Investing in Bonds

 Describe bonds and how they are used by corporations and investors.
 Describe the major characteristics of bonds.
 Differentiate among the four general types of bonds.

 Describe what the investor should consider before investing in bonds, particularly the current yield and yield to maturity.
 List the advantages and disadvantages of investing in bonds.

Descriptive Terms for Bond Features
., REVIEW BOOK: Personal Finance.
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 Registered and bearer
 Zero-coupon
 Callable
 Warrants
 Convertibility

 Indenture
 Face value, coupon rate, maturity date
 Secured and unsecured
 Senior and subordinated

 Assume you purchase $1,000 corporate bond issued by AT&T Corporation. The interest rate for this bond is 6.70%. The annual interest is $67 as shown below:
Dollar amount of annual return = Face value x interest rate
= 1,000 x 6.7%
= 1,000 x .067
= $67.00

 Corporate bonds
 U.S. government securities
 Treasury bills, notes, and bonds
 Federal agency issues
 Municipal Bonds

 Assume you purchase a Verizon Communications bond that pays 5.5% interest based on a face value of $1,000 until maturity in 2017. Also assume new corporate bond issues of comparable quality are currently paying 7%. The approximate market value of your Verizon bond is $786 calculated as follows:
Dollar amount of annual interest = $1,000 x 5.5% = $55
Approximate market value = Dollar amount of annual interest
Comparable interest rate
= $55
7%
= $786

Current yield = current annual income current market price
= $55
$786
= 7%

Municipal Bonds
General Obligation Bonds
Revenue Bonds

Effective Yield of a Tax-Free
Investment
 Not paying tax effectively increases your rate of return
 you get to keep all of your profits, instead of only a portion

 
1 r
 taxbracket




100
 Example: 28% tax bracket, 5% rate of return


.
05

1

.
28




100
= 6.94%

What is the Yield or Rate of Return on a
Financial Investment?
 Annualized Percentage Change:

 

 1



 new
 old old






1 n

1


100
Example: original price=$20/share, current price=$100/share, stock held for 9 years

Tax-
Exempt
Yield
4%
5%
6%
7%
15%
Tax
Rate
25%
Tax
Rate
28%
Tax
Rate
33%
Tax
Rate
35%
Tax
Rate
4.71% 5.33% 5.56% 5.97% 6.15%
5.88% 6.67% 6.94% 7.46% 7.69%
7.06% 8.00% 8.33% 8.96% 9.23%
8.24% 9.33% 9.72% 10.45% 10.77%

What is the Yield or Rate of Return on a
Financial Investment?




1

100

20
20


1
9

1


100
=19.58%

Assume that a bond has a price quote of 84. The actual price for the bond is $840, as calculated below:
Bond price = Face value (usually $1,000) x bond quote
= $1,000 x 84 percent
= $1,000 x .84
= $840

A plus sign (“+”) following a rating indicates that it is likely to be upgraded, while a minus sign (“-“) following a rating indicates that it is likely to be downgraded.
., REVIEW BOOK: Personal Finance.
Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890
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Considerations Before Investing in
Bonds
 Susceptibility to certain risks
 Credit

Callability
 Inflation
 Interest rate

Considerations Before Investing in
Bonds
 Premiums and discounts
 Current yield
 Yield to maturity
 Tax-equivalent yields
 When to sell

Bond Prices, Bond Yields, and Interest
Rates
., REVIEW BOOK: Personal Finance.
Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890
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Effective Yield of a Tax-Free
Investment
 Not paying tax effectively increases your rate of return
 you get to keep all of your profits, instead of only a portion

 
1 r
 taxbracket




100
 Example: 28% tax bracket, 5% rate of return


.
05

1

.
28




100
= 6.94%

 Pay higher interest rates than savings
 Offer safe return of principle
 Have less volatility than stocks
 Offer regular income
 Require smaller initial investment

Disadvantages of Investing in Bonds
 No hedge against inflation
 Can be quite volatile
 Compounding is almost impossible
 Subject to investors tax rate
 Poor marketability

., REVIEW BOOK: Personal Finance.
Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890
.