Personal Finance
Bennie Waller
wallerbd@longwood.edu
434-395-2046
Longwood University
201 High Street
Farmville, VA 23901
Bennie D Waller, Longwood University
Bonds
Bennie D Waller, Longwood University
BONDS





Used to raise capital instead of giving up ownership
Generally lower return, but also lower risk
Source of steady income
Price of bond - credit quality and duration Provide diversification
 Safe investment if held to maturity
 Interest rate risk
 Purchasing power risk (inflation)
 Default or business risk
 Liquidity risk
 Call risk
(investopedia.com)
Bennie D Waller, Longwood University
BONDS
Bond - A debt investment in which an investor loans money to an
entity (corporate or governmental) for a given period at fixed rate.
 Bonds are used by companies, municipalities, states and U.S.
and foreign governments to raise capital (money).
 Par Value (Face Value) –The dollar amount assigned to a
security when first issued. Generally $1,000 for corporate
issues.
 Coupon – interest to be paid and stated on a bond when it's
issued. It is called a "coupon" because some bonds literally have
coupons attached to them. This is less common today as more
records are kept electronically.
 Coupon Rate = Coupon Payment / Par Value
 Maturity Date - The date on which principal is to be repaid
Bennie D Waller, Longwood University
(Investopedia.com)
BONDS
Example: 10% annual coupon bond with 30 year maturity
1
-1000 100
2
3
100
100
4
100
Bennie D Waller, Longwood University
28
29
30
100
100
100
+1000
BONDS
Bond Prices are inversely related to interest rates
 Bonds sell at par when: coupon rate = market rate
 Bonds sell below par when: coupon rate < market rate
 Bonds sells above par when: coupon rate > market rate
 Premium Bond - If a bond's price is higher than its par value it
is selling at a premium; this occurs because the bond’s interest
(coupon) rate is higher than current market rates
 Discount Bond - A bond that is currently trading for less than its
par value. The term "discount" means that the price is par. This
occurs when the coupon rate is less than current market rate.
Bennie D Waller, Longwood University
Bonds
 Because bonds are contractual in nature, changes in the interest
rate will impact their value prior to the bond’s maturity.
 A 10% annual coupon bond with 30 year maturity was
purchased 5 years ago
 It has 25 years remaining. If the bond were to be sold, its
value is dependent upon current interest rates (assuming the
companies credit worthiness remains constant).
 Value of bond if current market rate is same as coupon rate
Bennie D Waller, Longwood University
Time Value of Money
PV = 1000
FV = 1000
N = 25
I = 10
PMT= 100
Bennie D Waller, Longwood University
Time Value of Money
Value if market rates increase to 12%
PV = 843.13
FV = 1000
N = 25
I = 12
PMT= 100
Bennie D Waller, Longwood University
Time Value of Money
Value if market rates decrease to 8%
PV = 1213.50
FV = 1000
N = 25
I = 12
PMT= 100
1213.50
Bennie D Waller, Longwood University
BONDS
Coupon rate > market rate, so
bond will sell at premium
Coupon rate = market rate
Coupon rate < market rate, so
bond will sell at discount
Source:bogleheads.org/wiki/Bond_Pricing
Bennie D Waller, Longwood University
Bonds
 Another example
Bennie D Waller, Longwood University
Time Value of Money
Example: A $1,000 par
value bond pays interest of
$35 each quarter and will
mature in 10 years. If your
nominal annual required rate
of return is 12 percent with
quarterly compounding, how
much should you be willing
to pay for this bond?
PV = 1115.57
FV = 1000
N = 40
I = 12/4=3
PMT= 35
Bennie D Waller, Longwood University
BONDS
Example
Assume that you are considering the purchase of a $1,000 par value
bond that pays interest of $70 each six months and has 10 years to go
before it matures. If you buy this bond, you expect to hold it for 5
years and then to sell it in the market.
You (and other investors) currently require a nominal annual rate of
16 percent, but you expect the market to require a nominal rate of
only 12 percent when you sell the bond due to a general decline in
interest rates.
How much should you be willing to pay for this bond?
Example
Bennie D Waller, Longwood University
BONDS
5 years of semi-annual
coupon payments at $70.
5
10
-1000
12% $1,000
rate in 5
years
This is a two step problem. First we solve for the value of the bond in 5 years, when we
plan to sell it. We know that the bond will be worth 1,000 at maturity, we know the
coupon payment is $70 every six months and we know there will be 5 years (10 periods)
until the bond matures (5 years from now) and we know that market rates are expected to
be 12% annually when we sell.
Value of Bond
in 5 years
If the above assumptions are correct, I should be able to sell the bond for 1073.60 in
five years.
Calculator Example
Bennie D Waller, Longwood University
Time Value of Money
PV = 1073.60
FV = 1000
N = 10
I = 12/2=6
PMT= 70
Bennie D Waller, Longwood University
BONDS
5 years of semi-annual
coupon payments at $70.
5
Price of Bond
today
16% required rate
to invest
10
$1,073.60 –
Value in 5
years
Next we determine the price (value) of the bond given, our current required return of
16% and the expected selling price of $1,073.60 in five years.
Calculator Example
Bennie D Waller, Longwood University
Time Value of Money
PV = 966.99
FV = 1073.60
N = 10
I = 16/2=8
PMT= 70
Bennie D Waller, Longwood University
BONDS
Zero-coupon bond - A debt security that doesn't pay interest (a
coupon) but is traded at a deep discount, rendering profit at
maturity when the bond is redeemed for its full face value.
Example: A 30 year, zero coupon bond that sold for 231.38
today would yield a 5% return, if purchased today and held
until maturity.
Example
Bennie D Waller, Longwood University
Time Value of Money
PV = 231.38
FV = 1000
N = 30
I =5
PMT= 0
Bennie D Waller, Longwood University
BONDS
 Current yield – ratio of the annual interest payments over price
 Yield to Maturity –is the rate earned by an investor who buys
the bond and holds it until maturity. Yield to maturity is simply
the discount rate at which the sum of all future cash flows from
the bond are equal to the price of the bond.
 Yield to call - The yield of a bond or note if you were to buy
and hold the security until the call date. This yield is valid only
if the security is called prior to maturity. The calculation of yield
to call is based on the coupon rate, the length of time to the call
date and the market price.
 Bonds that are called typically will pay a call premium.
 Why would a company call their bonds? For the same reason
that people refinance their homes when rates go down?
Bennie D Waller, Longwood University
BONDS
Example: Palmer Products has outstanding bonds with an
annual 8 percent coupon. The bonds have a par value of $1,000
and a price of $865. The bonds will mature in 11 years.
What is the yield to maturity on the bonds?
Bennie D Waller, Longwood University
BONDS
Example
A corporate bond matures in 14 years. The bond has an 8
percent semiannual coupon and a par value of $1,000. The
bond is callable in five years at a call price of $1,050. The
price of the bond today is $1,075.
What are the bond’s yield to maturity and yield to call?
Bennie D Waller, Longwood University
Time Value of Money
Yield To Maturity or YTM
I = 3.57x2=7.14
FV = 1000
N = 28
PV = -1,075
PMT= 80/2=40
Bennie D Waller, Longwood University
Time Value of Money
Yield To Call or YTC
I = 3.52x2=7.05
FV = 1050
N = 10
PV = -1,075
PMT= 80/2=40
Bennie D Waller, Longwood University
Bonds
 Treasury Bonds
 Risk free (default)
 Not callable
 Lower rate (but lower risk)
 Most are exempt from taxes
 Municipal Bonds
 Issued by states, counties, public agencies
 Junk Bonds (High yield) – bonds with agency rating BB or
below. This bonds are very risky, may be considered
speculative.
Bennie D Waller, Longwood University
Bonds
Bond Ratings – measure of financial stability
 Moody’s and Standard & Poor’s provide ratings
on corporate and municipal bonds.
 Ratings involve a judgment about a bond’s future
risk potential.
 The poorer the rating, the higher the rate of return
demanded by investors.
 Safest bonds receive AAA, D is extremely risky.
Bennie D Waller, Longwood University
Bonds
Bennie D Waller, Longwood University
Mutual Funds
 Mutual fund—an investment that raises from investors, pools
the money, and invests it in stocks, bonds, and other
investments.
 Each investor owns a share of the fund proportionate to his/her
investment.
 A mutual fund pools money from investors with similar
financial goals.
 You are investing in a diversified portfolio that’s professionally
managed according to set goals.
 Investment objectives are clearly stated.
Bennie D Waller, Longwood University
Mutual Funds
 Advantages of mutual funds:
 Professional management
 Minimal transaction costs
 Liquidity
 Flexibility
 Service
 Avoidance of bad brokers
 Disadvantages of mutual funds:
 Lower-than-market performance
 Costs
 Risks
 You can’t diversity away a market crash
 Taxes
Bennie D Waller, Longwood University
Stock Mutual Funds
• Aggressive growth funds
• Small company growth funds
• Growth funds
• Growth-and-income funds
• Sector funds
• Index funds
• International funds
Bennie D Waller, Longwood University
Balanced Mutual Funds
• Tries to balance objectives of long-term growth,
income, and stability
• Hold both common stock and bonds and
sometimes preferred stock
• Aimed at those needing income to live on and
moderate stability in their investment
• Less volatile than stock mutual funds
Bennie D Waller, Longwood University
Bond Funds
• Mutual funds that invest primarily in bonds
• Fluctuate in value with market interest rates
• Use for small amounts of money, to keep
investments liquid
• Otherwise, use individual bonds where there is
no professional management or fees
Bennie D Waller, Longwood University
Thank You
Bennie D Waller, Longwood University