Chapter 11
Investing Basics
and Evaluating
Bonds
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
11-1
Investing Basics and Evaluating Bonds
Chapter Learning Objectives
LO11.1 Explain why you should establish an
investment program.
LO11.2 Describe how safety, risk, income, growth, and
liquidity affect your investment program.
LO11.3 Identify the factors that reduce investment
risk.
LO11.4 Understand why investors purchase
government bonds.
LO11.5 Recognize why investors purchase corporate
bonds.
LO11.6 Evaluate bonds when making an investment.
11-2
Learning Objective LO11.1
Explain Why You Should Establish an
Investment Program
Establishing Investment Goals
• Financial goals should be:
– Specific
– Written Down
– Measurable
– Tailored to your financial needs
– Aimed at what you want to accomplish
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Establishing Investment Goals
1. How much money do you need to satisfy
your investment goals?
2. How will you obtain the money?
3. How long will it take you to obtain the
money?
4. How much risk are you willing to assume
in an investment program?
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Establishing Investment Goals
5. What possible economic or personal
conditions could alter your investment
goals?
6. Considering your current and
anticipated economic circumstances,
are your investment goals easonable?
7. Are you willing to make the sacrifices
necessary to ensure that you meet
your investment goals?
11-5
Performing a Financial Checkup
• Pay your bills on time
• Work to balance your budget
• Manage your credit card debt
– Pay in full each month
– Do not use credit for small purchases
– Do not use the cash advance option
– Think about the number of cards you need
– Get help if you are in trouble
11-6
Performing a Financial Checkup
• Start an emergency fund you can access
quickly
– At least three months of living expenses
• Have access to other sources of cash for
emergencies
– Pre-approved line of credit
– Cash advance on your credit card
– Home equity
11-7
Managing an Economic Crisis
1. Establish a larger than usual emergency
fund
2. Know what you owe
• Identify debts that must be paid
3. Reduce spending
4. Notify credit card companies and lenders if
you are unable to make payments
5. Monitor the value of your investment and
retirement accounts.
6. Consider converting investments to cash to
preserve value.
11-8
Getting the Money Needed to Start
an Investing Program
11-9
How the Time Value of Money
Affects Your Investments
• Even small amounts invested regularly
grow over a long period of time. The value of
one cup of coffee per day invested over 40
years grows to $390,000.
• Use the Time Value of Money calculation
methods in the Chapter 1 Appendix to
calculate future values.
• The higher the rate of return the greater the
risk
11-10
Learning Objective LO11.2
Factors Affecting the Choice of
Investments
• Safety and risk
– Risk = uncertainty about the outcome
– Investment Safety = minimal risk of loss
– Risk-Return Trade-Off
• The potential return on any investment should
be directly related to the risk the investor
assumes
– Speculative investments are high risk, made by
those seeking a large profit in a short time
11-11
Components of the Risk Factor
• Inflation risk  during periods of high
inflation your investment return may not
keep pace with inflation
• Interest rate risk  the value of bonds or
preferred stock may increase or decrease
with changes in interest rates
• Business failure risk  affects stocks and
corporate bonds
• Market risk  the risk of being in the market
versus in a risk-free asset
11-12
Investment Income
•
Investment Income
– A predictable source of income (dividends or
interest)
– Most conservative = passbook savings, CDs and
government securities
– Other choices:
•
•
•
•
•
•
Municipal and corporate bonds
Preferred stock
Utility stocks
Selected common stocks
Selected Mutual funds
Rental real estate
11-13
Investment Income, Growth
and Liquidity
• Investment Growth
– Growth in value (price appreciation)
– Common stock usually offers the greatest potential
for growth
– Mutual funds, ETFs and real estate offer growth
potential
• Investment Liquidity
– 2 dimensions
• Ability to buy or sell an investment quickly
• Without substantially affecting the
investment’s value
11-14
Learning Objective LO11.3
Factors that Reduce Investment Risk
Asset Allocation and Diversification
• Asset allocation
=
=
The process of spreading your assets
among several different types of
investments
Diversification
• Stocks
• Bonds
• Risk-free assets
• Real-estate
11-15
Traditional Investment Evaluation
Factors
11-16
Asset Allocation and
Diversification
• Other factors to consider:
– Your age
• Growth versus income
• Recovery time if investments nosedive
–
–
–
–
–
Your investment objectives
How much can you save and invest each year?
The dollar value of your current investments
The economic outlook for the economy
Your tolerance for risk
• At what point can you no longer sleep easily?
– Your investment horizon
• When will you need the money?
• How long can your money continue to grow?
11-17
Portfolio Investing
Brokerage firms frequently construct sample portfolios for
client consideration. A suggested asset allocation for a
young investor is shown below.
11-18
Investment Pyramid
11-19
Your Role in the Investment
Process
1. Evaluate potential investments
2. Monitor the value of your investments
3. Keep accurate records
4. Other factors
 Seek help from personal financial
planner
 Consider the tax consequences of
selling your investments
11-20
Learning Objective LO11.4
Conservative Investment Options:
Government Bonds
• Government bonds = written pledge to:
– Repay a specified sum of money (face value)
– At maturity
– Along with periodic interest payments
• Sold to fund the national debt and the ongoing
costs of government at all levels
• Three levels of government issues:
– Federal
– State
– Local municipalities
11-21
U.S. Treasury Bills, Notes and Bonds
Treasury Bills (T-Bills)
•
•
•
•
$100 minimum
4, 13, 26 and 52 weeks to maturity
Sold at a discount
Federal but no state tax on interest earned
Treasury Notes
•
•
•
•
•
$100 units
Typical maturities = 2, 3, 5, 7, and 10 years
Interest paid every six months
Higher rate than T-bills
Federal but no state tax on interest earned
11-22
U.S. Treasury Bills, Notes and Bonds
Treasury Bonds
•
•
•
•
Issued in minimum units of $100
30 year maturity dates
Interest rates higher than notes and bills
Interest paid every six months
Treasury Inflation-Protected Securities
(TIPS)
•
•
•
•
Sold in minimum units of $100
Sold with 5, 10, or 30 year maturities
Principal changes with inflation
Pays interest twice a year at a fixed rate
11-23
Treasury Securities
11-24
State and Local Government
Securities
Municipal Bonds (“munis”)
• Issued by a state or local government
– Cities
– Counties
– School districts
– Special taxing districts
• Funds used for ongoing costs and to build
major projects such as schools, airports,
and bridges
11-25
State and Local Government
Securities
Municipal Bonds (“munis”)
• General obligation bonds
– Backed by the full faith, credit, and taxing
authority of the issuing state or local
government
• Revenue bonds
– Repaid from money generated by the
project the funds finance, such as a toll
bridge
11-26
State and Local Government
Securities
Municipal Bonds (“munis”)
• Key characteristic:
– Interest may be exempt from federal taxes
– Capital gains may NOT be tax exempt
– Usually exempt from state and local taxes in
state where issued
– Exempt status determined by use of funds
• Insured municipal bonds
– Private insurance to reduce risk
11-27
Taxable Equivalent Yield
Used to compare tax exempt and taxable
bonds
Tax - exempt yie ld
Taxable Equivalent Yield 
1 - Your tax rate
Example :
.05
Taxable Equivalent Yield 
 .0694  6.94%
1 - .28
11-28
Learning Objective LO11.5
Conservative Investment Options:
Corporate Bonds
Corporate Bonds
• A corporation’s written pledge to repay a
specified amount of money with interest
• An interest-only loan
• Considered safer than stocks
• A “fixed-income” security
• A form of debt financing
11-29
Corporate Bonds
• Face value:
– Dollar amount bondholder receives at
bond’s maturity date
– Usually $1,000
• Coupon rate
– Stated interest rate
– Interest payments made every six months
• Maturity date = date on which face
value repaid
11-30
Corporate Bonds
• Bond Indenture
– Legal document describing conditions of
the bond issue
• Trustee
– Financially independent firm that acts as
the bondholder’s representative
– Usually a commercial bank or other
financial institution
11-31
Why Corporations Sell Bonds
• To raise funds for major purchases
• To fund ongoing business activities
• When difficult or impossible to sell stock
• To improve financial leverage
• Interest paid to bondholders is tax
deductible for the firm
11-32
Types of Corporate Bonds
•
Debenture
– Unsecured, > 10 yr maturity
– Backed only by the reputation of the
issuing company
•
Mortgage bond
– Secured by various assets of the issuing
firm, usually real estate
– Lower interest (coupon) rate since debt is
secured
11-33
Types of Corporate Bonds
•
Convertible bond
– Can be exchanged, at the owner’s option,
for a specified number of shares of the
corporation’s common stock
– Generally, the coupon rate on a convertible
bond is 1 to 2 percent lower than the rate
paid on traditional bonds
11-34
Provisions For Repayment
Call Feature of a Bond
• Corporation can “call in” or buy back
outstanding bonds before the maturity date
• Most corporate bonds are callable
• Usually call protected for the first 5 to 10
years after issue
• A firm may call a bond issue if the coupon
rate they are paying is much higher than the
market rate
11-35
Provisions For Repayment
• Sinking fund
– Corporations deposit money annually
– Trustee uses the money to retire the bond
issue prior to maturity
• Serial bonds
– Bonds of a single issue that
mature on different dates
11-36
Why Investors Purchase Corporate
Bonds
1. Interest income - “fixed income”
– Registered bond
• Interest and principal paid to registered
owner
– Registered coupon bond
• Registered for principal only
• Coupon must be presented to obtain
payment
11-37
Why Investors Purchase Corporate
Bonds
2. Dollar appreciation of bond value
– Bond values change with market interest
rates in the economy
•
Bond value vs. Interest rates = inverse
relationship
– Bond values change with the financial
condition of the issuing company or
government unit
3. Bond repayment at maturity
– Face value repaid on maturity date
– Bondholders may keep till maturity or sell
11-38
Learning Objective LO11.6
Evaluate Bonds When Making an
Investment
• Sources of information – The Internet
– The issuing firm’s website
– www.bondsonline.com
– www.bondsearch123.com
– http://bonds.yahoo.com
• Price information (quotes)
• Trade bonds online
• Research on the issuing corporation
• Financial coverage of bond transactions
– Wall Street Journal, Barrons, Internet
11-39
Corporate Bond Quotes
Coupon(% ) Maturity
YTM(% )
Current
Fitch
Yield(% ) Ratings
Issue
Price
HOME DEPOT INC
93.51
5.875
16-Dec-36
6.365
6.283
AA
HOME DEPOT INC
95.81
5.400
1-Mar-16
6.027
5.636
AA
HOME DEPOT INC
98.70
5.250
16-Dec-13
5.492
5.319
AA
The first bond in the list:
• Matures in 2036
• Current price = 93.51% of par (discount) = $935.10
• Pays an annual coupon rate of 5.875% = $58.75
• Yield-to-Maturity = 6.365%
• Current yield = 6.283% = 58.75/935.10
11-40
Bond Ratings
Measure Default Risk
11-41
Bond Yield Calculations
• Yield = rate of return earned by an investor
who holds the bond to maturity
Current Yield = Annual interest amount
Current Price
• Other Sources of Information
– Business Periodicals
– Federal Agencies
•
•
•
•
www.federalreserve.gov
www.treasury.gov
www.commerce.gov
www.sec.gov
11-42
Chapter Summary
Learning Objective LO11.1
•
•
•
Investment goals must be specific and measurable.
Make sure your personal financial affairs are in
order.
Accumulate an emergency fund equal to at least
three months’ living expenses.
–
•
•
Increase the amount in your emergency fund if you think
you may lose your job or the nation is experiencing an
economic crisis.
Then, it is time to save the money needed to
establish an investment program.
Use the time value of money concept to help you
achieve your goals—especially if you start sooner
rather than later.
11-43
Chapter Summary
Learning Objective LO11.2
• All investors must consider the factors of
safety, risk, income, growth, and liquidity.
• Especially important is the relationship
between safety and risk.
• Basically, this relationship can be
summarized as follows:
– The potential return for any investment should
be directly related to the risk the investor
assumes.
– In addition to safety and risk, investors choose
investments that provide income, growth, or
liquidity.
11-44
Chapter Summary
Learning Objective LO11.3
• Before making the decision to invest, you
should consider:
– Asset allocation = the process of spreading your
assets among several different types of
investments to lessen risk.
– The amount of time before you need your money.
– Your age is a factor that influences investment
choices.
• Younger investors tend to invest a large percentage of
their nest egg in growth-oriented investments.
• Older investors tend to be more conservative.
11-45
Chapter Summary
Learning Objective LO11.3
• Improve your investment returns by:
– Evaluating all potential investments
– Monitoring the value of your investments
– Keeping accurate and current records
• Professional help and your tax situation
may also affect your investment decisions.
11-46
Chapter Summary
Learning Objective LO11.4
• Conservative investments include:
– Savings accounts
– Certificates of deposit
– Money market accounts
– Savings bonds
– Government securities.
• Generally, most investors consider U.S.
government securities to be a safe harbor in
troubled economic times.
• Municipal bonds are conservative
investments and may provide tax-exempt
income.
11-47
Chapter Summary
Learning Objective LO11.5
•
Bonds are issued by corporations to raise
capital. Investors purchase corporate bonds
for three reasons:
(1) interest income
(2) possible increase in value
(3) repayment at maturity
•
Bonds also can be an excellent way to
diversify a portfolio.
11-48
Chapter Summary
Learning Objective LO11.5
•
•
•
The method used to pay bondholders
interest depends on whether they own
registered bonds or registered coupon
bonds.
Most corporate bonds are bought and sold
through full-service brokerage firms,
discount brokerage firms, or the Internet.
Investors pay commissions when bonds are
bought and sold.
11-49
Chapter Summary
Learning Objective LO11.6
•
•
•
•
The internet can be used to obtain
information and trade bonds online.
Study the ratings provided by Standard &
Poor’s, Moody’s, and Fitch Ratings to
determine the quality of a bond issue.
Calculate a bond’s current yield to
evaluate a decision to buy or sell a bond
issue.
Business periodicals and government
sources provide valuable information.
11-50