prentice-hall, inc.1 chapter 14 investing in bonds and other investments
TRANSCRIPT
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Chapter 14
Investing in bonds and other investments
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Why Consider Bonds?
Bonds reduce risk through diversification.
Bonds produce steady current income.Bonds can be a safe investment if held
to maturity.
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Basic Bond Terminology and Features
Par value -- the amount returned to the holder at maturity
Coupon interest rate -- indicates the percentage of the face value that will be paid annually to the holder in the form of interest
Indenture -- a document that outlines the terms of the loan agreement
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Basic Bond Terminology and Features (Cont’d)
Call provision -- allows the issuer to repurchase the bonds before the maturity date– Deferred calls provide more protection.
Sinking fund -- money set aside annually to pay off the bonds at maturity
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Different Types of Bonds
Corporate bonds Treasury and
agency bonds Municipal bonds Special situation
bonds
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Corporate Bonds
Secured corporate debts are secured by collateral or real property liens– Secured bond– Mortgage bond
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Corporate Bonds (Cont’d)
Unsecured corporate debts are not secured by collateral, and pay a higher return – Debenture -- long-term unsecured bond– Can have a hierarchy of payment, with
unsubordinated and subordinated debentures
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Treasury and Agency BondsTreasury bonds
– Bills, notes, and bonds– Treasury inflation-indexed bonds
Savings bonds– U.S. Series ee bonds– I bonds
Agency bonds– Pass-through certificates
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Treasury Bills, Notes, and Bonds
Considered risk free – no default or call risk
Pay a lower rate of interest than other bonds
Most interest is exempt from state and local taxes
Treasury direct avoids brokerage fees
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Treasury Bills, Notes, Bonds (Cont’d)
Bills mature in 3, 6, or 12 months
Notes mature in 2, 3, 5, or 10 years
Bonds mature in 10 to 30 years
All are sold in denominations of $1,000
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Agency Bonds
Issued by government agencies; authorized by congress– Federal national mortgage association (FNMA)– Federal home loan banks (FHLB)
Low risk, with interest rates slightly higher than treasury issues
Minimum denomination of $25,000 with maturities from 1 to 40 years
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Pass-through Certificates
Issued by government national mortgage association (GNMA)
Minimum $25,000 certificate for pool of mortgages
Principal and interest repaid monthly
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Treasury Inflation-indexed Bonds
Maturities of 10 years and a minimum par value of $1,000
Inflation increases the face value of the bond, guaranteeing the investor a real return
Tax complication -- must pay taxes annually on par value adjustments
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U.S. Series Ee BondsPurchase price is one-half of the face
value, ranging from $50 to $10,000Rate of return varies with the market
rateHave a guaranteed minimum interest
rate based on treasury securitiesHigh level of liquidity, but cashing in
before maturity may reduce yield
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Municipal Bonds (Muni’s)
Issued by to fund public projects Interest earnings are federal tax-exemptCan be exempt from state taxes if you
live in the state where bonds issued Not very liquid, due to the lack of a
secondary market
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Municipal Bonds (Cont’d)
Two basic types– General obligation– Revenue
Serial maturity -- a portion of the debt comes due each year for a set number of years
Not risk free; check the bond ratings
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Special Situation Bonds
Zero-coupon bonds Junk bonds
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Zero-coupon Bonds Issued by corporations, municipalities,
and the treasury (e.G., STRIPS)Do not pay interestAre sold at a discount from face valueAnnual appreciation is taxed although it
is not realizedFluctuate more with interest rate
changes than traditional bonds
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Junk Bonds
Have very low ratings
Normally offer very high interest rates
Have a high default rate
Are almost always callable
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Bond Yield
Is the total return on a bond investment Is not the same as the interest rate Is affected by the bond price which may
be more or less than face value
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Ways to Measure Bond Yield
Current yield Yield to maturity Equivalent taxable
yield on muni’s
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Current Yield
Ratio of annual interest payments to the bond’s market price
Current yield =
Annual interest payments
Market price of the bond
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Yield to MaturityTrue yield received if the bond is held to
maturity
Approximate yield to maturity =
Annual interest + par value - current price payments years to maturity par value + current price
2
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Equivalent Taxable Yield Equation for Muni’s
Equivalent taxable yield =
Tax-free yield on the municipal bond (1 - investor’s marginal tax
bracket)
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Bond Ratings – A Measure of Riskiness
Generally ratings run from AAA or aaa for the safest to D for the extremely risky
Ratings categorize bonds by default riskRating companies
– Standard & Poor’s– Moody’s
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Corporate Bond Quotes in The Wall Street Journal
Bonds -- the name of the issuerCur yld -- the annual interest divided by
the most current priceVol -- the volume, or number, of bonds
traded
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Corporate Bond Quotes (Cont’d)
Close -- the last price paid for that issue. Measured in 1/8s or $1.25.
Net chg -- the change in closing price from the prior day’s closing price. Measured in 1/8s or $1.25.
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Reading Treasury Quotes in The Wall Street Journal
Rate -- the original interest rate on the bond Maturity mo/yr -- the year and month the
issue will mature Bid -- the previous day’s mid-afternoon bid
price that treasury dealers were willing to buy the issue for. Measured in 32nds of a point; a point equals one-hundredth of par.
Asked -- the previous day’s mid-afternoon ask price the treasury dealers were willing to sell the issue for
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Reading Treasury Quotes (Cont’d)
Chg -- change from the prior day’s bid price
Ask yld -- is the effective rate of return on the investment
STRIPS -- refers to zero-coupon bondsDays to mat -- listed for t-bills due to
their short maturity lengths
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Bond Valuation Principles
Value of a bond =
Present value of + present value of repayment
All interest payments of par at maturity
Bonds fluctuate in value, and the longer the time to maturity the greater the fluctuation.
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Valuation Principles (Cont’d) Why would an investors
required rate of return change?– Change in the risk
associated with the firm issuing the bond.
– Change in general interest rates in the market.
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Valuation Principles (Continued)
As the available rate of return increases, the value of a lower rated bond decreases and an investor would pay a discount.
As the available rate of return drops, the value of a higher rated bond increases and an investor would pay a premium.
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Valuation Principles (Cont’d)
Interest rates affect bond valuation by changing the demand, and price, for a bond.
Interest rates and bond values are inversely related in the secondary market. But the call price limits the upward price on a bond with a call provision.
As a bond approaches its maturity date, its market value approaches it par value.
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Bond Valuation Relationships and The Investor
If you expect interest rates to increase, buy short-term bonds.
If you expect interest rates to decrease, buy long-term non-callable bonds.
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The Pros of Investing in Bonds
If interest rates drop, bond prices will rise.
Bonds reduce risk through diversification.
Bonds produce steady current income.Bonds can be a safe investment if held
to maturity.
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The Cons of Investing in Bonds
If interest rates rise, bond prices will fall. If the issuer experiences financial
problems, the bondholder may lose. If interest rates drop, rather than
experiencing price appreciation, the bond may be called.
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The Cons of Investing in Bonds (Cont’d)
If you need to sell your bonds early, you may have a problem selling them at a reasonable price.
Finding a good investment outlet for the interest you receive may be difficult.
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Analyzing Bond ChoicesThink about taxes.Keep the inverse relationship between
interest rates and bond price in mind.Avoid losers, and don’t worry about
picking winners.Consider only high quality bonds.Buy a bond when it is first issued, rather
than in the secondary market.
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Analyzing Bond Choices (Cont’d)
Avoid bonds that might get called.Match your bond’s maturity to your
investment time horizon.Stick to large issues.When in doubt, go treasury!
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Preferred Stock -- An Alternative to Bonds
Hybrid security with characteristics of stocks and bonds.
Dividend payments can be skipped, without the company being bankrupt.
Dividends are a fixed amount – a fixed dollar amount or a percentage of the stock’s par value.
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Preferred Stock -- An Alternative to Bonds (Cont’d)
Dividends are paid before common stock dividends
Do not share in other profits with the common stockholders
No voting rightsNo fixed maturity dateRated like bonds, typically medium
grade
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Features and Characteristics of Preferred Stock
Multiple issues – some companies have multiple issues of preferred stock, each with a different dividend
Cumulative feature – all past unpaid dividends must be paid before common stock dividends are paid
Adjustable rate – the dividend rate changes with the market interest rate rather than letting the value of the stock drop
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Features and Characteristics of Preferred Stock (Cont’d)
Convertibility – preferred stock can be exchanged for common stock at any time
Callability – issuer can repurchase the stock in case interest rates drop
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The Valuation of Preferred Stock
The value of preferred stock is the present value of the perpetuity of dividends
Value = annual dividend required rate of return
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Risks Associated With Preferred Stock
If interest rates rise, the value of the preferred stock drops.
If interest rates drop, the value rises, and the stock may be called.
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Risks of Preferred Stock Investing (Cont’d)
Investors don’t participate in the capital gains that common stockholders receive.
Preferred stock does not have the safety of a bond, because dividends can be passed without the risk of bankruptcy.
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Investing in Real EstateDirect investments
– Vacation homes– Commercial property (e.G., Apartment
buildings, office buildings, etc.)– Undeveloped land
Indirect investments– Real estate syndicates– Real estate investment trusts (REIT)
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Real Estate: Pros and Cons
Income produced with an opportunity of capital appreciation
Few tax advantagesDirect investment is active – time,
energy, and knowledge required IlliquidityOverbuilding can hurt prices
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Investing (Speculating) in Metals, Gems, Collectibles
Just don’t do it! Speculation is not
investing. Collectibles are fine
as entertainment, but not as savings vehicles.
Price depends on supply and demand.
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Summary
Reasons to invest in bondsDeterminants of a bond’s return
– Annual interest payments– Return of the par value
Measures of bond returns– Current yield– Yield to maturity
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Summary (Cont’d)
Sources of bonds– Corporations– Treasury and other agencies– Municipalities
Bond ratings -- AAA to DBond valuation and the relationship with
interest rates
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Summary (Cont’d)
Features of preferred stockReal estate investmentsSpeculative “investments” -- precious
metals, gems, and collectibles