Prentice-Hall, Inc.1 Chapter 14 Investing in bonds and other investments

Prentice-Hall, Inc.2 Why Consider Bonds?  Bonds reduce risk through diversification.  Bonds produce steady current income.  Bonds can be a safe investment if held to maturity.

Prentice-Hall, Inc.3 Basic Bond Terminology and Features  Par value -- the amount returned to the holder at maturity  Coupon interest rate -- indicates the percentage of the face value that will be paid annually to the holder in the form of interest  Indenture -- a document that outlines the terms of the loan agreement

Prentice-Hall, Inc.4 Basic Bond Terminology and Features (Cont’d)  Call provision -- allows the issuer to repurchase the bonds before the maturity date –Deferred calls provide more protection.  Sinking fund -- money set aside annually to pay off the bonds at maturity

Prentice-Hall, Inc.5 Different Types of Bonds  Corporate bonds  Treasury and agency bonds  Municipal bonds  Special situation bonds

Prentice-Hall, Inc.6 Corporate Bonds  Secured corporate debts are secured by collateral or real property liens – Secured bond – Mortgage bond

Prentice-Hall, Inc.7 Corporate Bonds (Cont’d)  Unsecured corporate debts are not secured by collateral, and pay a higher return – Debenture -- long-term unsecured bond – Can have a hierarchy of payment, with unsubordinated and subordinated debentures

Prentice-Hall, Inc.8 Treasury and Agency Bonds  Treasury bonds –Bills, notes, and bonds –Treasury inflation-indexed bonds  Savings bonds –U.S. Series ee bonds –I bonds  Agency bonds –Pass-through certificates

Prentice-Hall, Inc.9 Treasury Bills, Notes, and Bonds  Considered risk free – no default or call risk  Pay a lower rate of interest than other bonds  Most interest is exempt from state and local taxes  Treasury direct avoids brokerage fees

Prentice-Hall, Inc.10 Treasury Bills, Notes, Bonds (Cont’d)  Bills mature in 3, 6, or 12 months  Notes mature in 2, 3, 5, or 10 years  Bonds mature in 10 to 30 years  All are sold in denominations of $1,000

Prentice-Hall, Inc.11 Agency Bonds  Issued by government agencies; authorized by congress –Federal national mortgage association (FNMA) –Federal home loan banks (FHLB)  Low risk, with interest rates slightly higher than treasury issues  Minimum denomination of $25,000 with maturities from 1 to 40 years

Prentice-Hall, Inc.12 Pass-through Certificates  Issued by government national mortgage association (GNMA)  Minimum $25,000 certificate for pool of mortgages  Principal and interest repaid monthly

Prentice-Hall, Inc.13 Treasury Inflation-indexed Bonds  Maturities of 10 years and a minimum par value of $1,000  Inflation increases the face value of the bond, guaranteeing the investor a real return  Tax complication -- must pay taxes annually on par value adjustments

Prentice-Hall, Inc.14 U.S. Series Ee Bonds  Purchase price is one-half of the face value, ranging from $50 to $10,000  Rate of return varies with the market rate  Have a guaranteed minimum interest rate based on treasury securities  High level of liquidity, but cashing in before maturity may reduce yield

Prentice-Hall, Inc.15 Municipal Bonds (Muni’s)  Issued by to fund public projects  Interest earnings are federal tax-exempt  Can be exempt from state taxes if you live in the state where bonds issued  Not very liquid, due to the lack of a secondary market

Prentice-Hall, Inc.16 Municipal Bonds (Cont’d)  Two basic types – General obligation – Revenue  Serial maturity -- a portion of the debt comes due each year for a set number of years  Not risk free; check the bond ratings

Prentice-Hall, Inc.17 Special Situation Bonds  Zero-coupon bonds  Junk bonds

Prentice-Hall, Inc.18 Zero-coupon Bonds  Issued by corporations, municipalities, and the treasury (e.G., STRIPS)  Do not pay interest  Are sold at a discount from face value  Annual appreciation is taxed although it is not realized  Fluctuate more with interest rate changes than traditional bonds

Prentice-Hall, Inc.19 Junk Bonds  Have very low ratings  Normally offer very high interest rates  Have a high default rate  Are almost always callable

Prentice-Hall, Inc.20 Bond Yield  Is the total return on a bond investment  Is not the same as the interest rate  Is affected by the bond price which may be more or less than face value

Prentice-Hall, Inc.21 Ways to Measure Bond Yield  Current yield  Yield to maturity  Equivalent taxable yield on muni’s

Prentice-Hall, Inc.22 Current Yield  Ratio of annual interest payments to the bond’s market price  Current yield = Annual interest payments Market price of the bond

Prentice-Hall, Inc.23 Yield to Maturity  True yield received if the bond is held to maturity  Approximate yield to maturity = Annual interest + par value - current price payments years to maturity par value + current price 2

Prentice-Hall, Inc.24 Equivalent Taxable Yield Equation for Muni’s  Equivalent taxable yield = Tax-free yield on the municipal bond (1 - investor’s marginal tax bracket)

Prentice-Hall, Inc.25 Bond Ratings – A Measure of Riskiness  Generally ratings run from AAA or aaa for the safest to D for the extremely risky  Ratings categorize bonds by default risk  Rating companies – Standard & Poor’s – Moody’s

Prentice-Hall, Inc.26 Corporate Bond Quotes in The Wall Street Journal  Bonds -- the name of the issuer  Cur yld -- the annual interest divided by the most current price  Vol -- the volume, or number, of bonds traded

Prentice-Hall, Inc.27 Corporate Bond Quotes (Cont’d)  Close -- the last price paid for that issue. Measured in 1/8s or $1.25.  Net chg -- the change in closing price from the prior day’s closing price. Measured in 1/8s or $1.25.

Prentice-Hall, Inc.28 Reading Treasury Quotes in The Wall Street Journal  Rate -- the original interest rate on the bond  Maturity mo/yr -- the year and month the issue will mature  Bid -- the previous day’s mid-afternoon bid price that treasury dealers were willing to buy the issue for. Measured in 32nds of a point; a point equals one-hundredth of par.  Asked -- the previous day’s mid-afternoon ask price the treasury dealers were willing to sell the issue for

Prentice-Hall, Inc.29 Reading Treasury Quotes (Cont’d)  Chg -- change from the prior day’s bid price  Ask yld -- is the effective rate of return on the investment  STRIPS -- refers to zero-coupon bonds  Days to mat -- listed for t-bills due to their short maturity lengths

Prentice-Hall, Inc.30 Bond Valuation Principles Value of a bond = Present value of + present value of repayment All interest payments of par at maturity  Bonds fluctuate in value, and the longer the time to maturity the greater the fluctuation.

Prentice-Hall, Inc.31 Valuation Principles (Cont’d)  Why would an investors required rate of return change? –Change in the risk associated with the firm issuing the bond. –Change in general interest rates in the market.

Prentice-Hall, Inc.32 Valuation Principles (Continued)  As the available rate of return increases, the value of a lower rated bond decreases and an investor would pay a discount.  As the available rate of return drops, the value of a higher rated bond increases and an investor would pay a premium.

Prentice-Hall, Inc.33 Valuation Principles (Cont’d)  Interest rates affect bond valuation by changing the demand, and price, for a bond.  Interest rates and bond values are inversely related in the secondary market. But the call price limits the upward price on a bond with a call provision.  As a bond approaches its maturity date, its market value approaches it par value.

Prentice-Hall, Inc.34 Bond Valuation Relationships and The Investor  If you expect interest rates to increase, buy short-term bonds.  If you expect interest rates to decrease, buy long-term non-callable bonds.

Prentice-Hall, Inc.35 The Pros of Investing in Bonds  If interest rates drop, bond prices will rise.  Bonds reduce risk through diversification.  Bonds produce steady current income.  Bonds can be a safe investment if held to maturity.

Prentice-Hall, Inc.36 The Cons of Investing in Bonds  If interest rates rise, bond prices will fall.  If the issuer experiences financial problems, the bondholder may lose.  If interest rates drop, rather than experiencing price appreciation, the bond may be called.

Prentice-Hall, Inc.37 The Cons of Investing in Bonds (Cont’d)  If you need to sell your bonds early, you may have a problem selling them at a reasonable price.  Finding a good investment outlet for the interest you receive may be difficult.

Prentice-Hall, Inc.38 Analyzing Bond Choices  Think about taxes.  Keep the inverse relationship between interest rates and bond price in mind.  Avoid losers, and don’t worry about picking winners.  Consider only high quality bonds.  Buy a bond when it is first issued, rather than in the secondary market.

Prentice-Hall, Inc.39 Analyzing Bond Choices (Cont’d)  Avoid bonds that might get called.  Match your bond’s maturity to your investment time horizon.  Stick to large issues.  When in doubt, go treasury!

Prentice-Hall, Inc.40 Preferred Stock -- An Alternative to Bonds  Hybrid security with characteristics of stocks and bonds.  Dividend payments can be skipped, without the company being bankrupt.  Dividends are a fixed amount – a fixed dollar amount or a percentage of the stock’s par value.

Prentice-Hall, Inc.41 Preferred Stock -- An Alternative to Bonds (Cont’d)  Dividends are paid before common stock dividends  Do not share in other profits with the common stockholders  No voting rights  No fixed maturity date  Rated like bonds, typically medium grade

Prentice-Hall, Inc.42 Features and Characteristics of Preferred Stock  Multiple issues – some companies have multiple issues of preferred stock, each with a different dividend  Cumulative feature – all past unpaid dividends must be paid before common stock dividends are paid  Adjustable rate – the dividend rate changes with the market interest rate rather than letting the value of the stock drop

Prentice-Hall, Inc.43 Features and Characteristics of Preferred Stock (Cont’d)  Convertibility – preferred stock can be exchanged for common stock at any time  Callability – issuer can repurchase the stock in case interest rates drop

Prentice-Hall, Inc.44 The Valuation of Preferred Stock  The value of preferred stock is the present value of the perpetuity of dividends  Value = annual dividend required rate of return

Prentice-Hall, Inc.45 Risks Associated With Preferred Stock  If interest rates rise, the value of the preferred stock drops.  If interest rates drop, the value rises, and the stock may be called.

Prentice-Hall, Inc.46 Risks of Preferred Stock Investing (Cont’d)  Investors don’t participate in the capital gains that common stockholders receive.  Preferred stock does not have the safety of a bond, because dividends can be passed without the risk of bankruptcy.

Prentice-Hall, Inc.47 Investing in Real Estate  Direct investments – Vacation homes – Commercial property (e.G., Apartment buildings, office buildings, etc.) – Undeveloped land  Indirect investments – Real estate syndicates – Real estate investment trusts (REIT)

Prentice-Hall, Inc.48 Real Estate: Pros and Cons  Income produced with an opportunity of capital appreciation  Few tax advantages  Direct investment is active – time, energy, and knowledge required  Illiquidity  Overbuilding can hurt prices

Prentice-Hall, Inc.49 Investing (Speculating) in Metals, Gems, Collectibles  Just don’t do it!  Speculation is not investing.  Collectibles are fine as entertainment, but not as savings vehicles.  Price depends on supply and demand.

Prentice-Hall, Inc.50 Summary  Reasons to invest in bonds  Determinants of a bond’s return – Annual interest payments – Return of the par value  Measures of bond returns – Current yield – Yield to maturity

Prentice-Hall, Inc.51 Summary (Cont’d)  Sources of bonds – Corporations – Treasury and other agencies – Municipalities  Bond ratings -- AAA to D  Bond valuation and the relationship with interest rates

Prentice-Hall, Inc.52 Summary (Cont’d)  Features of preferred stock  Real estate investments  Speculative “investments” -- precious metals, gems, and collectibles