Chapter 16

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Chapter 16
Investing in Bonds
Copyright ©2004 Pearson Education, Inc. All rights reserved.
Chapter Objectives
• Identify the different types of bonds
• Explain what affects the return from
investing in a bond
• Describe why some bonds are risky
• Identify common bond investment
strategies
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Background on Bonds
• Bonds: long-term debt securities issued
by government agencies or corporations
• Par value: for a bond, its face value, or
the amount returned to the investor at
the maturity date when a bond is due
• Most bonds have maturities between
10–30 years
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Background on Bonds
• Issuers required to make interest
payments and repay par value
• Bond Characteristics
– Call feature: a feature on a bond that
allows the issuer to repurchase the bond
from the investor before maturity
• These bonds offer a slightly higher return
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Background on Bonds
– Convertible bond: a bond that can be
converted into a stated number of shares
of the issuer’s stock if the stock price
reaches a specified price
• These bonds tend to offer a slightly lower return
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Background on Bonds
• A bond’s yield to maturity: the annualized
return on a bond if it is held to maturity
– If a bond sells at par value, its yield to
maturity equals the coupon rate
– If a bond sells below par value, its yield to
maturity would exceed the coupon rate
– If a bond sells above par value, its yield to
maturity would be less than the coupon rate
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Financial Planning Online: Your
Bond’s Yield
• Go to:
http://www.financenter.com/products/
sellingtools/calculators
• Click on: “Bond,” then “What is my yield
to maturity?”
• This Web site provides an estimate of
the yield to maturity of your bond.
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Background on Bonds
• Bonds trading in the secondary market
– Investors sell their bonds to other investors
before they reach maturity
– Bond prices change in response to interest
rates
– Brokerage firms also take orders to buy
or sell bonds
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Types of Bonds
• Treasury bonds: long-term debt
securities issued by the U.S. Treasury
– Payments guaranteed by federal
government
– Interest is subject to federal income tax,
but exempt from state and local taxes
– Can easily be sold in the secondary market
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Types of Bonds
• Municipal bonds: long-term debt securities
issued by state and local government
agencies
– Low risk
– Interest exempt from federal income tax
• Federal agency bonds: long-term debt
securities issued by federal agencies
– Low default risk
– Interest is taxable
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Financial Planning Online:
Municipal Bond Quotations
• Go to:
http://www.bloomberg.com/markets/
psamuni.html
• This Web site provides quotations of
yields offered by municipal bonds with
various terms to maturity. Review this
information when considering
purchasing municipal bonds.
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Types of Bonds
• Corporate bonds: long-term debt
securities issued by large firms
– Subject to default risk
– High-yield (junk) bonds: bonds issued by
smaller, less stable corporations that are
subject to a higher degree of default risk
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Return from Investing in Bonds
• Impact of interest rate movements
on bond returns
– If interest rates rise, the value of your bond
decreases
– If interest rates fall, the value of your bond
increases
• Comparison of actual returns among bonds
– Varies among types of bonds and among holding
periods
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Return From
Investing in Bonds
Exhibit 16.1:
An Example of Corporate Bond
Quotations
Copyright © 2001 Dow Jones & Company, Inc.
All Rights Reserved.
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16-14
Return from Investing in Bonds
• Tax implications of investing in bonds
– Interest is taxed as ordinary income
(unless tax exempt)
– Selling bonds at a price higher than you
paid also results in a capital gain
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Return From Investing in Bonds
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Financial Planning Online: Today’s
Events That Could Affect Bond Prices
• Go to:
http://www.businessweek.com/investor/
• Click on: Economy and Bonds
• This Web site provides a summary of
recent financial news related to the
bond market, which you may consider
before selling or buying bonds.
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Risk from Investing in Bonds
• Default risk: risk that the borrower of
funds will not repay the creditors
– Risk premium: the extra yield required by
investors to compensate for the risk of
default
– Use of risk ratings to measure the default
risk
• Ratings reflect likelihood that issuers will repay
their debt over time
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Risk From Investing in Bonds
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Risk From Investing in Bonds
– Relationship of risk rating to risk premium
• The lower the risk rating, the higher the risk
premium offered on a bond
– Impact of economic conditions
• Higher risk of default when economic
conditions are weak
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Risk From Investing in Bonds
• Focus on Ethics: Accounting fraud and
default risk
– Prices of bonds issued by a firm with
questionable financial statements can
decline quickly
– Securities and Exchange Commission is to
ensure accuracy of a firm’s financial
statements
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Risk from Investing in Bonds
• Call (prepayment) risk: the risk that
a callable bond will be called
• Interest rate risk: the risk that a bond’s
price will decline in response to an
increase in interest rates
– Impact of a bond’s maturity on its interest
rate risk
• Bonds with longer terms more sensitive to
interest rate movements
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Risk From Investing in Bonds
– Selecting an appropriate bond maturity
• Choose maturities that reflect your expectations
of future interest rates
• Consider investing in bonds that have a
maturity that matches the time you will need the
funds
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Bond Investment Strategies
• Interest rate strategy: selecting bonds
for investment based on interest rate
expectations
– Purchase long-term bonds if you expect
interest rates to fall
• Passive strategy: investing in a
diversified portfolio of bonds that are
held for a long period of time
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Bond Investment Strategies
• Maturity matching strategy: investing in
bonds that will generate payments to
match future expenses
– For example, parents might invest in a
bond that will mature at the right time to
pay for their child’s college education
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How Bond Decisions Fit
within Your Financial Plan
• Key decisions about bonds for your
financial plan are:
– Should you consider buying bonds?
– What strategy should you use for investing
in bonds?
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Integrating Key Concepts
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Integrating Key Concepts
• Part 1: Financial Planning Tools
• Part 2: Liquidity Management
• Part 3: Financing
• Part 4: Protecting Your Assets and Income
• Part 5: Investing
– In Chapter 13 we learned about investment fundamentals
– In Chapter 14 we learned about stock analysis and valuation
– In Chapter 15 we learned about investing in stocks
– In Chapter 16 we learned about investing in bonds
– In Chapter 17 we will learn about investing in mutual funds
– In Chapter 18 we will cover asset allocation
• Part 6: Retirement and Estate Planning
Valuing a Bond
• Uses time value of money analysis
• Includes the present value of the future cash
flows or interest payments and the principal
payment at maturity
Value of Bond = Ct/(1 + k)t + Prin/(1 + k)t
Ct = coupon or interest payments in a year
Prin = principal payment at maturity
K = required rate of return
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Valuing a Bond
• Example
– Victor Kalafa is planning to purchase a bond that
has 7 years remaining until maturity, a par value of
$1,000, and a coupon rate of 6% (paid once
annually at the end of the year). He is willing to
purchase this bond only if he can earn a return of
8%, because he knows that he can earn 8% on
alternative bonds that are available.
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Valuing a Bond
• Future cash flows:
Coupon payment (C) = .06  $1,000
Principal payment (Prin) = $1,000
• Discount rate:
Required rate of return = 8 percent
• Value of bond
[C  (PVIFA,8%,7 yrs)]+[Prin  (PVIF,8%,7 yrs]
[$60  5.2064] + [$1,000  .5835]
$312.38 + $583.50 = $895.88
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16-31
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