C HAPTER 15

1. CHAPTER15 Investing in Bonds Personal Finance 6e Kapoor Dlabay Hughes 15-1

2. Characteristics of Corporate Bonds • Corporation’s written pledge to repay a specified amount of money with interest. • The face value is the dollar amount that the bondholder will receive at the bond’s maturity date. • Bondholders receive interest payments every six months at the stated interest rate. • The legal conditions are described in a bond indenture. • A trustee is the bondholder’s representative. 15-2

3. Why Corporations Sell Bonds • When it is difficult or impossible to sell stock. • To improve financial leverage. • To get money to operate or expand. • Because the interest they pay bondholders is a tax deductible business expense. 15-3

4. Four Types of Corporate Bonds • Debenture bond. • Most corporate bonds are debenture bonds. • Backed only by the reputation of the issuing company. • Mortgage bond. • A corporate bond that is secured by various assets of the issuing firm. 15-4

5. Four Types of Corporate Bonds (continued) • Subordinated debenture bond. • An unsecured bond that gives bondholders a claim secondary to that of other designated bond holders with respect to interest payments and assets. • Convertible bond. • Can be exchanged, at the owner’s option, for a specified number of shares of common stock. 15-5

6. Call Feature of Corporate Bonds • Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date. • Most agree not to call bonds for the first 5 to 10 years after they are issued. • They call bonds if the interest rate they are paying you is very much higher than the going rate. • Most corporate bonds and municipal bonds are callable. 15-6

7. Provisions For Repayment of Bonds • Sinking fund. • They deposit money in this fund each year and use the money to pay off the bondholders when the bond issue comes due. • Serial bonds. • One issue of bonds that mature at different dates. 15-7

8. Why Investors Buy Corporate Bonds? • For interest income. • Investors know the interest rate. • Interest will be paid to investors twice a year. • Appreciation of bond value. • May be able to sell the bond to someone else at a higher price if the interest rate on the bond is higher than the market rate. • Bond face amount will be repaid at maturity. 15-8

9. Bond Registration • A registered bond is registered in your name by the company or government who issued it. • A registered coupon bond is registered for principal only and not for interest. • A bearer bond is not registered in the investor’s name. • A zero coupon bond is sold well below face value, pays no interest, but is redeemed for face value at maturity. 15-9

10. Government Bonds and Debt Securities • Sold to get funds to pay on the national debt, and to fund the ongoing costs of government. 15-10

11. Treasury Note Treasury Bills, Notes and Bonds Treasury Bills (T-Bills). • $10,000 minimum. • Three months to one year. • Federal but no state taxon interest earned. Treasury Notes. • $1,000 to $5,000. • Two to ten year term. • Higher interest rate than T-bills. 15-11

12. Treasury Bills, Notes and Bonds (continued) • Treasury Bonds. • $1,000 units. • 30 year maturity. • Interest paid every six months. Treasury Bond 15-12

13. US Savings Bonds • Series EE. • Usually purchased and held to maturity. • Discounted (buy at $25, get $50 at maturity) • 4 - 6% interest or more if held >5 years. • Series HH. • Sold in $500 - $10,000 amounts. • Pay interest every six months. 15-13

14. Why do Investors Buy Government Bonds? • Virtually risk free if chosen carefully. • Better rate of return than most savings accounts or CD’s. 15-14

15. Federal Agency Debt Issues • Essentially risk free but earn higher interest than treasury options. • Issued for 1-40 years with 15 years the average. • Fannie Mae. • Federal National Mortgage Association. • Ginnie Mae. • Government National Mortgage Association. • Freddie Mac. • Federal Home Loan Mortgage Corporation. 15-15

16. State and Local Government Securities • Municipal bonds - called munis. • Municipalities includes cities, counties, school districts, and special taxing districts. • Use funds to build schools, bridges etc. • General obligation bonds are backed by the state or local government that issues them. • Revenue bonds are repaid from money generated by the project the funds finance. 15-16

17. Why do People Buy Municipal Bonds? • People like to invest in projects close to home. • You can hold the bond until maturity and collect the interest or sell it to another investor, perhaps at a premium. • Interest earned may be exempt from federal income tax so yield is higher. • Some are callable, but usually not until after the first ten years. 15-17

18. Making the Decision to Buy or Sell a Bond • Can the corporation, government or municipality... • Pay back the face value at maturity? • Will you receive interest payments until maturity? • Read the annual report. • How is the bond rated? • Rating range from AAA to D. • BB or below is called a junk (speculative) bond. • Rated by Standard and Poors and Moodys. 15-18

19. Making the Decision to Buy or Sell a Bond (continued) • Read the bond quotes in the newspaper. • Bid - highest price offered for the bond during a day (market value). • Asked - lowest price at which someone has offered to sell a bond during a day. • Maturity date. • Current yield. 15-19

20. Dollar Amount of annual Interest Current Market value Current % Yield of a Bond Example: Current yield = $75 $800 = 0.094 = 9.4% 15-20

21. Taxable Equivalent Yield Tax-exempt yield 1.0 - Your tax rate Example: Taxable equivalent yield = 0.06 1.0 - 0.28 = 0.083 = 8.3% 15-21

22. Yield to Maturity $ Amt. Annual Interest + Face value - Market value Number of periods Market value + Face value 2 Example: $60 + $1,000 - $900 $10 $900 + $1,000 2 = 0.074 = 7.4% 15-22

23. Primary and Secondary Bond Markets • Primary. • Buy via an investment bank or company representative. • Secondary. • Buy through a broker from another investor who wants to sell it, and pay a commission. 15-23