Chapter 16

Chapter 16 Investing in Bonds

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Chapter Objectives • Identify the different types of bonds • Explain what affects the return from investing in a bond • Describe why some bonds are risky • Identify common bond investment strategies

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Background on Bonds • Bonds: long-term debt securities issued by government agencies or corporations

• Par value: for a bond, its face value, or the amount returned to the investor at the maturity date when a bond is due • Most bonds have maturities between 10–30 years Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Background on Bonds • Issuers required to make interest payments and repay par value

• Bond Characteristics – Call feature: a feature on a bond that allows the issuer to repurchase the bond from the investor before maturity • These bonds offer a slightly higher return

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Background on Bonds – Convertible bond: a bond that can be converted into a stated number of shares of the issuer’s stock if the stock price reaches a specified price • These bonds tend to offer a slightly lower return

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Background on Bonds • A bond’s yield to maturity: the annualized return on a bond if it is held to maturity – If a bond sells at par value, its yield to maturity equals the coupon rate – If a bond sells below par value, its yield to maturity would exceed the coupon rate – If a bond sells above par value, its yield to maturity would be less than the coupon rate Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Financial Planning Online: Your Bond’s Yield • Go to: http://www.financenter.com/products/ sellingtools/calculators • Click on: “Bond,” then “What is my yield to maturity?”

• This Web site provides an estimate of the yield to maturity of your bond. Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Background on Bonds • Bonds trading in the secondary market – Investors sell their bonds to other investors before they reach maturity – Bond prices change in response to interest rates – Brokerage firms also take orders to buy or sell bonds

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Types of Bonds • Treasury bonds: long-term debt securities issued by the U.S. Treasury – Payments guaranteed by federal government – Interest is subject to federal income tax, but exempt from state and local taxes – Can easily be sold in the secondary market

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Types of Bonds • Municipal bonds: long-term debt securities issued by state and local government agencies – Low risk – Interest exempt from federal income tax

• Federal agency bonds: long-term debt securities issued by federal agencies – Low default risk – Interest is taxable Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Financial Planning Online: Municipal Bond Quotations • Go to: http://www.bloomberg.com/markets/ psamuni.html • This Web site provides quotations of yields offered by municipal bonds with various terms to maturity. Review this information when considering purchasing municipal bonds. Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Types of Bonds • Corporate bonds: long-term debt securities issued by large firms – Subject to default risk – High-yield (junk) bonds: bonds issued by smaller, less stable corporations that are subject to a higher degree of default risk

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Return from Investing in Bonds • Impact of interest rate movements on bond returns – If interest rates rise, the value of your bond decreases – If interest rates fall, the value of your bond increases

• Comparison of actual returns among bonds – Varies among types of bonds and among holding periods Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Return From Investing in Bonds

Exhibit 16.1: An Example of Corporate Bond Quotations Copyright © 2001 Dow Jones & Company, Inc. All Rights Reserved. Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Return from Investing in Bonds • Tax implications of investing in bonds – Interest is taxed as ordinary income (unless tax exempt) – Selling bonds at a price higher than you paid also results in a capital gain

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Return From Investing in Bonds

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Financial Planning Online: Today’s Events That Could Affect Bond Prices • Go to: http://www.businessweek.com/investor/

• Click on: Economy and Bonds • This Web site provides a summary of recent financial news related to the bond market, which you may consider before selling or buying bonds. Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Risk from Investing in Bonds • Default risk: risk that the borrower of funds will not repay the creditors – Risk premium: the extra yield required by investors to compensate for the risk of default – Use of risk ratings to measure the default risk • Ratings reflect likelihood that issuers will repay their debt over time Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Risk From Investing in Bonds

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Risk From Investing in Bonds – Relationship of risk rating to risk premium • The lower the risk rating, the higher the risk premium offered on a bond

– Impact of economic conditions • Higher risk of default when economic conditions are weak

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Risk From Investing in Bonds • Focus on Ethics: Accounting fraud and default risk – Prices of bonds issued by a firm with questionable financial statements can decline quickly – Securities and Exchange Commission is to ensure accuracy of a firm’s financial statements Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Risk from Investing in Bonds • Call (prepayment) risk: the risk that a callable bond will be called

• Interest rate risk: the risk that a bond’s price will decline in response to an increase in interest rates – Impact of a bond’s maturity on its interest rate risk • Bonds with longer terms more sensitive to interest rate movements Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Risk From Investing in Bonds – Selecting an appropriate bond maturity • Choose maturities that reflect your expectations of future interest rates

• Consider investing in bonds that have a maturity that matches the time you will need the funds

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Bond Investment Strategies • Interest rate strategy: selecting bonds for investment based on interest rate expectations – Purchase long-term bonds if you expect interest rates to fall

• Passive strategy: investing in a diversified portfolio of bonds that are held for a long period of time Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Bond Investment Strategies • Maturity matching strategy: investing in bonds that will generate payments to match future expenses – For example, parents might invest in a bond that will mature at the right time to pay for their child’s college education

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How Bond Decisions Fit within Your Financial Plan • Key decisions about bonds for your financial plan are: – Should you consider buying bonds? – What strategy should you use for investing in bonds?

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Integrating Key Concepts

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Integrating Key Concepts • Part 1: Financial Planning Tools • Part 2: Liquidity Management • Part 3: Financing • Part 4: Protecting Your Assets and Income • Part 5: Investing – In Chapter 13 we learned about investment fundamentals – In Chapter 14 we learned about stock analysis and valuation – In Chapter 15 we learned about investing in stocks

– In Chapter 16 we learned about investing in bonds – In Chapter 17 we will learn about investing in mutual funds – In Chapter 18 we will cover asset allocation

• Part 6: Retirement and Estate Planning

Valuing a Bond • Uses time value of money analysis • Includes the present value of the future cash flows or interest payments and the principal payment at maturity Value of Bond = Ct/(1 + k)t + Prin/(1 + k)t Ct = coupon or interest payments in a year Prin = principal payment at maturity K = required rate of return Copyright ©2004 Pearson Education, Inc. All rights reserved.

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Valuing a Bond • Example – Victor Kalafa is planning to purchase a bond that has 7 years remaining until maturity, a par value of $1,000, and a coupon rate of 6% (paid once annually at the end of the year). He is willing to purchase this bond only if he can earn a return of 8%, because he knows that he can earn 8% on alternative bonds that are available.

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Valuing a Bond • Future cash flows: Coupon payment (C) = .06  $1,000 Principal payment (Prin) = $1,000 • Discount rate: Required rate of return = 8 percent • Value of bond [C  (PVIFA,8%,7 yrs)]+[Prin  (PVIF,8%,7 yrs]

[$60  5.2064] + [$1,000  .5835] $312.38 + $583.50 = $895.88 Copyright ©2004 Pearson Education, Inc. All rights reserved.

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