Financial Markets Chapter 11 Section 2 Bonds and Other Financial Assets

Financial Markets Objectives: 1. Describe the characteristics of bonds as financial assets. 2. Identify different types of bonds. 3. Describe the characteristics of other types of financial assets. 4. Explain four different types of financial asset markets.

Financial Markets BONDS Coupon Rate Maturity Par Value Yield

Financial Markets How do borrowers raise money for investment? Selling bonds is one way Bonds are certificates sold by a company or government. They go to finance projects or expansion of the business.

Financial Markets 1942, the Federal Government sold bonds to encourage Americans to buy these “War Bonds” to help finance WWII. Americans stepped up to the plate and bought a plethora of bonds to help support the war effort.

Financial Markets Bonds as Financial Assets Bonds are basically loans or IOUs that represent debt that the government or a corporation must repay to an investor. Bonds usually have a fixed interest rate for a fixed period of time. Bonds are generally low-risk investments. They usually always pay off.

Financial Markets 3 Components of Bonds Coupon Rate – the interest rate that the bond issuer will pay to the bondholder. Maturity – the time at which payment to a bondholder is due. Some bonds have a maturity of 10, 20 or 30 years. Par Value – the amount that an investor pays to purchase a bond and that will be repaid to the investor at maturity.

Financial Markets Not all bonds are held to maturity. Over the lifetime of the bond, it might be bought or sold and the price may change. Bonds have a yield – the annual rate of return on the bond if the bond is held to maturity.

Financial Markets Buying Bonds at a Discount Investors earn interest on the bonds they buy. They can also earn money by buying a bond at a discount. A $1,000 bond may be bought for $ 960, so when it matures, a person would make $ 40. IF a person needs to sell a bond to pay for a new car, they may offer a discount to get rid of the bond.

Financial Markets Bond Ratings: 3 factors Standard & Poor Moody’s # 1 # 2 # 3

Financial Markets Bond Ratings: Bonds have a rating that is provided by one of two companies. Standard & Poor’s or Moody’s Factors that determine a bond rating Issuer’s ability to repay the bond Stability of the company History of the company at repaying bonds

Financial Markets Bond Ratings Standard & Poor – AAA down to a D Moody’s – Aaa down to a D D stands for Default. These bonds pay a very high rate of interest, but the chances they will be in business when your bond matures are slim. Highest Rated Bonds are AAA (may have 5%) BBB Bonds may have a interest rate of 7.5%

Financial Markets Selling price or a AAA Bond may be $ 1,100 and for BBB Bond may be $ 950. Bonds with a high rating keep their bonds until maturity face relatively little risk of losing their investment.

Financial Markets Advantages and Disadvantages Bonds are desirable for two reasons Once the bond is sold, the coupon rate for that bond will not go up or down. Unlike stockholders, bondholders do not own part of the company. Companies do not have to share their profits with bondholders. Bonds are desirable # 1 # 2

Financial Markets Bonds also pose two main disadvantages to the issuer. The company must make fixed interest payments, even in bad years when it does not make money. If the firm does not maintain financial health, its bonds may be downgraded to a lower bond rating.

Financial Markets Types of Bonds: Types of Bonds # 1 # 2 # 3 # 4 # 5

Financial Markets Types of Bonds 1. Savings Bonds These are low denomination ($ 50 to $10,000) bonds issued by the United States Government. Gov’t funds the sale of these bonds to pay for projects that they may have. There is NO risk with these bonds. The Gov’t will pay back the money.

Financial Markets 2. Treasury Bonds, Bills, and Notes The length of these bonds differ. Backed by the full faith and credit of the US. Treasury Bonds – 10 to 30 years Treasury Notes – 2 to 10 years T-Bills - 3, 6, or 12 months

Financial Markets 3. Municipal Bonds State and local governments and municipals issue bonds to finance such things as highway improvements, state buildings, libraries, parks, etc Also called “Munis” Good investment, because the government is not going out of business and they will pay back. Gov’t can use the power to tax to raise money to repay the bond if needed.

Financial Markets 4. Corporate Bonds Issued by corporations to raise money to expand their business. Issued in large denominations like $ 1,000…$5,000…. Or $ 10,000. Interest on Corporate Bonds is taxed as income Investors in corporate bonds must depend on the success of the company to get their money back. These bonds are rated as well Securities and Exchange Commission (SEC) regulates the sale of these bonds.

5. Junk Bonds They are high-yield securities, lower-rated, and potentially high-paying bonds. Could pay up to 12% on the bond They carry VERY low ratings. The company may be in default when the bond matures.

Financial Markets Other Types of Financial Assets 1. Certificate of Deposit CDs Available through a bank Fixed amount of time – 6 months to 1 year. Attractive to small investors. Low cost – usually start at $ 100

Financial Markets Other Types of Financial Assets 2. Money Market Mutual Funds Special type of mutual funds Investors receive a higher interest rate on these types of funds They ARE NOT covered by the FDIC Are considered to be slightly risky

Financial Markets 1. Capital Markets  Longer term Gov’t/Corp bonds or CDs  Usually more than 1 year 2. Money Markets  Money is lent for periods of less than 1 year.  Treasury Bills, short –term CDs, and etc.

Financial Markets Primary Markets Financial assets that can be redeemed only be the original holder are sold here. Savings Bonds, CDs, and etc Secondary Markets Financial assets that can be resold. This option provides liquidity for the investor who may need quick cash.