Personal Finance Chapter 13 Investing in Bonds Personal Finance Chapter 13

13.1 Characteristics of Bonds Corporate Bonds A call provision allows the bond issuer the right to pay off (call back) before its maturity date. A debenture is a corporate bond that is not backed by collateral by only the general credit standing of the corporation. A mortgage bond is a corporate bond backed by specific assets as collateral to assure repayment of the debt. A convertible bond is a corporate bond that the bondholder can choose to exchange for a specified number of share’s of a corporation’s common stock.

13.1 Characteristics of Bonds Government Bonds Municipal bonds are issued by state or local governments. Revenue bonds are municipal bonds issued to raise money for a public-works project. General obligation bonds are municipal bonds backed by the power of the issuing state or local government to levy taxes to pay back debt.

13.1 Characteristics of Bonds Zero-Coupon Bonds A bond that is sold at a deep discount, 50 to 75 percent below face value Makes no interest payments The principal must be paid at its maturity date

Check Your Understanding P. 312 What is a callable bond? A bond that the issuer has the right to pay off before its maturity date. Does this feature make the bond more attractive? It generally pays the bondholders a slight premium – an amount above the face value of the bond.

Check Your Understanding P. 312 2) Under what conditions would bonds sell at a premium? When bonds are issued for more than their face value, they are selling at a premium. People would be willing to pay more for the bond because it pays an interest rate higher than the current market rate.

Check Your Understanding P. 312 3) What is a major advantage to government and municipal bonds? Interest paid by the bonds is exempt from federal taxes and from state and local taxes in the state where they are issued.

13.2 Buying and Selling Bonds How to Buy and Sell Bonds Most bonds require a minimum investment of $1,000.

13.2 Buying and Selling Bonds Evaluating Bonds A junk bond is a bond that has a low rating, or no rating at all.

13.2 Buying and Selling Bonds Reading Bond Listings Column 1 – name of the bond Column 2 – the type of bond and the bond rating Column 3 – coupon rate (fixed rate of return) Column 4 – maturity date Column 5 – final closing bid for the day Column 6 – net change in price Column 7 – the current yield

13.2 Buying and Selling Bonds Tax Strategies Tax-exempt – when there is no tax due, either now or in the future Tax-deferred – when income will be taxed at a later time Tax shifting – when income taxes will be postponed to the following year Tax avoidance – legally reducing taxes by careful planning Tax evasion – the illegal use of actions to reduce taxes

Check Your Understanding P. 316 How can you purchase a bond? A savings bond can be purchased through payroll deduction or through a bank in your area.

Check Your Understanding P. 316 2) How are bonds rated? The highest bond rating is AAA. The lowest rating is a D. Independent rating services base their ratings on the financial condition of the issuing corporation or municipality.

Check Your Understanding P. 316 3) What factors affect bond prices? A bond that the issuer has the right to pay off before its maturity date.

Review Facts and Ideas P. 320 In what two main ways are bonds different from stocks? Bonds are debt instruments to corporations. Semiannual interest payments are made, and at maturity, the face value of the debt is repaid. Owners of stocks receive dividends that are declared by the board of directors and are based on a company’s profits.

Review Facts and Ideas P. 320 2) How does a bondholder make money from investing in bonds? Bondholders receive semiannual interest payments for the term of the bond. In addition, the bond was purchased at a discount. When the bond is repaid at face value, there is also a profit, or capital gain.

Review Facts and Ideas P. 320 3) Why would a corporation issue callable bonds? Callable bonds protect the corporation in the event interest rates drop. Then new bonds can be issued at the lower rates, or money can be borrowed from other sources at lower interest rates.

Review Facts and Ideas P. 320 4) How are debentures different from mortgage bonds? Debentures are issued against a corporation’s general ability to repay the debt, while mortgage bonds are secured. In other words, some specific property is pledged as collateral for repayment.

Review Facts and Ideas P. 320 5) How do state or local governments pay off the principal and interest of municipal bonds issued? State and local governments are able to pay principal and interest because they have taxing authority – the ability to collect income, property, and other taxes from citizens that can be used to repay debt.

Review Facts and Ideas P. 320 6) Why do municipal bonds pay lower interest rates than corporate bonds? Municipal bonds pay lower interest rates because of their tax-exempt status.

Review Facts and Ideas P. 320 7) How do investors make money on zero-coupon bonds? The bondholder makes money by selling the bonds before maturity at a price higher than they paid for them. They can also hold the bonds to maturity and receive the face value.

Review Facts and Ideas P. 320 8) What is “Treasury Direct”? Treasury Direct is a service of the Federal Reserve Banks that allows Treasury securities to be purchased directly from the Fed rather than through a bank or a broker.

Review Facts and Ideas P. 320 9) Why should you be concerned about a bond’s rating before you buy it? Rating tell the investor about the potential risk and safety of the bond investment. You should check the rating to determine the quality and risk associated with bond issues.

Review Facts and Ideas P. 320 10) Why would anyone buy junk bonds? Junk bonds are highly speculative and therefore pay a high yield. The risk associated with junk bonds is the chance of default and the ability of a corporation to make interest payments to bondholders.

Review Facts and Ideas P. 320 11) How do interest rates affect the price (value) of bonds? As interest rates increase, the market value of bonds declines. As interest rates decrease, the market value of bonds rises.