investing in bonds and other alternatives. 14-2 copyright © 2010 pearson education, inc. publishing...

Investing in Bonds and Other

Alternatives

14-2Copyright © 2010 Pearson Education, Inc.  Publishing as Prentice Hall

Learning Objectives

1. Invest in the bond market.

2. Understand basic bond terminology and compare the various types of bonds.

3. Calculate the value of a bond and understand the factors that cause bond value to change.

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Learning Objectives

4. Compare preferred stock to bonds as an investment option.

5. Understand the risks associated with investing in real estate.

6. Know why you shouldn’t invest in gold, silver, gems, or collectibles.

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Introduction

Bonds carry less risk than stocks.

Bonds provide steady income.

But returns from bonds are not necessarily low.

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Why Consider Bonds?

Bonds reduce risk through diversification.

Bonds produce steady income.

Bonds can be a safe investment if held to maturity.

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Basic Bond Terminologyand Features

Par value

Maturity

Coupon Interest Rate

Indenture

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Basic Bond Terminologyand Features

Indenture – a legal document that provides specific terms of the loan agreement.

It includes: A description of the bond. The rights of bondholders. The rights of the issuing firm. The responsibilities of the bond trustees.

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Basic Bond Terminologyand Features

Call Provision

Deferred call

Sinking Fund

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Corporate Bonds

Corporate bonds

Secured corporate debt Mortgage bond

Unsecured corporate debtDebenture

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Treasury and Agency Bonds

Risk-free

Not callable

Lower interest rate

Most interest payments are exempt from state and local taxes.

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Treasury and Agency Bonds

Treasury-issued debt has maturities from 3 months to 10 years.

Bills, notes, and bonds differ by maturity and denomination.

Agency bonds

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Treasury and Agency Bonds

Pass-through certificates issued by the Government National Mortgage Association “Ginnie Mae”

Treasury Inflation Protected Securities (TIPS)—par value changes with the consumer price index to guarantee investor a real rate of return

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Treasury and Agency Bonds

U.S. Series EE Bonds

I Bonds

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Municipal Bonds

“Munis”—issued by states, counties, cities, public agencies e.g. school districts

General obligation bond

Revenue Bonds

Serial maturities

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Special Situation Bonds

Zero Coupon Bonds—don’t pay interest and are sold at a deep discount from their par value

Junk Bonds—also high-yield bonds, very risk, low-rated BB or below

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Bond Ratings – A Measureof Riskiness

Moody’s and Standard & Poor’s provide ratings on corporate and municipal bonds.

Ratings involve a judgment about a bond’s future risk potential.

The poorer the rating, the higher the rate of return demanded by investors.

Safest bonds receive AAA, D is extremely risky.

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Bond Yield

Current Yield—ratio of annual interest payment to the bond’s market price.

Yield to maturity—true yield or return that the bondholder receives if a bond is held to maturity—measure of expected return

Equivalent taxable yield on municipal bonds

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Valuation Principles

Principle 3—time value of money

Principle 8—risk and return go hand in hand

Value in today’s dollars of the interest payments and principal payments, add them together.

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Bond Valuation

The value of a bond is the present value of the interest payments plus the present value of the repayment of the bond’s par value at maturity

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Bond Valuation

If the issuer becomes riskier, the required rate of return should rise.

A change in general interest rates, the required rate of return should increase.

When interest rates rise, the value of outstanding bonds falls.

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Why Bonds Fluctuate in Value

Inverse relationship between interest rates and bond values in the secondary market.

When interest rates rise, bond values drop, and when interest rates drop, bond values rise

Longer-term bonds fluctuate in price more than shorter-term bonds.

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Figure 14.1

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Why Bonds Fluctuate in Value

As a bond approaches maturity, the market value approaches its par value.

When interest rates go down, bond prices go up, but upward price movement on bonds with a call provision is limited by the call price.

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What Bond Valuation Relationships Mean to the Investor

If you expect interest rats to go up (bond prices to fall)—purchase very short-term bonds

If you expect interest rates to go down (bond prices to rise)—purchase bonds with long maturities and are not callable.

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Reading Corporate Bond Quotes in the Wall Street Journal Online

Selling price is quoted as percentage of par.

Also expected to pay accrued interest

Invoice price—sum of the quoted or stated price of a bond and the bond’s accrued interest—price of bond on secondary market.

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Preferred Stock—An Alternative to Bonds

A hybrid security with features of common stock and bonds.

Similar to common stock—no fixed maturity date, not paying dividends won’t bring bankruptcy.

Similar to bonds—dividends are fixed, paid before common and no voting rights.

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Features and Characteristicsof Preferred Stock

Multiple Issues

Cumulative Feature

Adjustable Rate

Convertibility

Callability

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Valuation of Preferred StockThe value of a share of preferred stock is the

present value of the perpetual stream of constant dividends.

Value of preferred stock= annual preferred stock dividend

required rate of return

As market interest rates rise and fall, the value of preferred stock moves in an opposite manner

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Risks Associated withPreferred Stock

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

If interest rates drop, the value of preferred stock rises and it is called away.

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Risks Associated withPreferred Stock

Investor does not participate in the capital gains that common stockholders receive.

Investor doesn’t have the safety of bond interest payments, preferred dividends can be passed without the risk of bankruptcy.

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Investing in Real Estate

Requires time, energy and sophistication.

Direct investments in real estate

Indirect investments in real estate

Investing in real estate: the bottom line

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Investing – Speculating in Gold, Silver, Gems, and Collectibles

Don’t do it!

This is not investing – it is speculation.

Collectibles may only have entertainment value.

Don’t expect them to provide for your financial future.

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Summary

Bonds reduce risk, produce steady income, and can be safe investment.

Hold bond until it matures—can get yield to maturity.

Value of bond is the present value of the stream of interest payments plus the present value of the repayment of the bond’s par value at maturity

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Summary

Preferred stock is a security with no fixed maturity date and with dividends that are generally set in amount and don’t fluctuate.

You own property with direct real estate investment but with indirect real estate investment, you’re an investor in a group.

Gold, silver, gems or collectibles are not investments but speculation.