Chapter 16 Investing in Bonds

Copyright ©2014 Pearson Education, Inc. All rights reserved.16-2 Chapter Objectives Identify the different types of bonds Explain what affects the return (yield) from investing in a bond Describe how bonds are valued Describe why some bonds are risky Identify common bond investment strategies

Copyright ©2014 Pearson Education, Inc. All rights reserved.16-3 Background on Bonds Bonds: long-term debt securities issued by government agencies or corporations Par value: for a bond, its face value, or the amount returned to the investor at the maturity date when a bond is due Most bonds have maturities between 10–30 years

Copyright ©2014 Pearson Education, Inc. All rights reserved.16-4 Background on Bonds (cont’d) Issuers required to make interest payments and repay par value Bond Characteristics –Call feature: a feature on a bond that allows the issuer to repurchase the bond from the investor before maturity These bonds offer a slightly higher return

Copyright ©2014 Pearson Education, Inc. All rights reserved.16-5 Background on Bonds (cont’d) –Convertible bond: a bond that can be converted into a stated number of shares of the issuer’s stock if the stock price reaches a specified price These bonds tend to offer a slightly lower return

Copyright ©2014 Pearson Education, Inc. All rights reserved.16-6 Background on Bonds (cont’d) A bond’s yield to maturity: the annualized return on a bond if it is held to maturity –If a bond sells at par value, its yield to maturity equals the coupon rate –If a bond sells below par value, its yield to maturity would exceed the coupon rate –If a bond sells above par value, its yield to maturity would be less than the coupon rate

Copyright ©2014 Pearson Education, Inc. All rights reserved.16-7 Financial Planning Online Go to /bondcalc.shtml This web site provides an estimate of the yield to maturity of your bond based on its present price, its coupon rate, and its maturity.

Copyright ©2014 Pearson Education, Inc. All rights reserved.16-8 Background on Bonds (cont’d) Bond trading in the secondary market –Investors sell their bonds to other investors before they reach maturity –Bond prices change in response to interest rates –Brokerage firms also take orders to buy or sell bonds

Copyright ©2014 Pearson Education, Inc. All rights reserved.16-9 Types of Bonds Treasury bonds: long-term debt securities issued by the U.S. Treasury –Payments guaranteed by federal government –Interest is subject to federal income tax, but exempt from state and local taxes –Can easily be sold in the secondary market

Copyright ©2014 Pearson Education, Inc. All rights reserved Types of Bonds (cont’d) Municipal bonds: long-term debt securities issued by state and local government agencies –Low risk –Interest exempt from federal income tax Federal agency bonds: long-term debt securities issued by federal agencies –Low default risk –Interest is taxable

Copyright ©2014 Pearson Education, Inc. All rights reserved Financial Planning Online Go to This Web site provides quotations of yields offered by municipal bonds with various terms to maturity. Review this information when considering purchasing municipal bonds.

Copyright ©2014 Pearson Education, Inc. All rights reserved Types of Bonds (cont’d) Corporate bonds: long-term debt securities issued by large firms –Subject to default risk –High-yield (junk) bonds: bonds issued by smaller, less stable corporations that are subject to a higher degree of default risk

Copyright ©2014 Pearson Education, Inc. All rights reserved Types of Bonds (cont’d) Corporate bond quotations –Coupon rate –Maturity –Current yield –Volume –Closing price –Net change in the price from the previous day

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Copyright ©2014 Pearson Education, Inc. All rights reserved Return from Investing in Bonds Impact of interest rate movements on bond returns –If interest rates rise, the value of your bond decreases –If interest rates fall, the value of your bond increases

Copyright ©2014 Pearson Education, Inc. All rights reserved Return from Investing in Bonds (cont’d) Tax implications of investing in bonds –Interest is taxed as ordinary income (unless tax exempt) –Selling bonds at a price higher than you paid also results in a capital gain

Copyright ©2014 Pearson Education, Inc. All rights reserved Return from Investing in Bonds (cont’d)

Copyright ©2014 Pearson Education, Inc. All rights reserved Valuing a Bond Uses time value of money –Present value of the future coupon payments –Present value of the principal payment Economic impact on bond values –Higher rate of return is only realized if firms are healthy enough to make payments –This may not be true in unfavorable economic conditions

Copyright ©2014 Pearson Education, Inc. All rights reserved Financial Planning Online Go to html html This Web site provides a summary of recent financial news related to the bond market, which you may consider before selling or buying bonds.

Copyright ©2014 Pearson Education, Inc. All rights reserved Risk from Investing in Bonds Default risk: risk that the borrower of funds will not repay the creditors –Risk premium: the extra yield required by investors to compensate for the risk of default –Use of risk ratings to measure the default risk Ratings reflect likelihood that issuers will repay their debt over time

Copyright ©2014 Pearson Education, Inc. All rights reserved Risk from Investing in Bonds (cont’d) –Impact of the financial crisis on default risk Many firms experienced financial problems and were unable to make bond payments –Relationship of risk rating to risk premium The lower the risk rating, the higher the risk premium offered on a bond –Impact of economic conditions Higher risk of default when economic conditions are weak

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Copyright ©2014 Pearson Education, Inc. All rights reserved Risk from Investing in Bonds (cont’d) Call (prepayment) risk: the risk that a callable bond will be redeemed by the issuer Interest rate risk: the risk that a bond’s price will decline in response to an increase in interest rates –Impact of a bond’s maturity on its interest rate risk Bonds with longer terms more sensitive to interest rate movements

Copyright ©2014 Pearson Education, Inc. All rights reserved Risk from Investing in Bonds (cont’d) –Selecting an appropriate bond maturity Choose maturities that reflect your expectations of future interest rates Consider investing in bonds that have a maturity that matches the time you will need the funds

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Investment Strategies Interest rate strategy: selecting bonds for investment based on interest rate expectations –Purchase long-term bonds if you expect interest rates to fall Passive strategy: investing in a diversified portfolio of bonds that are held for a long period of time

Copyright ©2014 Pearson Education, Inc. All rights reserved Bond Investment Strategies (cont’d) Maturity matching strategy: investing in bonds that will generate payments to match future expenses –For example, parents might invest in a bond that will mature at the right time to pay for their child’s college education

Copyright ©2014 Pearson Education, Inc. All rights reserved How Bond Decisions Fit within Your Financial Plan Key decisions about bonds for your financial plan are: –Should you consider buying bonds? –What strategy should you use for investing in bonds?

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