prentice-hall, inc.1 chapter 14 investing in bonds and other investments

Prentice-Hall, Inc. 1

Chapter 14

Investing in bonds and other investments


Why Consider Bonds?

Bonds reduce risk through diversification.

Bonds produce steady current income.Bonds can be a safe investment if held

to maturity.


Basic Bond Terminology and Features

Par value -- the amount returned to the holder at maturity

Coupon interest rate -- indicates the percentage of the face value that will be paid annually to the holder in the form of interest

Indenture -- a document that outlines the terms of the loan agreement


Basic Bond Terminology and Features (Cont’d)

Call provision -- allows the issuer to repurchase the bonds before the maturity date– Deferred calls provide more protection.

Sinking fund -- money set aside annually to pay off the bonds at maturity


Different Types of Bonds

Corporate bonds Treasury and

agency bonds Municipal bonds Special situation

bonds


Corporate Bonds

Secured corporate debts are secured by collateral or real property liens– Secured bond– Mortgage bond


Corporate Bonds (Cont’d)

Unsecured corporate debts are not secured by collateral, and pay a higher return – Debenture -- long-term unsecured bond– Can have a hierarchy of payment, with

unsubordinated and subordinated debentures


Treasury and Agency BondsTreasury bonds

– Bills, notes, and bonds– Treasury inflation-indexed bonds

Savings bonds– U.S. Series ee bonds– I bonds

Agency bonds– Pass-through certificates


Treasury Bills, Notes, and Bonds

Considered risk free – no default or call risk

Pay a lower rate of interest than other bonds

Most interest is exempt from state and local taxes

Treasury direct avoids brokerage fees


Treasury Bills, Notes, Bonds (Cont’d)

Bills mature in 3, 6, or 12 months

Notes mature in 2, 3, 5, or 10 years

Bonds mature in 10 to 30 years

All are sold in denominations of $1,000


Agency Bonds

Issued by government agencies; authorized by congress– Federal national mortgage association (FNMA)– Federal home loan banks (FHLB)

Low risk, with interest rates slightly higher than treasury issues

Minimum denomination of $25,000 with maturities from 1 to 40 years


Pass-through Certificates

Issued by government national mortgage association (GNMA)

Minimum $25,000 certificate for pool of mortgages

Principal and interest repaid monthly


Treasury Inflation-indexed Bonds

Maturities of 10 years and a minimum par value of $1,000

Inflation increases the face value of the bond, guaranteeing the investor a real return

Tax complication -- must pay taxes annually on par value adjustments


U.S. Series Ee BondsPurchase price is one-half of the face

value, ranging from $50 to $10,000Rate of return varies with the market

rateHave a guaranteed minimum interest

rate based on treasury securitiesHigh level of liquidity, but cashing in

before maturity may reduce yield


Municipal Bonds (Muni’s)

Issued by to fund public projects Interest earnings are federal tax-exemptCan be exempt from state taxes if you

live in the state where bonds issued Not very liquid, due to the lack of a

secondary market


Municipal Bonds (Cont’d)

Two basic types– General obligation– Revenue

Serial maturity -- a portion of the debt comes due each year for a set number of years

Not risk free; check the bond ratings


Special Situation Bonds

Zero-coupon bonds Junk bonds


Zero-coupon Bonds Issued by corporations, municipalities,

and the treasury (e.G., STRIPS)Do not pay interestAre sold at a discount from face valueAnnual appreciation is taxed although it

is not realizedFluctuate more with interest rate

changes than traditional bonds


Junk Bonds

Have very low ratings

Normally offer very high interest rates

Have a high default rate

Are almost always callable


Bond Yield

Is the total return on a bond investment Is not the same as the interest rate Is affected by the bond price which may

be more or less than face value


Ways to Measure Bond Yield

Current yield Yield to maturity Equivalent taxable

yield on muni’s


Current Yield

Ratio of annual interest payments to the bond’s market price

Current yield =

Annual interest payments

Market price of the bond


Yield to MaturityTrue yield received if the bond is held to

maturity

Approximate yield to maturity =

Annual interest + par value - current price payments years to maturity par value + current price

2


Equivalent Taxable Yield Equation for Muni’s

Equivalent taxable yield =

Tax-free yield on the municipal bond (1 - investor’s marginal tax

bracket)


Bond Ratings – A Measure of Riskiness

Generally ratings run from AAA or aaa for the safest to D for the extremely risky

Ratings categorize bonds by default riskRating companies

– Standard & Poor’s– Moody’s


Corporate Bond Quotes in The Wall Street Journal

Bonds -- the name of the issuerCur yld -- the annual interest divided by

the most current priceVol -- the volume, or number, of bonds

traded


Corporate Bond Quotes (Cont’d)

Close -- the last price paid for that issue. Measured in 1/8s or $1.25.

Net chg -- the change in closing price from the prior day’s closing price. Measured in 1/8s or $1.25.


Reading Treasury Quotes in The Wall Street Journal

Rate -- the original interest rate on the bond Maturity mo/yr -- the year and month the

issue will mature Bid -- the previous day’s mid-afternoon bid

price that treasury dealers were willing to buy the issue for. Measured in 32nds of a point; a point equals one-hundredth of par.

Asked -- the previous day’s mid-afternoon ask price the treasury dealers were willing to sell the issue for


Reading Treasury Quotes (Cont’d)

Chg -- change from the prior day’s bid price

Ask yld -- is the effective rate of return on the investment

STRIPS -- refers to zero-coupon bondsDays to mat -- listed for t-bills due to

their short maturity lengths


Bond Valuation Principles

Value of a bond =

Present value of + present value of repayment

All interest payments of par at maturity

Bonds fluctuate in value, and the longer the time to maturity the greater the fluctuation.


Valuation Principles (Cont’d) Why would an investors

required rate of return change?– Change in the risk

associated with the firm issuing the bond.

– Change in general interest rates in the market.


Valuation Principles (Continued)

As the available rate of return increases, the value of a lower rated bond decreases and an investor would pay a discount.

As the available rate of return drops, the value of a higher rated bond increases and an investor would pay a premium.


Valuation Principles (Cont’d)

Interest rates affect bond valuation by changing the demand, and price, for a bond.

Interest rates and bond values are inversely related in the secondary market. But the call price limits the upward price on a bond with a call provision.

As a bond approaches its maturity date, its market value approaches it par value.


Bond Valuation Relationships and The Investor

If you expect interest rates to increase, buy short-term bonds.

If you expect interest rates to decrease, buy long-term non-callable bonds.


The Pros of Investing in Bonds

If interest rates drop, bond prices will rise.

Bonds reduce risk through diversification.

Bonds produce steady current income.Bonds can be a safe investment if held

to maturity.


The Cons of Investing in Bonds

If interest rates rise, bond prices will fall. If the issuer experiences financial

problems, the bondholder may lose. If interest rates drop, rather than

experiencing price appreciation, the bond may be called.


The Cons of Investing in Bonds (Cont’d)

If you need to sell your bonds early, you may have a problem selling them at a reasonable price.

Finding a good investment outlet for the interest you receive may be difficult.


Analyzing Bond ChoicesThink about taxes.Keep the inverse relationship between

interest rates and bond price in mind.Avoid losers, and don’t worry about

picking winners.Consider only high quality bonds.Buy a bond when it is first issued, rather

than in the secondary market.


Analyzing Bond Choices (Cont’d)

Avoid bonds that might get called.Match your bond’s maturity to your

investment time horizon.Stick to large issues.When in doubt, go treasury!


Preferred Stock -- An Alternative to Bonds

Hybrid security with characteristics of stocks and bonds.

Dividend payments can be skipped, without the company being bankrupt.

Dividends are a fixed amount – a fixed dollar amount or a percentage of the stock’s par value.


Preferred Stock -- An Alternative to Bonds (Cont’d)

Dividends are paid before common stock dividends

Do not share in other profits with the common stockholders

No voting rightsNo fixed maturity dateRated like bonds, typically medium

grade


Features and Characteristics of Preferred Stock

Multiple issues – some companies have multiple issues of preferred stock, each with a different dividend

Cumulative feature – all past unpaid dividends must be paid before common stock dividends are paid

Adjustable rate – the dividend rate changes with the market interest rate rather than letting the value of the stock drop


Features and Characteristics of Preferred Stock (Cont’d)

Convertibility – preferred stock can be exchanged for common stock at any time

Callability – issuer can repurchase the stock in case interest rates drop


The Valuation of Preferred Stock

The value of preferred stock is the present value of the perpetuity of dividends

Value = annual dividend required rate of return


Risks Associated With Preferred Stock

If interest rates rise, the value of the preferred stock drops.

If interest rates drop, the value rises, and the stock may be called.


Risks of Preferred Stock Investing (Cont’d)

Investors don’t participate in the capital gains that common stockholders receive.

Preferred stock does not have the safety of a bond, because dividends can be passed without the risk of bankruptcy.


Investing in Real EstateDirect investments

– Vacation homes– Commercial property (e.G., Apartment

buildings, office buildings, etc.)– Undeveloped land

Indirect investments– Real estate syndicates– Real estate investment trusts (REIT)


Real Estate: Pros and Cons

Income produced with an opportunity of capital appreciation

Few tax advantagesDirect investment is active – time,

energy, and knowledge required IlliquidityOverbuilding can hurt prices


Investing (Speculating) in Metals, Gems, Collectibles

Just don’t do it! Speculation is not

investing. Collectibles are fine

as entertainment, but not as savings vehicles.

Price depends on supply and demand.


Summary

Reasons to invest in bondsDeterminants of a bond’s return

– Annual interest payments– Return of the par value

Measures of bond returns– Current yield– Yield to maturity


Summary (Cont’d)

Sources of bonds– Corporations– Treasury and other agencies– Municipalities

Bond ratings -- AAA to DBond valuation and the relationship with

interest rates


Summary (Cont’d)

Features of preferred stockReal estate investmentsSpeculative “investments” -- precious

metals, gems, and collectibles

prentice-hall, inc.1 chapter 14 investing in bonds and other investments

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