11-3 Investing Basics 1.Explain why you should establish an investment program 2.Describe how safety, risk, income, growth, and liquidity affect your investment program 3.Identify the factors that reduce investment risk 4.Understand why investors purchase government bonds 5.Recognize why investors purchase corporate bonds 6.Evaluate bonds when making an investment Chapter Objectives
11-4 Objective 1: Explain why you should establish an investment program Establishing Investment Goals Financial goals should be specific and measurable. They should be tailored to your financial needs and what you want to accomplish. To develop your goals ask yourself.. What will you use the money for? How much money do you need for your 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?
11-5 Establishing Investment Goals What possible economic or personal conditions could alter your investment goals? Considering your economic circumstances, are your investment goals reasonable? Are you willing to make the sacrifices necessary to ensure that you meet your investment goals? What will the consequences be if you don’t reach your investment goals? (continued)
11-6 Performing a Financial Checkup Work to balance your budget. – Do you regularly spend more than you make? – Pay off high interest credit card debt first. Obtain adequate insurance protection. Start an emergency fund you can access quickly. – Three months of living expenses. Have access to other sources of cash for emergencies. – Line of credit is a short-term loan approved before the money is needed. – Cash advance on your credit card.
11-7 Getting the Money Needed to Start an Investing Program Pay yourself first. Take advantage of employer- sponsored retirement programs. Participate in elective savings programs. Make a special savings effort one or two months each year. Take advantage of gifts, inheritances, and windfalls.
11-8 The Value of Long-Term Investing Programs Many people don’t start investing because they only have a small amount to invest, but even small amounts invested regularly grow over a long period of time. If you begin savings $2,000 each year (depending on the rate of return, you could have over $1 million by the time you are age 65—See Exhibit 11-1. The higher the rate of return the greater the risk.
11-9 Objective 2: Describe how safety, risk, income, growth, and liquidity affect your investment decisions Factors Affecting the Choice of Investments Safety and risk. –Safety in any investment means minimal risk of loss. –Risk means a measure of uncertainty about the outcome. –Investments range from very safe to very risky. –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.
11-10 Components of the Risk Factor Inflation risk - during periods of high inflation your investment return may not keep pace with the inflation rate. Interest rate risk – the value of bonds or preferred stock may increase or decrease because of changes in interest rates in the economy. Business failure risk - affects stocks and corporate bonds. Market risk - prices fluctuate because of behaviors of investors.
11-11 Investment Income, Growth and Liquidity Income - An investment will provide a predictable source of income. Growth - means investment will increase in value. –Common stock usually offers the greatest potential for growth. –Mutual funds, government and corporate bonds, and real estate offer growth potential. Liquidity –Ability to buy or sell an investment quickly without substantially affecting the investment’s value.
11-12 Objective 3: Identify the factors that can reduce investment risk. PORTFOLIO MANAGEMENTAND ASSET ALLOCATION Asset allocation is the process of spreading your assets among several different types of investments. Other factors to consider include : –The time factor –Your age
11-13 Your Role in the Investment Process Factors to consider when choosing different investments 1.Evaluate Potential Investments 2.Monitor the Value of your investments 3.Keep accurate and current records 4.Other Factors Seeking help from professionals or investment planners Tax consequences of your investments
11-14 Objective 4: Understand why investors purchase Government Bonds Government Bonds and Debt Securities Government bonds are written pledge to repay a specified sum of money along with interest Sold to obtain money to finance the national debt, and the ongoing costs of government. Three levels of government issue bonds: – Federal. – State. – Local municipalities.
11-15 U.S. Treasury Bills, Notes and Bonds Treasury Bills (T-Bills). $1,000 minimum. 4, 13, or 26 weeks to maturity. Sold at a discount. Federal but no state tax on interest earned. Treasury Notes. $1,000 units. Typical maturities are 2, 3, 5, and 10 years. Interest paid every six months, at a higher rate than T-bills. Federal but no state tax on interest earned.
11-16 U.S. Treasury Bills, Notes and Bonds Treasury Bonds Issued in minimum units of $1000 30 year maturity dates Interest rates higher than the notes and bills Interest paid every six months Treasury Inflation-protected Securities Sold in minimum units of $1000 Sold with 5, 10 or 20 year maturities Principal in TIPS increases with inflation and decreases with deflation Pays interest twice a year at a fixed rate
11-17 Federal Agency Debt Issues Essentially risk free, and earn slightly higher interest than government securities issued by the treasury department. Minimum investment may be as high as $25,000 Maturities range from 15 – 30 years. Average maturity is 15 years.
11-18 State and Local Government Securities Municipal bonds - sometimes called munis. Issued by a state or local government, including cities, counties, school districts, and special taxing districts. Use funds for ongoing costs and 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.
11-20 Objective 5: Recognize why investors purchase Corporate Bonds Corporate Bond: 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. 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.
11-21 Why Corporations Sell 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.
11-22 Types of Corporate 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.
11-23 Types of Corporate Bonds 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. –Generally, the interest rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds. –Convertible bonds, like all potential investments, must be carefully evaluated. (continued)
11-24 Provisions For Repayment Call Feature of a Bond Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date. Most corporate bonds are callable. Most agree not to call bonds for the first 5 to 10 years after they are issued. They call bonds if the interest rate they are paying is much higher than the going rate.
11-25 Provisions For Repayment 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. (continued) Bond
11-26 Why Investors Buy Corporate Bonds For interest income. –Investors know the interest rate. Registered bond Registered coupon bond Bearer bond Zero coupon bond 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 current interest rate. Bond face amount will be repaid at maturity.
11-27 Objective 6: Evaluate bonds when making an investment decision The Decision to Buy or Sell a Bond There are a number of sources of information that can be used to evaluate bond investments. – The internet –Use it for price information, trade bonds online and lastly do research on the issuing corporation and its bond issues Financial Coverage for Bond Transaction –Wall Street Journal, Barrons, Internet – Bid and Ask Price of Government Bonds Bond Ratings –Rating range from AAA to D. –BB or below is called a junk (speculative) bond. –Rated by Standard and Poors and Moodys, with information on their websites.
11-28 The Decision to Buy or Sell a Bond Bond Yield Calculations – Current Yield = annual interest amount Current Market value Other Sources of Information –Business Periodicals –Federal Agencies