Chapter 13Investing in Bonds

Chapter 13.1

What is the difference between stocks and bonds?

Stocks (aka Equities): Stocks represent partial ownership of a corporation. If the corporation does well, its value increases, and you share in the appreciation. However, if the corporation goes bankrupt, you can lose your entire initial investment.

What are bonds?

Bonds (aka Notes): Bonds represent a loan you make to a corporation or government.

For example, you can buy a US Treasury bond for $100, and get a guaranteed 4.75% interest rate for 5-years, and can expect to get your $100 back at the end of that 5-years. Your risk is repayment of the principal (amount invested). Because loaning $100 to the U.S. government is much less risky than loaning $100 to the Brazilian government, U.S. government bonds pay a much lower rate of interest ("coupon") for borrowing your money.

Stocks and Bonds .... How do they differ

Stocks are EQUITY. They represent shares of ownership in a Corporation. A Stockholder is actually one of many owners of a Publicly Owned Corporation. If a Corporation dissolves for any reason owners of Common Stock (the main type of stock issued) receive the value of the sold assets of the Corporation AFTER everyone else is paid, including the IRS, Employees, Bonds, Accounts Payable, etc.

Continued

Bonds are DEBT. They are sold by the Corporation in order to raise money for various purposes for use by the company. Bonds offer an interest rate to the Bondholder for the period of time that the Bondholder owns the bonds.

Since bonds do not represent ownership, the bondholder could lose their investment if the Corporation dissolves, but are paid BEFORE owners of stock.

Corporate Bonds

Face value of a bond is the amount the bondholder will be repaid at maturity. It is typically $1,000.

Features of Corporate Bonds

A callable bond is a bond that the issuer has the right to pay off before its maturity date.

Types of Corporate Bonds

Debentures are corporate bonds that are not backed by collateral but only by the general credit standing of the company.

A mortgage bond is a corporate bond backed by specific assets as collateral to assure repayment of the debt.

A convertible bond is a corporate bond that can be exchanged, at the owner’s option, for a specified number of shares of the company’s stock.

Calculating Current Yield

Once a bond is issued, the market determines the current price of the bond.

If the price is higher than 100, the bond is trading at a premium.

If the price is lower than 100, the bond is trading at a discount.

Municipal Bonds

A bond issued by state and local governments is called a municipal bond (muni). A revenue bond is a muni issued to raise money for

a public-works project. A general obligation bond is a muni backed by the

power of the issuing state or local government to levy taxes and borrow.

Municipal bonds are exempt from both federal and state taxes.

Agency Bonds and Zero-Coupon Bonds

When you purchase an agency bond, you are loaning money to one of the government agencies (FHLMC, FNMA, TVA).

A zero-coupon bond is a bond that is sold at a deep discount, makes no interest payments and is redeemable for its face value at maturity.

Comparing Taxable and Tax-Exempt Bonds

Corporate Municipal Bond Bond

Face Value (Principal) $10,000 $10,000

Rate of Interest 6% 5%

Amount of Annual Interest $ 600 $ 500

Tax on Interest Earned (28%) 168 0

Net Interest $ 432 $ 500

13.2How to Buy and Sell Bonds

You can purchase bonds from a discount broker, full-service broker or from a bank.

Bonds typically require a minimum of $1,000.

Evaluating Bonds

To help investors evaluate the risk level of bonds, Moody’s and S&P rate bonds on their level of safety. The highest rating is AAA. The lowest rating is D. A

D rating indicates the bond is in default. Any bond with a Baa or higher in Moody’s, or BBB or

higher is S&P is considered an investment-grade bond.

A junk bond is a bond that has a low rating, or no rating at all.

Bonds Top 10

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