Investing in Bonds and Other Alternatives

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Chapter 14

• Investing in Bonds and Other Alternatives

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Why Consider Bonds?

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

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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.

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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.

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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.

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Corporate Bonds

• Corporate bonds - allow firms to borrow money and
  are a major source of funding.
• Denominations in 1000.
• Secured bonds backed by collateral.
• Unsecured bonds called debentures.
• Hierarchy of bonds (more than 1 issue of
  debentures)
• Secured bonds.
• Unsubordinated (normal) debentures.
• Subordinated debentures are low on the list.

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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.

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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.

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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.

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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

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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.

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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 to finance the
  mortgages.
• 25,000 minimum denomination.
• Investor receives a monthly check of interest and
  principal, but amount varies.

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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 upward adjustment in par value
  although no cash is received (taxed as interest).

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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.

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Treasury and Agency Bonds

• I Bonds are accrual-type bonds.
• Interest is added to the value of bond and 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.
• Exempt from state and local taxes.

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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.

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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.

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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.

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Special Situation Bonds

• Zero Coupon Bonds do not pay interest.
• Sold at a discount and at maturity return the
  entire par value.
• Acts like a savings bond and appeals to those
  wanting a lump sum payment in the future without
  concerns of reinvesting interest.
• The annual appreciation in the bond is taxed (as
  interest) even though you do not receive income
  annually.
• Federal governments zero coupon bonds are called
  STRIPS.

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Special Situation Bonds

• Junk Bonds - low-rated bonds (also called
  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.
• Prudent investors avoid junk bonds.

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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.

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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.

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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.

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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.

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Bond Valuation

• What causes the required rate of return to
  change?
• If the issuer becomes riskier, the required rate
  of return should rise.
• When interest rates rise, the value of
  outstanding bonds falls.

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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.

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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.
• Investors will not pay more than the call price.

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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 stock.
• No voting rights.

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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.

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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 (causing your required
  rate of return to rise), the value of a share of
  preferred stock declines.

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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 because preferred dividends can be
  passed without the risk of bankruptcy.

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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

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Investing Speculating in Gold, Silver, Gems,
and Collectibles

• Dont do it!
• This is not investing it is speculation.
• Collectibles may only have entertainment value.