Chapter 11 Investing Basics and Evaluating Bonds McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Investing Basics and Evaluating Bonds Chapter Objectives Explain why you should establish an investment program. Describe how safety, risk, income, growth, and liquidity affect your investment program. Identify the factors that reduce investment risk. Understand why investors purchase government bonds. Recognize why investors purchase corporate bonds. Evaluate bonds when making an investment. 11-2

Objective 1 Explain Why You Should Establish an Investment Program Establishing Investment Goals Financial goals should be: Specific Measurable Tailored to your financial needs Aimed at what you want to accomplish 11-3

Establishing Investment Goals What will you use the money for? How much money do you need to satisfy your investment goals? How will you obtain the money? How long will it take you to obtain the money? How much risk are you willing to assume in an investment program? What possible economic or personal conditions could alter your investment goals? 11-4

Establishing Investment Goals Considering your economic circumstances, are your investment goals reasonable? Are you willing to make the sacrifices necessary to ensure that you meet your investment goals? What will the consequences be if you don’t reach your investment goals? 11-5

Performing a Financial Checkup Work to balance your budget Do you regularly spend more than you make? Pay off high interest credit card debt first Obtain adequate insurance protection Start an emergency fund you can access quickly Three months of living expenses Have access to other sources of cash for emergencies Pre-approved line of credit Cash advance on your credit card 11-6

Surviving a Financial Crisis Establish a larger than usual emergency fund Know what you owe Identify debts that must be paid Reduce spending Pay off credit cards Apply for a line of credit at your bank, credit union, or financial institution Notify credit card companies and lenders if you are unable to make payments Monitor the value of your investment and retirement accounts 11-7

Getting the Money Needed to Start an Investing Program Pay yourself first Take advantage of employer- sponsored retirement programs Participate in elective savings programs Make a special savings effort one or two months each year Take advantage of gifts, inheritances, and windfalls 11-8

The Value of Long-Term Investing Programs Even small amounts invested regularly grow over a long period of time If you begin saving $2,000 each year. depending on the rate of return, you could have over $1 million by the time you are age 65 (See Exhibit 11-1) The higher the rate of return the greater the risk 11-9

Factors Affecting the Choice of Investments Objective 2 Describe How Safety, Risk, Income, Growth, and Liquidity Affect Your Investment Decisions Factors Affecting the Choice of Investments Safety and risk Risk = uncertainty about the outcome Investment Safety = minimal risk of loss Risk-Return Trade-Off The potential return on any investment should be directly related to the risk the investor assumes Speculative investments are high risk, made by those seeking a large profit in a short time 11-10

Components of the Risk Factor Inflation risk  during periods of high inflation your investment return may not keep pace with inflation Interest rate risk  the value of bonds or preferred stock may increase or decrease with changes in interest rates Business failure risk  affects stocks and corporate bonds Market risk  the risk of being in the market versus in a risk-free asset 11-11

Investment Income, Growth and Liquidity A predictable source of income (dividends or interest) Most conservative = passbook savings, CDs and government securities Other choices: Municipal and corporate bonds Preferred stock Utility stocks Selected common stocks Selected Mutual funds Rental real estate 11-12

Investment Income, Growth and Liquidity Investment Growth Growth in value (price appreciation) Common stock usually offers the greatest potential for growth Mutual funds and real estate offer growth potential Investment Liquidity 2 dimensions Ability to buy or sell an investment quickly Without substantially affecting the investment’s value 11-13

Traditional Investment Evaluation Factors 11-14

Objective 3 Identify the Factors that can Reduce Investment Risk Portfolio Management & Asset Allocation Asset allocation = The process of spreading your assets among several different types of investments = Diversification Stocks Bonds Risk-free assets Real-estate etc 11-15

Portfolio Management & Asset Allocation Other factors to consider: Your tolerance for risk At what point can you no longer sleep easily? Your investment horizon When will you need the money? How long can your money continue to grow? Your age Growth versus income Recovery time if investments nosedive 11-16

Portfolio Investing Brokerage firms may construct sample portfolios for client consideration: 11-17

Your Role in the Investment Process Evaluate potential Investments Monitor the value of your investments Keep accurate records Other factors Seek help from personal financial planner Consider the tax consequences of selling your investments 11-18

Objective 4 Understand Why Investors Purchase Government Bonds Government Bonds and Debt Securities Government bonds = written pledge to: Repay a specified sum of money (face value) At maturity Along with periodic interest (coupon payments) Sold to fund the national debt and the ongoing costs of government Three levels of government issues: Federal State Local municipalities 11-19

U.S. Treasury Bills, Notes and Bonds Treasury Bills (T-Bills) $100 minimum 4, 13, 26 and 52 weeks to maturity Sold at a discount Federal but no state tax on interest earned Treasury Notes $100 units Typical maturities = 2, 3, 5, 7, and 10 years Interest paid every six months Higher rate than T-bills 11-20

U.S. Treasury Bills, Notes and Bonds Treasury Bonds Issued in minimum units of $100 30 year maturity dates Interest rates higher than notes and bills Interest paid every six months Treasury Inflation-Protected Securities (TIPS) Sold in minimum units of $100 Sold with 5, 10 or 20 year maturities Principal changes with inflation Pays interest twice a year at a fixed rate 11-21

Federal Agency Debt Issues Essentially risk free Slightly higher interest rates than Treasury securities Minimum investment may be as high as $10,000 to $25,000 Maturities range from 1 – 30 years Average maturity = 12 years Issuing agencies sample: Fannie Mae Freddie Mac GNMA TVA 11-22

State and Local Government Securities Municipal Bonds (“munis”) Issued by a state or local government Cities Counties School districts Special taxing districts Funds used for ongoing costs and to build major projects such as schools, airports, and bridges 11-23

State and Local Government Securities Municipal Bonds (“munis”) General obligation bonds Backed by the full faith, credit and taxing authority of the issuing state or local government Revenue bonds Repaid from money generated by the project the funds finance, such as a toll bridge 11-24

State and Local Government Securities Municipal Bonds (“munis”) Key characteristic: Interest exempt from federal taxes Capital gains may NOT be tax exempt Usually exempt from state and local taxes in state where issued Exempt status determined by use of funds Insured municipal bonds Private insurance to reduce risk 11-25

Taxable Equivalent Yield Used to compare tax exempt and taxable bonds 11-26

Objective 5 Recognize Why Investors Purchase Corporate Bonds A corporation’s written pledge to repay a specified amount of money with interest An interest-only loan Considered safer than stocks A “fixed-income” security A form of debt financing 11-27

Corporate Bonds Face value: Coupon rate Dollar amount bondholder receives at bond’s maturity date Usually $1,000 Coupon rate Stated interest rate Interest payments made every six months Maturity date = date on which face value repaid 11-28

Corporate Bonds Bond Indenture Trustee Legal document describing conditions of the bond issue Trustee Financially independent firm that acts as the bondholder’s representative Usually a commercial bank or other financial institution 11-29

Why Corporations Sell Bonds To raise funds for major purchases To fund ongoing business activities When difficult or impossible to sell stock To improve financial leverage Interest paid to bondholders is tax deductible for the firm 11-30

Types of Corporate Bonds Debenture Unsecured Backed only by the reputation of the issuing company Mortgage bond Secured by various assets of the issuing firm, usually real estate Lower interest (coupon) rate since debt is secured 11-31

Types of Corporate Bonds Convertible bond Can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock Generally, the coupon rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds 11-32

Provisions For Repayment Call Feature of a Bond Corporation can “call in” or buy back outstanding bonds before the maturity date Most corporate bonds are callable Call protected for the first 5 to 10 years after issue A firm calls a bond issue if the coupon rate they are paying is much higher than the market rate 11-33

Provisions For Repayment Sinking fund Corporations deposit money annually Trustee uses the money to retire the bond issue prior to maturity Serial bonds Bonds of a single issue that mature on different dates Bond 11-34

Why Investors Purchase Corporate Bonds Interest income - “fixed income” Registered bond Coupon and principal paid to registered owner Registered coupon bond Registered for principal only Coupon must be presented to obtain payment Zero coupon bond Pays no interest Sold at a discount from face value 11-35

Why Investors Purchase Corporate Bonds Dollar appreciation of bond value Bond values change with market interest rates Bond value vs. Interest rates = inverse relationship If Market rate< Coupon rate Price > Face value Bond values change with the financial condition of the issuing company or government unit Bond repayment at maturity Face value repaid on maturity date Bondholders may keep till maturity or sell 11-36

Objective 6 Evaluate Bonds When Making an Investment Sources of information – The Internet The issuing firm’s website www.bondsonline.com www.bondsearch123.com http://bonds.yahoo.com Price information (quotes) Trade bonds online Research on the issuing corporation Financial coverage of bond transactions Wall Street Journal, Barrons, Internet 11-37

Corporate Bond Quotes The first bond in the list: Matures in 2036 Current price = 93.51% of par (discount) = $935.10 Pays an annual coupon rate of 5.875% = $58.75 Yield-to-Maturity = 6.365% Current yield = 6.283% = 5.875/93.51 Or see Exhibit 11-6 11-38 38

Bond Ratings Measure Default Risk 11-39

Bond Yield Calculations Yield = rate of return earned by an investor who holds the bond to maturity Current Yield = Annual interest amount Current Price Other Sources of Information Business Periodicals Federal Agencies www.federalreserve.gov www.treasury.gov www.commerce.gov www.sec.gov 11-40

END OF CHAPTER 11 11-41

Additional Video Financial Advice for the Meltdown What Advisors Are Doing Differently (Instructors see the notes section for directions.) SYNOPIS: Information about how financial planners can help investors reduce risk in their investment portfolio is presented in this video. Measurement tools and questions to ask when choosing a financial planner are also presented. 1. Assume the stocks, mutual funds, and other investments you own are declining in value because of a depressed economy. Based on the information in this video, your age, and your tolerance for risk, would you sell your investments, hold your investments, or buy more of the same investments? 2. How can you tell if the advice you are getting from a financial planner is helping you achieve your investment goals? 3. What suggestions were made in this video to help someone choose a financial advisor? This video is NOT available on the DVD. The authors have added the link, synopsis and follow up questions as an additional option for your course. The link to this Business Week video is: http://feedroom.businessweek.com/index.jsp?auto_band=x&rf=sv&fr_story=5f18df92b0e98c90aa134e7b49797b3dc7a8f5d9. If you are viewing this PPT presentation in the slide show format and are connected to the Internet, you can simply click on the link “Financial Advice for the Meltdown: What Advisors are Doing Differently” and you will be connected to the site. 11-42