PERSONAL  FINANCIAL  MANAGEMENT  INVESTING  IN  BONDS    Stocks  have  traditionally  returned  more  than  other  investment  alternatives  but  bonds  are  often  considered  a  safer   investment.  Bond  can  be  a  safe   investment  during  an  economic  crisis.  They  are   also   an   excellent  way   to   diversify   an   investment   portfolio   and   apply   the   concept   of   asset  allocation.   Investors  choose  bond  for  the  current   income  when  the  annual  coupon  payment   is  made.  Some  bonds  are  chosen  on  their  maturity  to  coincide  with  planned  expenditure.    CHARACTERISTICS  OF  CORPORATE  BONDS    A   corporate   bond   is   a   corporation’s   written   pledge   that   it   will   repay   a   specified   amount   of  money,   with   interest.   The   specified   sum   or   face   value   is   the   sum   that   the   bondholder   will  receive   at   maturity   date.   Between   the   time   of   purchase   and   date   of   maturity,   bondholders  receive  interest  or  coupon  payments  every  six  months  at  the  stated  interest/coupon  rate.      A  bond  indenture  is  a  legal  document  that  details  all  of  the  conditions  relating  to  a  bond  issue.  To  facilitate  the  administration  of  bonds,  corporations  appoint  trustee  to  manage  them.  Trustee  (usually   commercial  bank  or   financial   institution)   is   a   financially   independent   firm   that  acts  as  the   bondholders’   representatives.   Corporations   report   to   trustee   regarding   its   ability   to   pay  coupon   payment   and   eventually   redeem   the   bond   at   maturity.   Trustee   then   transmits   the  information   to   the  bondholders.   If   corporation   fails   to  meet   the   terms  of   the  bond   indenture,  trustee  may  bring  legal  action  to  protect  the  bondholders.    WHY  CORPORATIONS  SELL  CORPORATE  BONDS    Corporations  issue  bonds  as  a  mean  of  borrowing  fund  when  they:    do  not  have  enough  money  to  pay  for  major  purposes  need  to  finance  a  corporation’s  ongoing  business  activities  find  it  difficult  or  impossible  to  sell  stock  want  to  improve  a  corporation’s  financial  leverage  -­‐  the  use  of  borrowed  funds  to  increase  the  

firm’s  return  on  investment  use   the   interest   paid   to   bondholders   as   a   tax-­‐deductible   expense   that   reduces   the   taxes   the  

corporation  pays.    

Raising  bonds  for  capital  costs  less  than  to  issue  new  stocks.    Bonds  are  debt  financing  in  which  the  face  value  and  coupon  interest  need  to  be  paid  while  stock  is  equity  financing  in  which  the  stock  need  not  be  paid  and  dividend  need  not  be  declared.  in  the  event  of  bankruptcy,  the  bond  has  priority  over  stocks  to  claim  the  firm’s  assets.  Selling  bond  retain  control  of  the  corporation  with   bondholders   do   not   have   the   right   to   vote   while   issuing   stock   technically   transfer   the  ownership  of  the  corporation  to  the  stockholders.  Further,  stockholders  have  voting  right  which  determine  the  policies  of  the  corporation  including  to  elect  the  Board.    Types  of  Bonds    1. Debentures    

    Most  corporate  bonds  are  debentures,  unsecured  and  backed  only  by   the   reputation  of  the     issuing   corporation.     If   corporation   fails   to   pay   coupon   payments   and   face   value,     the     debenture  bondholders  become  general  creditors  and  on  bankruptcy  can  claim  any  assets     not  only  those  used  as  specific  collateral  for  a  loan  or  other  financial  obligation.    1. Mortgage  Bond/Secured  Bond         A   corporate   bond   that   is   secured   by   various   assets   of   the   issuing   firm;   usually   real  

estate.   Should   the   corporation   default,   the   corporate   assets   used   as   collateral   can   be  sold  to  repay  the  bondholders.  This  bond  is  safer  than  debentures.  However,  its  interest  rate  is  lower  because  it  is  secured  by  the  collateral  and  corporate  assets.  

 Subordinated  Debentures         An   unsecured   bond   that   gives   bondholders   a   claim   secondary   to   that   of  mortgage   or  

debenture  bondholders  with  respect   to   interest  payments  and  claim  on  assets.   It  pays  higher  interest  rate  due  to  higher  risk  associated  with  it.  

 1. Convertible  Bonds           A   special   kind   of   corporate   bond   that   can   be   exchanged,   at   the   owner’s   option,   for   a  

  specified   number   of   share   of   the   corporation’s   common   stock.   The   conversion  feature   allows   investors   to   enjoy   the   lower   risk   of   a   corporate   bond   but   also   take  advantage  of  the  speculative  nature  of  common  stock.  Example,    

    ABC’s   $1,000   bond   issue   with   a   2015   maturity   date   is   convertible.   Each   bond   can   be  

converted  to  35.6125  shares  of  ABC’s  common  stock.  It  means  you  can  convert  the  bond  to  stock  at  $28.08  ($1,000/35.6125)  per  stock  or  higher.      Bondholders  may  not  convert  convertible  bond  to  common  stock  because  if  the  market  value  of  common  stock  increases,  the  market  value  of  convertible  bond  also  increase.    There  are  three  reasons  why  corporations  sell  convertible  bonds:    

Interest  rates  on  convertible  bonds  are  lower  when  compared  to  traditional  bonds.  The  conversion  feature  attracts  investors  who  are  interested  in  speculative  investments.  If  the  bondholder  converts  a  convertible  bond  to  stock,  the  corporation  does  not  have  to  repay  

the  bond  at  maturity.    1. High  -­‐  Yield  Bond/Junk  Bond         Corporate  bonds  that  pay  higher  interest  but  also  have  a  higher  risk  of  default.    High-­‐yield  

  bonds     or   junk   bonds   are   sold   by   companies   with   a   poor   earnings   history,   having     questionable   credit   record   or   new   company   with   unproven   ability   to   increase   sales   or     earnings.    

      They   are   often   used   in   connection   with   leveraged   buyout;   a   situation   where   investors  

  acquire  a  company  and  sell  high-­‐yield  bonds  to  pay  for  the  company.  High-­‐yield  bond  pay     more  interest  than  typical  bond  but  the  inability  to  pay  annual  interest  and  face  value  at     maturity   is   real.   These   bonds   are   considered   too   risky   for   most   financial   institution   or  even     individual  investors.  

               

Provisions  For  Repayment    Today,   most   corporate   bonds   have   a   call   feature;   allows   the   corporation   to   call   in   or   buy  outstanding   bonds   from   current   bondholders   before   the  maturity   date.   For   bondholders  who  purchased  bonds   for   income,   a   problem   is   often   created  when  a  bond  paying  high   interest   is  called.  The  replacement  may  be  a  bond  with  lower  interest  or  if  the  interest  is  the  same,  the  risk  will  be  higher.    A  bond   is   called   if   the  market   interest   rate   is   lower   than   the  bond’s   interest   rate.  The  money  needed  to  call  a  bond  may  come  from  the  firm’s  profit,  the  sale  of  additional  stock  or  the  sale  of  a  new  bond  issue  that  has  a  lower  interest  rate.    In  most   cases,   corporations   issuing   callable  bonds   agree  not   to   call   them   for   the   first   5   to   10  years  after  the  bonds  have  been  issued.  When  a  call  feature  is  used,  the  corporation  may  have  to  pay  the  bondholders  a  premium,  an  additional  amount  above  the  face  value  of  the  bond.    A   corporation  may  use  one  of   two  methods   to  ensure   that   it  has   sufficient   funds  available   to  redeem  a  bond  issue  namely  sinking  fund  and  serial  bonds.    Sinking  fund  -­‐  a  fund  to  which  regular  deposits  are  made  for  the  purpose  of  redeeming  a  bond  

issue  when  the  bond  issue  comes  due.    Serial   bonds   -­‐   bonds   of   a   single   issue   that  matures   on   different   dates.   The   dates   of  maturity  

normally  coincide  with  the  dates  when  the  redemption  of  bonds  come  due.    WHY  INVESTORS  PURCHASE  CORPORATE  BONDS    Bond  investments  are  often  chosen  by   investors  who  want  to  diversify  and  use  the  concept  of  asset   allocation.     Asset   allocation   is   the   process   of   spreading   your   money   among   several  different   types   of   investments   to   lessen   risk   especially   during   troubled   economic   times  when  bond  is  a  safe  investment.    Basically,  investors  purchase  corporate  bond  for  three  reasons  (1)  interest  income,  (2)  possible  increase  in  value  and  (3)  repayment  at  maturity.    

   Interest  Income         Bondholders   received   interest   payment   normally   every   six   months.   The   amount   of  

interest  is     determined   by  multiplying   the   interest   rate   by   the   face   value   of   the   bond.  Since  the  interest     is  received  twice  a  year,  the  amount  is  divided  by  two.  

          The  method  used  to  pay  bondholders  their  interest  depends  on  whether  it  is  a  registered  

  bonds,  registered  coupon  bonds,  bearer  bonds  or  zero-­‐coupon  bonds.    Registered  bond  -­‐  the  bond  is  registered  in  the  owner’s  name  by  the  issuing     company.  

Interests  for  registered  bond  are  mailed  directly  to  the  bondholder  of     record.  Registered  coupon  bond  -­‐  the  bond  is  registered  for  principal  only,  not  for  interest.       To  

collect   interest  on  registered  coupon  bond,  the  owner  must  present  one  of  the    detachable  coupons  to  the  issuing  corporations  or  the  paying  agent.  

Bearer  bond  -­‐  a  bond  that  is  not  registered  in  the  investor’s  name.  They  are     generally  issued  by  corporation  outside  United  States.  

Zero-­‐coupon  bond  -­‐  a  bond  that  does  not  pay  interest  but  is  sold  at  a  price  far  below     its   face  value  and  is  redeemed  for  its  face  value  at  maturity.    

 Possible  increase  in  bond  value         Corporate  bonds   increase  or  decrease   in  value   in  opposite  to  the  market   interest  rate.  

The   financial  condition  of   the  corporation  and  the  probability  of   its   repaying   the  bond  also  affect  the  bond’s  value.  Possible  increase  in  bond  value  when  you  can  sell  the  bond  to   someone   else   at   a   higher   price   if   the   interest   rate   on   the   bond   is   higher   than   the  market  interest    rate.  

    Approximate  Market  Value  =  Amount  of  Annual  Interest/Comparable  Interest  Rate       Example,       You  purchase  ABC  bond  that  pay  5.5%  interest  on  a  face  value  of  $1,000  until  its  maturity  

in  2017.  Assume  a  new  corporate  bond  of  comparable  quality  are  currently  paying  7.0%.  The  approximate  market  value  of  your  bond,  

      Annual  interest  =  5.5%  x  $1,000  =$55     Approximate  market  value  =  $55/7%  =  $55/0.07  =  $786       Possible  increase  in  bond  is  $214  =  $1,000  -­‐  $786    Bond  Repayment  at  Maturity         Bond  face  amount  will  be  repaid  at  maturity.  When  you  purchase  a  bond,  you  have  two  

options;  keep  the  bond  until  maturity   then  redeem   it  or  you  may  sell   the  bond  at  any  time   to  another   investor.   It   is  also  possible   to  build  a  bond   ladder   to  balance   risk  and  return   in   an   investment   portfolio.     A   bond   ladder   is   a   strategy  where   investors   divide  their  investment  value  among  bonds  that  mature  at  regular  intervals  in  order  to  balance  risk  and  return.  

 A  TYPICAL  OF  BOND  TRANSACTION    Assume  that  on  January  4,  2000,  you  purchased  a  6.5%  corporate  bond  issued  by  ABC  Company  that   has   a   maturity   date   in   2028.   Your   cost   for   the   bond   was   $860   plus   a   $10   commission  charge,  for  a  total  investment  of  $870.  You  hold  on  to  the  bond  until  January  4,  2010,  when  you  sold  it  at  its  current  market  value  of  $1,080.  Show  the  return  on  your  investment.              

   THE  MECHANICS  OF  A  BOND  TRANSACTION    

Most   bonds   are   sold   through   full-­‐service   brokerage   firms,   discount   brokerage   firms   or   the  Internet.    You  have  to  pay  commission  when  you  buy  and  sell  bonds.    GOVERNMENT  BONDS  AND  DEBT  SECURITIES    In  addition   to   corporations,   governments   issue  bond   to  obtain   financing   for   the  national  debt  and  the  on  goings  costs  of  government.    Treasury  Bills,  Notes  and  Bonds    Why   investors   choose   government   securities   is   that   most   investors   consider   them   safe  investment  with  little  risk.  Government  securities  are  backed  by  the  full  faith  and  credit  of  the  government,  hence  they  offer  lower  interest  rates  than  corporate  bonds.  Treasury  bills  are  used  for  asset  allocation  and  lessen  overall  risk.    Federal  Agency  Debt  Issues    In  the  United  States,  debt  securities  can  also  be  issued  by  federal  agencies.  As  agencies  are  not  actually  part  of  the  government,  agency  debt  issues  often  have  slightly  higher  interest  rate  than  government  securities.    States  and  Local  Government  Securities    A  United  States  municipal  bond  or  muni,  is  a  debt  security  issued  by  a  state  or  local  government.  There  are  two  types  of  municipal  bonds:    A  general  obligation  bond  -­‐  a  bond  backed  by  the  full  faith,  credit  and  unlimited  taxing  power  of  

the  states/  municipal  that  issued  it.  A   revenue   bond   -­‐   a   bond   that   is   repaid   from   the   income   generated   by   the   project   it   is  

designated  to  finance.      THE  DECISION  TO  BUY  OR  SELL  BONDS    Evaluate  bonds  when  making  an  investment.  Ways  to  evaluate  bond  include:    Usage  of  the  Internet  

    The  Internet  can  be  used  to  obtain  the  bond  price  information,  trade  bond  online  for  a  lower   commission  and  obtain   research   information  on   the  corporation  or  government  bond  issues  online.  

 Obtaining  Annual  Reports       Get   the   issuing   corporation’s   annual   report   to   assess   their   financial   health;   strength   or  

  weaknesses.    Bond  Ratings  

Bond  ratings  provide  quality  and  risk  associated  with  bond  issues.    

   

                   

1. Bond  Yield  Calculations  Yield  is  the  rate  of  return  earned  by  an  investor  who  holds  a  bond  for  a  stated  period,    

1. Current  yield  on  corporate  bond  =  Annual  income  amount/Current  market  value    

1. Yield  to  Maturity,         Amount  of  Annual  Interest    +  (Face  value  -­‐  Market  value)/Number  of  periods  

    (Market  value  +  Face  value)/2           example,             $60  +  ($1,000  -­‐  $900)/10  =    $60  +  $100/10  =      $70/$950  =  0.074  =  7.4%  

                   ($900  +  $1,000)/2                                  $950