 2004 McGraw-Hill Ryerson Ltd. Kapoor Dlabay Hughes Ahmad Prepared by Cyndi Hornby, Fanshawe College Chapter 12 Investing in Bonds 12-1

 2004 McGraw-Hill Ryerson Ltd. Learning Objectives - Chapter 12 1.Describe the characteristics of corporate bonds. 2.Discuss why corporations issue bonds. 3.Explain why investors purchase corporate bonds. 4.Discuss why federal, provincial and municipal governments issue bonds and why investors purchase government bonds. 5.Evaluate bonds when making an investment. 12-2

 2004 McGraw-Hill Ryerson Ltd. Learning Objective # 1 Describe the characteristics of corporate bonds. 12-3

 2004 McGraw-Hill Ryerson Ltd. Characteristics of 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. Maturity date is the date on which the corporation is to repay the borrowed money. The legal conditions are described in a bond indenture. A trustee is the bondholder’s representative. Bond indenture is a legal document that details all the conditions relating to a bond issue. 12-4

 2004 McGraw-Hill Ryerson Ltd. Characteristics of Corporate Bonds Between time of issue and maturity, corporations pay interest to bondholders, usually semi-annually, at stated rate (coupon rate) 12-5 Dollar Amount of = Face Value x Interest Annual Interest (Coupon) Rate

 2004 McGraw-Hill Ryerson Ltd. Learning Objective # 2 Discuss why corporations issue bonds. 12-6

 2004 McGraw-Hill Ryerson Ltd. Why Corporations Sell Bonds To borrow money to pay for major purchases. Difficult or impossible to sell stock. Finance ongoing business activities. To get money to operate or expand. The interest paid to bondholders is a tax deductible business expense. 12-7

 2004 McGraw-Hill Ryerson Ltd. Four Types of Corporate Bonds  Debenture bond. Most corporate bonds are debenture bonds. Backed only by the reputation of the issuing company.  Mortgage bond. A corporate bond that is secured by various assets of the issuing firm. 12-8

 2004 McGraw-Hill Ryerson Ltd. Four Types of Corporate Bonds  Subordinated debenture bond. An unsecured bond that gives bondholders a claim secondary to that of other designated bond holders with respect to interest payments and assets.  Convertible bond. Can be exchanged, at the owner’s option, for a specified number of shares of common stock. (continued) 12-9

 2004 McGraw-Hill Ryerson Ltd. Provisions for Repayment Call Feature Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date. 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 you is very much higher than the going rate. Most corporate bonds and municipal bonds are callable

 2004 McGraw-Hill Ryerson Ltd. Provisions For Repayment Sinking fund. They deposit money in this fund each year and use the money to pay off the bondholders when the bond issue comes due. Serial bonds. One issue of bonds that mature at different dates

 2004 McGraw-Hill Ryerson Ltd. Learning Objective # 3 Explain why investors purchase corporate bonds

 2004 McGraw-Hill Ryerson Ltd. Why Investors Buy Corporate Bonds? For interest income. Investors know the interest rate. Interest will be paid to investors twice a year. 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 market rate. Bond face amount will be repaid at maturity

 2004 McGraw-Hill Ryerson Ltd. Bond Registration A registered bond is registered in your name by the company or government who issued it. A registered coupon bond is registered for principal only and not for interest. A bearer bond is not registered in the investor’s name. A zero coupon bond is sold well below face value, pays no interest, but is redeemed for face value at maturity

 2004 McGraw-Hill Ryerson Ltd. Dollar Appreciation of Bond Value Price of corporate bond may fluctuate until maturity Usually caused by changes in interest rates If interest rates fall, price of bond will increase since its coupon rate is higher (selling at a premium) If interest rates rise, price of bond will fall (selling at a discount) 12-15

 2004 McGraw-Hill Ryerson Ltd. Dollar Appreciation of Bond Value Approximate Market = Dollar Amount of Value Annual Interest Comparable Interest Rate Dollar Amount of Annual Interest = $100 x 4.875% = $48.75 Approximate Market Value = $ % = $

 2004 McGraw-Hill Ryerson Ltd. A Bond Transaction Bonds are sold through full-service or discount brokerage firms or the Internet Bond market is an “over-the-counter” exchange Bond or investment dealers are paid a fee 12-17

 2004 McGraw-Hill Ryerson Ltd. Learning Objective # 4 Discuss why federal, provincial and municipal governments issue bonds and why investors purchase government bonds

 2004 McGraw-Hill Ryerson Ltd. Government Bonds and Debt Securities Federal government sells bonds and securities to finance national debt and ongoing activities Considered low risk investments Offer lower interest rates than corporate bonds Government of Canada securities Marketable bonds Specific maturity date, interest rate and are transferable Treasury Bills Discounted securities Canada Savings Bonds Regular or compound interest 12-19

 2004 McGraw-Hill Ryerson Ltd. Government Bonds and Debt Securities Provincial governments issue bonds to fund program spending and fund deficits Municipal bonds Installment Debentures 12-20

 2004 McGraw-Hill Ryerson Ltd. Other Types of Bonds Mortgage Bonds / First Mortgage Bonds Collateral Trust Bonds Debentures Corporate Notes Domestic, Foreign, and Eurobonds Bonds or Debentures carrying warrants Units Real Estate bonds Strip Bonds 12-21

 2004 McGraw-Hill Ryerson Ltd. Learning Objective # 5 Evaluate bonds when making an investment

 2004 McGraw-Hill Ryerson Ltd. The Decision to Buy or Sell Bonds Can the corporation, government or municipality... Pay back the face value at maturity? Will you receive interest payments until maturity? Read the annual report. Look for signs of financial strengths and weaknesses is firm profitable? are sales revenues increasing? Are long term liabilities increasing? How is bond rated? AAA (the highest) to D (the lowest) 12-23

 2004 McGraw-Hill Ryerson Ltd. Current % Yield of a Bond Yield is the rate of return earned by an investor who holds a bond for a stated period of time. Current Yield: Dollar Amount of Annual Interest Current Market Value

 2004 McGraw-Hill Ryerson Ltd. Yield to Maturity $ Amt. Annual Interest + ( Face value - Market value) Number of periods Market value + Face value 2 Example: $70 + $1,000 - $830 $17 $830 + $1,000 2 = 8.7% Takes into account the relationship among the bond’s maturity value, the time to maturity, the current price and the dollar amount of interest