11B Investing Basics and Evaluating Bonds #2

Recall the concept of asset allocation

11-1

One Effect of Asset Allocation: A Weighted Total

Return

Ultraconservative “Investors” Are Really Just

“Savers”• People who invest very conservatively

• They do not get ahead financially over the long term because taxes and inflation offset most of their interest earnings

• Remember “The Rule of 72”?

– 72/4% = 18 years

– 72/8% = 9 years (money doubles much faster)

Identify the Types of Investments You Want to

MakeDo You Want to Lend Your Money or Own an Asset?

– Debts – “loanership” (lending) investments.

• Fixed Maturity – the borrower agrees to repay the principal to the investor on a specific date.

• Fixed Income – the borrower agrees to pay the investor a specific rate of return for use of the principal.

– Equities – “ownership” investments.

• Potential for a higher return by sharing in profits

The Risk Pyramid Reveals the Trade-offs Between Investment Risk and

Return

Inflation

• To beat inflation, one must invest money so that it earns a higher after-tax return than the inflation rate

• Real Rate of Return – the return after subtracting the effects of both inflation and income taxes.

Example:

10% return, 7.5% after taxes (25% tax bracket), 4% inflation, real rate of return of 3.5% after taxes and inflation

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 co. stocks

• A “fixed-income” security

• A form of debt financing (bond owners repaid in future)

11-7

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 – Example: $1,000 x 5.8% = $58 (in two $29

payments)

• Maturity Date = date on which face value repaid; generally 1 to 30 years

11-8

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

11-9

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

11-10

Types of Corporate Bonds

• Debenture

– Unsecured debt

– Investors become “creditors” if company fails

– Backed only by the reputation of the issuing

company; most corporate bonds are this type

• Mortgage Bond

– Secured by various assets of the issuing firm,

such as real estate and property

– Lower interest (coupon) rate since debt is secured

11-11

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, coupon rate on a convertible bond is 1%

to 2% lower than the rate paid on traditional bonds

– Would only want to convert when stock price gets

higher than the bond’s equivalent value in stock

11-12

Provisions For Repayment

Call Feature of Bonds

• Corporation can “call in” or buy back outstanding bonds before the maturity date

• Most corporate bonds are callable

• Call-protected for 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

– Like consumers refinancing to lower-rate mortgage

11-13What is the effect of called back bonds on investors?

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

– Example: After first 10 years, over the next 10

years, 10% of bonds mature each year

Bond

11-14

Why Investors Purchase Corporate Bonds

1. Interest Income - “Fixed Income”– Registered Bond- tracked electronically

• Coupon and principal paid to registered owner (check or direct deposit)

– 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• Redeemed at face value at maturity 11-15

Bond

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

• 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 (will be worth less due to inflation)

– Bondholders may keep till maturity or sell

4. Portfolio diversification beyond stock and cash assets

11-16

Approximate Bond Value Formula

• 5.875% interest on ($1,000 bond) = $58.75• New issues paying 5% (decrease in coupon rate)

• Dollar amount of interest $58.75

Comparable interest rate = 5% (.05) = $1,175

• Bond worth more than face value because it pays interest rate higher than current market rate

• New issues paying 6.5% (increase in coupon rate)

• Dollar amount of interest $58.75

Comparable interest rate = 6.5% (.065) = $903.85

• Bond worth less than face value because it pays interest rate lower than current market rate

Premiums and Discounts

When a bond is first issued, it is sold in one of three ways:

– at its face value

– at a discount below its face value or

– at a premium above its face value.

Price Changes for Bonds

What does this graph tell you?

Objective 6Evaluate Bonds When Making an

Investment• Sources of Information – The Internet

– The issuing firm’s website

– www.bondsonline.com

– http://bonds.yahoo.com

• Financial coverage of bond transactions– Wall Street Journal, Barrons, Internet

• Other Sources of Information– Business Periodicals– Federal Agencies

• www.federalreserve.gov• www.treasury.gov• www.sec.gov

11-20

Corporate Bond QuotesCurrentYield(%)

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% (considers bond maturity date)

• Current yield = 6.283% = 5.875/93.51 (interest/price)

11-21

Bond Ratings Measure Default Risk

11-22

Decisions Bond Investors Must Make

• Decide on risk level.

– Investment grade bonds: top 4 grades (BBB, A, AA, AAA)

– Junk bonds (a.k.a., high yield bonds): lower rated and higher risk

• Decide on maturity.

– Match to financial goals

• Determine the after-tax return.

– Taxable versus tax-exempt

Wrap Up

• Chapter Quiz

• Concept Check 11-5- Calculate Semi-annual Interest and Reasons That Investors Buy Bonds

• Concept Check 11-6- Current Value of Bonds; Explain Bond Ratings