1. Chapter 11 Investing Basics and Evaluating Bonds McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Investing Basics and Evaluating Bonds Chapter Objectives
Explain why you should establish an investment program.
Describe how safety, risk, income, growth, and liquidity affect your investment program.
Identify the factors that reduce investment risk.
Understand why investors purchase government bonds.
Recognize why investors purchase corporate bonds.
Evaluate bonds when making an investment.
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3. Objective 1 Explain Why You Should Establish an Investment Program
Establishing Investment Goals
Financial goals should be:
Specific
Measurable
Tailored to your financial needs
Aimed at what you want to accomplish
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4. Establishing Investment Goals
What will you use the money for?
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?
What possible economic or personal conditions could alter your investment goals?
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5. Establishing Investment Goals
Considering your economic circumstances, are your investment goals reasonable?
Are you willing to make the sacrifices necessary to ensure that you meet your investment goals?
What will the consequences be if you don’t reach your investment goals?
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6. Performing a Financial Checkup
Work to balance your budget
Do you regularly spend more than you make?
Pay off high interest credit card debt first
Obtain adequate insurance protection
Start an emergency fund you can access quickly
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
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7. Surviving a Financial Crisis
Establish a larger than usual emergency fund
Know what you owe
Identify debts that must be paid
Reduce spending
Pay off credit cards
Apply for a line of credit at your bank, credit union, or financial institution
Notify credit card companies and lenders if you are unable to make payments
Monitor the value of your investment and retirement accounts
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8. Getting the Money Needed to Start an Investing Program
Pay yourself first
Take advantage of employer- sponsored retirement programs
Participate in elective savings programs
Make a special savings effort one or two months each year
Take advantage of gifts, inheritances, and windfalls
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9. The Value of Long-Term Investing Programs
Even small amounts invested regularly grow over a long period of time
If you begin saving $2,000 each year. depending on the rate of return, you could have over $1 million by the time you are age 65 (See Exhibit 11-1)
The higher the rate of return the greater the risk
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10. Factors Affecting the Choice of Investments
Objective 2 Describe How Safety, Risk, Income, Growth, and Liquidity Affect Your Investment Decisions
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
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11. 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
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12. Investment Income, Growth and Liquidity
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
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13. Investment Income, Growth and Liquidity
Investment Growth
Growth in value (price appreciation)
Common stock usually offers the greatest potential for growth
Mutual funds 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
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14. Traditional Investment Evaluation Factors
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15. Objective 3 Identify the Factors that can Reduce Investment Risk
Portfolio Management & Asset Allocation
Asset allocation
= The process of spreading your assets among several different types of investments
= Diversification
Stocks
Bonds
Risk-free assets
Real-estate etc
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16. Portfolio Management & Asset Allocation
Other factors to consider:
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?
Your age
Growth versus income
Recovery time if investments nosedive
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17. Portfolio Investing
Brokerage firms may construct sample portfolios for
client consideration:
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18. 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
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19. Objective 4 Understand Why Investors Purchase Government Bonds
Government Bonds and Debt Securities
Government bonds = written pledge to:
Repay a specified sum of money (face value)
At maturity
Along with periodic interest (coupon payments)
Sold to fund the national debt and the ongoing costs of government
Three levels of government issues:
Federal
State
Local municipalities
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20. 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
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21. 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 20 year maturities
Principal changes with inflation
Pays interest twice a year at a fixed rate
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22. Federal Agency Debt Issues
Essentially risk free
Slightly higher interest rates than Treasury securities
Minimum investment may be as high as $10,000 to $25,000
Maturities range from 1 – 30 years
Average maturity = 12 years
Issuing agencies sample:
Fannie Mae
Freddie Mac
GNMA
TVA
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23. 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
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24. 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
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25. State and Local Government Securities
Municipal Bonds (“munis”)
Key characteristic:
Interest 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
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26. Taxable Equivalent Yield
Used to compare tax exempt and taxable bonds
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27. Objective 5 Recognize Why Investors Purchase 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
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28. 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
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29. 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
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30. 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
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31. Types of Corporate Bonds
Debenture
Unsecured
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
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32. 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
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33. 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
Call protected for the first 5 to 10 years after issue
A firm calls a bond issue if the coupon rate they are paying is much higher than the market rate
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34. 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
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35. Why Investors Purchase Corporate Bonds
Interest income - “fixed income”
Registered bond
Coupon and principal paid to registered owner
Registered coupon bond
Registered for principal only
Coupon must be presented to obtain payment
Zero coupon bond
Pays no interest
Sold at a discount from face value
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36. Why Investors Purchase Corporate Bonds
Dollar appreciation of bond value
Bond values change with market interest rates
Bond value vs. Interest rates = inverse relationship
If Market rate< Coupon rate Price > Face value
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
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37. Objective 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
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38. 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 = % = 5.875/93.51
Or see Exhibit 11-6
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39. Bond Ratings Measure Default Risk
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40. 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
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41. END OF CHAPTER 11
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42. Additional Video
Financial Advice for the Meltdown What Advisors Are Doing Differently
(Instructors see the notes section for directions.)
SYNOPIS: Information about how financial planners can help investors reduce risk in their investment portfolio is presented in this video. Measurement tools and questions to ask when choosing a financial planner are also presented.
1. Assume the stocks, mutual funds, and other investments you own are declining in value because of a depressed economy. Based on the information in this video, your age, and your tolerance for risk, would you sell your investments, hold your investments, or buy more of the same investments?
2. How can you tell if the advice you are getting from a financial planner is helping you achieve your investment goals?
3. What suggestions were made in this video to help someone choose a financial advisor?
This video is NOT available on the DVD. The authors have added the link, synopsis and follow up questions as an additional option for your course.
The link to this Business Week video is:
If you are viewing this PPT presentation in the slide show format and are connected to the Internet, you can simply click on the link “Financial Advice for the Meltdown: What Advisors are Doing Differently” and you will be connected to the site.
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