Chapter 15
Investing in Bonds
Chapter 15
Investing in Bonds
Chapter 15Learning ObjectivesDescribe the characteristics of corporate bonds
Discuss why corporations issue bonds
Explain why investors purchase corporate bonds
Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds
Evaluate bonds when making an investment
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Characteristics of Corporate BondsObjective 1: Describe the characteristics of
corporate bonds
Corporation’s written pledge to repay a specified
amount of money with interest
The face value is the dollar amount that the
bondholder will receive at the bond’s maturity date-
usually $1,000
Bondholders receive interest payments every six
months at the stated interest rate3
Characteristics of Corporate Bonds
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•Par value = $1,000
•Coupon = 6.5% of par value per year,
or $65 per year ($32.50 every six
months).
•Maturity = 27 years (matures in 2036)
•Issued by AT&T.
Characteristics of Corporate Bonds The legal conditions are described in a
bond indenture
A trustee is a financially independent firm that acts as the bondholder’s representative
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Characteristics of Corporate BondsRisks of bonds
Interest risk
Purchasing power risk
Business risk
Liquidity risk
Call risk
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Characteristics of Corporate BondsFour important features:
Interest rate increases, bond value
decreases
Market value of bond will be less than
the par value if investor’s required rate is
above the coupon interest rate
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Characteristics of Corporate BondsFour important features:
As maturity date approaches, the market value of bond approaches its par value
Long-term bonds have greater interest
rate risk than do short-term bonds
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Why Corporations Sell BondsObjective 2: Discuss why corporations
issue bonds
To get funds for major purchases
To fund ongoing business activities
When it is difficult or impossible to sell stock
To improve financial leverage
Interest paid to bondholders is a tax deductible business expense that can be used to reduce the federal and state taxes corporations must pay
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Why Corporations Sell Bonds (continued) TYPES OF BONDS
Debenture bondMost corporate bonds are debenture bondsUnsecured - backed only by the reputation
of the issuing company
Mortgage bondA corporate bond that is secured by
various assets of the issuing firm, usually real estate
Interest rate is lower because it is secured by the collateral and corporate assets
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Why Corporations Sell Bonds (continued)
Subordinated debenture bondAn unsecured bond that gives bondholders
a claim secondary to that of other designated bond holders with respect to interest payments and claim on assets
Convertible bondA special kind of corporate bond that can
be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock
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Why Corporations Sell Bonds (continued)
PROVISIONS OF REPAYMENTCall Feature
Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date
Most agree not to call bonds for the first 5 to 10 years after they are issued
Bonds called, if their interest rate is much higher than the going rate
Most corporate bonds are callable
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Why Corporations Sell Bonds (continued)
Sinking fundCorporations deposit money in this fund
annually or semiannually and use the money to pay off the bondholders when the bond issue comes due
Serial bondsBonds of a single issue that mature on
different dates
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Why Investors Buy Corporate Bonds Objective 3: Explain why investors
purchase corporate bonds Interest Income
Investors receive interest every six months Interest will be paid to investors twice a
year, with the payment based on the interest rate and the face value of the bond
Registered bonds, Bearer bonds, Zero-coupon bonds
Dollar Appreciation of Bond Value May be able to sell the bond to someone else
at a higher price if the interest rate on the bond is higher than the market rate
Bond face amount will be repaid at maturity
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Why Investors Buy Corporate Bonds (continued)
THE MECHANICS OF BOND TRANSACTION
Bonds can be held until maturity or sold in the secondary market
Most bonds sold through full-service brokerage firms, discount brokerage firms, or the Internet
Corporate bonds may be purchased in the primary market or secondary market
Generally a minimum commission of $10-$35 on a $1,000 bond
Interest and capital gains from selling bonds are both taxable
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Government Bonds and Debt Securities
Objective 4: Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds
Sold to obtain money to finance the national debt, and the ongoing costs of government
Three levels of government issue bonds:Federal-no state income tax on the interestStateLocal municipalities
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Government Bonds and Debt SecuritiesTREASURY BILLS, NOTES, AND BONDS
Treasury Bills (T-Bills)$100 minimum4, 13, 26, or 52 weeks to matureSold at a discount
Treasury Notes (T-Notes)$100 units2, 5, and 10 year termsInterest paid every six months
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Government Bonds and Debt Securities (continued)
Treasury Bonds
Issued in minimum units of $100
Have maturities of 30 years
Interest rates are generally higher than those of T-bills and T-Notes
Interest is paid every 6 months
Held until maturity or sold before maturity
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Government Bonds and Debt Securities (continued)
FEDERAL AGENCY DEBT ISSUES
Fannie Mae ( www.fanniemae.com)Federal National Mortgage Association
Ginnie Mae - pay interest once a monthGovernment National Mortgage Association
Freddie MacFederal Home Loan Mortgage Corporation
Slightly higher risk than Treasury securities, so slightly higher interest rates
Issued for 1-30 years, 12 year average
Minimum denominations may be as high as $10,000-$25,000
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Government Bonds and Debt Securities (continued)
STATE AND LOCAL GOVERNMENT SECURITIES
General obligation bonds are backed by the state or local government that issues them
Revenue bonds are repaid from money generated by the project the funds finance, such as a toll bridge
Municipal bonds or munisIssued by a state or local government, such as cities,
counties, school districtsUse funds for ongoing costs & to build major
projects such as schools, airports, and bridges
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Government Bonds and Debt Securities (continued)
Features of Municipal Bond
People like to invest in projects close to home
They like insured municipal bonds, or states that guarantee payment
May be callable, but usually not until after the first ten years
Interest earned may be exempt from federal income tax so yield is higher
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Government Bonds and Debt Securities (continued)
Taxable equivalent yield= Tax-exempt yield1.0 - Your tax rate
Example:Taxable equivalent yield = .06
1.0 - 0.28
= 0.083 = 8.3%
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The Decision to Buy or Sell BondsObjective 5: Evaluate bonds when making
an Investment
THE INTERNETThe Internet can be used in the following ways
to evaluate a bondObtain the price information Trade bonds online for a lower commissionResearch information on the corporation and
bond issues onlineSome relevant Websites are:
www.bondsonline.com www.emuni.com www.buysellbonds.com www.fmsbonds.com www.municipalbonds.com
www.investiginbonds.com 23
The Decision to Buy or Sell Bonds (continued)
ANNUAL REPORTS
Write or telephone the corporation to receive the annual report
Corporations maintain web site that provides access to annual reports
Some financial publications provide a reader’s service to request an annual report
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The Decision to Buy or Sell Bonds (continued)
BOND RATINGS
Bond ratings provide quality and risk associated with bond issues
Moody’s Investor Service Inc. and Standard & Poor’s Corporation
Bond ratings generally range from AAA to D
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The Decision to Buy or Sell Bonds (continued)
BOND YIELD CALCULATIONS
Yield is the rate of return earned by an investor who holds a bond for a stated period
Current yield on corporate bond = Annual income amount Current market value
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The Decision to Buy or Sell Bonds (continued)
Yield to maturity
-- The rate of return investors earn on a bond if they
hold it to maturity.
Suppose we paid $898.90 for a $1,000 par 10%
coupon bond with 8 years to maturity and semi-annual
coupon payments. What is our yield to maturity?
N = 16, PV = -898.9 PMT = 50 FV = 1000
Solve I% = 6%
6% * 2 = 12%
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Online ActivityGo to one of these sites and look up information about municipal bonds in your area.
www.emuni.com www.munidipalbonds.com
…What do you think of the rates these bonds are paying?
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