19 Investing in Bonds Introduction to Finance Chapter Lawrence J. Gitman Jeff Madura Introduction to Finance Investing in Bonds

Learning Goals List the different types of bonds. Explain how investors use bond quotations. Describe how yields and returns are measured for bonds. Describe the risks of investing in bonds. Identify the factors that affect bond prices over time. Describe the strategies commonly used for investing in bonds.

Forms of Debt Bearer Bonds Bearer bonds are often referred to as coupon bonds because they are not registered to any particular person. The coupons are submitted twice a year and the authorized bank pays the interest. For instance, a twenty year $1,000 bond paying 8% interest would have 40 coupons for $40 each. Bearer bonds can be used like cash. They are highly negotiable. There are still many in circulation. However, the Tax Reform Act of 1982 ended the issuance of bearer bonds.

Forms of Debt Registered Bonds Today, bonds are sold in a fully registered form. They come with your name already on them. Twice a year, you receive a check for the interest. At maturity, the registered owner receives a check for the principal. A partially registered bond is a cross between a registered bond and a coupon bond. The bond comes registered to you; however, it has coupons attached which you send in for payment.

Treasury Bonds Treasury bonds are issued by the federal government and are perceived to be free from default risk. Some Treasury bonds are stripped, splitting the bonds into a coupon security and a principal security. An inflation indexed Treasury bond is a bond whose coupon rate is lower than that of traditional bonds but whose principal value changes semiannually in response to changes in the inflation rate.

Municipal Bonds Municipal bonds are issued by state and local government agencies. Municipal bonds are particularly attractive because the income earned on “munis” is exempt from federal taxes. Municipal bonds with lower quality ratings generally have higher expected returns.

Federal Agency Bonds Federal agency bonds are bonds issued by federal agencies. Agency bonds are unlike Treasury bonds in that they are not guaranteed by the United States Treasury. Examples of agency issues include Ginnie Mae bonds, Freddie Mac bonds, and Fannie Mae bonds.

Corporate Bonds Corporate bonds are debt securities issued by large firms. Investors lend money to the corporation in exchange for a specified promised amount of (coupon) interest income. Most bonds are issued with face values of $1,000 and maturities of 10 to 30 years. At the end of the bond term, investors receive the face value of the bond.

Corporate Bonds Investors who are willing to tolerate more risk have the opportunity to purchase bonds with much higher expected returns. In particular, they may consider junk bonds, which are corporate bonds that are below investment grade and are perceived to have a high degree of default risk but that pay higher returns than better-quality corporate debt.

International Bonds International bonds are bonds issued by international governments or corporations. International bonds are commonly denominated in a foreign currency so that the coupon and principal payments must be converted into dollars which can lead to unanticipated gains or losses. International bonds are exposed to many of the same risks that are present in domestic bonds, but have an additional exchange rate risk component.

Bond Quotations Figure 19.1

Bond Quotations Figure 19.2

Bond Quotations Figure 19.3

Bond Quotations Figure 19.4

Bond Quotations Figure 19.5

Bond Quotations Figure 19.6

Bond Yields and Returns A bond’s yield to maturity is the annual rate of interest that is paid by the issuer to the bondholder over the life of the bond. A bond’s holding period return is the return from investment in a bond that is held for a period of time less than the life of the bond. Holding period returns for periods other than one year can be annualized for comparison.

Bond Yields and Returns

Bond Yields and Returns Six months ago Pat Bacavis purchased a bond with a par value of $1,000,000 and a 7% coupon rate. She received $35,000 in coupon payments over the last six months. She paid $990,000 for the bonds and just sold them for $970,000. The holding period can be calculated as follows:

Bond Yields and Returns The expected holding period return [E(HPR)] is the projected value for the return on a bond over a particular holding period.

Bond Yields and Returns Lenz Insurance Company considers purchasing corporate bonds that have a par value of $1,000,000 and a coupon interest rate of 8%. The prevailing price of the bonds is $980,000. Lenz expects to sell the bonds in the secondary market one year from now for $995,000. The E(HPR) can be calculated as follows:

Bond Yields and Returns The holding period returns on international bonds must account for the exchange rate fluctuations over the holding period. Stetson Bank of the United States considers investing in Canadian Treasury bonds because the yield to maturity offered on those bonds exceeds that of U.S. Treasury bonds. The prevailing price of the bonds is C$100,000, the coupon rate is 9%, and the interest of $9,000 (.09 x $100,000) is to be paid at year end. Stetson plans to hold the bonds for 1 year and sell them for C$100,000. The Canadian dollar is presently worth $.60, but Stetson expects it to appreciate to $.66 by year end. Based on this information, calculate the E(HPR).

Bond Yields and Returns

Bond Yields and Returns Stetson is subject to the risk that the exchange rate of the Canadian dollar will weaken over the holding period. For example, assume that Stetson recognizes that under specific economic conditions, the Canadian dollar would depreciate over the year and would be valued at $.56 by the end of the year. The E(HPR) is:

Bond Risk Table 19.1

Bond Risk How maturity affects bond price sensitivity How the coupon interest rate affects bond price sensitivity

Factors that Affect Bond Prices Over Time Factors that Affect the Risk-Free Rate The Fed’s monetary policy Impact of inflation Impact of economic growth Factors that Affect the Default Risk Premium: Change in economic conditions Change in a firm’s financial conditions Bond Market Indicators Indicators of inflation Indicators of economic growth Indicators of a firm’s financial condition

Bond Investment Strategies A passive strategy is a strategy in which investors establish a diversified portfolio of bonds and maintain the portfolio for a long period of time. A matching strategy is a strategy in which investors estimate future cash outflows and choose bonds whose coupon or principal payments will cover the projected cash outflows. A laddered strategy is a strategy in which investors evenly allocate funds invested in bonds in each of several different maturity classes to minimize interest rate sensitivity.

Bond Investment Strategies A barbell strategy is a strategy in which investors allocate funds into bonds with short-term and long-term, but few or no intermediate-term maturities. An interest rate strategy is a strategy in which investors allocate funds to capitalize on interest rate forecasts and revise their portfolio in response to changes in interest rate expectations.

19 End of Chapter Introduction to Finance Chapter Lawrence J. Gitman Jeff Madura Introduction to Finance End of Chapter