chapter 16 investing in bonds. copyright ©2014 pearson education, inc. all rights reserved.16-2...

Chapter 16

Investing in Bonds

Chapter Objectives

• Identify the different types of bonds

• Explain what affects the return (yield) from investing in a bond

• Describe how bonds are valued

• 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 (cont’d)

• 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

– 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

• 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

• Go to www.calculatorweb.com/calculators/bondcalc.shtml

• This web site provides an estimate of the yield to maturity of your bond based on its present price, its coupon rate, and its maturity.

• Bond 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 (cont’d)

• 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

• Go to www.bloomberg.com/markets/rates/index

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

• Corporate bond quotations– Coupon rate– Maturity– Current yield– Volume– Closing price– Net change in the price from the previous day

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

Return from Investing in Bonds (cont’d)

• 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 (cont’d)

Valuing a Bond

• Uses time value of money– Present value of the future coupon payments– Present value of the principal payment

• Economic impact on bond values– Higher rate of return is only realized if firms are

healthy enough to make payments– This may not be true in unfavorable economic

conditions

• Go to www.bloomberg.com/news/markets/bonds.html

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

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 (cont’d)

– Impact of the financial crisis on default risk• Many firms experienced financial problems and were

unable to make bond payments

– 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

• Call (prepayment) risk: the risk that a callable bond will be redeemed by the issuer

• 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 (cont’d)

• 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?

chapter 16 investing in bonds. copyright ©2014 pearson education, inc. all rights reserved.16-2...

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