Investing in Bonds and Other Alternatives Chapter 14 Investing in Bonds and Other Alternatives

Introduction Bonds carry less risk than stocks. Bonds provide steady income. But returns from bonds are not necessarily low.

Why Consider Bonds? Bonds reduce risk through diversification. Bonds produce steady income. Bonds can be a safe investment if held to maturity.

Basic Bond Terminology and Features Par value Maturity Coupon Interest Rate Indenture

Treasury and Agency Bonds Risk-free Not callable Lower interest rate Most interest payments are exempt from state and local taxes.

Treasury and Agency Bonds Treasury-issued debt has maturities from 3 months to 10 years. Bills, notes, and bonds differ by maturity and denomination. Agency bonds

Treasury and Agency Bonds Pass-through certificates issued by the Government National Mortgage Association “Ginnie Mae” Treasury Inflation Protected Securities (TIPS)—par value changes with the consumer price index to guarantee investor a real rate of return

Municipal Bonds “Munis”—issued by states, counties, cities, public agencies e.g. school districts General obligation bond Revenue Bonds Serial maturities

Special Situation Bonds Zero Coupon Bonds—don’t pay interest and are sold at a deep discount from their par value Junk Bonds—also high-yield bonds, very risk, low-rated BB or below

Bond Ratings – A Measure of Riskiness Moody’s and Standard & Poor’s provide ratings on corporate and municipal bonds. Ratings involve a judgment about a bond’s future risk potential. The poorer the rating, the higher the rate of return demanded by investors. Safest bonds receive AAA, D is extremely risky.

Table 14.1 Interpreting Bond Ratings

Bond Yield Current Yield—ratio of annual interest payment to the bond’s market price Yield to maturity—true yield or return that the bondholder receives if a bond is held to maturity—measure of expected return Equivalent taxable yield on municipal bonds

Bond Valuation The value of a bond is the present value of the interest payments plus the present value of the repayment of the bond’s par value at maturity.

Bond Valuation If the issuer becomes riskier, the required rate of return should rise. A change in general interest rates, the required rate of return should increase. When interest rates rise, the value of outstanding bonds falls.

Why Bonds Fluctuate in Value Inverse relationship between interest rates and bond values in the secondary market. When interest rates rise, bond values drop, and when interest rates drop, bond values rise. Longer-term bonds fluctuate in price more than shorter-term bonds.

Why Bonds Fluctuate in Value As a bond approaches maturity, the market value approaches its par value. When interest rates go down, bond prices go up, but upward price movement on bonds with a call provision is limited by the call price.

Figure 14.3 The Price Path of a 12 Percent Coupon Bond over Its Life

What Bond Valuation Relationships Mean to the Investor If you expect interest rates to go up (bond prices to fall)—purchase very short-term bonds. If you expect interest rates to go down (bond prices to rise)—purchase bonds with long maturities and are not callable.

Figure 14.4 How to Read Online Corporate Bond Listings

Preferred Stock—An Alternative to Bonds A hybrid security with features of common stock and bonds. Similar to common stock—no fixed maturity date, not paying dividends won’t bring bankruptcy. Similar to bonds—dividends are fixed, paid before common and no voting rights.

Investing in Real Estate Requires time, energy, and sophistication Direct investments in real estate Indirect investments in real estate Investing in real estate: the bottom line

Investing – Speculating in Gold, Silver, Gems, and Collectibles Don’t do it! This is not investing—it is speculation. Collectibles may only have entertainment value. Don’t expect them to provide for your financial future.