Chapter 11

Investing Basics

and Evaluating

Bonds

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Investing Basics and Evaluating Bonds

Chapter Objectives

1. Explain why you should establish an investment program.

2. Describe how safety, risk, income, growth, and liquidity affect your investment program.

3. Identify the factors that reduce investment risk.

4. Understand why investors purchase government bonds.

5. Recognize why investors purchase corporate bonds.

6. Evaluate bonds when making an investment.11-2

Objective 1Explain 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

11-3

Establishing Investment Goals

1. What will you use the money for?

2. How much money do you need to satisfy your

investment goals?

3. How will you obtain the money?

4. How long will it take you to obtain the money?

5. How much risk are you willing to assume in an

investment program?

6. What possible economic or personal conditions could

alter your investment goals?

11-4

Establishing Investment Goals

7. Considering your economic

circumstances, are your investment

goals reasonable?

8. Are you willing to make the sacrifices

necessary to ensure that you meet

your investment goals?

9. What will the consequences be if you

don’t reach your investment goals?

11-5

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 11-6

Surviving a Financial Crisis

1. Establish a larger than usual emergency fund

2. Know what you owe• Identify debts that must be paid

3. Reduce spending

4. Pay off credit cards

5. Apply for a line of credit at your bank, credit union, or financial institution

6. Notify credit card companies and lenders if you are unable to make payments

7. Monitor the value of your investment and retirement accounts

11-7

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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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

11-9

Objective 2Describe 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 time11-10

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

11-11

Investment Income, Growth

and Liquidity

• Investment Income

– 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

11-12

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

11-13

Traditional Investment Evaluation

Factors

11-14

Objective 3Identify 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

11-15

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

11-16

Portfolio Investing

Brokerage firms may construct sample portfolios for

client consideration:

11-17

Your Role in the Investment

Process

1. Evaluate potential Investments

2. Monitor the value of your investments

3. Keep accurate records

4. Other factors

Seek help from personal financial

planner

Consider the tax consequences of

selling your investments

11-18

Objective 4Understand 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

11-19

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

• Federal but no state tax on interest earned11-20

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 rate11-21

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

– TVA11-22

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

11-23

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

11-24

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

11-25

Taxable Equivalent Yield

%94.60694..28 - 1

.05 Yield Equivalent Taxable

:Example

rate tax Your - 1

ldexempt yie-Tax Yield Equivalent Taxable

Used to compare tax exempt and taxable

bonds

11-26

Objective 5Recognize Why Investors Purchase

Corporate Bonds

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

11-27

Corporate Bonds

• Face value:

– 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

11-28

Corporate Bonds

• Bond Indenture

– 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

11-29

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

11-30

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

11-31

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

11-32

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

11-33

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

11-34

Why Investors Purchase Corporate Bonds

1. 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

11-35

Why Investors Purchase Corporate Bonds

2. 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

3. Bond repayment at maturity

– Face value repaid on maturity date

– Bondholders may keep till maturity or sell

11-36

Objective 6Evaluate Bonds When Making an

Investment

• Sources of information – The Internet

– The issuing firm’s website

– www.bondsonline.com

– www.bondsearch123.com

– http://bonds.yahoo.com

• Price information (quotes)

• Trade bonds online

• Research on the issuing corporation

• Financial coverage of bond transactions

– Wall Street Journal, Barrons, Internet

11-37

Corporate Bond Quotes

Current

Yield(%)

HOME DEPOT INC 93.51 5.875 16-Dec-36 6.365 6.283 AA

HOME DEPOT INC 95.81 5.400 1-Mar-16 6.027 5.636 AA

HOME DEPOT INC 98.70 5.250 16-Dec-13 5.492 5.319 AA

HOME DEPOT INC 100.32 5.200 1-Mar-11 5.101 5.183 AA

Maturity YTM(%)

Fitch

RatingsIssue Price Coupon(%)

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 = 6.283% = 5.875/93.51

11-38

Bond Ratings Measure Default Risk

11-39

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• www.federalreserve.gov

• www.treasury.gov

• www.commerce.gov

• www.sec.gov

11-40

END OF CHAPTER 11

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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?

11-42