Chapter 15

Investing in Bonds

Chapter 15

Investing in Bonds

Chapter 15Learning ObjectivesDescribe the characteristics of corporate bonds

Discuss why corporations issue bonds

Explain why investors purchase corporate bonds

Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds

Evaluate bonds when making an investment

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Characteristics of Corporate BondsObjective 1: Describe the 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-

usually $1,000

Bondholders receive interest payments every six

months at the stated interest rate3

Characteristics of Corporate Bonds

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•Par value = $1,000

•Coupon = 6.5% of par value per year,

or $65 per year ($32.50 every six

months).

•Maturity = 27 years (matures in 2036)

•Issued by AT&T.

Characteristics of Corporate Bonds The legal conditions are described in a

bond indenture

A trustee is a financially independent firm that acts as the bondholder’s representative

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Characteristics of Corporate BondsRisks of bonds

Interest risk

Purchasing power risk

Business risk

Liquidity risk

Call risk

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Characteristics of Corporate BondsFour important features:

Interest rate increases, bond value

decreases

Market value of bond will be less than

the par value if investor’s required rate is

above the coupon interest rate

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Characteristics of Corporate BondsFour important features:

As maturity date approaches, the market value of bond approaches its par value

Long-term bonds have greater interest

rate risk than do short-term bonds

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Why Corporations Sell BondsObjective 2: Discuss why corporations

issue bonds

To get funds for major purchases

To fund ongoing business activities

When it is difficult or impossible to sell stock

To improve financial leverage

Interest paid to bondholders is a tax deductible business expense that can be used to reduce the federal and state taxes corporations must pay

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Why Corporations Sell Bonds (continued) TYPES OF BONDS

Debenture bondMost corporate bonds are debenture bondsUnsecured - backed only by the reputation

of the issuing company

Mortgage bondA corporate bond that is secured by

various assets of the issuing firm, usually real estate

Interest rate is lower because it is secured by the collateral and corporate assets

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Why Corporations Sell Bonds (continued)

Subordinated debenture bondAn unsecured bond that gives bondholders

a claim secondary to that of other designated bond holders with respect to interest payments and claim on assets

Convertible bondA special kind of corporate bond that can

be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock

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Why Corporations Sell Bonds (continued)

PROVISIONS OF REPAYMENTCall Feature

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

Bonds called, if their interest rate is much higher than the going rate

Most corporate bonds are callable

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Why Corporations Sell Bonds (continued)

Sinking fundCorporations deposit money in this fund

annually or semiannually and use the money to pay off the bondholders when the bond issue comes due

Serial bondsBonds of a single issue that mature on

different dates

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Why Investors Buy Corporate Bonds Objective 3: Explain why investors

purchase corporate bonds Interest Income

Investors receive interest every six months Interest will be paid to investors twice a

year, with the payment based on the interest rate and the face value of the bond

Registered bonds, Bearer bonds, Zero-coupon bonds

Dollar 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

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Why Investors Buy Corporate Bonds (continued)

THE MECHANICS OF BOND TRANSACTION

Bonds can be held until maturity or sold in the secondary market

Most bonds sold through full-service brokerage firms, discount brokerage firms, or the Internet

Corporate bonds may be purchased in the primary market or secondary market

Generally a minimum commission of $10-$35 on a $1,000 bond

Interest and capital gains from selling bonds are both taxable

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Government Bonds and Debt Securities

Objective 4: Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds

Sold to obtain money to finance the national debt, and the ongoing costs of government

Three levels of government issue bonds:Federal-no state income tax on the interestStateLocal municipalities

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Government Bonds and Debt SecuritiesTREASURY BILLS, NOTES, AND BONDS

Treasury Bills (T-Bills)$100 minimum4, 13, 26, or 52 weeks to matureSold at a discount

Treasury Notes (T-Notes)$100 units2, 5, and 10 year termsInterest paid every six months

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Government Bonds and Debt Securities (continued)

Treasury Bonds

Issued in minimum units of $100

Have maturities of 30 years

Interest rates are generally higher than those of T-bills and T-Notes

Interest is paid every 6 months

Held until maturity or sold before maturity

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Government Bonds and Debt Securities (continued)

FEDERAL AGENCY DEBT ISSUES

Fannie Mae ( www.fanniemae.com)Federal National Mortgage Association

Ginnie Mae - pay interest once a monthGovernment National Mortgage Association

Freddie MacFederal Home Loan Mortgage Corporation

Slightly higher risk than Treasury securities, so slightly higher interest rates

Issued for 1-30 years, 12 year average

Minimum denominations may be as high as $10,000-$25,000

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Government Bonds and Debt Securities (continued)

STATE AND LOCAL GOVERNMENT SECURITIES

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, such as a toll bridge

Municipal bonds or munisIssued by a state or local government, such as cities,

counties, school districtsUse funds for ongoing costs & to build major

projects such as schools, airports, and bridges

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Government Bonds and Debt Securities (continued)

Features of Municipal Bond

People like to invest in projects close to home

They like insured municipal bonds, or states that guarantee payment

May be callable, but usually not until after the first ten years

Interest earned may be exempt from federal income tax so yield is higher

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Government Bonds and Debt Securities (continued)

Taxable equivalent yield= Tax-exempt yield1.0 - Your tax rate

Example:Taxable equivalent yield = .06

1.0 - 0.28

= 0.083 = 8.3%

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The Decision to Buy or Sell BondsObjective 5: Evaluate bonds when making

an Investment

THE INTERNETThe Internet can be used in the following ways

to evaluate a bondObtain the price information Trade bonds online for a lower commissionResearch information on the corporation and

bond issues onlineSome relevant Websites are:

www.bondsonline.com www.emuni.com www.buysellbonds.com www.fmsbonds.com www.municipalbonds.com

www.investiginbonds.com 23

The Decision to Buy or Sell Bonds (continued)

ANNUAL REPORTS

Write or telephone the corporation to receive the annual report

Corporations maintain web site that provides access to annual reports

Some financial publications provide a reader’s service to request an annual report

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The Decision to Buy or Sell Bonds (continued)

BOND RATINGS

Bond ratings provide quality and risk associated with bond issues

Moody’s Investor Service Inc. and Standard & Poor’s Corporation

Bond ratings generally range from AAA to D

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The Decision to Buy or Sell Bonds (continued)

BOND YIELD CALCULATIONS

Yield is the rate of return earned by an investor who holds a bond for a stated period

Current yield on corporate bond = Annual income amount Current market value

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The Decision to Buy or Sell Bonds (continued)

Yield to maturity

-- The rate of return investors earn on a bond if they

hold it to maturity.

Suppose we paid $898.90 for a $1,000 par 10%

coupon bond with 8 years to maturity and semi-annual

coupon payments. What is our yield to maturity?

N = 16, PV = -898.9 PMT = 50 FV = 1000

Solve I% = 6%

6% * 2 = 12%

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Online ActivityGo to one of these sites and look up information about municipal bonds in your area.

www.emuni.com www.munidipalbonds.com

…What do you think of the rates these bonds are paying?

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