Chapter 15 Investing in Bonds McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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-usually $1,000. Bondholders receive interest payments every six months at the stated interest rate. The legal conditions are described in a bond indenture. A trustee is a financially independent firm that acts as the bondholder’s representative. 15-2

Why Corporations Sell Bonds To get funds for major purchases. To fund ongoing business activities. When it is difficult or impossible to sell stock. To improve financial leverage. Interest paid to bondholders is a tax deductible business expense that can be used to reduce the federal and state taxes corporations must pay. 15-3

Four Types of Corporate Bonds  Debenture bond.  Most corporate bonds are debenture bonds.  Unsecured - Backed only by the reputation of the issuing company.  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. 15-4

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 claim on assets.  Convertible bond.  A special kind of corporate bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock. (continued) 15-5

Call Feature of Corporate Bonds 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. Bonds called if their interest rate is much higher than the going rate. Most corporate bonds are callable. 15-6

Provisions For Repayment of Bonds 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. 15-7

Why Investors Buy Corporate Bonds For interest income.  Investors know the interest rate.  Interest will be paid to investors twice a year, with the payment based on the interest rate and the face value of the bond. Appreciation of bond value.  May be able to sell a bond with a fixed interest rate to someone else at a higher price if overall interest rates fall. Bond face amount will be repaid at maturity. 15-8

Bond Registration Registered bond: Registered in your name by the company who issued it. Interest checks will be mailed directly to you. A bearer bond is not registered in your name. Also has detachable coupons. No longer issued by U.S. corporations. Zero coupon bonds: Sold for below face value; it pays no interest; redeem it for face value at maturity. Interest is taxed as you earn it. 15-9

Other Bond Information Can hold bond until maturity or sell it in the secondary market. Success or failure of the business and changes in market interest rates will affect the price of the bond. Interest and capital gains from selling bonds are both taxable

Government Bonds and Debt Securities Sold to obtain money to finance the national debt, and the ongoing costs of government. Three levels of government issue bonds:  Federal-no state income tax on the interest.  State.  Local municipalities

U.S. Government Treasury Bills and Notes Treasury Bills (T-Bills). $1,000 minimum. 4, 13, or 26 weeks to mature. Sold at a discount. Treasury Notes (T-Notes). $1,000 units. 2, 3, 5, and 10 year terms. Interest paid every six months, higher rates than T-bills

Why Do Investors Buy Government Bonds? Pay a lower interest rate than corporate bond, but virtually risk free if chosen carefully. Often used by investors to diversify their investment holdings

Federal Agency Debt Issues Fannie Mae (  Federal National Mortgage Association. Ginnie Mae - pay interest once a month.  Government National Mortgage Association. Freddie Mac.  Federal Home Loan Mortgage Corporation. Slightly higher risk than Treasury securities, so slightly higher interest rates. Issued for 1-30 years, 12 year average. Minimum may be as high as $25,

State and Local Government Securities Municipal bonds or munis. Issued by a state or local government, such as cities, counties, school districts. Use funds for ongoing costs & to build major projects such as schools, airports, and bridges. 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

Why do People Buy Municipal Bonds? People like to invest in projects close to home. They like insured municipal bonds, or states that guarantee payment. May be callable, but usually not until after the first ten years. Interest earned may be exempt from federal income tax so yield is higher

Taxable Equivalent Yield Tax-exempt yield Your tax rate Example: Taxable equivalent yield = = = 8.3% 15-17

Making the Decision to Buy or Sell a Bond Will the bond be repaid at maturity? Will you receive interest payments until maturity? Read the annual report, looking for strengths and weaknesses. Bond ratings? (see Exhibit 15-6).  Rating range from AAA to D.  BB or below is called a junk (speculative) bond.  Rated by Standard and Poors and Moodys, with information on their websites,  are online sources of information on bonds

Making the Decision to Buy or Sell a Bond Read bond quotes in the newspaper.  Bid price is the highest price offered for the bond during a day (market value).  Asked price is the lowest price at which someone has offered to sell a bond during a day.  Look at the maturity date.  Determine the current yield.  A bond listed at 100 is really selling for $1, (continued)

Current Yield of a Bond (%) Example: Current yield = $75 $800 = = 9.4% The Investment’s Current Market value Dollar Amount of Income Generated Yearly

Yield to Maturity $ Amt. Annual Interest + Face value - Market value Number of periods Market value + Face value 2 Example: $60 + $1,000 - $ $900 + $1,000 2 = = 7.4% 15-21

Online Activity Go to one of these sites and look up information about municipal bonds in your area. What do you think of the rates these bonds are paying? 15-22