cashed for $50 • Can be cashed at any time before maturity at a reduced yield

14. Treasury and Agency Bonds • I Bonds – bonds where interest is added to the value of the bond and is paid when the bond is cashed • Bonds are sold at face value, and interest is added to the value as time passes • Includes a fixed interest rate plus a semiannual inflation rate • Range in price from $50 to $10,000 • Allow for deferred Federal taxes and are tax exempt from state and local income taxes • Very liquid

15. Municipal Bonds • “Munis” - issued by states, counties, cities, other public agencies, e.g. school districts • General obligation bond – a state or muni bond backed back the taxing power of the issuer • Revenue Bond – state or muni bond paid for with funds from a project or specific tax • Serial maturities – part of the debt matures, or is paid each year until the bond is fully mature

16. Special Situation Bonds • Zero Coupon Bonds - don’t pay interest and are sold at a deep discount from their par value; at maturity they pay par value • Although you don’t get paid interest, you are taxed as if you do, on annual appreciation in value • Junk Bonds - also called high-yield bonds, very risky, low-rated at BB or below • They give higher interest rates because they are riskier

17. 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 (lower) the rating, the higher the rate of return demanded by investors • Safest bonds receive AAA or AA ratings; riskiest receive D ratings

18. Table 14.1 Interpreting Bond Ratings

19. Bond Yield • Current Yield – return on investment expressed as an interest rate percentage of the price of the bond, not necessarily on its par value • Yield to maturity - true yield or return that the bondholder receives if a bond is held to maturity—it is the measure of expected return • There is also an equivalent taxable yield on municipal bonds

20. Valuation Principles • The valuation of bonds is based on: • Principle 3 - time value of money – allows us to bring the investment returns back to the present • Principle 8 - risk and return go hand in hand – the riskier the bond the more interest it will pay • The value of a bond is the present value of all the interest payments and principal payments added together

21. Bond Valuation • If the issuer of the bond (the corporation or the government entity) becomes riskier, the required rate of return should rise • With a drop 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 • There is an 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 The Relationship Between Bond Prices and Changes in Interest Rates

24. Figure 14.2 The Relationship Between the Length of a Bond’s Maturity and the Amount of Price Fluctuation When Interest Rates Change

25. Why Bonds Fluctuate in Value • As a bond approaches maturity, the market value approaches its par value, • At maturity, the market value equals the par value, so prices for short-term bonds don’t change very much • 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 • Investors won’t pay more than the call price, because the bond could be called at any time

26. Figure 14.3 The Price Path of a 12 Percent Coupon Bond over Its Life

27. Table 14.2 The Pros and Cons of Investing in Bonds

28. Checklist 14.1

29. What Bond Valuation Relationships Mean to the Investor • If you expect interest rates 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 that are not callable

30. Reading Corporate Bond Quotes in the Wall Street Journal Online • Selling price is quoted as percentage of par value • You are also expected to pay accrued interest, or interest that has accumulated without being paid yet • Invoice price - sum of the quoted or stated price of a bond and the bond’s accrued interest; this is the price of the bond on secondary market

31. Figure 14.4 How to Read Online Corporate Bond Listings

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

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

34. 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

35. 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

36. 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

37. Investing in Real Estate • Requires time, energy, and sophistication • Direct investments in real estate – you own the property • Indirect investments in real estate – you are an investor in a group that owns the property • Investing in real estate: the bottom line – the major advantage is the opportunity for capital gains, or increase in value of property

38. 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; their resale value is speculative • Don’t expect them to provide for your financial future

39. 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

40. 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