PART 4: MANAGING YOUR MONEY Chapter 14 Investing in Bonds and Other Alternatives

14-2 Why Consider Bonds? Bonds reduce risk through diversification. Bonds reduce risk through diversification. Bonds produce steady income. Bonds produce steady income. Bonds can be a safe investment if held to maturity. Bonds can be a safe investment if held to maturity.

14-3 Basic Bond Terminology and Features Par value – the face value or amount returned at maturity. Par value – the face value or amount returned at maturity. Usually $1000 for corporate bonds. Usually $1000 for corporate bonds. Bonds selling at 99½% are selling for $995. Bonds selling at 99½% are selling for $995. Coupon Interest Rate – the percentage of par value that will be paid out annually in the form of interest. Coupon Interest Rate – the percentage of par value that will be paid out annually in the form of interest. 8½% coupon pays $85 annually. 8½% coupon pays $85 annually.

14-4 Basic Bond Terminology and Features Indenture – a legal document that provides specific terms of the loan agreement. Indenture – a legal document that provides specific terms of the loan agreement. It includes: It includes: A description of the bond. A description of the bond. The rights of bondholders. The rights of bondholders. The rights of the issuing firm. The rights of the issuing firm. The responsibilities of the bond trustees. The responsibilities of the bond trustees.

14-5 Basic Bond Terminology and Features Call Provision – entitles issuer to repurchase (“call”) back the bonds at stated prices. Call Provision – entitles issuer to repurchase (“call”) back the bonds at stated prices. If interest rates decline, the issuer will call the bonds and replace with lower-cost debt. If interest rates decline, the issuer will call the bonds and replace with lower-cost debt. Sinking Fund – issuer sets aside money on a regular basis to pay off bonds at maturity. Sinking Fund – issuer sets aside money on a regular basis to pay off bonds at maturity. Firm calls or repurchases in the open market. Firm calls or repurchases in the open market.

14-6 Corporate Bonds Corporate bonds - allow firms to borrow money and are a major source of funding. Corporate bonds - allow firms to borrow money and are a major source of funding. Denominations in $1000. Denominations in $1000. Secured bonds – backed by collateral. Secured bonds – backed by collateral. Unsecured bonds – called debentures. Unsecured bonds – called debentures. Hierarchy of bonds (more than 1 issue of debentures): Hierarchy of bonds (more than 1 issue of debentures): Secured bonds. Secured bonds. Unsubordinated (“normal”) debentures. Unsubordinated (“normal”) debentures. Subordinated debentures are low on the list. Subordinated debentures are low on the list.

14-7 Treasury and Agency Bonds U.S. government is the largest issuer of debt. U.S. government is the largest issuer of debt. Government spends more than it takes in. Government spends more than it takes in. To finance an unbalanced budget, it can: To finance an unbalanced budget, it can: Sell assets. Sell assets. Raise taxes. Raise taxes. Borrow more money. Borrow more money.

14-8 Treasury and Agency Bonds Viewed as risk-free - given the government’s ability to tax and print money. Viewed as risk-free - given the government’s ability to tax and print money. With no default risk and no call risk, they pay a lower interest rate. With no default risk and no call risk, they pay a lower interest rate. Most government interest payments are exempt from state and local taxes. Most government interest payments are exempt from state and local taxes.

14-9 Treasury and Agency Bonds Treasury-issued debt has maturities from 3 months to 10 years. Treasury-issued debt has maturities from 3 months to 10 years. Until 2001, 30-year bonds were issued. Until 2001, 30-year bonds were issued. 70% of the debt has maturities of 5 years or less. 70% of the debt has maturities of 5 years or less. Government issues include bills, notes, and bonds. Government issues include bills, notes, and bonds.

14-10 Treasury and Agency Bonds Government Debt Treasury Bills Treasury Bills Treasury Notes Treasury Notes Treasury Bonds Treasury Bonds Maturity When Issued 3, 6, or 12 months 2, 3, 5, or 10 years Over 10 years

14-11 Treasury and Agency Bonds Federal National Mortgage Association (FNMA) and the Federal Home Loan Banks (FHLB) issue agency bonds. Federal National Mortgage Association (FNMA) and the Federal Home Loan Banks (FHLB) issue agency bonds. Not directly issued through the Treasury. Not directly issued through the Treasury. Considered to be virtually risk-free. Considered to be virtually risk-free. Interest rate higher than Treasuries. Interest rate higher than Treasuries. Minimum denomination is $25,000. Minimum denomination is $25,000.

14-12 Treasury and Agency Bonds Government National Mortgage Association (GNMA) issues “pass-through certificates.” Government National Mortgage Association (GNMA) issues “pass-through certificates.” Represents an interest in a pool of federally insured mortgages. Represents an interest in a pool of federally insured mortgages. GNMA packages a group of mortgages, guarantees them, then sells certificates to finance the mortgages. GNMA packages a group of mortgages, guarantees them, then sells certificates to finance the mortgages. $25,000 minimum denomination. $25,000 minimum denomination. Investor receives a monthly check of interest and principal, but amount varies. Investor receives a monthly check of interest and principal, but amount varies.

14-13 Treasury and Agency Bonds Treasury Inflation Protected Securities (TIPS) is the newest Treasury bond. Treasury Inflation Protected Securities (TIPS) is the newest Treasury bond. Maturities of 5, 10, or 20 years. Maturities of 5, 10, or 20 years. Par value of $1,000. Par value of $1,000. Par value changes when CPI changes. Par value changes when CPI changes. Investors guaranteed a real return – a return above inflation. Investors guaranteed a real return – a return above inflation. Must pay taxes on upward adjustment in par value although no cash is received (taxed as interest). Must pay taxes on upward adjustment in par value although no cash is received (taxed as interest).

14-14 Treasury and Agency Bonds U.S. Series EE Bonds – savings bonds aimed at small investor. U.S. Series EE Bonds – savings bonds aimed at small investor. Face values from $50 to $10,000. Face values from $50 to $10,000. Purchased at half of face value. Purchased at half of face value. Bond doubles in value after a specified period. Bond doubles in value after a specified period. Liquid – can be cashed in at any time. Liquid – can be cashed in at any time.

14-15 Treasury and Agency Bonds I Bonds are accrual-type bonds. I Bonds are accrual-type bonds. Interest is added to the value of bond and paid when cashed in. Interest is added to the value of bond and paid when cashed in. Sold at face value, grow with inflation-indexed earnings for up to 30 years. Sold at face value, grow with inflation-indexed earnings for up to 30 years. Return includes a fixed return and a semiannual inflation rate. Return includes a fixed return and a semiannual inflation rate. Invest from $50 to $30,000 per year. Invest from $50 to $30,000 per year. Defer federal taxes up to 30 years. Defer federal taxes up to 30 years. Exempt from state and local taxes. Exempt from state and local taxes.

14-16 Municipal Bonds Munis are issued by states, counties, cities, and other public agencies. Munis are issued by states, counties, cities, and other public agencies. Over $1 trillion in outstanding value. Over $1 trillion in outstanding value. Tax exempt from federal government and by state (as long as you live where the bonds were issued). Tax exempt from federal government and by state (as long as you live where the bonds were issued). Capital gains, from selling early, are taxed. Capital gains, from selling early, are taxed.

14-17 Municipal Bonds General Obligation Backed by the full faith and credit of issuer. Backed by the full faith and credit of issuer. Taxes used to pay back principal and interest. Taxes used to pay back principal and interest. Example: School district builds new school, taxes used to pay back the lenders. Example: School district builds new school, taxes used to pay back the lenders. Revenue Bonds Derive funds to pay interest and repay principal from a designated project. Example: Bond finances a new toll road, revenue from tolls pay back lenders.

14-18 Municipal Bonds Most munis have serial maturities – a portion of the debt matures each year. Most munis have serial maturities – a portion of the debt matures each year. Munis are not risk-free. Munis are not risk-free. Although rare, issuers can default. Although rare, issuers can default. Rating agencies evaluate bonds. Rating agencies evaluate bonds. Small issues may be illiquid. Small issues may be illiquid.

14-19 Special Situation Bonds Zero Coupon Bonds – do not pay interest. Zero Coupon Bonds – do not pay interest. Sold at a discount and at maturity return the entire par value. Sold at a discount and at maturity return the entire par value. Acts like a savings bond and appeals to those wanting a lump sum payment in the future without concerns of reinvesting interest. Acts like a savings bond and appeals to those wanting a lump sum payment in the future without concerns of reinvesting interest. The annual appreciation in the bond is taxed (as interest) even though you do not receive income annually. The annual appreciation in the bond is taxed (as interest) even though you do not receive income annually. Federal government’s zero coupon bonds are called STRIPS. Federal government’s zero coupon bonds are called STRIPS.

14-20 Special Situation Bonds Junk Bonds - low-rated bonds (also called high- yield bonds). Junk Bonds - low-rated bonds (also called high- yield bonds). Have ratings of BB or below. Have ratings of BB or below. Major issuers of junk bonds are new firms that have not yet established a performance record. Major issuers of junk bonds are new firms that have not yet established a performance record. With a greater risk of default, they have interest rates 3-5% above AAA long-term bonds. With a greater risk of default, they have interest rates 3-5% above AAA long-term bonds. Most are callable. Most are callable. Prudent investors avoid junk bonds. Prudent investors avoid junk bonds.

14-21 Evaluating Bonds Current Yield - refers to the ratio of interest payment to the bond’s market price. Current Yield - refers to the ratio of interest payment to the bond’s market price. Yield to Maturity – true yield received if bond is held to maturity. Yield to Maturity – true yield received if bond is held to maturity. Considers the annual interest payments as well as the difference between the bond’s current market price and maturity value. Considers the annual interest payments as well as the difference between the bond’s current market price and maturity value.

14-22 Evaluating Bonds Equivalent Taxable Yield on Municipal Bonds: Equivalent Taxable Yield on Municipal Bonds: Appeal of munis is their tax-exempt status. Appeal of munis is their tax-exempt status. Make comparisons between munis and taxable bonds. Make comparisons between munis and taxable bonds. Calculation refers to tax bracket – including federal, state, and local taxes avoided by the muni. Calculation refers to tax bracket – including federal, state, and local taxes avoided by the muni. The higher the tax bracket, the more attractive the muni. The higher the tax bracket, the more attractive the muni.

14-23 Bond Ratings – A Measure of Riskiness Moody’s and Standard & Poor’s provide ratings on corporate and municipal bonds. Moody’s and Standard & Poor’s provide ratings on corporate and municipal bonds. Ratings involve a judgment about a bond’s future risk potential. Ratings involve a judgment about a bond’s future risk potential. Default risk – ability to repay principal. Default risk – ability to repay principal. Inability to meet interest obligations. Inability to meet interest obligations. The lower the rating, the higher the rate of return demanded by investors. The lower the rating, the higher the rate of return demanded by investors. Safest bonds receive AAA; D is extremely risky. Safest bonds receive AAA; D is extremely risky.

14-24 Bond Valuation Bond owners receive interest payments for a number of years, and then par value at maturity. Bond owners receive interest payments for a number of years, and then par value at maturity. Value of a bond is the present value of the interest payments plus the present value of the repayment of par value at maturity. Value of a bond is the present value of the interest payments plus the present value of the repayment of par value at maturity.

14-25 Bond Valuation What causes the required rate of return to change? What causes the required rate of return to change? If the issuer becomes riskier, the required rate of return should rise. If the issuer becomes riskier, the required rate of return should rise. When interest rates rise, the value of outstanding bonds falls. When interest rates rise, the value of outstanding bonds falls.

14-26 Why Bonds Fluctuate in Value Inverse relationship between interest rates and bond values. Inverse relationship between interest rates and bond values. When interest rates rise, investors demand a higher return. When interest rates rise, investors demand a higher return. Because of the fixed coupon rate, the price must drop. Because of the fixed coupon rate, the price must drop.

14-27 Why Bonds Fluctuate in Value Longer-term bonds fluctuate in price more than shorter-term bonds. Longer-term bonds fluctuate in price more than shorter-term bonds. As a bond approaches maturity, the market value approaches par value. As a bond approaches maturity, the market value approaches par value. When interest rates go down, bond prices go up, but upward price movement on bonds with a call provision is limited by the call price. When interest rates go down, bond prices go up, but upward price movement on bonds with a call provision is limited by the call price. Investors will not pay more than the call price. Investors will not pay more than the call price.

14-28 Preferred Stock A hybrid security with features of common stock and bonds. A hybrid security with features of common stock and bonds. Similar to common: Similar to common: No fixed maturity date. No fixed maturity date. Not paying dividends won’t cause bankruptcy. Not paying dividends won’t cause bankruptcy. Similar to bonds: Similar to bonds: Dividends are fixed, paid before common stock. Dividends are fixed, paid before common stock. No voting rights. No voting rights.

14-29 Features and Characteristics of Preferred Stock Multiple Issues – more than one issue. Multiple Issues – more than one issue. Cumulative Feature – all unpaid dividends must be paid prior to declaring common dividends. Cumulative Feature – all unpaid dividends must be paid prior to declaring common dividends. Adjustable Rate – dividends fluctuate with interest rates. Adjustable Rate – dividends fluctuate with interest rates. Convertibility – holder can, at any time, exchange for predetermined number of common shares. Convertibility – holder can, at any time, exchange for predetermined number of common shares. Callability – if interest rates decline, preferred stock likely to be called. Callability – if interest rates decline, preferred stock likely to be called.

14-30 Valuation of Preferred Stock With a preferred stock, you receive a steady stream of dividends that go on forever. With a preferred stock, you receive a steady stream of dividends that go on forever. The value of a share of preferred stock is the present value of the perpetual stream of constant dividends. The value of a share of preferred stock is the present value of the perpetual stream of constant dividends. When interest rates rise (causing your required rate of return to rise), the value of a share of preferred stock declines. When interest rates rise (causing your required rate of return to rise), the value of a share of preferred stock declines.

14-31 Risks Associated with Preferred Stock If interest rates rise, the value of preferred stock drops. If interest rates rise, the value of preferred stock drops. If interest rates drop, the value of preferred stock rises and it is called away. If interest rates drop, the value of preferred stock rises and it is called away. Investor does not participate in the capital gains that common stockholders receive. Investor does not participate in the capital gains that common stockholders receive. Investor doesn’t have the safety of bond interest payments because preferred dividends can be passed without the risk of bankruptcy. Investor doesn’t have the safety of bond interest payments because preferred dividends can be passed without the risk of bankruptcy.

14-32 Investing in Real Estate Investing in real estate requires time, energy and sophistication. Investing in real estate requires time, energy and sophistication. Investment real estate can be: Investment real estate can be: Direct – own the property Direct – own the property Vacation homes, commercial property, undeveloped land Vacation homes, commercial property, undeveloped land Indirect – invest in a group, hire a manager Indirect – invest in a group, hire a manager Real Estate Investment Trust (REIT), real estate syndicates Real Estate Investment Trust (REIT), real estate syndicates

14-33 Investing – Speculating in Gold, Silver, Gems, and Collectibles Don’t do it! Don’t do it! This is not investing – it is speculation. This is not investing – it is speculation. Collectibles may only have entertainment value. Collectibles may only have entertainment value.