Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 16 Investing in Bonds

Copyright ©2004 Pearson Education, Inc. All rights reserved.16-2 Chapter Objectives Identify the different types of bonds Explain what affects the return from investing in a bond Describe why some bonds are risky Identify common bond investment strategies

Copyright ©2004 Pearson Education, Inc. All rights reserved.16-3 Background on Bonds Bonds: long-term debt securities issued by government agencies or corporations Par value: for a bond, its face value, or the amount returned to the investor at the maturity date when a bond is due Most bonds have maturities between 10–30 years

Copyright ©2004 Pearson Education, Inc. All rights reserved.16-4 Background on Bonds Issuers required to make interest payments and repay par value Bond Characteristics –Call feature: a feature on a bond that allows the issuer to repurchase the bond from the investor before maturity These bonds offer a slightly higher return

Copyright ©2004 Pearson Education, Inc. All rights reserved.16-5 Background on Bonds –Convertible bond: a bond that can be converted into a stated number of shares of the issuer’s stock if the stock price reaches a specified price These bonds tend to offer a slightly lower return

Copyright ©2004 Pearson Education, Inc. All rights reserved.16-6 Background on Bonds A bond’s yield to maturity: the annualized return on a bond if it is held to maturity –If a bond sells at par value, its yield to maturity equals the coupon rate –If a bond sells below par value, its yield to maturity would exceed the coupon rate –If a bond sells above par value, its yield to maturity would be less than the coupon rate

Copyright ©2004 Pearson Education, Inc. All rights reserved.16-7 Financial Planning Online: Your Bond’s Yield Go to: sellingtools/calculators sellingtools/calculators Click on: “Bond,” then “What is my yield to maturity?” This Web site provides an estimate of the yield to maturity of your bond.

Copyright ©2004 Pearson Education, Inc. All rights reserved.16-8 Background on Bonds Bonds trading in the secondary market –Investors sell their bonds to other investors before they reach maturity –Bond prices change in response to interest rates –Brokerage firms also take orders to buy or sell bonds

Copyright ©2004 Pearson Education, Inc. All rights reserved.16-9 Types of Bonds Treasury bonds: long-term debt securities issued by the U.S. Treasury –Payments guaranteed by federal government –Interest is subject to federal income tax, but exempt from state and local taxes –Can easily be sold in the secondary market

Copyright ©2004 Pearson Education, Inc. All rights reserved Types of Bonds Municipal bonds: long-term debt securities issued by state and local government agencies –Low risk –Interest exempt from federal income tax Federal agency bonds: long-term debt securities issued by federal agencies –Low default risk –Interest is taxable

Copyright ©2004 Pearson Education, Inc. All rights reserved Financial Planning Online: Municipal Bond Quotations Go to: psamuni.html psamuni.html This Web site provides quotations of yields offered by municipal bonds with various terms to maturity. Review this information when considering purchasing municipal bonds.

Copyright ©2004 Pearson Education, Inc. All rights reserved Types of Bonds Corporate bonds: long-term debt securities issued by large firms –Subject to default risk –High-yield (junk) bonds: bonds issued by smaller, less stable corporations that are subject to a higher degree of default risk

Copyright ©2004 Pearson Education, Inc. All rights reserved Return from Investing in Bonds Impact of interest rate movements on bond returns –If interest rates rise, the value of your bond decreases –If interest rates fall, the value of your bond increases Comparison of actual returns among bonds –Varies among types of bonds and among holding periods

Copyright ©2004 Pearson Education, Inc. All rights reserved Return From Investing in Bonds Exhibit 16.1: An Example of Corporate Bond Quotations Copyright © 2001 Dow Jones & Company, Inc. All Rights Reserved.

Copyright ©2004 Pearson Education, Inc. All rights reserved Return from Investing in Bonds Tax implications of investing in bonds –Interest is taxed as ordinary income (unless tax exempt) –Selling bonds at a price higher than you paid also results in a capital gain

Copyright ©2004 Pearson Education, Inc. All rights reserved Return From Investing in Bonds

Copyright ©2004 Pearson Education, Inc. All rights reserved Financial Planning Online: Today’s Events That Could Affect Bond Prices Go to: Click on: Economy and Bonds This Web site provides a summary of recent financial news related to the bond market, which you may consider before selling or buying bonds.

Copyright ©2004 Pearson Education, Inc. All rights reserved Risk from Investing in Bonds Default risk: risk that the borrower of funds will not repay the creditors –Risk premium: the extra yield required by investors to compensate for the risk of default –Use of risk ratings to measure the default risk Ratings reflect likelihood that issuers will repay their debt over time

Copyright ©2004 Pearson Education, Inc. All rights reserved Risk From Investing in Bonds

Copyright ©2004 Pearson Education, Inc. All rights reserved Risk From Investing in Bonds –Relationship of risk rating to risk premium The lower the risk rating, the higher the risk premium offered on a bond –Impact of economic conditions Higher risk of default when economic conditions are weak

Copyright ©2004 Pearson Education, Inc. All rights reserved Risk From Investing in Bonds Focus on Ethics: Accounting fraud and default risk –Prices of bonds issued by a firm with questionable financial statements can decline quickly –Securities and Exchange Commission is to ensure accuracy of a firm’s financial statements

Copyright ©2004 Pearson Education, Inc. All rights reserved Risk from Investing in Bonds Call (prepayment) risk: the risk that a callable bond will be called Interest rate risk: the risk that a bond’s price will decline in response to an increase in interest rates –Impact of a bond’s maturity on its interest rate risk Bonds with longer terms more sensitive to interest rate movements

Copyright ©2004 Pearson Education, Inc. All rights reserved Risk From Investing in Bonds –Selecting an appropriate bond maturity Choose maturities that reflect your expectations of future interest rates Consider investing in bonds that have a maturity that matches the time you will need the funds

Copyright ©2004 Pearson Education, Inc. All rights reserved Bond Investment Strategies Interest rate strategy: selecting bonds for investment based on interest rate expectations –Purchase long-term bonds if you expect interest rates to fall Passive strategy: investing in a diversified portfolio of bonds that are held for a long period of time

Copyright ©2004 Pearson Education, Inc. All rights reserved Bond Investment Strategies Maturity matching strategy: investing in bonds that will generate payments to match future expenses –For example, parents might invest in a bond that will mature at the right time to pay for their child’s college education

Copyright ©2004 Pearson Education, Inc. All rights reserved How Bond Decisions Fit within Your Financial Plan Key decisions about bonds for your financial plan are: –Should you consider buying bonds? –What strategy should you use for investing in bonds?

Copyright ©2004 Pearson Education, Inc. All rights reserved Integrating Key Concepts

Part 1: Financial Planning Tools Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Assets and Income Part 5: Investing –In Chapter 13 we learned about investment fundamentals –In Chapter 14 we learned about stock analysis and valuation –In Chapter 15 we learned about investing in stocks –In Chapter 16 we learned about investing in bonds –In Chapter 17 we will learn about investing in mutual funds –In Chapter 18 we will cover asset allocation Part 6: Retirement and Estate Planning

Copyright ©2004 Pearson Education, Inc. All rights reserved Valuing a Bond Uses time value of money analysis Includes the present value of the future cash flows or interest payments and the principal payment at maturity Value of Bond = C t /(1 + k) t + Prin/(1 + k) t C t = coupon or interest payments in a year Prin = principal payment at maturity K = required rate of return

Copyright ©2004 Pearson Education, Inc. All rights reserved Valuing a Bond Example –Victor Kalafa is planning to purchase a bond that has 7 years remaining until maturity, a par value of $1,000, and a coupon rate of 6% (paid once annually at the end of the year). He is willing to purchase this bond only if he can earn a return of 8%, because he knows that he can earn 8% on alternative bonds that are available.

Copyright ©2004 Pearson Education, Inc. All rights reserved Valuing a Bond Future cash flows: Coupon payment (C) =.06  $1,000 Principal payment (Prin) = $1,000 Discount rate: Required rate of return = 8 percent Value of bond [C  (PVIFA,8%,7 yrs)]+[Prin  (PVIF,8%,7 yrs] [$60  ] + [$1,000 .5835] $ $ = $895.88