Bonds & Mutual Funds Chapter 10

Bonds Two types What is a bond Corporate Government Essentially bondholder (investor) loaning money to a corporation or government entity

Why Issued Corporations Government Way to raise $$ when it is difficult or impossible to sell stock Government To help fund its regular ongoing activities Fund major projects Government – sell to fund ongoing activities and to finance the national debt State & local government – fund major projects - schools, airports, highways

Types of Corporate Bonds Debentures Mortgage Subordinated Debentures Convertible Bonds

Debentures Bond backed by reputation of the issuing corporation – not by assets Investors expect company to Repay face value of the bond Interest payments until maturity Backed by reputation not be assets of issuing corporation Investors buy this type of bond because they believe that the company/corporation is on solid financial ground.

Mortgage Bonds Also known as a secured bond Backed by assets of the corporation Less risk than a debenture Lower return Less risk than a debenture because backed by assets of corporation Assets can be sold to repay bonds Lower return because less risk

Subordinated Debentures Unsecured bond Bondholders have a claim to interest payments and assets of the corporation after all other bondholders have been paid Riskier than other bonds Higher return

Convertible Bonds Offer flexibility to investor Can trade for shares of corporation’s common stock Because of flexibility – interest rate 1 to 2 percent lower than on other types of bonds Many bondholders do not convert their bonds into stock even when stock values are high. Why? As market value of common stock increases so does the value of convertible bonds

How Repaid Premiums Sinking Funds Serial Bonds If pay before a specified, pay a premium Sinking Funds Corporation makes deposits for purpose of pay back bond issue Serial Bonds Mature at different times – not all at once Most bonds today are “callable” – they have a call feature that allows a corporation to buy back bonds from bondholders before the maturity date. Do this by: sell stock use profits or sell new bonds at a lower interest rate Example: Mobil Corp issued bonds at 8.5% Later interest rates on comparable bonds drops to 4.5% Mobil may decide to “call” the bonds sold at 8.5% Therefore, Mobil would not have to pay bondholders interest at the higher rate Bond indenture – details all the conditions pertaining to a particular bond issue. Side Note: Bonds, stocks, and mutual funds have prospectus’s – which is filed with the SEC outlining all the facts pertaining to issuance – risks, financial information about company, etc. Premiums – companies agree not to call their bonds for the first 5 to 10 years after issued. If they do – may have to pay a premium – additional amount over the face value of the bond. Serial – bonds mature at different intervals. For example, 10% of the bonds mature on an annual basis (usually no bonds mature for an initial period of time – 10 years). This allows corporation to repay bonds a few at a time instead of having to pay entire amount at once.

Why Buy Safe investment – relatively risk free Provide interest income May increase in value Face value repaid when reaches maturity On the flip side – relatively low rate of return Increase in value – depends on bond market, overall interest rates in the economy, and the reputation and assets of the issuer.

How Interest Paid Usually paid every 6 months Methods Registered bonds Coupon bonds Bearer bonds Zero-coupon bonds

Registered Bonds & Coupon Bonds Registered in owner’s name Interest checks mailed to owner Registered Coupon – Registered in owner’s name for the face value only – not the interest Comes with detachable coupons Anyone who holds the coupons can collect the interest Registered in owner’s name – owner is the only person who can collect the interest Coupons Bonds – to collect interest present one of the detachable coupons to the issuing corporation or the appropriate bank or broker

Bearer Bonds & Zero-Coupon Bonds Bearer – not registered in anyone’s name Anyone with physical possession of bond and coupons can collect interest Zero-Coupon – does not produce interest Sold at a price far below its face value Redeem for its full face value at maturity Bearer bonds are no longer issued by corporations Zero-Coupon – Because you buy it for less than its face value, you automatically make a profit when the bond is repaid

Maturity Value of a Bond Market value of bond may fluctuate prior to maturity date Bonds value affected by Financial condition of the issuing company Changes in the economy Law of supply and demand

Repayment at Maturity Corporate bonds – repaid at maturity After purchase investor can Hold bond until maturity date Sell the bond at any time to another investor Value of bond closely tied to the corporation’s ability to repay

Where Purchase Bonds Purchased same way as stocks Through a full-service, discount, or online brokerage firm – pay a commission Purchase in either primary or secondary markets Traded on the New York Bond Exchange and American Bond Exchange Primary market – purchase from an investment banker representing the firm Secondary market – trade financial securities with other investors Bonds issued by large companies are traded on the New York Bond Exchange and American bond Exchange

Government Bonds & Securities Federal government Fund regular activities and services Finance the national debt Issued by the U.S. Dept of the Treasury State and local governments Finance airports, highways, schools Relatively safe Can get insured muni bonds State and local government bonds known as “munis”

Government Bonds & Securities U.S. Department of the Treasury offers Treasury bills (T-bills) Treasury notes U.S. government savings bonds Can be cashed prior to or held until maturity date Must pay federal income tax on bond interest you receive Bonds can be issued by other federal agencies as well. Virtually risk free – offer only slightly higher interest rate than securities issued by the treasury department Have an average maturity of about 12 years Group Activity - Teaching Activity – page 315

Investing in Bonds Bond price quotations Percentage of face value Research – Internet, annual reports, business magazines, government reports, etc. Check bond ratings Calculate yield of bond investment Bond price quotation is expressed as a percentage of the face value. Example, $1,000 – if the price quoted is “84” this means that the current market value is 84% or $840 Research – just like for stocks Bond Ratings – bond issues are rated or evaluated by independent rating companies. Rating gives you a good idea of the quality and risk associated with that bond. Sources for bond ratings: Moody’s Bond Survey and S&P Stock and Bond Guide Handout – Bond Ratings – page 322 Yield of bond – is the rate of return Amount of annual interest income/current market value – see GO Figure on page 323

Group Activity Research interest rates and other pertinent facts about treasury bills, treasury notes, Series EE and I savings bonds What are advantages & disadvantages of each As a group which investment do you prefer and why http://www.savingsbonds.gov Divide students into 4 groups

Mutual Funds Mutual Fund Scavenger Hunt

Mutual Funds Investors pool their money to buy stocks, bonds, and other securities Fund selections made by professional managers Offer diversification – reduces risk Very popular 1970 – 361 funds 2003 – 8,300 funds

Types of Mutual Funds Closed-End Funds Open-End Funds Fixed number of shares issued Shares are traded between investors on the stock exchanges Open-End Funds Unlimited number of shares issued Redeemed by the investment company that manages the fund

Types of Mutual Funds Load Funds No-Load Funds Referred to as an “A” fund Pay a commission every time buy and sell Advantage – fund’s representative will offer advice and guidance about when to buy and sell No-Load Funds No commissions paid Load funds – commission can be as high as 8.5% - average load charge for mutual funds is between 3 ad 5 percent FEES: Investment companies also charge management fees. Generally range from .5 to 1.25 percent of the fund’s assets. Investors often charged a back-load fee versus being charged a fee when they purchase shares Back-load – meaning you are charged a fee for withdrawing money from the fund, this usually ranges from 1-5 percent and is based on how long you own the shares Also charged a 12b-1 fee – this is a fee for the marketing and advertising of a mutual fund – approx 1% of a fund’s assets per year

Fees and Other Charges Management Fee Back-end Load Fee 12b-1 Fee Fixed % of the fund’s asset value Range from .5 to 1.25% Back-end Load Fee Charge for withdrawing money Range from 1 to 5% Based on how long you own shares 12b-1 Fee Helps pay advertising and marketing costs Approximately 1% of fund’s assets per year

Capital Gain vs Capital Gain Distribution Results from the sale of an investment Proceeds from the sale minus initial cost Capital Gain Distribution Fund sells securities it holds Profits distributed to the shareholders Both are reported on your federal income Receive a 1099 form at year end

Making Informed Decisions Newspapers Prospectuses Annual Reports Financial Publications Professional Advice Internet

Categories of Mutual Funds Stock Mutual Funds Bond Mutual Funds Mixed Mutual Funds