1. Chapter 11 Investing Basics and Evaluating Bonds McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Investing Basics and Evaluating Bonds Chapter Learning Objectives
LO11.1 Explain why you should establish an investment program.
LO11.2 Describe how safety, risk, income, growth, and liquidity affect your investment program.
LO11.3 Identify the factors that reduce investment risk.
LO11.4 Understand why investors purchase government bonds.
LO11.5 Recognize why investors purchase corporate bonds.
LO11.6 Evaluate bonds when making an investment.

3. Establishing Investment Goals
Learning Objective LO11.1 Explain Why You Should Establish an Investment Program
Establishing Investment Goals
Financial goals should be:
Specific
Written Down
Measurable
Tailored to your financial needs
Aimed at what you want to accomplish

4. Establishing Investment Goals
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?

5. Establishing Investment Goals
5. What possible economic or personal conditions could alter your investment goals?
6. Considering your current and anticipated economic circumstances, are your investment goals easonable?
7. Are you willing to make the sacrifices necessary to ensure that you meet your investment goals?

6. Performing a Financial Checkup
Pay your bills on time
Work to balance your budget
Manage your credit card debt
Pay in full each month
Do not use credit for small purchases
Do not use the cash advance option
Think about the number of cards you need
Get help if you are in trouble

7. Performing a Financial Checkup
Start an emergency fund you can access quickly
At least 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
Home equity

8. Managing an Economic Crisis
Establish a larger than usual emergency fund
Know what you owe
Identify debts that must be paid
Reduce spending
Notify credit card companies and lenders if you are unable to make payments
Monitor the value of your investment and retirement accounts.
Consider converting investments to cash to preserve value.

9. Getting the Money Needed to Start an Investing Program

10. How the Time Value of Money Affects Your Investments
Even small amounts invested regularly grow over a long period of time. The value of one cup of coffee per day invested over 40 years grows to $390,000.
Use the Time Value of Money calculation methods in the Chapter 1 Appendix to calculate future values.
The higher the rate of return the greater the risk

11. Learning Objective LO11.2 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

12. 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

13. Investment Income Investment Income
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

14. Investment Income, Growth and Liquidity
Investment Growth
Growth in value (price appreciation)
Common stock usually offers the greatest potential for growth
Mutual funds, ETFs 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

15. Learning Objective LO11.3 Factors that Reduce Investment Risk
Asset Allocation and Diversification
Asset allocation
= The process of spreading your assets among several different types of investments
= Diversification
Stocks
Bonds
Risk-free assets
Real-estate

16. Traditional Investment Evaluation Factors

17. Asset Allocation and Diversification
Other factors to consider:
Your age
Growth versus income
Recovery time if investments nosedive
Your investment objectives
How much can you save and invest each year?
The dollar value of your current investments
The economic outlook for the economy
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?

18. Portfolio Investing
Brokerage firms frequently construct sample portfolios for client consideration. A suggested asset allocation for a young investor is shown below.

19. Investment Pyramid

20. 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

21. Learning Objective LO11.4 Conservative Investment Options: Government Bonds
Government bonds = written pledge to:
Repay a specified sum of money (face value)
At maturity
Along with periodic interest payments
Sold to fund the national debt and the ongoing costs of government at all levels
Three levels of government issues:
Federal
State
Local municipalities

22. 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

23. 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 30 year maturities
Principal changes with inflation
Pays interest twice a year at a fixed rate

24. Treasury Securities

25. 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

26. 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

27. State and Local Government Securities
Municipal Bonds (“munis”)
Key characteristic:
Interest may be 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

28. Taxable Equivalent Yield
Used to compare tax exempt and taxable bonds

29. Learning Objective LO11.5 Conservative Investment Options: 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

30. 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

31. 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

32. 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

33. Types of Corporate Bonds
Debenture
Unsecured, > 10 yr maturity
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

34. 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

35. 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
Usually call protected for the first 5 to 10 years after issue
A firm may call a bond issue if the coupon rate they are paying is much higher than the market rate

36. 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

37. Why Investors Purchase Corporate Bonds
Interest income - “fixed income”
Registered bond
Interest and principal paid to registered owner
Registered coupon bond
Registered for principal only
Coupon must be presented to obtain payment

38. Why Investors Purchase Corporate Bonds
Dollar appreciation of bond value
Bond values change with market interest rates in the economy
Bond value vs. Interest rates = inverse relationship
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

39. Learning Objective LO11.6 Evaluate Bonds When Making an Investment
Sources of information – The Internet
The issuing firm’s website
Price information (quotes)
Trade bonds online
Research on the issuing corporation
Financial coverage of bond transactions
Wall Street Journal, Barrons, Internet

40. 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 = % = 58.75/935.10
Or see Exhibit 11-6 40

41. Bond Ratings Measure Default Risk

42. 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

43. Chapter Summary Learning Objective LO11.1
Investment goals must be specific and measurable.
Make sure your personal financial affairs are in order.
Accumulate an emergency fund equal to at least three months’ living expenses.
Increase the amount in your emergency fund if you think you may lose your job or the nation is experiencing an economic crisis.
Then, it is time to save the money needed to establish an investment program.
Use the time value of money concept to help you achieve your goals—especially if you start sooner rather than later.

44. Chapter Summary Learning Objective LO11.2
All investors must consider the factors of safety, risk, income, growth, and liquidity.
Especially important is the relationship between safety and risk.
Basically, this relationship can be summarized as follows:
The potential return for any investment should be directly related to the risk the investor assumes.
In addition to safety and risk, investors choose investments that provide income, growth, or liquidity.

45. Chapter Summary Learning Objective LO11.3
Before making the decision to invest, you should consider:
Asset allocation = the process of spreading your assets among several different types of investments to lessen risk.
The amount of time before you need your money.
Your age is a factor that influences investment choices.
Younger investors tend to invest a large percentage of their nest egg in growth-oriented investments.
Older investors tend to be more conservative.

46. Chapter Summary Learning Objective LO11.3
Improve your investment returns by:
Evaluating all potential investments
Monitoring the value of your investments
Keeping accurate and current records
Professional help and your tax situation may also affect your investment decisions.

47. Chapter Summary Learning Objective LO11.4
Conservative investments include:
Savings accounts
Certificates of deposit
Money market accounts
Savings bonds
Government securities.
Generally, most investors consider U.S. government securities to be a safe harbor in troubled economic times.
Municipal bonds are conservative investments and may provide tax-exempt income.

48. Chapter Summary Learning Objective LO11.5
Bonds are issued by corporations to raise capital. Investors purchase corporate bonds for three reasons:
(1) interest income
(2) possible increase in value
(3) repayment at maturity
Bonds also can be an excellent way to diversify a portfolio.

49. Chapter Summary Learning Objective LO11.5
The method used to pay bondholders interest depends on whether they own registered bonds or registered coupon bonds.
Most corporate bonds are bought and sold through full-service brokerage firms, discount brokerage firms, or the Internet.
Investors pay commissions when bonds are bought and sold.

50. Chapter Summary Learning Objective LO11.6
The internet can be used to obtain information and trade bonds online.
Study the ratings provided by Standard & Poor’s, Moody’s, and Fitch Ratings to determine the quality of a bond issue.
Calculate a bond’s current yield to evaluate a decision to buy or sell a bond issue.
Business periodicals and government sources provide valuable information.