Investing in Bonds and Other Alternatives

14-2 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Learning Objectives 1. Invest in the bond market. 2. Understand basic bond terminology and compare the various types of bonds. 3. Calculate the value of a bond and understand the factors that cause bond value to change.

14-3 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Learning Objectives 4. Compare preferred stock to bonds as an investment option. 5. Understand the risks associated with investing in real estate. 6. Know why you shouldn’t invest in gold, silver, gems, or collectibles.

14-4 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Introduction Bonds carry less risk than stocks. Bonds provide steady income. But returns from bonds are not necessarily low.

14-5 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Why Consider Bonds? Bonds reduce risk through diversification. Bonds produce steady income. Bonds can be a safe investment if held to maturity.

14-6 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Basic Bond Terminology and Features Par value Maturity Coupon Interest Rate Indenture

14-7 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Basic Bond Terminology and Features Indenture – a legal document that provides specific terms of the loan agreement. It includes: A description of the bond. The rights of bondholders. The rights of the issuing firm. The responsibilities of the bond trustees.

14-8 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Basic Bond Terminology and Features Call Provision Deferred call Sinking Fund

14-9 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Corporate Bonds Corporate bonds Secured corporate debt Mortgage bond Unsecured corporate debt Debenture

14-10 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Treasury and Agency Bonds Risk-free Not callable Lower interest rate Most interest payments are exempt from state and local taxes.

14-11 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

14-12 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

14-13 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Treasury and Agency Bonds U.S. Series EE Bonds I Bonds

14-14 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Municipal Bonds “Munis”—issued by states, counties, cities, public agencies e.g. school districts General obligation bond Revenue Bonds Serial maturities

14-15 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

14-16 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-17 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 14.1

14-18 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

14-19 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Valuation Principles Principle 3—time value of money Principle 8—risk and return go hand in hand Value in today’s dollars of the interest payments and principal payments, add them together.

14-20 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

14-21 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

14-22 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-23 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 14.1

13-24 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 14.2

14-25 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

13-26 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 14.3

13-27 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Table 14.2

14-28 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall What Bond Valuation Relationships Mean to the Investor If you expect interest rats 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.

14-29 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Reading Corporate Bond Quotes in the Wall Street Journal Online Selling price is quoted as percentage of par. Also expected to pay accrued interest Invoice price—sum of the quoted or stated price of a bond and the bond’s accrued interest—price of bond on secondary market.

13-30 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Figure 14.4

14-31 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

14-32 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Features and Characteristics of Preferred Stock Multiple Issues Cumulative Feature Adjustable Rate Convertibility Callability

14-33 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Valuation of Preferred Stock The value of a share of preferred stock is the present value of the perpetual stream of constant dividends. Value of preferred stock = annual preferred stock dividend required rate of return As market interest rates rise and fall, the value of preferred stock moves in an opposite manner

14-34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Risks Associated with Preferred Stock If interest rates rise, the value of preferred stock drops. If interest rates drop, the value of preferred stock rises and it is called away.

14-35 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Risks Associated with Preferred Stock Investor does not participate in the capital gains that common stockholders receive. Investor doesn’t have the safety of bond interest payments, preferred dividends can be passed without the risk of bankruptcy.

14-36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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

14-37 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 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.

14-38 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Summary Bonds reduce risk, produce steady income, and can be safe investment. Hold bond until it matures—can get yield to maturity. Value of bond is the present value of the stream of interest payments plus the present value of the repayment of the bond’s par value at maturity

14-39 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Summary Preferred stock is a security with no fixed maturity date and with dividends that are generally set in amount and don’t fluctuate. You own property with direct real estate investment but with indirect real estate investment, you’re an investor in a group. Gold, silver, gems or collectibles are not investments but speculation.