copyright ©2004 pearson education, inc. all rights reserved. chapter 16 investing in bonds

Copyright ©2004 Pearson Education, Inc. All rights reserved.

Chapter 16

Investing in Bonds

Copyright ©2004 Pearson Education, Inc. All rights reserved. 16-2

Chapter Objectives

• Identify the different types of bonds

• Explain what affects the return from investing in a bond

• Describe why some bonds are risky

• Identify common bond investment strategies


Background on Bonds

• Bonds: long-term debt securities issued by government agencies or corporations

• Par value: for a bond, its face value, or the amount returned to the investor at the maturity date when a bond is due

• Most bonds have maturities between 10–30 years


Background on Bonds

• Issuers required to make interest payments and repay par value

• Bond Characteristics– Call feature: a feature on a bond that

allows the issuer to repurchase the bond from the investor before maturity

• These bonds offer a slightly higher return


Background on Bonds

– Convertible bond: a bond that can be converted into a stated number of shares of the issuer’s stock if the stock price reaches a specified price

• These bonds tend to offer a slightly lower return


Background on Bonds

• A bond’s yield to maturity: the annualized return on a bond if it is held to maturity– If a bond sells at par value, its yield to

maturity equals the coupon rate

– If a bond sells below par value, its yield to maturity would exceed the coupon rate

– If a bond sells above par value, its yield to maturity would be less than the coupon rate


Financial Planning Online: Your Bond’s Yield

• Go to: http://www.financenter.com/products/sellingtools/calculators

• Click on: “Bond,” then “What is my yield to maturity?”

• This Web site provides an estimate of the yield to maturity of your bond.

http://www.financenter.com/products/sellingtools/calculators




Background on Bonds

• Bonds trading in the secondary market– Investors sell their bonds to other investors

before they reach maturity

– Bond prices change in response to interest rates

– Brokerage firms also take orders to buy or sell bonds


Types of Bonds

• Treasury bonds: long-term debt securities issued by the U.S. Treasury– Payments guaranteed by federal

government

– Interest is subject to federal income tax, but exempt from state and local taxes

– Can easily be sold in the secondary market


Types of Bonds

• Municipal bonds: long-term debt securities issued by state and local government agencies– Low risk– Interest exempt from federal income tax

• Federal agency bonds: long-term debt securities issued by federal agencies– Low default risk– Interest is taxable


Financial Planning Online: Municipal Bond Quotations

• Go to: http://www.bloomberg.com/markets/psamuni.html

• This Web site provides quotations of yields offered by municipal bonds with various terms to maturity. Review this information when considering purchasing municipal bonds.

http://www.bloomberg.com/markets/psamuni.html




Types of Bonds

• Corporate bonds: long-term debt securities issued by large firms– Subject to default risk

– High-yield (junk) bonds: bonds issued by smaller, less stable corporations that are subject to a higher degree of default risk


Return from Investing in Bonds

• Impact of interest rate movements on bond returns

– If interest rates rise, the value of your bond decreases

– If interest rates fall, the value of your bond increases

• Comparison of actual returns among bonds

– Varies among types of bonds and among holding periods


Return From Investing in Bonds

Exhibit 16.1: An Example of Corporate Bond QuotationsCopyright © 2001 Dow Jones & Company, Inc. All Rights Reserved.


Return from Investing in Bonds

• Tax implications of investing in bonds– Interest is taxed as ordinary income

(unless tax exempt)

– Selling bonds at a price higher than you paid also results in a capital gain


Return From Investing in Bonds


Financial Planning Online: Today’s Events That Could Affect Bond Prices

• Go to: http://www.businessweek.com/investor/

• Click on: Economy and Bonds

• This Web site provides a summary of recent financial news related to the bond market, which you may consider before selling or buying bonds.

http://www.businessweek.com/investor/


Risk from Investing in Bonds

• Default risk: risk that the borrower of funds will not repay the creditors– Risk premium: the extra yield required by

investors to compensate for the risk of default

– Use of risk ratings to measure the default risk

• Ratings reflect likelihood that issuers will repay their debt over time


Risk From Investing in Bonds



– Relationship of risk rating to risk premium• The lower the risk rating, the higher the risk

premium offered on a bond

– Impact of economic conditions• Higher risk of default when economic

conditions are weak



• Focus on Ethics: Accounting fraud and default risk– Prices of bonds issued by a firm with

questionable financial statements can decline quickly

– Securities and Exchange Commission is to ensure accuracy of a firm’s financial statements


Risk from Investing in Bonds

• Call (prepayment) risk: the risk that a callable bond will be called

• Interest rate risk: the risk that a bond’s price will decline in response to an increase in interest rates– Impact of a bond’s maturity on its interest

rate risk• Bonds with longer terms more sensitive to interest

rate movements



– Selecting an appropriate bond maturity• Choose maturities that reflect your expectations

of future interest rates

• Consider investing in bonds that have a maturity that matches the time you will need the funds


Bond Investment Strategies

• Interest rate strategy: selecting bonds for investment based on interest rate expectations– Purchase long-term bonds if you expect

interest rates to fall

• Passive strategy: investing in a diversified portfolio of bonds that are held for a long period of time


Bond Investment Strategies

• Maturity matching strategy: investing in bonds that will generate payments to match future expenses– For example, parents might invest in a

bond that will mature at the right time to pay for their child’s college education


How Bond Decisions Fit within Your Financial Plan

• Key decisions about bonds for your financial plan are:– Should you consider buying bonds?

– What strategy should you use for investing in bonds?


Integrating Key Concepts

Integrating Key Concepts

• Part 1: Financial Planning Tools

• Part 2: Liquidity Management

• Part 3: Financing

• Part 4: Protecting Your Assets and Income

• Part 5: Investing– In Chapter 13 we learned about investment fundamentals

– In Chapter 14 we learned about stock analysis and valuation

– In Chapter 15 we learned about investing in stocks

– In Chapter 16 we learned about investing in bonds

– In Chapter 17 we will learn about investing in mutual funds

– In Chapter 18 we will cover asset allocation

• Part 6: Retirement and Estate Planning


Valuing a Bond

• Uses time value of money analysis

• Includes the present value of the future cash flows or interest payments and the principal payment at maturity

Value of Bond = Ct/(1 + k)t + Prin/(1 + k)t

Ct = coupon or interest payments in a year

Prin = principal payment at maturity

K = required rate of return


Valuing a Bond

• Example

– Victor Kalafa is planning to purchase a bond that has 7 years remaining until maturity, a par value of $1,000, and a coupon rate of 6% (paid once annually at the end of the year). He is willing to purchase this bond only if he can earn a return of 8%, because he knows that he can earn 8% on alternative bonds that are available.


Valuing a Bond

• Future cash flows:Coupon payment (C) = .06 $1,000Principal payment (Prin) = $1,000

• Discount rate:Required rate of return = 8 percent

• Value of bond[C (PVIFA,8%,7 yrs)]+[Prin (PVIF,8%,7 yrs]

[$60 5.2064] + [$1,000 .5835] $312.38 + $583.50 = $895.88

copyright ©2004 pearson education, inc. all rights reserved. chapter 16 investing in bonds

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