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Chapter 15

Investing in Bonds

McGraw-Hill/Irwin

Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

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Chapter 15
Learning Objectives

  • Describe the characteristics of corporate bonds

  • Discuss why corporations issue bonds

  • Explain why investors purchase corporate bonds

  • Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds

  • Evaluate bonds when making an investment

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Characteristics of Corporate Bonds

Objective 1: Describe the characteristics of corporate bonds

  • Corporation’s written pledge to repay a specified amount of money with interest

  • The face value is the dollar amount that the bondholder will receive at the bond’s maturity date-usually $1,000

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Characteristics of Corporate Bonds (continued)

  • Bondholders receive interest payments every six months at the stated interest rate

  • The legal conditions are described in a bond indenture

  • A trustee is a financially independent firm that acts as the bondholder’s representative

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Why Corporations Sell Bonds

Objective 2: Discuss why corporations issue bonds

  • To get funds for major purchases

  • To fund ongoing business activities

  • When it is difficult or impossible to sell stock

  • To improve financial leverage

  • Interest paid to bondholders is a tax deductible business expense that can be used to reduce the federal and state taxes corporations must pay

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Why Corporations Sell Bonds (continued)

TYPES OF BONDS

Debenture bond

  • Most corporate bonds are debenture bonds
  • Unsecured - backed only by the reputation of the issuing company

Mortgage bond

  • A corporate bond that is secured by various assets of the issuing firm, usually real estate
  • Interest rate is lower because it is secured by the collateral and corporate assets

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Why Corporations Sell Bonds (continued)

Subordinated debenture bond

  • An unsecured bond that gives bondholders a claim secondary to that of mortgage or debenture bond holders with respect to interest payments and claim on assets

  • Convertible bond

  • A special kind of corporate bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock

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Why Corporations Sell Bonds (continued)

  • High Yield bond
  • A bond that pays a higher rate of interest but, has a higher risk of default.

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Why Corporations Sell Bonds (continued)

PROVISIONS OF REPAYMENT

  • Call Feature
  • Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date

  • Most agree not to call bonds for the first 5 to 10 years after they are issued

  • Bonds are typically called if their interest rate is much higher than the going rate

  • Most corporate bonds are callable

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Why Corporations Sell Bonds (continued)

Sinking fund

  • Corporations deposit money in this fund annually or semiannually and use the money to pay off the bondholders when the bond issue comes due

Serial bonds

  • Bonds of a single issue that mature on different dates

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Why Investors Buy Corporate Bonds

Objective 3: Explain why investors purchase corporate bonds

  • Interest Income
  • Investors receive interest every six months
  • The annual interest is computed by multiplying the interest rate by the face value of the bond
  • Registered bonds, Registered Coupon bond, Bearer bonds, Zero-coupon bonds

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Why Investors Buy Corporate Bonds (continued)

  • Dollar Appreciation of Bond Value
  • May be able to sell the bond to someone else at a higher price if the interest rate on the bond is higher than the market rate
  • Approximate Market Value = Dollar amount of annual interest / Comparable interest rate.
  • Bond ladders

  • Bond face amount will be repaid at maturity

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Why Investors Buy Corporate Bonds (continued)

THE MECHANICS OF A BOND TRANSACTION

  • Bonds can be held until maturity or sold in the secondary market

  • Most bonds sold through full-service brokerage firms, discount brokerage firms, or the Internet

  • Generally a minimum commission of $5-$35 on a $1,000 bond

  • Interest and capital gains from selling bonds are both taxable

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Government Bonds
and Debt Securities

Objective 4: Discuss why federal, state, and local governments issue bonds, and why investors purchase government bonds

  • Sold to obtain money to finance the national debt, and the ongoing costs of government

  • Three levels of government issue bonds:

  • Federal-no state income tax on the interest

  • State

  • Local municipalities

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Government Bonds and Debt Securities

TREASURY BILLS, NOTES, AND BONDS

Treasury Bills (T-Bills)

  • $100 minimum
  • 4, 13, 26, or 52 weeks to mature
  • Sold at a discount

Treasury Notes (T-Notes)

  • $100 units
  • 2, 3, 5, 7, and 10 year terms
  • Interest paid every six months

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Government Bonds and Debt Securities (continued)

Treasury Bonds

  • Issued in minimum units of $100

  • Have maturities of 30 years

  • Interest rates are generally higher than those of T-bills and T-Notes

  • Interest is paid every 6 months

  • Held until maturity or sold before maturity

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Government Bonds and Debt Securities (continued)

TIPS (Treasury Inflation Protected Securities)

  • Issued in minimum units of $100

  • Sold in 5, 10, and 30 year terms

  • Valued based upon the consumer price index

  • Interest is paid every 6 months, and will vary

  • Held until maturity or sold before maturity

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Government Bonds and Debt Securities (continued)

FEDERAL AGENCY DEBT ISSUES

  • Fannie Mae (http://www.fanniemae.com/)
  • Federal National Mortgage Association

  • Ginnie Mae - pay interest once a month
  • Government National Mortgage Association

  • Freddie Mac
  • Federal Home Loan Mortgage Corporation

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Government Bonds and Debt Securities (continued)

FEDERAL AGENCY DEBT ISSUES (continued)

  • Slightly higher risk than Treasury securities, so slightly higher interest rates

  • Issued for 1-30 years, 12 year average

  • Minimum denominations may be as high as $10,000-$25,000
  • Agency debt is callable before maturity

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Government Bonds and Debt Securities (continued)

STATE AND LOCAL GOVERNMENT SECURITIES

  • Municipal bonds or munis
  • Issued by a state or local government, such as cities, counties, school districts
  • Use funds for ongoing costs & to build major projects such as schools, airports, and bridges

  • General obligation bonds are backed by the state or local government that issues them

  • Revenue bonds are repaid from money generated by the project the funds finance, such as a toll bridge

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Government Bonds and Debt Securities (continued)

Features of Municipal Bond

  • People like to invest in projects close to home

  • They like insured municipal bonds, or states that guarantee payment

  • May be callable, but usually not until after the first 5 to 10 years

  • Interest earned may be exempt from federal income tax so yield is higher (depends on use of funds)

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Government Bonds and Debt Securities (continued)

Taxable equivalent yield= Tax-exempt yield

1.0 - Your tax rate

Example:

Taxable equivalent yield = .06

1.0 - 0.28

= 0.083 = 8.3%

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The Decision to Buy or Sell Bonds

Objective 5: Evaluate bonds when making an Investment

THE INTERNET

  • The Internet can be used in the following ways to evaluate a bond
  • Obtain the price information
  • Trade bonds online for a lower commission
  • Research information on the corporation or government bond issues online

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The Decision to Buy or Sell Bonds (continued)

OBTAINING ANNUAL REPORTS

  • Write or telephone the corporation to receive the annual report

  • Corporations maintain web site that provides access to annual reports

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The Decision to Buy or Sell Bonds (continued)

BOND RATINGS

  • Bond ratings provide quality and risk associated with bond issues

  • Moody’s Investor Service Inc., Standard & Poor’s Corporation, and Fitch ratings provide bond ratings

  • Bond ratings generally range from AAA to D

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The Decision to Buy or Sell Bonds (continued)

BOND YIELD CALCULATIONS

  • Yield is the rate of return earned by an investor who holds a bond for a stated period

Current yield on corporate bond = Annual income amount Current market value

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The Decision to Buy or Sell Bonds (continued)

$ Amt. Annual Interest + Face value - Market value

Number of periods

Market value + Face value

2

Example:

$60 + $1,000 - $900

10

$900 + $1,000

2

= 0.074 = 7.4%

Yield to Maturity Calculation:

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