Investing in Bonds and Other Alternatives

1
Chapter 14

• Investing in Bonds and Other Alternatives

2
Why Consider Bonds?

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

3
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

4
Basic Bond Terminology and Features (contd)

• 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

5
Different Types of Bonds

• Corporate bonds
• Treasury and agency bonds
• Municipal bonds
• Special situation bonds

6
Corporate Bonds

• Secured corporate debts are secured by collateral
  or real property liens
• Secured bond
• Mortgage bond

7
Corporate Bonds (contd)

• 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

8
Treasury and Agency Bonds

• Treasury bonds
• Bills, notes, and bonds
• Treasury inflation-indexed bonds
• Savings bonds
• U.S. Series EE bonds
• I bonds
• Agency bonds
• Pass-through certificates

9
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

10
Treasury Bills, Notes, Bonds (contd)

• 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
• Can be purchased directly from the Treasury

11
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

13
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

14
U.S. Series EE Bonds

• Purchase price is one-half of the face value,
  ranging from 50 to 10,000
• Rate of return varies with the market rate
• Have a guaranteed minimum interest rate based on
  Treasury securities
• High level of liquidity, but cashing in before
  maturity may reduce yield

15
Municipal Bonds (Munis)

• Issued to fund public projects
• Interest earnings are federal tax-exempt
• Can 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 (contd)

• 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 interest
• Are sold at a discount from face value
• Annual appreciation is taxed although it is not
  realized
• Fluctuate more with interest rate changes than
  traditional bonds

19
Junk Bonds

• Have very low ratings
• Normally offer very high interest rates
• Have a high default rate
• Are almost always callable

20
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 munis

22
Current Yield

• Ratio of annual interest payments to the bonds
  market price
• Current yield
• annual interest payments
• market price of the bond

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Yield to Maturity

• True 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 Munis

• Equivalent taxable yield
• tax-free yield on the municipal bond
• (1 - investors marginal tax bracket)

25
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 risk.
• Rating companies
• Standard Poors
• Moodys

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Corporate Bond Quotes in The Wall Street Journal

• Bonds the name of the issuer
• Cur Yld the annual interest divided by the most
  current price
• Vol the volume, or number, of bonds traded

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Corporate Bond Quotes (contd)

• 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 days closing price. Measured in 1/8s or
  1.25.

28
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 days 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 days mid-afternoon ask
  price the Treasury dealers were willing to sell
  the issue for

29
Reading Treasury Quotes (contd)

• Chg change from the prior days bid price
• Ask Yld is the effective rate of return on the
  investment
• STRIPS refers to zero-coupon bonds
• Days 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 (contd)

• 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 (contd)

• 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 (contd)

• 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 its 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 (contd)

• 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 Choices

• Think about taxes.
• Keep the inverse relationship between interest
  rates and bond price in mind.
• Avoid losers, and dont 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 (contd)

• Avoid bonds that might get called.
• Match your bonds maturity to your investment
  time horizon.
• Stick to large issues.
• When in doubt, go Treasury!

40
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 stocks par value

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Preferred Stock An Alternative to Bonds (contd)

• Dividends are paid before common stock dividends
• Do not share in other profits with the common
  stockholders
• No voting rights
• No fixed maturity date
• Rated 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

43
Features and Characteristics of Preferred Stock
(contd)

• 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 (contd)

• Investors dont 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 Estate

• Direct 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 advantages
• Direct investment is active time, energy, and
  knowledge required
• Illiquidity
• Overbuilding can hurt prices

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Investing (Speculating) in Metals, Gems,
Collectibles

• Just Dont 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 bonds
• Determinants of a bonds return
• Annual interest payments
• Return of the par value
• Measures of bond returns
• Current yield
• Yield to maturity

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Summary (contd)

• Sources of bonds
• Corporations
• Treasury and other agencies
• Municipalities
• Bond ratings AAA to D
• Bond valuation and the relationship with interest
  rates

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Summary (contd)

• Features of preferred stock
• Real estate investments
• Speculative investments precious metals,
  gems, and collectibles