1. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? A bond is the legal evidence of a long-term loan made by the bondholder to the corporation that issued the bond. –Typically the loan must be repaid as of a specified date, referred to as the “maturity date.” –Interest at a stated rate is paid by the corporation to the bondholder. Generally paid every six months The interest rate is usually fixed when the bonds are issued and does not change during the life of the bond. –High yield (junk bonds) issues vs. investment grade rated issues

2. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 When is the use of this tool indicated? When a primary concern of the investor is safety of principal. When a relatively high current return on the investment is desired. When a secure and consistent flow of income is necessary. When an investor anticipates holding the investment for a minimum of three to five years.

3. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 When is the use of this tool indicated? When an investor’s cash flow and capital needs can be planned to coincide with scheduled bond interest payments and maturities. For high yield issues, when an investor desires a substantial cash flow and return on investment (ROI), but also has the capacity to bear the added risk and volatility of lower-rated issues. –This capacity includes financial and psychological considerations.

4. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 Advantages Income and principal are relatively safe. –Both are guaranteed by the general credit of the issuing corporation. –The security of both are in direct proportion to the financial strength of the issuer. –Secured bonds are backed by specified collateral, which can include: Real property owned by the corporation The earning power of the firm Other firm assets –Payment of both takes precedence over payment of dividends. –In the event of insolvency or bankruptcy, holders of secured bonds generally will receive better treatment than unsecured creditors, general creditors, or stockholders.

5. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Advantages Interest income is normally paid on a regular basis. –Interest payments on bonds are a nondiscretionary legal obligation. –It is possible for an investor to be assured of a regular income. Gain on the sale of a bond held for more than one year is eligible for long-term capital gain treatment. –This also applies to the difference between the maturity value and the paid price for a bond purchased on the market, assuming the bond is held to maturity and the maturity value exceeds the purchase price. –The Tax Reform Act of 1984 treats the difference between the purchase price and the issue price as interest income, not a capital gain. –If the original issue price is less than the maturity value, the excess of the maturity value over the original issue price must be included as interest income as it accrues over the life of the bond.

6. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Advantages Corporate bonds provide a high current rate of return on capital. –Historically, the current yield has ranged from 2% - 8% higher than the dividend yield on common stocks. High yield bonds provide a higher level of current income when compared to investment grade bonds. –They also have the potential for significant capital appreciation if a bond’s rating is upgraded at some future point in time.

7. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 Disadvantages The purchasing power of fixed interest payments may be eroded by inflation. –The longer the period of time to maturity, the more likely that the purchasing power of each fixed dollar payment will decline. Interest payments are fixed, even if the financial condition of the company or the economy improves. –As creditors and not owners, bondholders do not share in the growth or prosperity of the company. Inflation will also reduce the purchasing power of a bondholder’s principal.

8. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 Disadvantages Bond prices fluctuate with changes in current market interest rates. –Increasing interest rates will cause older bonds paying lower rates of interest to be less attractive to investors. Prices must drop to increase attractiveness. –The decline in prices of old bonds increases their competitiveness in terms of “yield to maturity.” Yield to maturity is the average annualized rate of return that an investor will earn if a bond is held until it matures. –If interest rates fall, the reverse is true.

9. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Disadvantages If the overall financial condition of the issuing corporation deteriorates, the resale price of its bonds is likely to fall. –The higher risk associated with the lower credit and quality rating causes buyers to demand a higher rate of return. –Interest payments cannot be increased, leaving price adjustments as the principle means of satisfying new required rates of return. An investor’s ability to sell his bonds may be adversely affected by: –The size of the issue A smaller issue is less likely to be actively traded. –Dispersion of ownership Issues owned in large blocks by a few large institutions often have low levels of trading. –The quality rating of the issuer.

10. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Disadvantages Today, most corporate bonds are issued as general credit obligations (“debentures”). –These involve higher risk than “secured” debt obligations that are backed by real assets of the corporation. –“Subordinated debentures” These have security preference over only the equity of the issuing company. They usually pay a higher interest rate than general credit obligations. They also offer warrants for the purchase of common stock. High yield bonds typically involve additional risks: –Greater price volatility –Increased risk of default –Less liquid markets with higher bid-ask spreads

11. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 Tax Implications Interest income paid on a regular basis is generally taxable when received at ordinary income rates. Profits or losses on the sale or maturity of corporate bonds are treated as capital gains or losses. –Long-term capital gains are generally taxable at a maximum rate of 15%. –Capital losses may be used to offset only capital gains and up to $3,000 of ordinary income per year. Unused losses may be carried forward by individuals and applied against future income.

12. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 Tax Implications If a bond is sold at a loss and then repurchased, the investor may be subject to the “wash sale” rules. Bonds held at death in the sole name of the investor will be subject to both federal estate tax and state death tax. –Subject to EGTRRA 2001 changes Bonds issued with “original issue discount” yield taxable income to bondholders with respect to the discount over the life of the bond. –This occurs even though the discount “income” will not be received until the bond matures.

13. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 Tax Implications Special rules apply where bonds are purchased at a “market discount.” –Generally, the amount of market discount need not be recognized as income until the bond is sold or matures. –There is a limit on the deductibility of interest expense on debt incurred to purchase or carry market discount bonds. The deductibility is limited to interest income on the bond that is includable in income. Beyond that amount, interest expense may be deducted only to the extent it is more than the market discount allocable to the days the bond was held in the year. –Interest expense not currently deductible may be deducted the year the investor disposes of the bond.

14. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 Tax Implications High yield bonds are treated similarly to other corporate debt instruments for income tax purposes. –Interest income is subject to both federal and state income taxes. It is taxed as “ordinary income.” –Gains and losses on high yield bond sales are also taxed like other capital transactions.

15. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company15 Alternatives Municipal bonds generating a comparable or higher after-tax yield. Single-premium deferred annuities providing a fixed annual payment. Certain preferred stocks with a fixed dividend. Intermediate or long-term securities of the federal government or federal agencies that provide a comparable or slightly lower after-tax yield. “Zero coupon” bonds –No interest until maturity –Offer a comparable overall yield –Should be considered by investors who do not need current income

16. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company16 Alternatives High-yield mutual funds –Widely diversified portfolio of lower-quality bonds, which reduces the impact of default risk from any one issue. Foreign bonds –Includes offerings of foreign governments and foreign corporations –Should be considered by more sophisticated, risk-oriented investors –Foreign bond mutual funds give investors the best means for achieving a desirable level of risk management and diversification.

17. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company17 Where and How do I get it? Corporate bonds can be purchased directly by calling most brokerage firms, banks, and other financial institutions. Bond prices are established through dealers on the basis of supply and demand. Most bonds are traded on the “over-the-counter” (OTC) market. –Extremely active and large bond issues are traded on the NYSE. Information on new bond issues are often available in the business section of newspapers. –“Tombstone ads” –Often indicate the issuer of the bond, the size of the issue, the maturity date, the interest rate, etc. –The advertisements also often show the underwriters, which are the brokerage firms who originally purchased the bonds from the issuing corporation.

18. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company18 Where and How do I get it? “Premiums” and “discounts” on bond prices are often caused by: –Changes in interest rates, or –The specific bond’s maturity. The period of time to maturity can range from a few days to more than 30 years. Price volatility is directly related to the length of time to maturity. Long-term bonds tend to fluctuate more in price than short-term bonds. “ Round lots” vs. “Odd lots” –Institutional investors tend to trade in “round lots.” Large blocks of securities amounting to $100,000 or more. –Individual investors typically make smaller purchases referred to as “odd lots.”

19. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company19 Where and How do I get it? The selection of a particular broker or bond dealer can affect the price an investor pays for the bond. –The commission or fees charged by different brokers can vary considerably. –Some brokers may be willing to sell bonds at a lower price in order to reduce their inventory of a particular issue. Mutual funds of corporate bonds –They are managed portfolios holding a large variety of corporate bonds of different maturities and issuers. –Offer diversification, which can help achieve safety of principal and income.

20. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company20 Where and How do I get it? Mutual funds of corporate bonds –The two common ways of purchasing corporate bond funds are: Directly from the fund itself (“No-load”) –Advertised in newspapers –Transactions are carried out by mail –No sales commission is charged Through a brokerage firm (“Load”) –Typically distributed through brokerage firms –The purchaser is charged a sales fee –The price of a bond fund’s shares will be determined by changes in the value of bonds in the fund’s portfolio.

21. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company21 What fees or other acquisition costs are involved? The investor will pay no commission on the purchase of a new issue. –The corporation selling the bonds or the underwriter absorbs the sales costs. In all other cases, buyers and sellers can expect to pay a brokerage fee ranging from $2.50 to $20.00 per bond. –Some brokers will charge a minimum fee of $30 regardless of the number of bonds being bought or sold.

22. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company22 How do I select the best of its type? Investors should consider the following metrics: –Quality rating of the bond Assigned by a professional appraisal service such as S & P’s Bond Guide or Moody’s Investors Service Ratings run from “AAA” (highest rating) to “D” (default) The rating is a current assessment of the creditworthiness of the issuer and is based on information furnished by the company or obtained by the rating service. –Current yield The rate of return based on the current market price of the bond Obtained by dividing the annual interest amount by the current purchase price of the bond –Yield to maturity (YTM) The rate of return on a bond held to its maturity date and redeemed by the issuer at its par value

23. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company23 How do I select the best of its type? A maturity date should be consistent with the investor’s projected cash flow or capital needs objectives. It may be desirable to coordinate maturities with potential shifts in tax brackets. –An investor should select maturities that delay the gain until he or she will be in a lower tax bracket or can utilize offsetting deductions. Preference should be given to the larger issues of strong, well-managed corporations. –The bonds of such firms are likely to be actively traded. Increased marketability Less costly to sell in a short time

24. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company24 How do I select the best of its type? Bonds with shorter maturity dates will generally have greater price stability than longer-term bonds with the same quality rating. –The tradeoff may be a lower yield. For high yield bonds, investors would be wise to: –Diversify their holdings across issuers and industry sectors Concentrating in only a few issues greatly increases the risk of holding junk bonds. –Adjust their portfolios over economics cycles Increase holding during periods of economic expansion and decrease holding as the economy slows or contracts –Monitor the rating agencies Rating agencies often put companies on a “credit watch” list prior to downgrading an issue.

25. Corporate Bonds Chapter 3 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company25 Where Can I Find Out More About It? Statistical rating agencies –Standard & Poor’s (www.standardandpoors.com)www.standardandpoors.com –Moody’s Investors Service (www.moodys.com)www.moodys.com Newspapers which quote bond prices daily –The New York Times (www.nytimes.com)www.nytimes.com –The Wall Street Journal (www.wsj.com)www.wsj.com Major brokerage firms or banks Other internet sources –Bondsonline (www.bondsonline.com)www.bondsonline.com –Investinginbonds.com (www.investinginbonds.com)www.investinginbonds.com