Investing in Bonds

Objectives Describe bonds and how they are used by corporations and investors. Describe the major characteristics of bonds. Differentiate among the four general types of bonds.

Objectives Describe what the investor should consider before investing in bonds, particularly the current yield and yield to maturity. List the advantages and disadvantages of investing in bonds.

Descriptive Terms for Bond Features., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from

Registered and bearer Zero-coupon Callable Warrants and exercise price Convertibility Sinking Funds General Obligation vs Revenue  Exempt vs State and Local Exemptions Language of Bond Investing

Indenture Face value, coupon rate, maturity date Secured and unsecured  Mortgage and Debenture Senior and subordinated Language of Bond Investing

Interest Income Assume you purchase $1,000 corporate bond issued by AT&T Corporation. The interest rate for this bond is 6.70%. The annual interest is $67 as shown below: Dollar amount of annual return = Face value x interest rate = 1,000 x 6.7% = 1,000 x.067 = $67.00

Approximate Bond Value Assume you purchase a Verizon Communications bond that pays 5.5% interest based on a face value of $1,000 until maturity in Also assume new corporate bond issues of comparable quality are currently paying 7%. The approximate market value of your Verizon bond is $786 calculated as follows: Dollar amount of annual interest = $1,000 x 5.5% = $55 Approximate market value = Dollar amount of annual interest Comparable interest rate = $55 7% = $786

Current Yield Current yield = annual interest payments current market price = $55 $786 = 7%

Effective Yield of a Tax-Free Investment Not paying tax effectively increases your rate of return  you get to keep all of your profits, instead of only a portion Example: 28% tax bracket, 5% rate of return = 6.94%

What is the Yield or Rate of Return on a Financial Investment? Annualized Percentage Change: Example: original price=$20/share, current price=$100/share, stock held for 9 years

Comparison of Taxable vs Tax Exempt Investments Tax- Exempt Yield 15% Tax Rate 25% Tax Rate 28% Tax Rate 33% Tax Rate 35% Tax Rate 4%4.71%5.33%5.56%5.97%6.15% 5%5.88%6.67%6.94%7.46%7.69% 6%7.06%8.00%8.33%8.96%9.23% 7%8.24%9.33%9.72%10.45%10.77%

What is the Yield or Rate of Return on a Financial Investment? Approximate = annual int. Par value – current price Yield to maturity payments + # of years to maturity par value + current price 2 Let’s look at a bond with 10 yrs. to maturity, a par value of $1,000, a current price of $880, and a coupon interest rate of 10%: $1,000 – $880 Approximate = $ Yield to maturity $1,000 + $880 2 $120 = $ $940 = $112/$940 = 11.91%

Bond Price Calculation Assume that a bond has a price quote of 84. The actual price for the bond is $840, as calculated below: Bond price = Face value (usually $1,000) x bond quote = $1,000 x 84 percent = $1,000 x.84 = $840

Bond Ratings., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from A plus sign (“+”) following a rating indicates that it is likely to be upgraded, while a minus sign (“-“) following a rating indicates that it is likely to be downgraded.

Susceptibility to certain risks  Credit  Callability  Inflation  Interest rate Considerations Before Investing in Bonds

Premiums and discounts Current yield Yield to maturity Tax-equivalent yields When to sell Considerations Before Investing in Bonds

Bond Prices, Bond Yields, and Interest Rates., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from

Effective Yield of a Tax-Free Investment Not paying tax effectively increases your rate of return  you get to keep all of your profits, instead of only a portion Example: 28% tax bracket, 5% rate of return = 6.94%

Pay higher interest rates than savings Offer safe return of principle Have less volatility than stocks Offer regular income Require smaller initial investment Advantages of Investing in Bonds

No hedge against inflation Can be quite volatile Compounding is almost impossible Subject to investors tax rate Poor marketability Disadvantages of Investing in Bonds