Investing in Bonds and Other Alternatives

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Investing in Bonds and Other Alternatives

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Investing in Bonds and Other Alternatives Learning Objectives Invest in the bond market. Understand basic bond terminology and compare the various types of bonds. – PowerPoint PPT presentation

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Title: Investing in Bonds and Other Alternatives


1
Chapter 14
  • Investing in Bonds and Other Alternatives

2
Learning Objectives
  • Invest in the bond market.
  • Understand basic bond terminology and compare the
    various types of bonds.
  • Calculate the value of a bond and understand the
    factors that cause bond values to change.
  • Understand the risks associated with investing in
    real estate.
  • Know why you shouldnt invest in gold, silver,
    gems, or collectibles.

3
Why Consider Bonds?
  • Bonds reduce risk through diversification.
  • Bonds produce steady income.
  • Bonds can be a safe investment if held to
    maturity.

4
Basic Bond Terminologyand Features
  • Par value the face value or amount returned at
    maturity.
  • Usually 1000 for corporate bonds.
  • Bonds selling at 99½ are selling for 995.
  • Coupon Interest Rate the percentage of par
    value that will be paid out annually in the form
    of interest.
  • 8½ coupon pays 85 annually.

5
Basic Bond Terminologyand Features
  • Indenture a legal document that provides
    specific terms of the loan agreement.
  • It includes
  • A description of the bond.
  • The rights of bondholders.
  • The rights of the issuing firm.
  • The responsibilities of the bond trustees.

6
Basic Bond Terminologyand Features
  • Call Provision entitles issuer to repurchase
    (call) back the bonds at stated prices.
  • If interest rates decline, the issuer will call
    the bonds and replace with lower-cost debt.
  • Sinking Fund issuer sets aside money on a
    regular basis to pay off bonds at maturity.
  • Firm calls or repurchases in the open market.

7
Corporate Bonds
  • Corporate bonds - allow firms to borrow money,
    are a major source of funding.
  • Denominations in 1000.
  • Secured bond backed by collateral.
  • Unsecured bond a debenture.
  • Hierarchy of bonds subordinated debentures are
    low on the list.

8
Treasury and Agency Bonds
  • U.S. government is the largest issuer of debt.
  • Government spends more than it takes in.
  • To finance an unbalanced budget, it can
  • Sell assets.
  • Raise taxes.
  • Borrow more money.

9
Treasury and Agency Bonds
  • Viewed as risk-free - given the governments
    ability to tax and print money.
  • With no default risk and no call risk, they pay a
    lower interest rate.
  • Most government interest payments are exempt from
    state and local taxes.

10
Treasury and Agency Bonds
  • Treasury-issued debt has maturities from 3 months
    to 10 years.
  • Until 2001, 30-year bonds were issued.
  • 70 of the debt has maturities of 5 years or
    less.
  • Government issues include bills, notes, and bonds.

11
Treasury and Agency Bonds
  • Government Debt
  • Treasury Bills
  • Treasury Notes
  • Treasury Bonds
  • Maturity When Issued
  • 3, 6, or 12 months
  • 2, 3, 5, or 10 years
  • Over 10 years

12
Treasury and Agency Bonds
  • Federal National Mortgage Association (FNMA) and
    the Federal Home Loan Banks (FHLB) issue agency
    bonds.
  • Not directly issued through the Treasury.
  • Considered to be virtually risk-free.
  • Interest rate higher than Treasuries.
  • Minimum denomination is 25,000.

13
Treasury and Agency Bonds
  • Government National Mortgage Association (GNMA)
    issues pass-through certificates.
  • Represents an interest in a pool of federally
    insured mortgages.
  • GNMA packages a group of mortgages, guarantees
    them, then sells certificates.
  • 25,000 minimum denomination.
  • Investor receives a monthly check of interest and
    principal, but amount varies.

14
Treasury and Agency Bonds
  • Treasury Inflation Protected Securities (TIPS) is
    the newest Treasury bond.
  • Maturities of 5, 10, or 20 years.
  • Par value of 1,000.
  • Par value changes when CPI changes.
  • Investors guaranteed a real return a return
    above inflation.
  • Must pay taxes on adjustment although no cash is
    received.

15
Treasury and Agency Bonds
  • U.S. Series EE Bonds savings bonds aimed at
    small investor.
  • Face values from 50 to 10,000.
  • Purchased at half of face value.
  • Bond doubles in value after a specified period.
  • Liquid can be cashed in at any time.

16
Treasury and Agency Bonds
  • Bonds are accrual-type bonds.
  • Interest added to the value of bond, paid when
    cashed in.
  • Sold at face value, grow with inflation-indexed
    earnings for up to 30 years.
  • Return includes a fixed return and a semiannual
    inflation rate.
  • Invest from 50 to 30,000 per year.
  • Defer federal taxes up to 30 years.

17
Municipal Bonds
  • Munis are issued by states, counties, cities, and
    other public agencies.
  • Over 1 trillion in outstanding value.
  • Tax exempt from federal government and by state
    (as long as you live where the bonds were
    issued).
  • Capital gains, from selling early, are taxed.

18
Municipal Bonds
  • General Obligation
  • Backed by the full faith and credit of issuer.
  • Taxes used to pay back principal and interest.
  • Example School district builds new school, taxes
    used to pay back the lenders.
  • Revenue Bonds
  • Derive funds to pay interest and repay principal
    from a designated project.
  • Example Bond finances a new toll road, revenue
    from tolls pay back lenders.

19
Municipal Bonds
  • Most munis have serial maturities a portion of
    the debt matures each year.
  • Munis are not risk-free.
  • Although rare, issuers can default.
  • Rating agencies evaluate bonds.
  • Small issues may be illiquid.

20
Special Situation Bonds
  • Zero Coupon Bonds no interest payments.
  • Sold at a discount, returns par value at
    maturity.
  • Acts like a savings bond, appeals to those
    wanting a lump sum payment in the future without
    concerns of reinvesting interest.
  • Although interest is not received annually, the
    investor is taxed on interest income.
  • Federal government issues STRIPS.

21
Special Situation Bonds
  • Junk Bonds - low-rated bonds or high-yield bonds.
  • Have ratings of BB or below.
  • Major issuers of junk bonds are new firms that
    have not yet established a performance record.
  • With a greater risk of default, they have
    interest rates 3-5 above AAA long-term bonds.
  • Most are callable.

22
Evaluating Bonds
  • Current Yield - refers to the ratio of interest
    payment to the bonds market price.
  • Yield to Maturity true yield received if bond
    is held to maturity.
  • Considers the annual interest payments as well as
    the difference between the bonds current market
    price and maturity value.

23
Evaluating Bonds
  • Equivalent Taxable Yield on Municipal Bonds
  • Appeal of munis is their tax-exempt status.
  • Make comparisons between munis and taxable bonds.
  • Calculation refers to tax bracket including
    federal, state, and local taxes avoided by the
    muni.
  • The higher the tax bracket, the more attractive
    the muni.

24
Bond Ratings A Measureof Riskiness
  • Moodys and Standard Poors provide ratings on
    corporate and municipal bonds.
  • Ratings involve a judgment about a bonds future
    risk potential.
  • Default risk ability to repay principal.
  • Inability to meet interest obligations.
  • The lower the rating, the higher the rate of
    return demanded by investors.
  • Safest bonds receive AAA, D is extremely risky.

25
Reading Corporate Bond Quotes in the Wall Street
Journal
  • Selling price is quoted as a percent of par.
  • Price listed at 101 -- 101 x 1000 1010.
  • Include accrued interest.
  • Invoice price is the sum of the quoted price and
    accrued interest.

26
Reading Treasury Quotes inthe Wall Street Journal
  • Treasury and agency securities trade in
    thirty-seconds (1/32).
  • Price listed as 10231 102 31/32
  • If par value is 10,000 then price is 10,296.88.
  • Paper lists both bid and ask prices.

27
Bond Valuation
  • Bond owners receive interest payments for a
    number of years, and then par value at maturity.
  • Value of a bond is the present value of the
    interest payments plus the present value of the
    repayment of par value at maturity.

28
Bond Valuation
  • The value of a bond should be approximately the
    same as its price.
  • The interest payments come in the form of an
    annuity.
  • The repayment of par comes in the form of a
    single cash flow.

29
Bond Valuation
  • What causes the required rate of return to
    change?
  • If the issuer becomes riskier, the required rate
    of return should rise.
  • A change in general interest rates, increase in
    expected inflation, the required rate of return
    should increase.
  • When interest rates rise, the value of
    outstanding bonds falls.

30
Why Bonds Fluctuate in Value
  • Inverse relationship between interest rates and
    bond values.
  • When interest rates rise, investors demand a
    higher return.
  • Because of the fixed coupon rate, the price must
    drop.
  • Longer-term bonds fluctuate in price more than
    shorter-term bonds.

31
Why Bonds Fluctuate in Value
  • Longer-term bonds fluctuate in price more than
    shorter-term bonds.
  • As a bond approaches maturity, the market value
    approaches par value.
  • When interest rates go down, bond prices go up,
    but upward price movement on bonds with a call
    provision is limited by the call price.

32
Preferred Stock
  • A hybrid security with features of common stock
    and bonds.
  • Similar to common
  • No fixed maturity date.
  • Not paying dividends wont cause bankruptcy.
  • Similar to bonds
  • Dividends are fixed, paid before common.
  • No voting rights.

33
Features and Characteristicsof Preferred Stock
  • Multiple Issues more than one issue.
  • Cumulative Feature all unpaid dividends must be
    paid prior to declaring common dividends.
  • Adjustable Rate dividends fluctuate with
    interest rates.
  • Convertibility holder can, at any time,
    exchange for predetermined number of common
    shares.
  • Callability if interest rates decline,
    preferred stock likely to be called.

34
Valuation of Preferred Stock
  • With a preferred stock, you receive a steady
    stream of dividends that go on forever.
  • The value of a share of preferred stock is the
    present value of the perpetual stream of constant
    dividends.
  • When interest rates rise, value decreases.

35
Risks Associated withPreferred Stock
  • If interest rates rise, the value of preferred
    stock drops.
  • If interest rates drop, the value of preferred
    stock rises and it is called away.
  • Investor does not participate in the capital
    gains that common stockholders receive.
  • Investor doesnt have the safety of bond interest
    payments, preferred dividends can be passed
    without the risk of bankruptcy.

36
Investing in Real Estate
  • Investing in real estate requires time, energy
    and sophistication.
  • Investment real estate can be
  • Direct own the property
  • Vacation homes, commercial property, undeveloped
    land
  • Indirect invest in a group, hire a manager
  • Real Estate Investment Trust (REIT), real estate
    syndicates

37
Investing Speculating in Gold, Silver, Gems,
and Collectibles
  • Dont do it!
  • This is not investing it is speculation.
  • Collectibles may only have entertainment value.
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