FIN 200:
Personal Finance
Topic 19–Bonds
Lawrence Schrenk, Instructor
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Learning Objectives
1.
2.
3.
Explain the features basic common to all
bonds. ▪
Compare and contrast the bonds issued by
different government levels and agencies.
Describe the various features found in
corporate bonds. ▪
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Bonds Basics
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Bond Cash Flows

Bonds are loans.



Regular Interest Payments (Coupons)
Principle Repaid at End
Example: Three year annual bond with a
principal or $1,000 and coupon rate of 10%.
Year 1
Year 2
Year 3
Coupon
$100
$100
$100
Principal
$1,000
TOTAL
$100
$100
$1,100
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Bond Terminology





Principal, Par Value, Face Value
Coupon, Coupon Rate
Maturity
Discount Rate
Periods
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Bond Valuation

Example: Three year annual bond with a principal of
$1,000 and coupon rate of 10% (r = 8%).
Year 1
Year 2
Year 3
Coupon
$100
$100
$100
Principal
$1,000
TOTAL
$100
$100
$1,100
P rice =
100
1 .0 8
+
100
 1 .0 8 
2
+
1 ,1 0 0
 1 .0 8 
3
= $ 1 ,0 5 1 .5 4
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Bond Price Movement


Interest Rate Risk
Interest Rates and Bond Prices

Inversely Related
↑
Interest Rates ↓
Interest Rates
↓
Bond Prices ↑
Bond Prices
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More Complicated Bonds



‘Straight’ Bond
Premium versus Discount Bonds
Features




Callable Bonds
Convertible Bonds
Sinking Funds
Debt Covenant


Financial Ratios
Technical Default
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Federal Government
Bonds
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Government Bonds

US Treasury



Bills, Notes and Bonds
Savings Bonds
Inflation-Adjusted Bonds



TIPS
I-Bonds
Other Agencies
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Why do Investors Purchase Government
Bonds?


Government bonds are written pledge to
repay a specified sum of money along with
interest
Sold to obtain money to finance the national
debt, and the ongoing costs of government.
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U.S. Treasury Bills, Notes and Bonds

Treasury Bills (T-Bills)




Treasury Notes




4, 13, or 26 weeks to maturity
Sold at a discount
Federal but no state tax on interest earned
Typical maturities are 2, 3, 5, and 10 years
Interest paid every six months, at a higher rate than T-bills
Federal but no state tax on interest earned
Treasury Bonds



30 year maturity dates
Interest rates higher than the notes and bills
Interest paid every six month
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U.S. Savings Bonds.
 U.S. Savings Bonds.




Series EE sold at half of face value, with potential tax
advantages if used to pay tuition and fees.
Series HH pays interest every six months.
I bonds which earns a fixed rate plus an inflation rate which
changes twice a year
See www.savingsbonds.gov for rates.
 Advantages


Exempt from state and local income taxes.
You don’t have to pay federal income tax on earnings until
you redeem the bonds.
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Treasury Inflation-Protected
Securities (TIPS)


Treasury Inflation-Protected Securities
(TIPS) started in 1997
Provide protection against inflation

Principal increases with inflation (CPI)


When a TIPS matures, the investor is paid the
inflation-adjusted principal or original principal,
whichever is greater
Interest paid semiannually at a fixed rate

The rate is applied to the adjusted principal; so, like
the principal, interest payments rise with inflation
and fall with deflation
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Payments in TIPS



Consider a 3-year TIPS, par value of $1,000, and a coupon rate of
4%.
Assume that the inflation turns out to be 2%, 3%, and 4% in the next
3 years
Returns in the first year
N om inal =
Interest + P rice A ppreciation
Initial P rice
=
40.80 + 20.00
= 6.08%
1,000
R e a l = N o m in a l - In fla tio n = 6 .0 8 - 4 = 4 .0 8 %
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TIPS versus Regular Bonds
Price Response of
Increase in
TIPS
Regular Bonds
Expected Inflation
0
-
Realized Inflation
+
0
Real Yields
-
-
Risk of Inflation
0
-
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Historical Yields on TIPS
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Federal Agency Debt Issues

Agencies, examples…







Government National Mortgage Association (GNMA)
Export-Import Bank
Farmers Housing Administration (FHA)
Higher interest than government securities issued by
the treasury department.
Minimum investment may be as high as $25,000
Maturities range from 15-30 years.
Average maturity is 15 years.
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State and Local Bonds
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State and Local Government
Securities





Municipal Bonds (Muni’s)
Issued by a state or local government, including
cities, counties, school districts, and special taxing
districts.
Use funds for ongoing costs and to build major
projects such as schools, airports, and bridges.
Tax Status
Two Types:


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.
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Corporate Bonds
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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.
Bondholders receive interest payments every
six months at the stated interest rate.
The legal conditions are described in a bond
indenture (or covenant).
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Major Classifications

Collateral



Secured Debt (Mortgage) versus
Unsecured Debt (Debenture)
Seniority


Senior Debt versus
Subordinated Debt
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Why Corporations Sell Bonds




To get funds for major purchases.
To fund ongoing business activities.
As an alternate to selling stock.
Interest Payments are tax deductible

Versus dividend payments, which are not.
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Types of Corporate Bonds
Unsecured (Debenture) Bond
1.


Most corporate bonds are debenture bonds.
Unsecured - Backed only by the reputation of the
issuing company.
Secured (Mortgage) Bond
2.


A corporate bond that is secured by various
assets of the issuing firm, usually real estate.
Interest rate is lower because it is secured.
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Types of Corporate Bonds (cont’d)
Convertible Bond
3.


A special kind of corporate bond that can be
exchanged for a specified number of shares of
the corporation’s common stock.
Generally, the interest rate on a convertible bond
is 1 to 2 percent lower than the rate paid on
traditional bonds.
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Provisions for Repayment

Call Feature of a Bond




Corporation can call in or buy back outstanding
bonds from current bondholders before the
maturity date.
Most corporate bonds are callable.
Most agree not to call bonds for the first 5 to 10
years after they are issued.
They call bonds if the interest rate they are paying
is much higher than the going rate.
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Provisions for Repayment (cont’d)

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.
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Bond Rating Agencies




Standard & Poor's (S&P)
Moody's
Fitch
NOTE: There are similar to the ratings given
insurance companies.
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Bond Rating Classifications
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‘Junk’ Bonds

Alternate Names/Different Spin





High Yield Bonds
Non-investment Grade Bonds
Speculative Grade Bonds
Junk Bonds
Higher Risk of Default, Higher Yield
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Bonds Indices
Lehman Aggregate Bond Index
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Project Note
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Ethical Dilemma
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