Investing in bonds


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Investing in bonds

  1. 1. Lecture 18 Investing in Bonds
  2. 2. Bonds - To buy or not to buy <ul><li>Over a long period of time, stocks have provided higher returns each year than bonds. Why would people choose bonds? </li></ul><ul><li>What makes bonds a good investment for one investor and poor for another? </li></ul>15-2
  3. 3. WHY BONDS <ul><li>Bonds are excellent way of diversification. </li></ul><ul><li>Bonds pay regular income semi-annually </li></ul><ul><li>Long term financial needs can be met. </li></ul><ul><li>Conservative investment in down turn economy. </li></ul>15-2
  4. 4. Characteristics of Bonds <ul><li>Corporation’s written pledge to repay a specified amount of money with interest. </li></ul><ul><li>The face value is the rupee amount that the bondholder will receive at the bond’s maturity date. </li></ul><ul><li>Bondholders receive interest payments every six months at the stated interest rate. </li></ul><ul><li>The legal conditions are described in a bond indenture. </li></ul><ul><li>A trustee is a financially independent firm that acts as the bondholder’s representative. </li></ul>15-2
  5. 5. Why Corporations Sell Bonds <ul><li>To get funds for major purchases. </li></ul><ul><li>To fund ongoing business activities. </li></ul><ul><li>When it is difficult or impossible to sell stock. </li></ul><ul><li>To improve financial leverage. </li></ul><ul><li>Interest paid to bondholders is a tax deductible business expense that can be used to reduce taxes corporations must pay. </li></ul>15-3
  6. 6. Four Types of Corporate Bonds <ul><li>Debenture bond. </li></ul><ul><ul><li>Most corporate bonds are debenture bonds. </li></ul></ul><ul><ul><li>Unsecured - Backed only by the reputation of the issuing company. </li></ul></ul><ul><li>Mortgage bond- secured bond </li></ul><ul><ul><li>A corporate bond that is secured by various assets of the issuing firm, usually real estate. </li></ul></ul><ul><ul><li>Interest rate is lower because it is secured. </li></ul></ul>15-4
  7. 7. Types of Corporate Bonds <ul><li>Subordinated debenture bond. </li></ul><ul><ul><li>An unsecured bond that gives bondholders a claim secondary to that of other designated bond holders with respect to interest payments and claim on assets. </li></ul></ul><ul><li>Convertible bond. </li></ul><ul><ul><li>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. </li></ul></ul>(continued) 15-5
  8. 8. Call Feature of Corporate Bonds <ul><li>Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date. </li></ul><ul><li>Most agree not to call bonds for the first 5 to 10 years after they are issued. </li></ul><ul><li>Bonds called if their interest rate is much higher than the going rate. </li></ul><ul><li>Most corporate bonds are callable. </li></ul>15-6
  9. 9. Provisions For Repayment of Bonds <ul><li>Sinking fund. </li></ul><ul><ul><li>Corporations deposit money in this fund annually or semiannually and use the money to pay off the bondholders when the bond issue comes due. </li></ul></ul><ul><li>Serial bonds. </li></ul><ul><ul><li>Bonds of a single issue that mature on different dates – where the bonds are redeemed say 10 percent each year until the bonds retire at the end of term. Acall provision is possible before maturity. </li></ul></ul>15-7
  10. 10. Why Investors Buy Corporate Bonds <ul><li>For interest income. </li></ul><ul><ul><li>Investors know the interest rate. </li></ul></ul><ul><ul><li>Interest will be paid to investors twice a year, with the payment based on the interest rate and the face value of the bond. </li></ul></ul><ul><li>Appreciation of bond value. </li></ul><ul><ul><li>May be able to sell a bond with a fixed interest rate to someone else at a higher price if overall interest rates fall. </li></ul></ul><ul><li>Bond face amount will be repaid at maturity. </li></ul>15-8
  11. 11. Bond Registration <ul><li>Registered bond: Registered in your name by the company who issued it. Interest checks will be mailed directly to you. </li></ul><ul><li>Zero coupon bonds: Sold for below face value; it pays no interest; redeem it for face value at maturity. Interest is taxed as you earn it. </li></ul>15-9
  12. 12. Other Bond Information <ul><li>Can hold bond until maturity or sell it in the secondary market. </li></ul><ul><li>Success or failure of the business and changes in market interest rates will affect the price of the bond. </li></ul><ul><li>Interest and capital gains from selling bonds are both taxable. </li></ul>15-10
  13. 13. Government Bonds and Debt Securities <ul><li>Sold to obtain money to finance the national debt, and the ongoing costs of government. </li></ul><ul><li>Three levels of government issue bonds: </li></ul><ul><ul><li>Federal-no state income tax on the interest. </li></ul></ul><ul><ul><li>State. </li></ul></ul><ul><ul><li>Local municipalities. </li></ul></ul>15-11
  14. 14. Government Treasury Bills and Notes <ul><li>Treasury Bills (T-Bills). </li></ul><ul><li>4, 13, or 26 weeks to mature. </li></ul><ul><li>Sold at a discount. T-bill yield is more than stated rate of interest. </li></ul><ul><li>Treasury Notes (T-Notes). </li></ul><ul><li>2, 3, 5, and 10 year terms. </li></ul><ul><li>Interest paid every six months, higher rates than T-bills. </li></ul>15-12
  15. 15. Why Do Investors Buy Government Bonds? <ul><li>Pay a lower interest rate than corporate bond, but virtually risk free if chosen carefully. </li></ul><ul><li>Often used by investors to diversify their investment holdings. </li></ul>15-13
  16. 16. State and Local Government Securities <ul><li>Municipal bonds or munis. </li></ul><ul><li>Issued by a state or local government, such as cities, counties, school districts. </li></ul><ul><li>Use funds for ongoing costs & to build major projects such as schools, airports, and bridges. </li></ul><ul><li>General obligation bonds are backed by the state or local government that issues them. </li></ul><ul><li>Revenue bonds are repaid from money generated by the project the funds finance, such as a toll bridge. </li></ul>15-15
  17. 17. Why do People Buy Municipal Bonds? <ul><li>People like to invest in projects close to home. </li></ul><ul><li>They like insured municipal bonds, or states that guarantee payment. </li></ul><ul><li>May be callable, but usually not until after the first ten years. </li></ul><ul><li>Interest earned may be exempt from federal income tax so yield is higher. </li></ul>15-16
  18. 18. Taxable Equivalent Yield <ul><li>Tax-exempt yield </li></ul><ul><li>1.0 - Your tax rate </li></ul><ul><li>Example: </li></ul><ul><li>Taxable equivalent yield = 0.06 </li></ul><ul><li> 1.0 - 0.28 </li></ul><ul><li> = 0.083 = 8.3% </li></ul>15-17
  19. 19. Making the Decision to Buy or Sell a Bond <ul><li>Will the bond be repaid at maturity? </li></ul><ul><li>Will you receive interest payments until maturity? </li></ul><ul><li>Read the annual report, looking for strengths and weaknesses. </li></ul><ul><li>Bond ratings? </li></ul><ul><ul><li>Rating range from AAA to D. </li></ul></ul><ul><ul><li>BB or below is called a junk (speculative) bond. </li></ul></ul><ul><ul><li>Rated by Standard and Poors and Moodys, with information on their websites </li></ul></ul>15-18
  20. 20. Making the Decision to Buy or Sell a Bond <ul><li>Read bond quotes in the newspaper. </li></ul><ul><ul><li>Bid price is the highest price offered for the bond during a day (market value). </li></ul></ul><ul><ul><li>Asked price is the lowest price at which someone has offered to sell a bond during a day. </li></ul></ul><ul><ul><li>Look at the maturity date. </li></ul></ul><ul><ul><li>Determine the current yield. </li></ul></ul>15-19 (continued)
  21. 21. Current Yield of a Bond (%) 15-20 Example: Current yield = 75 800 = 0.094 = 9.4% The Investment’s Current Market value Rupee Amount of Income Generated Yearly
  22. 22. Yield to Maturity <ul><li>Amt. Annual Interest + Face value - Market value </li></ul><ul><li> Number of periods </li></ul><ul><li> Market value + Face value </li></ul><ul><li>2 </li></ul><ul><li>Example: </li></ul><ul><li> $60 + $1,000 - $900 </li></ul><ul><li> 10 </li></ul><ul><li> $900 + $1,000 </li></ul><ul><li> 2 </li></ul><ul><li> = 0.074 = 7.4% </li></ul>15-21
  23. 23. Market value of bond <ul><li>Amt. Annual Interest </li></ul><ul><li>Comparable Interest rate </li></ul><ul><li>Example:Global bond issued at 4% on face value of Rs 1000. Assume new corporate bonds issues of comparable quality are paying 5%. </li></ul><ul><li>Approx market value: 40 </li></ul><ul><li>5% Rs 800. </li></ul>15-21