1 (of 23) FIN 200: Personal Finance Topic 19–Bonds Lawrence Schrenk, Instructor

2 (of 23`) Learning Objectives 1. Explain the features basic common to all bonds. ▪ 2. Compare and contrast the bonds issued by different government levels and agencies. 3. Describe the various features found in corporate bonds. ▪

3 (of 23) Bonds Basics

4 (of 23`) Bond Cash Flows Bonds are loans.  Regular Interest Payments (Coupons)  Principle Repaid at End Example: Three year annual bond with a principal or $1,000 and coupon rate of 10%. Year 1Year 2Year 3 Coupon$100$100 $100 Principal$1,000 TOTAL$100$100$1,100

5 (of 23`) Bond Terminology Principal, Par Value, Face Value Coupon, Coupon Rate Maturity Discount Rate Periods

6 (of 23`) Bond Valuation Example: Three year annual bond with a principal of $1,000 and coupon rate of 10% (r = 8%). Year 1Year 2Year 3 Coupon$100$100 $100 Principal$1,000 TOTAL$100$100$1,100

7 (of 23`) Bond Price Movement Interest Rate Risk Interest Rates and Bond Prices  Inversely Related Interest Rates ↑ Bond Prices ↓ Interest Rates ↓ Bond Prices ↑

8 (of 23`) More Complicated Bonds ‘Straight’ Bond Premium versus Discount Bonds Features  Callable Bonds  Convertible Bonds  Sinking Funds Debt Covenant  Financial Ratios  Technical Default

9 (of 23) Federal Government Bonds

10 (of 23`) Government Bonds US Treasury  Bills, Notes and Bonds  Savings Bonds  Inflation-Adjusted Bonds TIPS I-Bonds Other Agencies

11 (of 23`) Why do Investors Purchase Government Bonds? 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.

12 (of 23`) U.S. Treasury Bills, Notes and Bonds Treasury Bills (T-Bills)  4, 13, or 26 weeks to maturity  Sold at a discount  Federal but no state tax on interest earned Treasury Notes  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 Treasury Bonds  30 year maturity dates  Interest rates higher than the notes and bills  Interest paid every six month

13 (of 23`) U.S. Savings Bonds.  Series EE sold at half of face value, with potential tax advantages if used to pay tuition and fees.  Series HH pays interest every six months.  I bonds which earns a fixed rate plus an inflation rate which changes twice a year  See for rates. Advantages  Exempt from state and local income taxes.  You don’t have to pay federal income tax on earnings until you redeem the bonds.

14 (of 23`) Treasury Inflation-Protected Securities (TIPS) Treasury Inflation-Protected Securities (TIPS) started in 1997 Provide protection against inflation  Principal increases with inflation (CPI) When a TIPS matures, the investor is paid the inflation-adjusted principal or original principal, whichever is greater  Interest paid semiannually at a fixed rate The rate is applied to the adjusted principal; so, like the principal, interest payments rise with inflation and fall with deflation

15 (of 23`) Payments in TIPS Consider a 3-year TIPS, par value of $1,000, and a coupon rate of 4%. Assume that the inflation turns out to be 2%, 3%, and 4% in the next 3 years Returns in the first year

16 (of 23`) TIPS versus Regular Bonds

17 (of 23`) Historical Yields on TIPS

18 (of 23`) Federal Agency Debt Issues Agencies, examples…  Government National Mortgage Association (GNMA)  Export-Import Bank  Farmers Housing Administration (FHA) Higher interest than government securities issued by the treasury department. Minimum investment may be as high as $25,000 Maturities range from years. Average maturity is 15 years.

19 (of 23) State and Local Bonds

20 (of 23`) State and Local Government Securities Municipal Bonds (Muni’s) 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. Tax Status Two Types:  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.

21 (of 23) Corporate Bonds

22 (of 23`) Corporate Bonds 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 (or covenant).

23 (of 23`) Major Classifications Collateral  Secured Debt (Mortgage) versus  Unsecured Debt (Debenture) Seniority  Senior Debt versus  Subordinated Debt

24 (of 23`) Why Corporations Sell Bonds To get funds for major purchases. To fund ongoing business activities. As an alternate to selling stock. Interest Payments are tax deductible  Versus dividend payments, which are not.

25 (of 23`) Types of Corporate Bonds 1. Unsecured (Debenture) Bond  Most corporate bonds are debenture bonds.  Unsecured - Backed only by the reputation of the issuing company. 2. Secured (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.

26 (of 23`) Types of Corporate Bonds (cont’d) 3. Convertible Bond  A special kind of corporate bond that can be exchanged 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.

27 (of 23`) 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.

28 (of 23`) Provisions for Repayment (cont’d) 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.

29 (of 23`) Bond Rating Agencies Standard & Poor's (S&P) Standard & Poor's Moody's Fitch NOTE: There are similar to the ratings given insurance companies.

30 (of 23`) Bond Rating Classifications

31 (of 23`) ‘Junk’ Bonds Alternate Names/Different Spin  High Yield Bonds  Non-investment Grade Bonds  Speculative Grade Bonds  Junk Bonds Higher Risk of Default, Higher Yield

32 (of 23`) Bonds Indices Lehman Aggregate Bond Index

Project Note 33 (of 23`)

34 (of 23`) Ethical Dilemma