1. McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER PLAYLIST SONG: “If You Got the Money, I Have the Time” by Willie Nelson Bonds

2. 14-2 Learning Objectives LO 14-1 Define the basics of bonds. LO 14-2 Contrast the different types of bonds. LO 14-3 Explain how bonds are valued. LO 14-4 Evaluate bond risks and returns. LO 14-5 Plan where and how to buy bonds.

3. 14-3 Bond Basics A bond is a debt instrument issued by the government or a company for the purpose of raising money to fund construction, take on new projects, or grow the business A bond is a promise to repay the principal along with interest (coupons) by a specified date (maturity)

4. 14-4 Excerpt of Reuters Report on Boeing

5. 14-5 Old Fashioned Bonds

6. 14-6 How Bonds Work Bond with a face value of $10,000, purchased for $10,000 at 5% interest with a maturity of 10 years Interest payments every six months of $250.00 Bondholder receives $10,000 (face value) at maturity Bonds can be bought and sold on secondary markets Inverse relationship with interest rates

7. 14-7 How Bonds Work – Premium Example When interest rates go up, bond prices fall When interest rates go down, bond prices increase

8. 14-8 How Bonds Work – Discount Example Closer to maturity date, the more likely it is to be close to its original (par) value because there is less time until maturity and less time for the bond to accrue interest Call feature on a bond allows the issuer to buy back the bond from you before the maturity date

9. 14-9 Doing the Math

10. 14-10 Types of Bonds Federal Government Bonds www.treasurydirect.govwww.treasurydirect.gov  United States Savings Bonds  Bonds, Treasury Bills, Notes, and TIPS Municipal Bonds Corporate Bonds  Convertible Bonds  High-Yield (Junk) Bonds

11. 14-11 U.S. Savings Bonds Introduced in 1935 by President Franklin D. Roosevelt Known as “War Bonds”; allowed the average citizen to help finance WWII  Series EE Bonds, purchased through www.treasurydirect.gov, local financial institutions or through payroll deductionwww.treasurydirect.gov  Paper EE Savings Bonds  Sold at half their face value  Purchase in denominations of $50, $75, $100, $200, $500, $1000, $5000, and $10,000.  $5,000 maximum purchase in one calendar year.  Issued as paper bond certificates.  Electronic Issued EE Savings Bonds  Sold at face value  Purchase in amounts of $25 or more, to the penny.  $5,000 maximum purchase in one calendar year.  Issued electronically to your designated account.

12. 14-12 Treasury Bonds, Bills, Notes, and Tips Treasury Bonds  30-year maturity  Fixed rate  Pay interest every six months Treasury Bills  Short-term – up to 52 weeks in maturity  Sold at a discount  Mature at face value Treasury Notes  Maturities up to 10 years  Pay interest every six months TIPS (Treasury Inflation- Protected Securities)  Principal is adjusted by changes in the consumer price index (CPI)  Pay interest every six months  Issued with maturities of 5, 10, and 30 years.

13. 14-13 Municipal Bonds  General obligation bonds  Backed by the taxing authority of the municipality  Revenue bonds  Backed by the revenue generated by the project; i.e., a water plant being repaid by fees charged for water service  Municipal bonds have default risk  Municipalities can declare bankruptcy

14. 14-14 Corporate Bonds  Issued by private and public corporations  At risk of declaring bankruptcy, therefore must pay a “risk premium” to attract investors to buy their bonds  Risk ratings provided by Moody's, Fitch, and Standard & Poor’s

15. 14-15 Bond Ratings

16. 14-16 Corporate Bonds  Convertible Bonds  Hybrid bonds, with features of both debt and equity  Have an option to convert the bond to stock  Advantage to the company: the company does not have to repay the debt obligation, yet gives up some ownership through stock  Advantage for the bondholder: ability to participate in the upside of a growing company and increased returns High-Yield (Junk) Bonds  Junk bonds are considered below investment-grade bonds (BB or lower)  The lower the rating, the more a company has to pay in terms of a risk premium (high interest rate) for investors to buy the bond

17. 14-17 Municipal and Corporate Bonds (Figure 14.6)

18. 14-18 Example: Toxic Asset Junk Bond NPR Toxic Asset Video Part One: Meet Our Toxic Asset (1:53) Part Two: Toxie's Dead (3:13)

19. 14-19 Bond Evaluation Bond Ratings  Standard & Poor’s, Moody’s, and Fitch rate the creditworthiness of companies, municipalities, states, and nations  Credit ratings help determine the interest rate on bonds  The lower the rating, the higher the interest; the higher the rating, the lower the interest Researching Bonds  Decide on investment objective and time horizon  Compare interest rates with the risk-free rate (Treasuries)  Read reports on the company by the rating agencies  Try to predict the future  Use a bond screener  Yahoo bond screener Yahoo bond screener

20. 14-20 Bond Screener Example (Figure 14.8)

21. 14-21 Sample Online Bond Report (Figure 14.9)

22. 14-22 Bond Value Yield: Interest rate of the bond Yield to Maturity: Interest rate you receive between the date you buy the bond and the date it is repaid, including all payouts, coupons, and capital gains/losses Called: When a bond is repaid earlier than its maturity date Yield to Call: Interest rate you receive between now and the early repayment date Coupon Yield (Coupon Rate): Interest rate paid on the bond as a percentage of the bond’s current market price

23. 14-23 Researching Bond Value Online Review

24. 14-24 Researching Bond Value Online Review (Continued)

25. 14-25 Calculating the Value of a Bond Value of a Bond = c(1 + r) -1 + c(1 + r) -2 + c(1 + r) -Y + B(1 + r) -Y = P Where c = Annual coupon payment in dollars r = Interest rate (yield to maturity) Y = Number of years to maturity B = Par value P = Purchase price

26. 14-26 Doing the Math

27. 14-27 Accounting for Taxes Some bonds are exempt from federal income tax Some bonds are exempt from state income tax Some bonds are exempt from both federal and state income tax Some bonds are not exempt from either federal or state income tax What are the advantages of tax-exempt bonds? Who do these bonds benefit?

28. 14-28 Benefits of Bonds Fixed-income securities - they pay a fixed amount of cash interest As an investment strategy, build a bond ladder, buying bills, notes, and bonds that mature in different years – you will benefit from higher interest rates on longer-term bonds while taking less risk than investing only in long-term bonds Because bonds are repaid or redeemed on their maturity date, they are safer than stock; a stock purchase is never “repaid”

29. 14-29 Bond Ladder Investment Strategy

30. 14-30 Risks of Bonds Never guaranteed that the issuer won’t default on its debt Interest-rate, liquidity, inflation, and call risk Investing in bond mutual funds spreads risks  Risk spread among government, corporate, and mortgage- backed bonds Short-term bonds are considered the least risky Long-term bonds generally have a higher interest rate but are considered riskier because their prices can be fairly volatile over the 10+ year period

31. 14-31 Balancing Bond Risk Bond mutual funds  Immediate diversification  Professional funds manager  Extra expenses and cost In your own portfolio  Have varying maturity dates  Have a variety of bonds – diversify

32. 14-32 In the News Given the past period performance of investment options across the board, what role do junk bonds play in balancing a portfolio in today’s market? At what point might junk bonds be a good option for you, and at what percentage of your portfolio?

33. 14-33 Bond Buying Strategy Diversify in terms of both types of bonds and maturity dates. If you expect interest rates to decline, invest heavier in long-term bonds whose prices will increase the most with the fall of interest rates. Passive strategy: Invest in a diversified portfolio of bonds that are held for a long period of time to generate interest income in the form of coupon payments. Target strategy: Align the maturity date with the savings goal so that the principal can be made available to fund the goal, all the while receiving income from the investment until the needed date.

34. 14-34 Where to Buy Bonds Buy U.S. Treasury bonds online (www.TreasuryDirect.gov)www.TreasuryDirect.gov Buying and selling corporate bonds is harder than buying and selling stocks; bonds tend to trade only every few days and have fewer buyers and sellers (http://online.wsj.com/mdc/public/page/mdc_bonds.html)http://online.wsj.com/mdc/public/page/mdc_bonds.html You can buy and sell bonds in the secondary market before bonds reach maturity; have to use a broker and pay a transaction fee, which reduces the yield Some bonds are traded on stock exchanges; others are traded in the over-the-counter market

35. 14-35 Learn LO 14-1 Define the basic of bonds. LO 14-2 Contrast the different types of bonds. LO 14-3 Explain how bonds are valued. LO 14-4 Evaluate bond risks and returns. LO 14-5 Plan where and how to buy bonds.

36. 14-36 Plan & Act  Confirm that you or family members do not have any buried treasure (unclaimed savings or Treasury bonds) (www.treasurydirect.gov)www.treasurydirect.gov  Investigate options for a ladder strategy approach for bond investments (Worksheet 14.1)  Check if your city has a bond offering and assess its appeal as an investment option for you (Worksheet 14.2)

37. 14-37 Evaluate Review your online GoalTracker. How can bonds play a role in helping you achieve your goals? Note how the investment ideas from this chapter may support your SMART goals.

38. 14-38 Continuing Case: Investment Club Leigh wants the investment club to diversify and buy bonds. She knows that they are not as exciting as the stock options Peter and Brett presented, but she wants something less risky. Leigh knows that you are taking this class so she comes to you to talk about bonds. What advice would you give Leigh to help her convince the investment club that they should buy bonds?