Unit 5 Microeconomics: Money and Finance Chapters 11.2 Economics Mr. Biggs

Bonds as Financial Assets Bonds are basically loans that represent debt that government or corporations must repay to an investor. Bonds and Other Financial Assets

The Three Components of Bonds 1. Coupon rate - The interest rate that the bond issuer will pay to the bondholder. 2. Maturity - The time at which payment to the bondholder is due (typically 10, 20, or 30 years). 3. Par Value - The amount that an investor pays to buy the bond that will be repaid to the investor at maturity (also known as the face value or principal). Yield - The annual rate of return on the bond if it were held to maturity. For example: Coupon rate = 5% Maturity = 10 years Par Value = $1,000 The coupon rate is 5% ($50 per year yield) and after 10 years, the holder of the bond will have earned $500 interest. The holder will then sell the bond at its par value of $1,000. After 10 years, the holder turned $1,000 into $1,500.

Buying Bonds at Discount Investors earn interest (coupon rate) on the bonds they buy, but they can also earn money by buying bonds at a discount (discount from par value). For example, if you have to sell your 10 year $1,000 bond with a 5% coupon rate, but the current coupon rate is 6%, you will not be able to find a buyer unless you sell it at a discounted par value. The reason is because your yield is $50, but current buyers can purchase bonds with a $60 yield.

Bond Ratings Standard & Poor’s and Moody’s are firms that rate a bond issuer’s ability to repay interest and principal at maturity. The ratings range from AAA to D. The higher the bond rating, the lower the interest rate the company usually has to pay to get people to buy its bonds. Also, the higher the bond rating, the higher the price at which the bond will sell. For example, a AAA $1,000 bond may actually sell for $1,100.

Advantages and Disadvantages to the Issuer From the point of view of the investor, bonds are good because they are relatively safe. Bonds are advantageous to the issuer because: The coupon rate for that bond will not go up or down. Unlike stockholders, bondholders do not own a part of the company. Bonds are disadvantageous to the issuer because: The company must pay fixed interest payments, even in a bad year. A companies' bond rating may be lowered, making it harder to sell unless they are offered at discount.

Types of Bonds There are 5 different types of bonds: Savings bond Treasury bills, notes, and bonds Municipal bonds Corporate bonds Junk bonds Savings Bond Savings bond - A low denomination bond issued by the United States government ($50 to $10,000). A savings bond does not issue coupon payments to its bondholders. Instead, a savings bond costs less than the par value. For example, a $50 bond might cost $25 and pay the $50 at maturity.

Treasury Bonds, Bills and Notes The United States Treasury issues $1,000 T-bills, T-notes, and T-bonds which are considered safe investments because they are backed by the federal government. T-bills have a 1 month to 1 year maturity, are sold at a discount of the par value, and have no coupon payments. T-notes have a 1 year to 10 year maturity and have coupon payments every 6 months. T-bonds have a 10 year to 30 year maturity and have coupon payments every 6 months. Municipal Bonds Municipal bond - A bond issued by a state, local or municipal government to finance such improvements as highways, state buildings, libraries, parks, and schools.

Corporate Bonds Corporate Bond - A bond issued by a corporation to raise money to expand its business. Corporations that issue bonds are watched by Standard & Poor’s and the Securities and Exchange Commission (SEC). Securities and Exchange Commission (SEC) - An independent agency of the government that regulates financial markets and investment companies. Junk Bonds Junk bonds - A lower rated, potentially higher- paying bond. For example, junk bonds with lower medium grades (B) have been known to pay over 12% when government bonds were paying 8%.

Other Types of Financial Assets Other types of financial assets include: CDs Money market mutual funds Stocks Certificate of Deposits (CDs) CDs are one of the most common forms of investment. They are available through banks and are popular because they cost as little as a $100. Investors can choose among many terms of maturity.

Money Market Mutual Funds Money market mutual funds are special types of mutual funds. Intermediaries collect money from individual investors and buy short term financial assets. Investors receive higher interest rates than a savings plan, but the investment is not insured by the FDIC. Money Market Mutual Funds are slightly riskier than CDs. Financial Assets Market Bonds, CDs, and money market mutual funds are traded on the financial assets market.

Capital and Money Markets Capital and money markets are classified by the length of time for which funds are lent. Money markets - Market in which money is lent for a period of less than a year. These include short-term CDs, T- bills, and money market mutual funds. Capital market - Market in which money is lent for periods longer than a year. These include long-term CDs, corporate bonds, T-notes, and T- bonds.

Primary and Secondary Markets Primary and secondary markets are classified according to whether assets can be resold to other buyers. Primary market - Market for selling financial assets that can only be redeemed by the original holder. These include savings bonds and small amount CDs. Secondary market - Market for reselling financial assets. These include stocks sold in the stock market.

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