1. 11B Investing Basics and Evaluating Bonds #2
Recall the concept of asset allocation
11-1

2. One Effect of Asset Allocation: A Weighted Total Return

3. Ultraconservative “Investors” Are Really Just “Savers”
People who invest very conservatively
They do not get ahead financially over the long term because taxes and inflation offset most of their interest earnings
Remember “The Rule of 72”?
72/4% = 18 years
72/8% = 9 years (money doubles much faster)

4. Identify the Types of Investments You Want to Make
Do You Want to Lend Your Money or Own an Asset?
Debts – “loanership” (lending) investments.
Fixed Maturity – the borrower agrees to repay the principal to the investor on a specific date.
Fixed Income – the borrower agrees to pay the investor a specific rate of return for use of the principal.
Equities – “ownership” investments.
Potential for a higher return by sharing in profits

5. The Risk Pyramid Reveals the Trade-offs Between Investment Risk and Return

6. Inflation
To beat inflation, one must invest money so that it earns a higher after-tax return than the inflation rate
Real Rate of Return – the return after subtracting the effects of both inflation and income taxes.
Example:
10% return, 7.5% after taxes (25% tax bracket), 4% inflation, real rate of return of 3.5% after taxes and inflation

7. Objective 5 Recognize Why Investors Purchase Corporate Bonds
A corporation’s written pledge to repay a specified amount of money with interest
An interest-only loan
Considered safer than co. stocks
A “fixed-income” security
A form of debt financing (bond owners repaid in future)
11-7

8. Corporate Bonds Face Value Coupon rate
Dollar amount bondholder receives at bond’s maturity date
Usually $1,000
Coupon rate
Stated interest rate
Interest payments made every six months
Example: $1,000 x 5.8% = $58 (in two $29 payments)
Maturity Date = date on which face value repaid; generally 1 to 30 years
11-8

9. Corporate Bonds Bond Indenture Trustee
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
11-9

10. 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
11-10

11. Types of Corporate Bonds
Debenture
Unsecured debt
Investors become “creditors” if company fails
Backed only by the reputation of the issuing company; most corporate bonds are this type
Mortgage Bond
Secured by various assets of the issuing firm, such as real estate and property
Lower interest (coupon) rate since debt is secured
11-11

12. 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, coupon rate on a convertible bond is 1% to 2% lower than the rate paid on traditional bonds
Would only want to convert when stock price gets higher than the bond’s equivalent value in stock
11-12

13. Provisions For Repayment
Call Feature of Bonds
Corporation can “call in” or buy back outstanding bonds before the maturity date
Most corporate bonds are callable
Call-protected for first 5 to 10 years after issue
A firm calls a bond issue if the coupon rate they are paying is much higher than the market rate
Like consumers refinancing to lower-rate mortgage
What is the effect of called back bonds on investors?
11-13

14. 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
Example: After first 10 years, over the next 10 years, 10% of bonds mature each year
Bond
11-14

15. Why Investors Purchase Corporate Bonds
Interest Income - “Fixed Income”
Registered Bond- tracked electronically
Coupon and principal paid to registered owner (check or direct deposit)
Registered Coupon Bond
Registered for principal only
Coupon must be presented to obtain payment
Zero-Coupon Bond
Pays no interest
Sold at a discount from face value
Redeemed at face value at maturity
Bond
11-15

16. Why Investors Purchase Corporate Bonds
Dollar Appreciation of Bond Value
Bond values change with market interest rates
Bond value vs. Interest rates = inverse relationship
If Market rate< Coupon rate  Price > Face value
If Market rate > Coupon rate ← Price < Face value
Bond values change with the financial condition of the issuing company or government unit
Bond Repayment at Maturity
Face value repaid on maturity date (will be worth less due to inflation)
Bondholders may keep till maturity or sell
Portfolio diversification beyond stock and cash assets
11-16

17. Approximate Bond Value Formula
5.875% interest on ($1,000 bond) = $58.75
New issues paying 5% (decrease in coupon rate)
Dollar amount of interest $58.75
Comparable interest rate = 5% (.05) = $1,175
Bond worth more than face value because it pays interest rate higher than current market rate
New issues paying 6.5% (increase in coupon rate)
Comparable interest rate = % (.065) = $903.85
Bond worth less than face value because it pays interest rate lower than current market rate

18. Premiums and Discounts
When a bond is first issued, it is sold in one of three ways:
at its face value
at a discount below its face value or
at a premium above its face value.

19. Price Changes for Bonds
What does this graph tell you?

20. Objective 6 Evaluate Bonds When Making an Investment
Sources of Information – The Internet
The issuing firm’s website
Financial coverage of bond transactions
Wall Street Journal, Barrons, Internet
Other Sources of Information
Business Periodicals
Federal Agencies
11-20

21. Corporate Bond Quotes The first bond in the list: Matures in 2036
Current price = 93.51% of par (discount) = $935.10
Pays an annual coupon rate of 5.875% = $58.75
Yield-to-Maturity = 6.365% (considers bond maturity date)
Current yield = % = 5.875/93.51 (interest/price)
Or see Exhibit 11-6
11-21 21

22. Bond Ratings Measure Default Risk
11-22

23. Decisions Bond Investors Must Make
Decide on risk level.
Investment grade bonds: top 4 grades (BBB, A, AA, AAA)
Junk bonds (a.k.a., high yield bonds): lower rated and higher risk
Decide on maturity.
Match to financial goals
Determine the after-tax return.
Taxable versus tax-exempt

24. Wrap Up
Chapter Quiz
Concept Check Calculate Semi- annual Interest and Reasons That Investors Buy Bonds
Concept Check Current Value of Bonds; Explain Bond Ratings