Chapter 13 Investing in Bonds 13 1 Evaluating

Lesson 13. 1 Evaluating Bonds GOALS n Discuss the features, types, and earnings on corporate bonds. n Describe the different types of government bonds. Chapter 13 © 2010 South-Western, Cengage Learning 2

Corporate Bonds n Bonds are loans (debt) that must be repaid at maturity. n Bondholders (those who invest in bonds) receive interest twice a year. n When the bond matures on its maturity date, it is repaid. n Bond maturities typically range from 1 to 30 years. Chapter 13 © 2010 South-Western, Cengage Learning 3

Face Value n Face value is the amount the bondholder will be repaid at maturity. n Face value is also referred to as par value because the face value is the dollar amount printed on the certificate. Chapter 13 © 2010 South-Western, Cengage Learning 4

Features of Corporate Bonds n Corporate bonds are sold on the open market through brokers, just like stocks. n Bonds are known as “fixed-income investments. ” n Fixed-income investments pay a specified amount of interest on a regular schedule. n A bond’s interest does not go up and down. Chapter 13 © 2010 South-Western, Cengage Learning 5

(continued) Features of Corporate Bonds n A bond’s contract rate (also called its interest rate) is the percentage of face value that the bondholder will receive as interest each year. n Usually, payments of half the annual interest are made twice a year. n Interest received on corporate bonds is taxable. Chapter 13 © 2010 South-Western, Cengage Learning 6

(continued) Features of Corporate Bonds n Registered bond n A registered bond is recorded in the owner’s name by the issuing company. n Interest checks for registered bonds are mailed semiannually, directly to the bondholder. n Today, most bonds are registered. n Coupon bond n A coupon bond (also called a bearer bond) is not registered by the issuing company. n To collect interest on a coupon bond, bondholders must clip a coupon and then cash it in at a bank, following the procedures outlined by the issuer. Chapter 13 © 2010 South-Western, Cengage Learning 7

(continued) Features of Corporate Bonds n A callable bond is a bond that the

Types of Corporate Bonds n Debentures n Secured bond n Convertible bonds Chapter 13

Debenture n A debenture is a corporate bond that is based on the general creditworthiness of the company. n The issuer does not pledge any specific assets to assure repayment of the loan. n Debentures are considered unsecured bonds. Chapter 13 © 2010 South-Western, Cengage Learning 10

Secured Bond n A secured bond, also called a mortgage bond, is backed by specific assets which serve as security to assure repayment of the debt. n If the corporation fails to repay the loan as agreed, the bondholder may claim the property used as security for the debt. n The asset most often used for security is real estate, a building, or some other type of property. Chapter 13 © 2010 South-Western, Cengage Learning 11

Convertible Bond n A convertible bond is a corporate bond that can be converted to shares of common stock. n If the bondholder converts to common stock, the bond is no longer due and payable at maturity. n Convertible bonds can be exchanged for a certain number of common shares at a specific price per share. Chapter 13 © 2010 South-Western, Cengage Learning 12

Earnings on Corporate Bonds n All corporate bonds are issued with a stated face value and fixed contract rate. n There is no compounding. n Half the annual amount of simple interest is paid every six months. n While the interest rate on your bond is fixed, the market price (what you could sell it for) can change. Chapter 13 © 2010 South-Western, Cengage Learning 13

Zero-Coupon Bonds n A zero-coupon bond is sold at a deep discount, makes no interest payments, and is redeemable for its face value at maturity. n These bonds may also be issued by the U. S. government or municipalities. n As the bond progresses toward maturity, it may appreciate, or increase in value. n The bondholders make money by selling the bonds before maturity at a price higher than they paid for them. n Or, they can hold the bonds to maturity and receive the face value and interest. Chapter 13 © 2010 South-Western, Cengage Learning 14

Government Bonds n Municipal bonds n Savings bonds n Treasury securities n Agency bonds

Municipal Bonds n A bond issued by state and local governments is called a municipal bond. n Municipal bonds are also known as “munis. ” n Municipal bonds generally pay a lower interest rate than corporate bonds. n However, the interest is exempt from federal taxes (and often state and local taxes as well), so the effective rate is higher than the stated rate. Chapter 13 © 2010 South-Western, Cengage Learning 16

Types of Municipal Bonds n A revenue bond is a municipal bond issued to raise money for a public-works project. n The revenues (income) generated by the project are used to pay the interest and repay the bonds at maturity. n Major projects financed by revenue bonds include airports, hospitals, toll roads, and public housing facilities. n A general obligation bond (or GO) is a municipal bond backed by the power of the issuing state or local government to levy taxes to pay back the debt. Chapter 13 © 2010 South-Western, Cengage Learning 17

Comparing Taxable and Tax-Exempt Bonds Corporate Bond Face Value (Principal) Rate of Interest Amount of Annual Interest Tax on Interest Earned (28%) Net Interest $10, 000 6% $600 $168 $432 Municipal Bond $10, 000 5% $500 $0 $500 Chapter 13 © 2010 South-Western, Cengage Learning 18

Savings Bonds n You can buy U. S. savings bonds three ways: n From commercial banks n Through payroll deduction plans n Directly from a Federal Reserve Bank n You can buy up to $20, 000 worth of these bonds a year. Chapter 13 © 2010 South-Western, Cengage Learning 19

(continued) Savings Bonds n Series EE bonds are sold at one half of their face value. Investors who buy these bonds often hold them to maturity. n These bonds are issued with maturity values that range from $50 to $10, 000. n Series I bonds are sold at face value and have fixed plus variable rates of return that increase as general interest rates rise. n This helps protect you from the effects of rising prices (inflation). Chapter 13 © 2010 South-Western, Cengage Learning 20

Treasury Securities n Treasury securities are virtually risk-free, since they have the backing of the U. S. government. n They are taxable at the federal level but are exempt from state and local taxes and are usually not callable. Chapter 13 © 2010 South-Western, Cengage Learning 21

(continued) Treasury Securities n Types of treasury securities n Treasury notes n Treasury bills n Treasury bonds n These investments exist as bookkeeping entries in the records of the U. S. Treasury Department itself or in the records of commercial banks. Chapter 13 © 2010 South-Western, Cengage Learning 22

Agency Bonds n When you purchase an agency bond, you are loaning money to a federal agencies. n Federal agencies that issue bonds include: n Federal Home Loan Mortgage Corporation (Freddie Mac) n Federal National Mortgage Association (Fannie Mae) n Federal Housing Administration (FHA) n Student Loan Marketing Association (Sallie Mae) Chapter 13 © 2010 South-Western, Cengage Learning 23

(continued) Agency Bonds n The agencies use this funding to provide low-cost financing to certain groups of people. n Agency bonds are basically risk-free and they offer a slightly higher yield than securities issued by the Treasury. n Agency bonds are usually exempt from state and local taxes, but not federal tax. Chapter 13 © 2010 South-Western, Cengage Learning 24

Lesson 13. 2 Buying and Selling Bonds GOALS n Explain how to buy and sell bonds, considering both risk and return. n Explain how to read the bond listings of financial pages. Chapter 13 © 2010 South-Western, Cengage Learning 25

Owning Bonds n Full-service broker n Discount broker n Banks n Federal Reserve System

Return on Bonds n Earn interest for each day they own the bond. n Redeem the bond for its face value at maturity. n Bond redemption occurs when it is paid off at maturity. n The issuer of the bond pays back the original amount that was borrowed. n Sell a bond before maturity. n Bonds often appreciate in value, especially when interest rates are dropping. n Bondholders may be able to sell the bond before maturity for a price higher than they paid for it. Chapter 13 © 2010 South-Western, Cengage Learning 27

(continued) Return on Bonds are a safer investment than many other choices because they have a fixed interest rate and represent a loan that the issuer must repay. n Bond prices tend to remain steadier than do stock prices. n Also, bond prices tend to react in the opposite direction of stock prices. Chapter 13 © 2010 South-Western, Cengage Learning 28

(continued) Return on Bonds n Bond investments serve as a hedge to help offset the risk of the stocks in your portfolio. n A hedge is any investment or action that helps offset against loss from another investment or action. n Hedging is a tactic used to reduce overall risk. Chapter 13 © 2010 South-Western, Cengage Learning 29

Risk on Bonds n To help investors evaluate the risk level of different bonds, independent rating services rate bonds according to their safety. n A bond rating tells the investor the risk category that has been assigned to a bond. Chapter 13 © 2010 South-Western, Cengage Learning 30

(continued) Risk on Bonds n Bond rating services base their ratings on the financial condition of the issuing corporation or municipality. n Bond default means that the bond issuer cannot meet the interest and/or principal payments. n Because bonds are not insured, investors can lose their money if the corporation or municipality defaults. Chapter 13 © 2010 South-Western, Cengage Learning 31

Investment-grade Bonds n A bond with a rating of Baa or higher in Moody’s, or BBB or higher in Standard & Poor’s, is considered an investmentgrade bond. n Investment-grade bonds are considered the highest-quality, lowest-risk bonds. n The higher the bond’s rating, the lower the interest rate you will earn. Chapter 13 © 2010 South-Western, Cengage Learning 32

Junk Bond n A junk bond has a low rating, or no rating at all. n Any bond with a rating of Ba/BB or lower is called a junk bond. n Because of its low or no rating, this type of bond is highly speculative. n In most cases, interest rates on junk bonds are high because they are high risk, since the companies issuing them are not financially sound. Chapter 13 © 2010 South-Western, Cengage Learning 33

Bond Fund n A bond fund is a group of bonds that have been bundled together and sold in shares (like stock) to investors. n Typically, a bond fund would contain some investment-grade bonds along with bonds of some newer companies, foreign bonds, and a few junk bonds as well. n Mutual funds, brokers, and investment services at financial institutions offer bond funds to their customers as a method of hedging against the risk of loss from other investments. Chapter 13 © 2010 South-Western, Cengage Learning 34

Reading Corporate Bond Listings Excerpt from stock exchange (bond) listings: Mat. 3 p. m. Bid Net Chg. Yld 3 4 5 6 7 a/BB 9. 125 12/08 98½ unch 9. 46 b/B+ 10. 000 8/11 unch 9. 57 Am Std a/BB+ 7. 375 2/10 – 1¼ 7. 56 Chanclr b/BB+ 8. 125 12/09 103 unch 7. 36 Echostar a/B 9. 375 2/11 101¼ unch 9. 52 Name Type/ Rating Coup. 1 2 AK Steel Allied Waste 102 98½ Chapter 13 © 2010 South-Western, Cengage Learning 35