Bond

Module 12
Bonds
“Gentlemen prefer bonds.”
-Andrew Mellon
Learning objective:
Understand what bonds are.
Know the pros and cons of bonds.
Know the types of bonds.
What are bonds?
The indebted entity (issuer) issues a bond and receives cash.
The bond states the interest rate (coupon) that will be paid and
when the loaned funds (bond principal) are to be returned
(maturity date).
Interest on bonds is usually paid every six months (semi-annually).
The main categories of bonds are corporate bonds, municipal
bonds, and U.S. Treasury bonds, notes and bills.
From: http://www.investopedia.com/terms/b/bond.asp
Video: Bonds
What are bonds?
When your purchase a bond you are loaning your money for a
certain period of time to the issuer either a corporation or the
government.
Bonds can be a critical component of your investment plan.
Bonds are generally very safe but not extremely profitable.
(Remember risk premium)
Bonds are generally considered a form of a fixed income
security.
Understanding Bonds
Question Cluster 1
Advantages of Bonds:
• Bonds are generally a safe investment.
• Corporate bond holders will be paid back before stockholders.
• Therefore a corporate bond is safer than the stock of the same company.
• Bonds are considered a safe harbor. If you think economic down
turns are about to occur it may be a good idea to move money
into bonds.
• Increases your diversification
• Some government bonds (municipal bonds) are tax free.
Disadvantages of Bonds
• Bonds will generally not have as high of a return as other investments
(stock and mutual funds).
• There is a chance that the interest rate on a bond will not keep up with
inflation.
• If you have $100 in bonds that receives 10% you will get $10 in return.
• Interest rates go to 20% but you still only get $10 in return when you could be making
$20 off something else.
• Bond returns are very dependent on changes in the general interest rate.
• Bonds have an inverse relationship with interest rates. If interest rates
increase the value of your bonds decrease.
• There is no such thing as a completely safe investment.
Bonds and your Investment Plan
Bonds act as a safety

investment. You will usually
heavily invest in bonds later in
your investment lifespan
Investing in Bonds
Think of it this way:
You are 25 years old and looking to invest. You have on
average 40 years before you retire and therefore it makes more
sense for you to make investments with higher growth but
lower safety (stocks). You have a large time span to recover
from any economic down turns or losses you may incur from
poor investment decisions. In other words, you have more
time and incentive to gamble a little bit. You have more
breathing room.
On the other hand:
Suppose you are 60 years old, and have about 3-5 before
retirement. You are about to retire, your main concern is
holding on to what you have. An economic downturn or
investment business failure could mean delaying your
retirement for several years. You want something safe,
therefore you are more likely to invest heavily in bonds.
Question Cluster 2
Government Bonds & Debt Securities:
Government bonds are a written guarantee to:
Repay a stated sum of money (face value)
At maturity
With interest (coupon payments)
Fund national debt and the cost of government
Three levels of government issues are:
Federal
State
Local municipalities
Treasury Bills (T-Bills):
$100 minimum
Short Maturities of 4,13,26,52 weeks
Sold at a discount (buy a $1,000 T-bill for $800)
Federal but no state tax on interest earned
T-Bills
Treasury Notes:
Purchase in $100 units
Longer Maturities of 2,3,5,7 & 10 years
Interest is paid every 6 months (steady, predictable income)
Higher rate than T-bills
Federal but no state tax on interest earned
Treasury Bonds:
Interest rates higher than notes and bills, but have 30 year maturity dates
Issued in units of $100
Interest paid every 6 months
Treasury Inflation-Protected Securities (TIPS):

Principal changes with inflation
5,10 or 20 year maturities
Interest is paid twice a year at fixed rates
TIPS
Federal Agency Debt Issues-
Issued my quasi government organizations (Fannie Mae)
Almost risk free
Marginally higher interest rates than Treasury securities
Minimum investment required can be as high as $25,000
Maturities can be from 1-30 years.
State and Local Government Securities
Municipal Bonds:
Issued by a state or local government
Sold to fund major projects such as schools, airports, and bridges
Key characteristic:
Interest earned is exempt from federal taxes
Capital gains may NOT be tax exempt
Generally exempt from state and local taxes in state where issued
Exempt status determined by usage of funds
Insured municipal bonds
Private insurance is used to reduce risk
State and Local Government Securities
Municipal Bonds may either be:
General Obligation
Fully backed by the credit and authority of the Government that
issues them
Revenue Bonds
Used to fund income producing projects. Paid back from money
generated by these projects.
Question Cluster 3
Corporate Bonds
Corporate Bonds:
A corporation’s documented pledge to repay a stated sum of money with
interest
Why Corporations Sell Bonds:
To fund business activities including major purchases and projects
When they find it difficult or impossible to sell stock
To increase financial leverage
Interest dispersed to bondholders is tax deductible for the corporation
Bond Calculations
Amount of annual interest = face value x interest rate
= $1,000 x 5% (paid semi-annually)
= $50
The yearly interest made on this bond is $50 a year. The bond is semiannual
meaning it will receive two $25 payments twice a year. The $1,000 face value
is paid back on maturity date.
Reading
Bond Calculations
Types of Corporate Bonds
Debenture:
Unsecured
Supported solely by the reputation of the issuing company
Mortgage bond:
Secured by many assets of the issuing firm, such as real estate
Yield a lower interest (coupon) rate as debt is backed
Convertible bond:
At the owners request can be exchanged for a certain amount of shares of the
corporation’s stock
Normally the coupon rate on a convertible bond is 1 to 2% lower than the rate paid on
traditional bonds
Provisions For Repayment
Callable bonds:
The majority of corporate bonds are callable, meaning they can call
in, or buy bonds from holders before it hits the maturity date.
A callable bond is protected from being called back for the first 5 to 10
years after being issued
A firm generally calls a bond issue if the coupon rate they are paying
to the holder is higher than the market rate. As this would mean they
would be paying you more than it was worth to them.
Be aware that your bond investments can be called in before they
mature. In which case you will get your fair share but not everything.
Bond Ratings
Not all bonds are created equal.
Bonds receive ratings based on
their quality and risk. There are
three companies responsible for
rating thousands. The higher up
in the alphabet, the safer the
investment. Companies with
low ratings generally pay higher
interest, however.
Buying and Selling Bonds
U.S. Treasuries are sold by the federal government at regularly
scheduled auctions. You can buy them through a bank or broker for a
fee, however the easiest and cheapest way to participate in this market
is to buy them directly from the Treasury.
Corporate bonds are bought and sold much like stock. New bond
issues are issued by the company through an investment bank. Older
bonds are traded on the “secondary market.” Most bonds are bought
and sold over the counter rather than on an exchange. Bonds can be
bought individually or through a “bond fund.”
Which bond?
You can obtain information on bonds through:
The Newspaper
Government Websites
 Buy Bonds
Individual Corporate Websites
Financial websites (the better ones will often charge you)
Websites for the three bond rating agencies.
Question Cluster 4

Bond

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Module 12

Bonds act as a safety

Treasury Inflation-Protected Securities (TIPS):

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