11-2 Investing Basics and Evaluating Bonds Chapter Learning Objectives LO11.1Explain why you should establish an investment program. LO11.2Describe how safety, risk, income, growth, and liquidity affect your investment program. LO11.3Identify the factors that reduce investment risk. LO11.4Understand why investors purchase government bonds. LO11.5Recognize why investors purchase corporate bonds. LO11.6Evaluate bonds when making an investment.
11-3 Learning Objective LO11.1 Explain Why You Should Establish an Investment Program Establishing Investment Goals Financial goals should be: –Specific –Written Down –Measurable –Tailored to your financial needs –Aimed at what you want to accomplish
11-4 Establishing Investment Goals 1.How much money do you need to satisfy your investment goals? 2.How will you obtain the money? 3.How long will it take you to obtain the money? 4.How much risk are you willing to assume in an investment program?
11-5 Establishing Investment Goals 5.What possible economic or personal conditions could alter your investment goals? 6.Considering your current and anticipated economic circumstances, are your investment goals easonable? 7.Are you willing to make the sacrifices necessary to ensure that you meet your investment goals?
11-6 Performing a Financial Checkup Pay your bills on time Work to balance your budget Manage your credit card debt –Pay in full each month –Do not use credit for small purchases –Do not use the cash advance option –Think about the number of cards you need –Get help if you are in trouble
11-7 Performing a Financial Checkup Start an emergency fund you can access quickly –At least three months of living expenses Have access to other sources of cash for emergencies –Pre-approved line of credit –Cash advance on your credit card –Home equity
11-8 Managing an Economic Crisis 1.Establish a larger than usual emergency fund 2.Know what you owe Identify debts that must be paid 3.Reduce spending 4.Notify credit card companies and lenders if you are unable to make payments 5.Monitor the value of your investment and retirement accounts. 6.Consider converting investments to cash to preserve value.
11-9 Getting the Money Needed to Start an Investing Program
11-10 How the Time Value of Money Affects Your Investments Even small amounts invested regularly grow over a long period of time. The value of one cup of coffee per day invested over 40 years grows to $390,000. Use the Time Value of Money calculation methods in the Chapter 1 Appendix to calculate future values. The higher the rate of return the greater the risk
11-11 Learning Objective LO11.2 Factors Affecting the Choice of Investments Safety and risk –Risk = uncertainty about the outcome –Investment Safety = minimal risk of loss –Risk-Return Trade-Off The potential return on any investment should be directly related to the risk the investor assumes –Speculative investments are high risk, made by those seeking a large profit in a short time
11-12 Components of the Risk Factor Inflation risk during periods of high inflation your investment return may not keep pace with inflation Interest rate risk the value of bonds or preferred stock may increase or decrease with changes in interest rates Business failure risk affects stocks and corporate bonds Market risk the risk of being in the market versus in a risk-free asset
11-13 Investment Income –A predictable source of income (dividends or interest) –Most conservative = passbook savings, CDs and government securities –Other choices: Municipal and corporate bonds Preferred stock Utility stocks Selected common stocks Selected Mutual funds Rental real estate
11-14 Investment Income, Growth and Liquidity Investment Growth –Growth in value (price appreciation) –Common stock usually offers the greatest potential for growth –Mutual funds, ETFs and real estate offer growth potential Investment Liquidity –2 dimensions Ability to buy or sell an investment quickly Without substantially affecting the investment’s value
11-15 Learning Objective LO11.3 Factors that Reduce Investment Risk Asset Allocation and Diversification Asset allocation = The process of spreading your assets among several different types of investments = Diversification Stocks Bonds Risk-free assets Real-estate
11-16 Traditional Investment Evaluation Factors
11-17 Asset Allocation and Diversification Other factors to consider: –Your age Growth versus income Recovery time if investments nosedive –Your investment objectives –How much can you save and invest each year? –The dollar value of your current investments –The economic outlook for the economy –Your tolerance for risk At what point can you no longer sleep easily? –Your investment horizon When will you need the money? How long can your money continue to grow?
11-18 Portfolio Investing Brokerage firms frequently construct sample portfolios for client consideration. A suggested asset allocation for a young investor is shown below.
11-19 Investment Pyramid
11-20 Your Role in the Investment Process 1.Evaluate potential investments 2.Monitor the value of your investments 3.Keep accurate records 4.Other factors Seek help from personal financial planner Consider the tax consequences of selling your investments
11-21 Learning Objective LO11.4 Conservative Investment Options: Government Bonds Government bonds = written pledge to: –Repay a specified sum of money (face value) –At maturity –Along with periodic interest payments Sold to fund the national debt and the ongoing costs of government at all levels Three levels of government issues: –Federal –State –Local municipalities
11-22 U.S. Treasury Bills, Notes and Bonds Treasury Bills (T-Bills) $100 minimum 4, 13, 26 and 52 weeks to maturity Sold at a discount Federal but no state tax on interest earned Treasury Notes $100 units Typical maturities = 2, 3, 5, 7, and 10 years Interest paid every six months Higher rate than T-bills Federal but no state tax on interest earned
11-23 U.S. Treasury Bills, Notes and Bonds Treasury Bonds Issued in minimum units of $ year maturity dates Interest rates higher than notes and bills Interest paid every six months Treasury Inflation-Protected Securities (TIPS) Sold in minimum units of $100 Sold with 5, 10, or 30 year maturities Principal changes with inflation Pays interest twice a year at a fixed rate
11-24 Treasury Securities
11-25 State and Local Government Securities Municipal Bonds (“munis”) Issued by a state or local government –Cities –Counties –School districts –Special taxing districts Funds used for ongoing costs and to build major projects such as schools, airports, and bridges
11-26 State and Local Government Securities Municipal Bonds (“munis”) General obligation bonds –Backed by the full faith, credit, and taxing authority of the issuing state or local government Revenue bonds –Repaid from money generated by the project the funds finance, such as a toll bridge
11-27 State and Local Government Securities Municipal Bonds (“munis”) Key characteristic: –Interest may be exempt from federal taxes –Capital gains may NOT be tax exempt –Usually exempt from state and local taxes in state where issued –Exempt status determined by use of funds Insured municipal bonds –Private insurance to reduce risk
11-28 Taxable Equivalent Yield Used to compare tax exempt and taxable bonds
11-29 Learning Objective LO11.5 Conservative Investment Options: Corporate Bonds Corporate Bonds A corporation’s written pledge to repay a specified amount of money with interest An interest-only loan Considered safer than stocks A “fixed-income” security A form of debt financing
11-30 Corporate Bonds Face value: –Dollar amount bondholder receives at bond’s maturity date –Usually $1,000 Coupon rate –Stated interest rate –Interest payments made every six months Maturity date = date on which face value repaid
11-31 Corporate Bonds Bond Indenture –Legal document describing conditions of the bond issue Trustee –Financially independent firm that acts as the bondholder’s representative –Usually a commercial bank or other financial institution
11-32 Why Corporations Sell Bonds To raise funds for major purchases To fund ongoing business activities When difficult or impossible to sell stock To improve financial leverage Interest paid to bondholders is tax deductible for the firm
11-33 Types of Corporate Bonds Debenture –Unsecured, > 10 yr maturity –Backed only by the reputation of the issuing company Mortgage bond –Secured by various assets of the issuing firm, usually real estate –Lower interest (coupon) rate since debt is secured
11-34 Types of Corporate Bonds Convertible bond –Can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock –Generally, the coupon rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds
11-35 Provisions For Repayment Call Feature of a Bond Corporation can “call in” or buy back outstanding bonds before the maturity date Most corporate bonds are callable Usually call protected for the first 5 to 10 years after issue A firm may call a bond issue if the coupon rate they are paying is much higher than the market rate
11-36 Provisions For Repayment Sinking fund –Corporations deposit money annually –Trustee uses the money to retire the bond issue prior to maturity Serial bonds –Bonds of a single issue that mature on different dates Bon d
11-37 Why Investors Purchase Corporate Bonds 1.Interest income - “fixed income” –Registered bond Interest and principal paid to registered owner –Registered coupon bond Registered for principal only Coupon must be presented to obtain payment
11-38 Why Investors Purchase Corporate Bonds 2.Dollar appreciation of bond value –Bond values change with market interest rates in the economy Bond value vs. Interest rates = inverse relationship –Bond values change with the financial condition of the issuing company or government unit 3.Bond repayment at maturity –Face value repaid on maturity date –Bondholders may keep till maturity or sell
11-39 Learning Objective LO11.6 Evaluate Bonds When Making an Investment Sources of information – The Internet –The issuing firm’s website –www.bondsonline.comwww.bondsonline.com –www.bondsearch123.comwww.bondsearch123.com –http://bonds.yahoo.comhttp://bonds.yahoo.com Price information (quotes) Trade bonds online Research on the issuing corporation Financial coverage of bond transactions –Wall Street Journal, Barrons, Internet
11-40 Corporate Bond Quotes The first bond in the list: Matures in 2036 Current price = 93.51% of par (discount) = $ Pays an annual coupon rate of 5.875% = $58.75 Yield-to-Maturity = 6.365% Current yield = 6.283% = 58.75/935.10
11-41 Bond Ratings Measure Default Risk
11-42 Bond Yield Calculations Yield = rate of return earned by an investor who holds the bond to maturity Current Yield = Annual interest amount Current Price Other Sources of Information –Business Periodicals –Federal Agencies
11-43 Chapter Summary Learning Objective LO11.1 Investment goals must be specific and measurable. Make sure your personal financial affairs are in order. Accumulate an emergency fund equal to at least three months’ living expenses. –Increase the amount in your emergency fund if you think you may lose your job or the nation is experiencing an economic crisis. Then, it is time to save the money needed to establish an investment program. Use the time value of money concept to help you achieve your goals—especially if you start sooner rather than later.
11-44 Chapter Summary Learning Objective LO11.2 All investors must consider the factors of safety, risk, income, growth, and liquidity. Especially important is the relationship between safety and risk. Basically, this relationship can be summarized as follows: –The potential return for any investment should be directly related to the risk the investor assumes. –In addition to safety and risk, investors choose investments that provide income, growth, or liquidity.
11-45 Chapter Summary Learning Objective LO11.3 Before making the decision to invest, you should consider: –Asset allocation = the process of spreading your assets among several different types of investments to lessen risk. –The amount of time before you need your money. –Your age is a factor that influences investment choices. Younger investors tend to invest a large percentage of their nest egg in growth-oriented investments. Older investors tend to be more conservative.
11-46 Chapter Summary Learning Objective LO11.3 Improve your investment returns by: –Evaluating all potential investments –Monitoring the value of your investments –Keeping accurate and current records Professional help and your tax situation may also affect your investment decisions.
11-47 Chapter Summary Learning Objective LO11.4 Conservative investments include: –Savings accounts –Certificates of deposit –Money market accounts –Savings bonds –Government securities. Generally, most investors consider U.S. government securities to be a safe harbor in troubled economic times. Municipal bonds are conservative investments and may provide tax-exempt income.
11-48 Chapter Summary Learning Objective LO11.5 Bonds are issued by corporations to raise capital. Investors purchase corporate bonds for three reasons: (1) interest income (2) possible increase in value (3) repayment at maturity Bonds also can be an excellent way to diversify a portfolio.
11-49 Chapter Summary Learning Objective LO11.5 The method used to pay bondholders interest depends on whether they own registered bonds or registered coupon bonds. Most corporate bonds are bought and sold through full-service brokerage firms, discount brokerage firms, or the Internet. Investors pay commissions when bonds are bought and sold.
11-50 Chapter Summary Learning Objective LO11.6 The internet can be used to obtain information and trade bonds online. Study the ratings provided by Standard & Poor’s, Moody’s, and Fitch Ratings to determine the quality of a bond issue. Calculate a bond’s current yield to evaluate a decision to buy or sell a bond issue. Business periodicals and government sources provide valuable information.