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CHAPTER 11Investing Basics and Evaluating Bonds

“If a little money does not go out, great money will not come in.”

-- Confucius

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The Answer is…

“A Voluntary Tax on Stupid

People”What is the Question?

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Silly, the Question is…

“What is the

A Voluntary Tax on Stupid People

Lottery?”

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What are the Odds of Winning? The odds of winning the California Mega

Millions Jackpot are 176 million to 1 “But somebody has to win, right?” Yes, but that somebody will not be you!

If a person purchases 50 lottery tickets each week, he or she will win the Mega Millions Jackpot about once every 50,000 years “Let’s see. $50 per week at 10% for 50,000

years…”

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Speaking of Odds… Astronomers have located an asteroid that is

possibly on a collision course with Earth The asteroid could hit the Earth in 2029

Triggering untold destruction and the end of tens of thousands of species, including the human race

The odds of the asteroid hitting the Earth are currently set at 300 to 1 But those odds will probably lessen as more is

learned about the asteroid’s orbit

So Why Aren’t the Nations Preparing for This!?

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Because it Ain’t Gonna’ Happen!

And You Ain’t Gonna’ Win the Lottery!So Start Saving Now

But, of course, if the asteroid does hit, we will have plenty of warning for you to go out and

spend all your savings on a really great time!Now, let’s get serious…

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Establishing Investment Goals You already know the #1 Financial Goal:

“Spend Less Than You Earn” “Live Beneath Your Means” “Make Love, Not Loans” “Pay Yourself First” “Frugal, Frugal, Frugal!”

If Goal #1 is followed, everything else is easy! For each investment goal, assess the time frame

Is it short-term, intermediate-term, or long-term Choose an appropriate investment for the time frame

This chapter gives you a thumb-nail view of each type With an emphasis on bond investments

We will look at some of the others in detail later on

Which one is your favorite?

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Essentials Before Investing

Work to balance your budget Pay off high interest credit card debt first

Start an emergency fund you can access quickly Three to nine months of living expenses

I simply do not agree with the concept of an “emergency fund” of three to nine months of living expenses. As long as you have access to cash via a home equity line of credit, for example, there is no good reason to keep $20,000 to $30,000 or more in a savings account earning 0.01%. Instead, use the money to pay down high interest debt, especially credit card debt.

P.S. The Wealthy Barber agrees with me.

P.P.S. You are adequately insured, right?Exceptions: Salespeople

and the self-employed

They are important but not essentialOr so says our book…

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First: Some Investment Terms Safety – Guarantee of return of principal Risk – Uncertainty about an outcome

Inflation risk Interest rate risk Business failure risk Market risk Global investment risk

Liquidity Ability to buy or sell an investment quickly without

substantially affecting the investment’s value

“I am not so much concerned with the return on my money as I am with the return of my money.”

-- Will Rogers

What is your tolerance for risk? (http://njaes.rutgers.edu/money/riskquiz/) Unfortunately, you can’t know until you have some skin in the game …

and then lose some skin!

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“Where Do I Get the Money to Invest?”

Pay Yourself First Take advantage of employer-sponsored

retirement programs [401(k), 403(b), etc.] These come right out of your paycheck

Take advantage of automatic contributions from your checking or savings account [Roth IRA] Schedule them to occur right after you normally

receive your paycheck

They work like a pay raise, only in reverse

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“How Much Do I Need?” Start small!

“Can you afford $50 per month?” Small amounts invested regularly become

large amounts over time Obviously, the more the better

But it is better to get started with a small amount now than to lazily dream of a day when you’ll be able to put away far more – Get Started Now!

You can always increase the amount Try to increase the amount each year Especially when you get a pay raise

12 Regular Taxable Accounts versus Tax-Qualified Accounts

Taxable Account Tax-Qualified Account

StocksBonds

Mutual Funds

“Cash”

StocksBonds

Mutual Funds

“Cash”

Although there are many subtle and not-so-subtle differences, the major differences are how they are taxed by the IRS, how much

money you can contribute, and what you can have in the account.

a.k.a. Retirement Account, Education Accounts, MSA HSA

a.k.a. Regular account

No limit on contributions Strict limits on contributions

OptionsFutures

Strict limits on investment typesNo limits on investment types

MarginingShorting

Pay taxes every year on gains Tax-deferred (pre-tax) orTax-free (post-tax)

All contributions are post-tax dollars Most are pre-tax; Some are post-tax

Account Statement Examples

Real Estate

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Types of Investment Accounts Taxable Accounts (a.k.a. Regular Accounts)

All interest, dividends, capital gains, and rent are taxable each year

Best for short-term or intermediate-term investments but can also be used for long-term

Tax-Qualified Accounts (a.k.a. Retirement Accounts, Education Accounts, MSAs HSAs) Tax-deferred – Pay no taxes until you withdraw

the funds (normally in retirement) Best for intermediate-term or long-term

investments (but mostly for long-term)Account Statement Examples

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Types of Retirement Accounts Pre-tax Contributions

401(k), 403(b) for private & public employees Traditional IRA for everyone SEP-IRA, SIMPLE IRA and Keogh for self-

employed or those working for small business Tax Break Now

Deduct contributions from income tax Pay taxes in retirement (when tax bracket is lower)

Post-tax Contributions (a.k.a. After-tax contributions) Roth IRA for everyone, Roth 401(k), Roth 403(b)

Tax Break Later (Tax-Free in Retirement!) Annuities (pre-tax and post-tax)

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A Pre-tax Contribution Lowers Your Taxes Now Examples: IRA, 401(k) / 403(b)

You contribute via your paycheck: $100

Your Federal tax withholding is lowered by: $25

Your California tax withholding is lowered by: $8

Total government subsidy: $33

Your take home pay is only reduced by: $67

But the whole $100 still goes into your account!

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“So What’s the Catch?” You pay income tax on any amounts

withdrawn in retirement But people in retirement are usually in a lower

tax bracket If you withdraw the funds before retirement…

You pay the income tax, and You pay a 10% penalty!

Exceptions for first home purchase, higher education expenses and medical disability

This is a long-term investment Don’t even think about dipping into it for a car,

vacation, etc. (A first home or higher education? Okay)

17 A Post-tax Contribution Gives You NoTax Break Now Examples: Roth IRA, Roth 401(k)

You contribute to a Roth IRA: $100

Your Federal tax withholding is lowered by: $0

Your California tax withholding is lowered by: $0

Total government subsidy: $0

Your disposable income is reduced by: $100

So Why Bother Contributing to a Roth IRA?

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“Because a Roth IRA is So Cool!” Tax-Free in Retirement is a Golden

Opportunity No other investment choice comes close! Eventually, I think they will probably be gotten rid of

Plus, you can withdraw the contributions at any time with no penalty You have already paid taxes on the contributions

This makes the Roth IRA also an excellent intermediate-term investment account Purchase of a house or other high-ticket item Great for college expenses

Currently not used in Financial Aid calculations

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Limitations on Roth IRAs Contributions Only single taxpayers with an AGI of $112,000 or

less and married couples with an AGI of $178,000 or less can fully contribute to a Roth IRA If you do not qualify, Congratulations!

But you can contribute to a Roth IRA anyway If you find that you have made over the limit, you can

“recharacterize” the contributions into a Traditional IRA (which does not have the same limitations) before you file your taxes

And then you convert the Traditional IRA to a Roth I know. I know. Who voted for these bozos?

Oh, yeah. We did …

But Contributing to a Roth Can Be Tricky for High Income Earners

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Education Savings Accounts 529 Plans

Works like a Roth IRA Post-tax dollars No tax on earnings as long as you use the money

for higher education High penalty if you use the money for any other

purpose Coverdell Education Plans (nee Education IRA)

Like the 529 plan, only much worse But if you use either of these plans, then you

can’t take advantage of the Hope and Lifelong Learning Educational Tax Credits (Gee, Thanks!)

529 plans were set to expire in 2011 but have been extended

indefinitely.

21 Medical Savings AccountsHealth Savings Accounts Medical Savings Accounts (MSAs)

Tax-deductible contributions Pre-tax dollars

No tax on withdrawals as long as you use the money for medical purposes High penalty if you use the money for any other

purposes Only available to self-employed and those

working for small business They are now changing to …

Health Savings Accounts (HSAs) Anyone can have one, not just self-employed or

small businesses

22 Review: Types of Investment Accounts Taxable Accounts (a.k.a. Regular Accounts) Tax-Qualified Accounts (a.k.a. Retirement

Accounts, Educational Savings Accounts, MSAs, HSAs) Pre-tax Contributions – tax-deferred

Traditional IRA, 401(k), 403(b), etc.

Post-tax Contributions – tax-free Roth IRA, Roth 401(k), Roth 403(b)

This is where the types of investments reside They are not the investments!

Okay. Now, What Do We Invest In? (In other words, what investments do we put in our taxable or tax-qualified accounts?)

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Investment Alternatives Stocks – “You are an Owner” Bonds – “You are a Loaner” “Cash” – “You are Guaranteed”

a.k.a. Short-term investments

Annuities – “Have we got a (bad) deal for you!” Real Estate – “Yes, but it is not without risk” Other Investment Alternatives…

…That I hope you will avoid Unless you know what you are doing or are willing to lose

a good chunk of your money or, preferably, both

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Investment Alternatives: Stocks Stocks represent ownership in companies Benefits include…

Stockholders are owners and share in the success of the company (capital gains)

Shareholders receive distribution of company’s earnings (dividends)

Stock Prices are Volatile But you knew that already, didn’t you?

Average returns over decades – 8% to 10% Best overall long-term investment returns Stocks are long-term investments

Fancy term for “You’se can lose a lot of yer money!”

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Investment Alternatives: Bonds Bonds represent loans to…

Companies (Corporate bonds) State & local municipalities (Municipal bonds) Federal government (Treasury bonds)

Bondholders receive interest on the loan Loan is repaid (Bond is redeemed) in 1 to 30 years Bondholders are first in line for repayment if there

is default on the loans Bond prices are less volatile but still do fluctuate

Average returns over decades – 4% to 8% Intermediate-term to long-term investments

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Investment Alternatives: “Cash”

Better term is “Short-term Investments”a.k.a. “Short-term Instruments, short-term vehicles”

Guaranteed Return of Principal Savings Accounts, Certificates of Deposit (CDs),

Money Market Accounts Money Market Mutual Funds

Not guaranteed but pretty darned close Average returns over decades – 2% to 5%

Currently, they are paying the lowest rates in over 50 years – less than 1% (some paying zero!)

Huge Opportunity CostThese are short-term investments

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Investment Alternatives: Annuities An annuity is a financial contract written by an

insurance company that provides you with a regular income for a specified time For the rest of your life or For 10-year, 20-year, etc. periods

Guaranteed contracts that will continue to pay your heirs if you die before the end of the time period

People buy annuities to supplement retirement income and to shelter income from taxes

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Those who expect to live longer than average benefit most from annuities But if you die one month after you have signed up

for the annuity, the life insurance company keeps all the money! Great deal, huh?

“No problem!” sez Mr. InsuranceMan. “You can choose a definite payout period … but we will pay you less.”

Annuities are tax-deferred investment plans Contributions are after-tax money but earnings are

tax-deferred You pay taxes on the earnings when you draw the

money out (The contributions are returned tax-free)

(continued)Investment Alternatives: Annuities

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Suffice to say that annuities are for people who have already put as much money as they can into all other retirement options, already have plenty of investments outside of retirement accounts and still have plenty of money to invest

“Money to burn” goes into an annuity Even then, they are not the best investment options

Average returns over decades Fixed annuities – 2% to 6% – bonds

But they have a guaranteed minimum payout (2% to 3%) Variable annuities – 2% to 8% – stocks & bonds

Can lose money – no guaranteed minimum

(continued)Investment Alternatives: Annuities

30 Investment Alternatives:

Real Estate Real Estate is Tricky but can be Very Profitable

Real Estate is an illiquid investment Purchase and manage rental property, or REIT’s (Real Estate Investment Trust)

Trade like stocks – liquid They manage the real estate for you You receive the rent and any capital gains

Minus the REIT’s management fees, of course Average returns over decades – 7% to 8%

Uh, San Diego is a notable exception But as we have seen, some people have literally lost

everything after the real estate bubble of the 2000’s burst Intermediate-term to long-term investments

31 Investment Alternatives:

The “Others” Derivatives: Options, Futures, and Commodities

Very, very risky They derive their value from another investment (?)

These are speculations (gambling), not investments Precious Metals and Gems

If you believe the global economy is going to fall apart anytime soon, buy these in large quantities

Even De Beers now admits that diamonds are awful investments

Collectibles, Antiques, Fine Art, Coins & Stamps It may be fun, but do not call it investing Unless you know exactly what you are doing!

None of these are eligible for retirement accounts Does that tell you anything?

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“So What Is Your Choice?” If the goal is long-term (example: retirement),

then my choice is high-quality stocks Although some people prefer bonds because they

are less risky than stocks (or a combination of both)

If the goal is intermediate-term, then bonds or REITs make sense

If the goal is short-term, you have no choice but to use a guaranteed short-term “cash” investment such as a money market account Although bonds close to maturity could also work

The “Others” never make sense except for a small percentage of the population

33 “So I am buying stocks and bonds. Great! How do I get started?”

Well, actually, you don’t… Buy the stocks and bonds, that is…

For the vast majority of people, the best investments are mutual funds that buy the stocks and bonds for them Professional money management Diversification

“But you got me all excited about buying stocks and bonds all by myself! Besides, in their commercials on TV, Ameritrade and

Scottrade show everyday, hard-working Americans just like me happily and profitably buying and selling stocks all the time.”

34 Let me ask you a few questions… Do you have the discipline, courage and brains to buy

when everyone else is selling and sell when everyone else is buying?

Do you have a strong background in finance, business, marketing, economics, politics and history?

Are you a part of a global research team stationed all around the world?

Do you have the time and resources to visit in person the companies you intend to invest in? Plus their customers, competitors and suppliers?

Do you have enough money to buy at least 20 or more stocks representing various sectors of the economy?

Most importantly, do you have a knack or intuition for recognizing unrecognized value?

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Your results? If the answer to two or more of the previous

questions is, “No” (especially the last two: money for 20 or more stocks & an intuitive eye for value) Stay away from individual stocks! Bonds are also difficult since bond traders usually

deal in tens of thousands of dollars per trade (The exceptions are government bonds bought

directly from www.treasurydirect.gov) Mutual Funds are your Best Bet

And if it means anything to you, virtually all of my family’s financial investments (and my clients’) are in mutual funds (>99%) I certainly can’t answer “Yes” to all those questions

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Mutual Funds (a.k.a. Investment Company)

STOCKS BONDS “CASH”

Professional Money Management

Diversification

Stock mutual funds

Bond mutual funds

Money market mutual funds

Balanced mutual funds

a “mutual” fund

(investment company)

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“So, How Do I Pick a Mutual Fund?”

Pick a Mutual Fund that… Invests in high-quality stocks or bonds Is well-diversified across several industries and

sectors of the economy and countries of the world

Has a long-term perspective and a manager or (better yet) a management team with many years of experience Avoid companies that “shuffle” their managers

every few years (which is virtually all of them!) Has been around for decades and performed

consistently well in both good and bad marketsMore about choosing a good mutual fund when we get to Chapter 13.

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“How Do I Purchase a Mutual Fund?”

Normally, a little bit at a time Virtually all mutual funds will allow you to start an

automatic investment plan with as little as $25 to $50 per month Either through your employer (401k, 403b, etc.) Or from your checking or savings accounts (IRA,

Roth IRA) The ones that won’t are specialized funds that

you normally don’t want to deal with anyway Minimum purchases of $1,000 to $25,000 or more

Investing a fixed amount ($50, $100, etc.) periodically is called “dollar cost averaging.”

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Dollar Cost Averaging A system of buying an investment at regular

intervals with a fixed dollar amount $50 per month, $100 per month, etc.

With Dollar Cost Averaging, there is always “Good News” “The market is up! Good News!”

Your account is worth more “The market is down! Good News!”

Next month, you will get more shares at a lower price when the $50 or $100 comes out of your paycheck or checking account

Yippee!

Huh?!

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“But Now It All Sounds So Boring…”

In the investment world, Boring is Good! After you have built a solid foundation of high-

quality stock or bond investments through mutual funds, then you can “play the market” I used to call it my “Vega$ Fund”

Take no more than 5% to 10% of your financial assets and choose your own stocks Be prepared for “volatility”

“Volatility” is the investment world’s euphemism for large losses – Buy a stock for $12, sell it for 30¢

I kept my “Vega$ Fund” to no more than 1% of our total portfolio, by the way

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Coming Attractions Chapter 11 (continued) – Bonds Chapter 12 – Stocks Chapter 13 – Mutual Funds Lecture Notes – Real Estate & the “Others”

We will examine all of these in more detail

Plus…

Chapter 14 – Retirement & Estate Planning

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Investments: What are ___?

Investment companies that pool investors' money and invest in a diversified portfolio of securities. Investors get diversification and professional money management.

A. short-term securities (a.k.a. “cash”)

B. stocks

C. bonds

D. mutual funds

The correct answer is (D). Investment company is the legal term; mutual fund is the popular term.

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Investments: What are ___?

Represent ownership in a corporation. Investors receive dividends and capital gains (or capital losses).

A. real estate

B. stocks

C. bonds

D. short-term securities (a.k.a. “cash”)

The correct answer is (B). Stock investors are part-owners of corporations.

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Investments: What are ___?

Fixed-income securities that represent loans to corporations, municipalities (state & local governments & agencies), and the Federal government. Investors receive interest and a promise to repay the loan.

A. real estate

B. stocks

C. bonds

D. short-term securities (a.k.a. “cash”)

The correct answer is (C). Bonds are “fixed-income” investments.

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Investments: What are ___?

Investments with very little risk, and correspondingly, very little return. They are usually guaranteed or pretty darned close. There is a huge opportunity cost if you leave your money here for the long-term.

A. real estateB. stocksC. bondsD. short-term securities (a.k.a. “cash”)

The correct answer is (D). Low risk, low return.

46 What are Reasonable Expectations?

What are reasonable expectations of returns from the following investments?

A. stocks

B. bonds

C. short-term securities

D. real estate

E. mutual funds

F. the “others”

8% - 10%

4% - 8%

2% - 5%

?-?

7% - 8%

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Investing in Bonds Bonds represent loans to…

Companies (Corporate bonds) State & local municipalities (Municipal bonds, “Muni’s”) Federal government (Treasury bonds, “Governments”)

Bondholders receive interest on the loan Loan is repaid (Bond is redeemed) in 1 to 30 years

Bondholders are first in line for repayment if there is default on the loans (after taxes & payroll expenses)

Bond prices are less volatile but still fluctuate (?) Average returns over decades – 4% to 8% Intermediate-term to long-term investments

(But there is a way for bonds to be short-term)

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Why Do Investors Buy Bonds? For interest income

Investors know the interest rate Interest will be paid to investors twice a year

Bond face amount will be repaid at maturity Although there is always the risk of default

Normally, the risk of default is very, very small If the risk is high, the bonds are usually referred to as

“non-investment grade bonds” (a.k.a. “junk bonds”)

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 (“Huh?” “Later…”)

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Why Sell Bonds To raise money to operate or expand

Examples: Build a new factory, expand into a new country, build new or upgrade older schools, bridges, finance a war, etc. – Big ticket items

Can get better interest rates than if they went to a bank or other money-lending entity Also, sometimes the bond issuer can’t go to a bank!

(Can you imagine the Federal government asking your local credit union for a $900 billion loan to invade Iraq?)

Almost every election year in California, the voters are asked to approve a “bond proposition” for parks, schools, water projects, transportation, emergency and public safety equipment, etc. The State of California then sells the bonds to pay for the project and

must pay the interest and pay back the principal over 30 years.

When an entity sells bonds, it is borrowing money.

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Why Sell Bonds In the case where the bond issuer is a

corporation, sometimes it is difficult, not advantageous or impossible to sell stock And the interest is a tax-deductible expense for

corporations Whereas dividends to stock shareholders are not

To take advantage of “financial leverage” Use other people’s money to make your money

Bonds are “debt financing.” Corporations, municipalities, or the Federal government borrow for many of the same reasons that

individuals borrow for – to finance their operations. Stocks are “equity financing.” A corporation is selling a piece of itself to finance the operations of the company. (Governments do

not issue stocks because they can not sell pieces of themselves.)

(continued)

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Characteristics of Bonds Written pledge to repay a specified amount

(face value, par value) of money with interest The face value is the dollar amount that the

bondholder will receive when the bond matures Normally in $1,000 denominations (up to $10,000)

Bondholders receive interest payments every six months at the stated interest rate

The legal conditions are described in the bond indenture The indenture is the loan agreement

The trustee is the bondholders’ representative

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Types of Bonds Mortgage-backed bonds (“Secured”)

A bond that is secured by various assets of the issuing firm A mortgage bond is like a homeowner’s home mortgage

If the bond issuer does not pay, the asset is seized Debenture bonds (“Unsecured”)

Most bonds are debenture bonds Backed only by the reputation of the issuer

A debenture bond is like a credit card If the bond issuer does not pay, the bond investors must

go after whatever assets or income they can find Convertible bonds (only corporate bonds)

Can be exchanged, at the owner’s option, for a specified number of shares of common stock

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Call Feature of Bonds Corporations and municipalities can

sometimes “call in” (buy back) outstanding bonds from current bondholders before the maturity date Treasuries (Federal bonds) are never callable

Most agree not to call in their bonds for the first 5 to 10 years after they are issued a.k.a. Deferred Call, Call Protection Period

Bonds are called if the interest rate they are paying is higher than the going rate It is the same idea as when a homeowner

refinances his/her home mortgage loan

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Bonds and Taxes Bond interest is normally taxed at your

marginal tax rate Always true of corporate bonds However, municipal bonds are not subject to

Federal income taxes and … Federal bonds are not subject to state income tax

This is an important feature for wealthy investors Must look at the Taxable Equivalent Yield

Some municipal bonds are “double-tax free” If from your state, also exempt from state taxes Careful! If you are subject to the AMT, the interest

income from some municipal bonds is no longer exempt from Federal taxes

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Taxable Equivalent Yield

Tax-Exempt Yield

1.0 – Your Federal marginal tax rate

Example: 6% yield, 25% tax bracket

Taxable equivalent yield = 0.06

1.0 - 0.25

= 0.08 = 8%Federal income tax free

municipal bonds

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Taxable Equivalent Yield

Tax-Exempt Yield

1.0 - Your combined marginal tax rate

(Federal & state)

Example: 6% yield, 25% Fed, 8% state

Taxable equivalent yield = 0.06

1.0 – (0.25+0.08)

= 0.0895 = 8.95%

(continued)

If you purchase bonds from your state, they are usually “double

tax-free.”Federal & state income tax free.

57 Making the Decision to Buy or Sell a Bond

Can the corporation, municipality, or Federal government... Pay back the face value at maturity? Will you receive interest payments until maturity?

What is the bond’s rating? (Kinda’ like your credit score) Ratings range from AAA to D (AAA, AA, A, BBB, BB, etc., D)

BB or below is “non-investment grade” Also called a “junk bond” or speculative bond

Rated by one of the rating agencies Standard and Poor’s, Moody’s, Fitch’s

Think of the ratings as “idiot lights” on your car’s dashboard. By the time the agency downgrades the bond to C or D, it is already too late!

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Inverse relationship As interest rates fall, bond prices rise As interest rates rise, bond prices fall

Since the interest rate of your bond does not change (it is fixed), the price of the bond changes to reflect the change in interest rates within the financial industry (the price of the bond is not fixed) Great source of confusion and consternation to many in

and out of the investment world

Bonds and Interest Rates

When interest rates fall,

…bond prices rise,

and vice-versa.

59 Bonds and Interest Rates: Example

Bond paying 10% The bond’s face value is $1,000 The bond’s interest per year is $100

10% of $1,000 = $100 Interest rates fall to 5%

Now, investors have to pay $2,000 to get the same amount of interest 5% of $2,000 = $100

The result is your bond is now worth more than it once was (capital gain if sold) The bond could be sold at a high premium

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Bond paying 5% The bond’s face value is $1,000 The bond’s interest per year is $50

5% of $1,000 = $50 Interest rates rise to 10%

Now, investors only have to pay $500 to get the same amount of interest 10% of $500 = $50

The result is your bond is now worth less than it once was (capital loss if sold) The bond would be sold at a large discount

(continued)

Bonds and Interest Rates: Example

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Bond Pricing: Problem 1

Juan Zapata-Tyme bought a corporate bond paying 8% four years ago. Today, corporate bonds that are like Juan’s bond are paying 6%. Would Juan be able to sell his bond for more than he paid for it, less than he paid for it, or the same amount he paid for the bond?

A. He could sell it for more than he paid for it

B. He could sell it for less than he paid for it

C. He could sell it for the same that he paid for itThe correct answer is (A). If interest rates go down, bond

prices go up. The bond would sell at a premium.

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L. Coco bought a Treasury bond paying 5% two years ago. Today, like Treasury bonds are paying 7%. Would Señor Coco be able to sell his bond for more than he paid for it, less than he paid for it, or the same amount he paid for it?

A. He could sell it for more than he paid for it

B. He could sell it for less than he paid for it

C. He could sell it for the same that he paid for it

The correct answer is (B). If interest rates go up, bond prices go down. The bond would sell at a discount.

Bond Pricing: Problem 2

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Bonds and Interest Rates The relationship of bonds and interest rates is

why a bond will have different quoted rates Nominal Rate (a.k.a. Coupon Rate)

This is the rate that the bond pays on the original amount of the loan (usually in $1,000 increments)

Current Yield This is the true rate of interest that the bond buyer is

currently getting since it reflects the premium or discount price the buyer had to pay

Yield to Maturity This is the yield you would receive if you were to hold

onto the bond until it matures If the Nominal Rate, Current Yield and the Yield

to Maturity are all the same, the bond is said to be selling at par There is no premium nor is there a discount

(continued)

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Current % Yield of a Bond

Example: 6%, $1100 market valueCurrent yield = $60

$1100 = 0.0545454 5.45%

Current Market Value

Dollar Amount of Annual Interest

A bond selling at a premium has a

current yield lower than its stated nominal rate

(continued)

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Current % Yield of a Bond

Example: 6%, $900 market valueCurrent yield = $60

$900 = 0.06667 6.67%

Current Market Value

Dollar Amount of Annual Interest

A bond selling at a discount has a

current yield higher than its

stated nominal rate

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Yield to Maturity

Face value - Market value

Number of periods

Face value + Market value

2

Example: 6%, Selling at $900, 10-year maturity

$1,000 - $900

10 years

$1000 + $900

2

= 0.074 = 7.4%

$ Amt Annual Interest +

$60 +

¡Aye, Paquito!

67 Primary and Secondary Bond Markets

Primary bond market Buy via an investment bank or company

representative www.treasurydirect.gov

Secondary bond market Buy through a broker from another investor

who wants to sell it, and pay a commission

Very few small investors participate in the bond markets. Bond traders normally deal in the millions of dollars and want you to pony

up at least $25,000, preferably $100,000 or more. The major exceptions are Federal Treasury bonds. The small investor is

welcome at www.treasurydirect.gov.

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Bond Mutual Funds Most small investors are better served by

investing in a bond mutual fund Professional Money Management Diversification Bond Traders are used to buying and selling in

the millions Smallest transactions are in the $10,000’s The mutual fund managers and pension fund

managers can get a much better deal because of their size

Although it is very easy to buy Treasury bonds directly from the Federal government at www.treasurydirect.gov

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Bottom Line on Bonds Bonds are good intermediate-term

investments Bonds are decent long-term investments

Especially good for those who would have trouble sleeping at night if they were fully invested in stocks

But don’t be fooled! Bonds have significant risks, too

Especially when interest rates are very low Like right now…