2Investing Basics and Evaluating Bonds Chapter Learning Objectives LO11.1 Explain why you should establish an investment program.LO11.2 Describe how safety, risk, income, growth, and liquidity affect your investment program.LO11.3 Identify the factors that reduce investment risk.LO11.4 Understand why investors purchase government bonds.LO11.5 Recognize why investors purchase corporate bonds.LO11.6 Evaluate bonds when making an investment.
3Establishing Investment Goals Learning Objective LO11.1 Explain Why You Should Establish an Investment ProgramEstablishing Investment GoalsFinancial goals should be:SpecificWritten DownMeasurableTailored to your financial needsAimed at what you want to accomplish
4Establishing Investment Goals How much money do you need to satisfy your investment goals?How will you obtain the money?How long will it take you to obtain the money?How much risk are you willing to assume in an investment program?
5Establishing 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?
6Performing a Financial Checkup Pay your bills on timeWork to balance your budgetManage your credit card debtPay in full each monthDo not use credit for small purchasesDo not use the cash advance optionThink about the number of cards you needGet help if you are in trouble
7Performing a Financial Checkup Start an emergency fund you can access quicklyAt least three months of living expensesHave access to other sources of cash for emergenciesPre-approved line of creditCash advance on your credit cardHome equity
8Managing an Economic Crisis Establish a larger than usual emergency fundKnow what you oweIdentify debts that must be paidReduce spendingNotify credit card companies and lenders if you are unable to make paymentsMonitor the value of your investment and retirement accounts.Consider converting investments to cash to preserve value.
9Getting the Money Needed to Start an Investing Program
10How 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
11Learning Objective LO11.2 Factors Affecting the Choice of Investments Safety and riskRisk = uncertainty about the outcomeInvestment Safety = minimal risk of lossRisk-Return Trade-OffThe potential return on any investment should be directly related to the risk the investor assumesSpeculative investments are high risk, made by those seeking a large profit in a short time
12Components of the Risk Factor Inflation risk during periods of high inflation your investment return may not keep pace with inflationInterest rate risk the value of bonds or preferred stock may increase or decrease with changes in interest ratesBusiness failure risk affects stocks and corporate bondsMarket risk the risk of being in the market versus in a risk-free asset
13Investment Income Investment Income A predictable source of income (dividends or interest)Most conservative = passbook savings, CDs and government securitiesOther choices:Municipal and corporate bondsPreferred stockUtility stocksSelected common stocksSelected Mutual fundsRental real estate
14Investment Income, Growth and Liquidity Investment GrowthGrowth in value (price appreciation)Common stock usually offers the greatest potential for growthMutual funds, ETFs and real estate offer growth potentialInvestment Liquidity2 dimensionsAbility to buy or sell an investment quicklyWithout substantially affecting the investment’s value
15Learning Objective LO11.3 Factors that Reduce Investment Risk Asset Allocation and DiversificationAsset allocation= The process of spreading your assets among several different types of investments= DiversificationStocksBondsRisk-free assetsReal-estate
17Asset Allocation and Diversification Other factors to consider:Your ageGrowth versus incomeRecovery time if investments nosediveYour investment objectivesHow much can you save and invest each year?The dollar value of your current investmentsThe economic outlook for the economyYour tolerance for riskAt what point can you no longer sleep easily?Your investment horizonWhen will you need the money?How long can your money continue to grow?
18Portfolio InvestingBrokerage firms frequently construct sample portfolios for client consideration. A suggested asset allocation for a young investor is shown below.
20Your Role in the Investment Process Evaluate potential investmentsMonitor the value of your investmentsKeep accurate recordsOther factorsSeek help from personal financial plannerConsider the tax consequences of selling your investments
21Learning Objective LO11.4 Conservative Investment Options: Government Bonds Government bonds = written pledge to:Repay a specified sum of money (face value)At maturityAlong with periodic interest paymentsSold to fund the national debt and the ongoing costs of government at all levelsThree levels of government issues:FederalStateLocal municipalities
22U.S. Treasury Bills, Notes and Bonds Treasury Bills (T-Bills)$100 minimum4, 13, 26 and 52 weeks to maturitySold at a discountFederal but no state tax on interest earnedTreasury Notes$100 unitsTypical maturities = 2, 3, 5, 7, and 10 yearsInterest paid every six monthsHigher rate than T-bills
23U.S. Treasury Bills, Notes and Bonds Treasury BondsIssued in minimum units of $10030 year maturity datesInterest rates higher than notes and billsInterest paid every six monthsTreasury Inflation-Protected Securities (TIPS)Sold in minimum units of $100Sold with 5, 10, or 30 year maturitiesPrincipal changes with inflationPays interest twice a year at a fixed rate
25State and Local Government Securities Municipal Bonds (“munis”)Issued by a state or local governmentCitiesCountiesSchool districtsSpecial taxing districtsFunds used for ongoing costs and to build major projects such as schools, airports, and bridges
26State and Local Government Securities Municipal Bonds (“munis”)General obligation bondsBacked by the full faith, credit, and taxing authority of the issuing state or local governmentRevenue bondsRepaid from money generated by the project the funds finance, such as a toll bridge
27State and Local Government Securities Municipal Bonds (“munis”)Key characteristic:Interest may be exempt from federal taxesCapital gains may NOT be tax exemptUsually exempt from state and local taxes in state where issuedExempt status determined by use of fundsInsured municipal bondsPrivate insurance to reduce risk
28Taxable Equivalent Yield Used to compare tax exempt and taxable bonds
29Learning Objective LO11.5 Conservative Investment Options: Corporate Bonds A corporation’s written pledge to repay a specified amount of money with interestAn interest-only loanConsidered safer than stocksA “fixed-income” securityA form of debt financing
30Corporate Bonds Face value: Coupon rate Dollar amount bondholder receives at bond’s maturity dateUsually $1,000Coupon rateStated interest rateInterest payments made every six monthsMaturity date = date on which face value repaid
31Corporate Bonds Bond Indenture Trustee Legal document describing conditions of the bond issueTrusteeFinancially independent firm that acts as the bondholder’s representativeUsually a commercial bank or other financial institution
32Why Corporations Sell Bonds To raise funds for major purchasesTo fund ongoing business activitiesWhen difficult or impossible to sell stockTo improve financial leverageInterest paid to bondholders is tax deductible for the firm
33Types of Corporate Bonds DebentureUnsecured, > 10 yr maturityBacked only by the reputation of the issuing companyMortgage bondSecured by various assets of the issuing firm, usually real estateLower interest (coupon) rate since debt is secured
34Types of Corporate Bonds Convertible bondCan be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stockGenerally, the coupon rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds
35Provisions For Repayment Call Feature of a BondCorporation can “call in” or buy back outstanding bonds before the maturity dateMost corporate bonds are callableUsually call protected for the first 5 to 10 years after issueA firm may call a bond issue if the coupon rate they are paying is much higher than the market rate
36Provisions For Repayment Sinking fundCorporations deposit money annuallyTrustee uses the money to retire the bond issue prior to maturitySerial bondsBonds of a single issue that mature on different datesBond
37Why Investors Purchase Corporate Bonds Interest income - “fixed income”Registered bondInterest and principal paid to registered ownerRegistered coupon bondRegistered for principal onlyCoupon must be presented to obtain payment
38Why Investors Purchase Corporate Bonds Dollar appreciation of bond valueBond values change with market interest rates in the economyBond value vs. Interest rates = inverse relationshipBond values change with the financial condition of the issuing company or government unitBond repayment at maturityFace value repaid on maturity dateBondholders may keep till maturity or sell
39Learning Objective LO11.6 Evaluate Bonds When Making an Investment Sources of information – The InternetThe issuing firm’s websitePrice information (quotes)Trade bonds onlineResearch on the issuing corporationFinancial coverage of bond transactionsWall Street Journal, Barrons, Internet
40Corporate Bond Quotes The first bond in the list: Matures in 2036 Current price = 93.51% of par (discount) = $935.10Pays an annual coupon rate of 5.875% = $58.75Yield-to-Maturity = 6.365%Current yield = % = 58.75/935.10Or see Exhibit 11-640
42Bond Yield Calculations Yield = rate of return earned by an investor who holds the bond to maturityCurrent Yield = Annual interest amountCurrent PriceOther Sources of InformationBusiness PeriodicalsFederal Agencies
43Chapter 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.
44Chapter 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.
45Chapter 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.
46Chapter Summary Learning Objective LO11.3 Improve your investment returns by:Evaluating all potential investmentsMonitoring the value of your investmentsKeeping accurate and current recordsProfessional help and your tax situation may also affect your investment decisions.
47Chapter Summary Learning Objective LO11.4 Conservative investments include:Savings accountsCertificates of depositMoney market accountsSavings bondsGovernment 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.
48Chapter 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 maturityBonds also can be an excellent way to diversify a portfolio.
49Chapter 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.
50Chapter 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.