1. Chapter 15 Investing in Bonds

2. Chapter 15 Learning Objectives
Describe the characteristics of corporate bonds
Discuss why corporations issue bonds
Explain why investors purchase corporate bonds
Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds
Evaluate bonds when making an investment

3. Characteristics of Corporate Bonds
Objective 1: Describe the characteristics of corporate bonds
Corporation’s written pledge to repay a specified amount of money with interest
The face value is the dollar amount that the bondholder will receive at the bond’s maturity date-usually $1,000
Bondholders receive interest payments every six months at the stated interest rate

4. Characteristics of Corporate Bonds
Par value = $1,000
Coupon = 6.5% of par value per year,
or $65 per year ($32.50 every six months).
Maturity = 27 years (matures in 2036)
Issued by AT&T.

5. Characteristics of Corporate Bonds
The legal conditions are described in a bond indenture
A trustee is a financially independent firm that acts as the bondholder’s representative

6. Characteristics of Corporate Bonds
Risks of bonds
Interest risk
Purchasing power risk
Business risk
Liquidity risk
Call risk

7. Characteristics of Corporate Bonds
Four important features:
Interest rate increases, bond value decreases
Market value of bond will be less than the par value if investor’s required rate is above the coupon interest rate

8. Characteristics of Corporate Bonds
Four important features:
As maturity date approaches, the market value of bond approaches its par value
Long-term bonds have greater interest rate risk than do short-term bonds

9. Why Corporations Sell Bonds
Objective 2: Discuss why corporations issue bonds
To get funds for major purchases
To fund ongoing business activities
When it is difficult or impossible to sell stock
To improve financial leverage
Interest paid to bondholders is a tax deductible business expense that can be used to reduce the federal and state taxes corporations must pay

10. Why Corporations Sell Bonds (continued)
TYPES OF BONDS
Debenture bond
Most corporate bonds are debenture bonds
Unsecured - backed only by the reputation of the issuing company
Mortgage bond
A corporate bond that is secured by various assets of the issuing firm, usually real estate
Interest rate is lower because it is secured by the collateral and corporate assets

11. Why Corporations Sell Bonds (continued)
Subordinated debenture bond
An unsecured bond that gives bondholders a claim secondary to that of other designated bond holders with respect to interest payments and claim on assets
Convertible bond
A special kind of corporate bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock

12. Why Corporations Sell Bonds (continued)
PROVISIONS OF REPAYMENT
Call Feature
Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date
Most agree not to call bonds for the first 5 to 10 years after they are issued
Bonds called, if their interest rate is much higher than the going rate
Most corporate bonds are callable

13. Why Corporations Sell Bonds (continued)
Sinking fund
Corporations deposit money in this fund annually or semiannually and use the money to pay off the bondholders when the bond issue comes due
Serial bonds
Bonds of a single issue that mature on different dates

14. Why Investors Buy Corporate Bonds
Objective 3: Explain why investors purchase corporate bonds
Interest Income
Investors receive interest every six months
Interest will be paid to investors twice a year, with the payment based on the interest rate and the face value of the bond
Registered bonds, Bearer bonds, Zero-coupon bonds
Dollar Appreciation of Bond Value
May be able to sell the bond to someone else at a higher price if the interest rate on the bond is higher than the market rate
Bond face amount will be repaid at maturity

15. Why Investors Buy Corporate Bonds (continued)
THE MECHANICS OF BOND TRANSACTION
Bonds can be held until maturity or sold in the secondary market
Most bonds sold through full-service brokerage firms, discount brokerage firms, or the Internet
Corporate bonds may be purchased in the primary market or secondary market
Generally a minimum commission of $10-$35 on a $1,000 bond
Interest and capital gains from selling bonds are both taxable

16. Government Bonds and Debt Securities
Objective 4: Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds
Sold to obtain money to finance the national debt, and the ongoing costs of government
Three levels of government issue bonds:
Federal-no state income tax on the interest
State
Local municipalities

17. Government Bonds and Debt Securities
TREASURY BILLS, NOTES, AND BONDS
Treasury Bills (T-Bills)
$100 minimum
4, 13, 26, or 52 weeks to mature
Sold at a discount
Treasury Notes (T-Notes)
$100 units
2, 5, and 10 year terms
Interest paid every six months

18. Government Bonds and Debt Securities (continued)
Treasury Bonds
Issued in minimum units of $100
Have maturities of 30 years
Interest rates are generally higher than those of T-bills and T-Notes
Interest is paid every 6 months
Held until maturity or sold before maturity

19. Government Bonds and Debt Securities (continued)
FEDERAL AGENCY DEBT ISSUES
Fannie Mae (
Federal National Mortgage Association
Ginnie Mae - pay interest once a month
Government National Mortgage Association
Freddie Mac
Federal Home Loan Mortgage Corporation
Slightly higher risk than Treasury securities, so slightly higher interest rates
Issued for 1-30 years, 12 year average
Minimum denominations may be as high as $10,000-$25,000

20. Government Bonds and Debt Securities (continued)
STATE AND LOCAL GOVERNMENT SECURITIES
General obligation bonds are backed by the state or local government that issues them
Revenue bonds are repaid from money generated by the project the funds finance, such as a toll bridge
Municipal bonds or munis
Issued by a state or local government, such as cities, counties, school districts
Use funds for ongoing costs & to build major projects such as schools, airports, and bridges

21. Government Bonds and Debt Securities (continued)
Features of Municipal Bond
People like to invest in projects close to home
They like insured municipal bonds, or states that guarantee payment
May be callable, but usually not until after the first ten years
Interest earned may be exempt from federal income tax so yield is higher

22. Government Bonds and Debt Securities (continued)
Taxable equivalent yield= Tax-exempt yield Your tax rate Example: Taxable equivalent yield = = = 8.3%

23. The Decision to Buy or Sell Bonds
Objective 5: Evaluate bonds when making an Investment
THE INTERNET
The Internet can be used in the following ways to evaluate a bond
Obtain the price information
Trade bonds online for a lower commission
Research information on the corporation and bond issues online
Some relevant Websites are:

24. The Decision to Buy or Sell Bonds (continued)
ANNUAL REPORTS
Write or telephone the corporation to receive the annual report
Corporations maintain web site that provides access to annual reports
Some financial publications provide a reader’s service to request an annual report

25. The Decision to Buy or Sell Bonds (continued)
BOND RATINGS
Bond ratings provide quality and risk associated with bond issues
Moody’s Investor Service Inc. and Standard & Poor’s Corporation
Bond ratings generally range from AAA to D

26. The Decision to Buy or Sell Bonds (continued)
BOND YIELD CALCULATIONS
Yield is the rate of return earned by an investor who holds a bond for a stated period
Current yield on corporate bond = Annual income amount Current market value

27. The Decision to Buy or Sell Bonds (continued)
Yield to maturity
-- The rate of return investors earn on a bond if they hold it to maturity.
Suppose we paid $ for a $1,000 par 10% coupon bond with 8 years to maturity and semi-annual coupon payments. What is our yield to maturity?
N = 16, PV = PMT = FV = 1000
Solve I% = 6%
6% * 2 = 12%

28. Online Activity
Go to one of these sites and look up information about municipal bonds in your area. …What do you think of the rates these bonds are paying?