Chapter 15 Investing in Bonds

Chapter 15 Learning Objectives Describe the characteristics of corporate bonds Discuss why corporations issue bonds Explain why investors purchase corporate bonds Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds Evaluate bonds when making an investment

Characteristics of Corporate Bonds Objective 1: Describe the characteristics of corporate bonds Corporation’s written pledge to repay a specified amount of money with interest The face value is the dollar amount that the bondholder will receive at the bond’s maturity date-usually $1,000 Bondholders receive interest payments every six months at the stated interest rate

Characteristics of Corporate Bonds Par value = $1,000 Coupon = 6.5% of par value per year, or $65 per year ($32.50 every six months). Maturity = 27 years (matures in 2036) Issued by AT&T.

Characteristics of Corporate Bonds The legal conditions are described in a bond indenture A trustee is a financially independent firm that acts as the bondholder’s representative

Characteristics of Corporate Bonds Risks of bonds Interest risk Purchasing power risk Business risk Liquidity risk Call risk

Characteristics of Corporate Bonds Four important features: Interest rate increases, bond value decreases Market value of bond will be less than the par value if investor’s required rate is above the coupon interest rate

Characteristics of Corporate Bonds Four important features: As maturity date approaches, the market value of bond approaches its par value Long-term bonds have greater interest rate risk than do short-term bonds

Why Corporations Sell Bonds Objective 2: Discuss why corporations issue bonds To get funds for major purchases To fund ongoing business activities When it is difficult or impossible to sell stock To improve financial leverage Interest paid to bondholders is a tax deductible business expense that can be used to reduce the federal and state taxes corporations must pay

Why Corporations Sell Bonds (continued) TYPES OF BONDS Debenture bond Most corporate bonds are debenture bonds Unsecured - backed only by the reputation of the issuing company Mortgage bond A corporate bond that is secured by various assets of the issuing firm, usually real estate Interest rate is lower because it is secured by the collateral and corporate assets

Why Corporations Sell Bonds (continued) Subordinated debenture bond An unsecured bond that gives bondholders a claim secondary to that of other designated bond holders with respect to interest payments and claim on assets Convertible bond A special kind of corporate bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock

Why Corporations Sell Bonds (continued) PROVISIONS OF REPAYMENT Call Feature Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date Most agree not to call bonds for the first 5 to 10 years after they are issued Bonds called, if their interest rate is much higher than the going rate Most corporate bonds are callable

Why Corporations Sell Bonds (continued) Sinking fund Corporations deposit money in this fund annually or semiannually and use the money to pay off the bondholders when the bond issue comes due Serial bonds Bonds of a single issue that mature on different dates

Why Investors Buy Corporate Bonds Objective 3: Explain why investors purchase corporate bonds Interest Income Investors receive interest every six months Interest will be paid to investors twice a year, with the payment based on the interest rate and the face value of the bond Registered bonds, Bearer bonds, Zero-coupon bonds Dollar Appreciation of Bond Value May be able to sell the bond to someone else at a higher price if the interest rate on the bond is higher than the market rate Bond face amount will be repaid at maturity

Why Investors Buy Corporate Bonds (continued) THE MECHANICS OF BOND TRANSACTION Bonds can be held until maturity or sold in the secondary market Most bonds sold through full-service brokerage firms, discount brokerage firms, or the Internet Corporate bonds may be purchased in the primary market or secondary market Generally a minimum commission of $10-$35 on a $1,000 bond Interest and capital gains from selling bonds are both taxable

Government Bonds and Debt Securities Objective 4: Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds Sold to obtain money to finance the national debt, and the ongoing costs of government Three levels of government issue bonds: Federal-no state income tax on the interest State Local municipalities

Government Bonds and Debt Securities TREASURY BILLS, NOTES, AND BONDS Treasury Bills (T-Bills) $100 minimum 4, 13, 26, or 52 weeks to mature Sold at a discount Treasury Notes (T-Notes) $100 units 2, 5, and 10 year terms Interest paid every six months

Government Bonds and Debt Securities (continued) Treasury Bonds Issued in minimum units of $100 Have maturities of 30 years Interest rates are generally higher than those of T-bills and T-Notes Interest is paid every 6 months Held until maturity or sold before maturity

Government Bonds and Debt Securities (continued) FEDERAL AGENCY DEBT ISSUES Fannie Mae ( www.fanniemae.com) Federal National Mortgage Association Ginnie Mae - pay interest once a month Government National Mortgage Association Freddie Mac Federal Home Loan Mortgage Corporation Slightly higher risk than Treasury securities, so slightly higher interest rates Issued for 1-30 years, 12 year average Minimum denominations may be as high as $10,000-$25,000

Government Bonds and Debt Securities (continued) STATE AND LOCAL GOVERNMENT SECURITIES General obligation bonds are backed by the state or local government that issues them Revenue bonds are repaid from money generated by the project the funds finance, such as a toll bridge Municipal bonds or munis Issued by a state or local government, such as cities, counties, school districts Use funds for ongoing costs & to build major projects such as schools, airports, and bridges

Government Bonds and Debt Securities (continued) Features of Municipal Bond People like to invest in projects close to home They like insured municipal bonds, or states that guarantee payment May be callable, but usually not until after the first ten years Interest earned may be exempt from federal income tax so yield is higher

Government Bonds and Debt Securities (continued) Taxable equivalent yield= Tax-exempt yield 1.0 - Your tax rate Example: Taxable equivalent yield = .06 1.0 - 0.28 = 0.083 = 8.3%

The Decision to Buy or Sell Bonds Objective 5: Evaluate bonds when making an Investment THE INTERNET The Internet can be used in the following ways to evaluate a bond Obtain the price information Trade bonds online for a lower commission Research information on the corporation and bond issues online Some relevant Websites are: www.bondsonline.com www.emuni.com www.buysellbonds.com www.fmsbonds.com www.municipalbonds.com www.investiginbonds.com

The Decision to Buy or Sell Bonds (continued) ANNUAL REPORTS Write or telephone the corporation to receive the annual report Corporations maintain web site that provides access to annual reports Some financial publications provide a reader’s service to request an annual report

The Decision to Buy or Sell Bonds (continued) BOND RATINGS Bond ratings provide quality and risk associated with bond issues Moody’s Investor Service Inc. and Standard & Poor’s Corporation Bond ratings generally range from AAA to D

The Decision to Buy or Sell Bonds (continued) BOND YIELD CALCULATIONS Yield is the rate of return earned by an investor who holds a bond for a stated period Current yield on corporate bond = Annual income amount Current market value

The Decision to Buy or Sell Bonds (continued) Yield to maturity -- The rate of return investors earn on a bond if they hold it to maturity. Suppose we paid $898.90 for a $1,000 par 10% coupon bond with 8 years to maturity and semi-annual coupon payments. What is our yield to maturity? N = 16, PV = -898.9 PMT = 50 FV = 1000 Solve I% = 6% 6% * 2 = 12%

Online Activity Go to one of these sites and look up information about municipal bonds in your area. www.emuni.com www.munidipalbonds.com …What do you think of the rates these bonds are paying?