The Basics of
Bonds
Leader’s Guide
Debra Pankow
NDSU Extension Family Economics Specialist
Resources
Learner Objectives
■
Understand the basic principles of bond
investing
■
Learn about different types of bonds
■
Understand the risk/rewards related to
bonds
■
Understand terminology related to bond
investing.
■ Investing in U. S. Government Bonds
Savings Bonds Owner’s Manual
http://www.savingsbonds.gov/mar/
marsbomtoc.htm
Investor’s Guide to Bond Basics
http://www.investinginbonds.com/
■ Corporate Bonds
http://www.investinginbonds.com/info/igcorp/
what.htm
■ Municipal Bonds
http://www.investinginbonds.com/info/igmunis/
what.htm
Activities
■ Word Search
http://www.savingsbonds.gov/sav/sbkwdsch.htm
■
Answer Sheet
http://www.savingsbonds.gov/sav/sbgmansw.htm
■ Word Scramble
http://www.savingsbonds.gov/sav/sbkscram.htm
■
North Dakota State University
Fargo, North Dakota 58105
September 2003
Answer Sheet
http://www.savingsbonds.gov/sav/sbkansb.htm
Sample Bonds
■
What does a bond look like?
http://www.savingsbonds.gov/sav/savbond.htm
■
What does an I Bond look like?
http://www.savingsbonds.gov/sav/sbilook.htm
■
What does a Patriot Bond look like?
http://www.savingsbonds.gov/sav/
savpatriotlook.htm
The Program
This is a basic introduction to
investing in bonds. Participants will
be at different levels of understanding.
Try to pick out facts that fit both
your time frame and your participant
knowledge level.
Before the Program
■
Read through all materials.
■
Decide what you will cover. Highlight those areas.
■
Make or borrow presentation materials from the
county office.
■
Order or pick up quantities of the handouts you
will use.
■
Make copies of the activities you will use.
■
Decide on a roll call idea.
The Basics of
Bonds
Slide 1
Many North Dakotans are interested in learning more
about investing. There are two general categories of
investments – ownership and loanership (owning
bonds). With ownership assets, investors own all or
part of an asset, they buy shares of company stock or
mutual funds, or acquire rental property. They have
equity or ownership interest in a company or property, and their principal and earning fluctuate with
market conditions and other factors, such as company earnings that, in turn, affect the asset’s value.
On the other hand, loanership assets are fixed income
investments. Investors loan their money to some
entity (by purchasing their bonds) and receive
interest on a regular basis. The rate of interest can be
fixed or it can fluctuate. Principal (the original
investment) is returned in full at maturity (the date on
which principal must be repaid).
With the recent volatility in the stock market, consumers’ interest in investing in bonds has increased.
Bonds tend to be safer than stocks because, in most
cases, if you hold bonds to their maturity date, you
won’t risk your principal. Some bonds also provide a
2
steady stream of income. The downside of bonds is
that they tend to provide a lower rate of return than
many other investments.
This program provides the beginner bond investor
with basic information concerning the type of bonds
available, the risks involved, and other information to
help make an informed decision regarding this form
of investment.
Current Annual Percentage Rate
Returns on Savings
Savings 1 Year
Account Cd
.75%
2.5 Year
CD
1.69% 2.8%
Money
Market
Mutual
Fund*
H Bond
1.98% 1.5%
EE
Savings
Bond
Slide 2
I Bond
U.S. Government Bonds
„
„
„
Series EE
Series I
Series HH
Slide 4
Savings bonds, such as series EE, HH and I are the
lowest-denomination securities issued by the federal
government. Income earned is exempt from local and
state tax, and deferred from federal taxes. Both I and
EE bonds can be purchased and redeemed at most
banks, many credit unions, and other financial
institutions in denominations ranging from $50 to
$10,000.
2.66% 4.66%
EE bonds are discount bonds —purchased for onehalf their face value ($50 for a $100 bond). Series EE
bonds purchased since May 1997 pay an interest rate
based on 90% of the average market yield of fiveyear Treasury securities (current yield is 2.66%).
These rates are adjusted twice a year on May 1 and
November 1. If the interest rates are low, the U. S.
Treasury will add a “make-up” to Series EE bonds so
that they are guaranteed to double their value, or
reach their face value, in 17 years.
Types of Bonds
Government
Municipality
„ Corporation
„ Mortgage Backed Securities
„ Specialty Bonds
„
„
Slide 3
A bond is a loan YOU make to some entity. These
entities include the federal government, municipalities, corporations, federal agencies, and various other
entities. Types of bonds range from U. S. government
securities, municipal bonds, corporate bonds, mortgage and asset-backed securities, federal agency
securities and foreign government bonds. (If you
have prepared sample bonds, pass them around at
this time).
Series I bonds are inflation-adjusted to earn a fixed
rate over and above the rate of inflation for as long as
30 years or until the bond is redeemed. These bonds
are currently earning 4.66%. Each I Bond features a
prominent American who has contributed to the
history of this country.
As of January 2003, both Series EE and Series I
bonds must be held 12 months before being eligible
for redemption. Redemptions prior to five years from
issue are subject to a 3-month interest penalty.
Earnings on both series may be tax-free if cashed in a
year when the owner pays qualified higher education
expenses. Income limits and other restrictions apply,
see IRS form 8815 for details.
HH Bonds are issued at full face value through an
exchange of EE bonds. This can result in deferring
federal income taxes on E/EE bond earnings for as
3
long as 20 additional years. Denominations range
from $500 to $10,000 and interest is paid semiannually.
„
Who are these
people…
„
And what
denomination
I Bond do they
appear on???
Slide 5
Optional Activity
Each I Bond features a prominent American
who has contributed to the history of this country.
For background information (short biographies)
on these people, see
http://www.savingsbonds.gov/sav/sbiwho.htm
Option 1. Each I Bond features a prominent
American who has contributed to the history
of this country. You may wish to cut up the
following list, one slip with the famous
American, the other with the denomination of
I bond. Have participants divide up the slips
and then match their slips with those of their
neighbors with the correct name/amount.
Another option. Have participants number a
piece of paper from 1 to 8. Then read off the
famous Americans and have participants rank
them in the order they think their bonds are
worth, with #1 being the most and #8 the
least. Read off the list of famous Americans in
random order.
And a final idea. Print off the biographies of
the famous Americans. Have a volunteer read
a biography, and have participants guess who
it is. Go through the entire list of eight Americans. Provide a small prize for the participant
with the most correct guesses.
Spark M. Matsunaga
4
$10,000
Marion Anderson
$5,000
Albert Einstein
$1,000
General George C. Marshall
$500
Chief Joseph
$200
Dr. Martin Luther King, Jr.
$100
Dr. Hector P. Garcia
$75
Helen Keller
$50
(e.g., fares, tolls, fees) and generally pay a slightly
higher return to reflect the slightly higher risk.
U. S. Treasury Securities
„
„
Treasury Notes
Treasury Bills
Slide 6
Both treasury notes and treasury bills require a
minimum deposit of $1000 and larger amounts are
available in increments of $1000. Treasury bills come
in short terms such as 3 and 6-month maturities.
Investors purchase these bills at a discount, and
receive back an amount called the “discount”, equal
to the interest rate determined by the most recent
auction rate. At maturity, the investor’s original
purchase amount or principal is returned.
Treasury notes come with 2, 5 and 10-year maturities. They pay a fixed rate of interested semiannually
until maturity, when investors will be paid their
principal plus interest.
Treasury securities can be purchased from a bank or
brokerage firm for a fee of about $50 or from the
Federal Reserve Bank’s “Treasury Direct” program
with no fee. An application, called a tender form, can
be obtained by contacting one of the Federal Reserve
banks or through the Treasury Department’s Web site
at http://www.publicdebt.treas.gov/.
Municipal bonds are generally attractive to people in
higher marginal tax brackets because interest is
generally federally tax-exempt and can be state
exempt if issued in the investor’s state of residence.
An exception would be private purpose municipal
bonds such as those sold to finance sports stadiums,
airports, or hospitals.
Municipal bonds are generally sold by brokerage
firms in $5000 increments, although less expensive
“mini-bonds” may be available for amounts as low as
$500. Interest is paid semi-annually.
Yield of Taxable and Tax-Exempt
Investments
Sample Federal Tax Bracket
15%
28%
33%
Taxable Investment Yield
4%
5%
6%
7%
4.7%
5.8%
7.0%
8.2%
5.6%
6.9%
8.3%
9.2%
6.0%
7.5%
9.0%
10.4%
Slide 8
Example: A person in a 28% tax bracket who
invests money in a tax-exempt municipal bond fund
paying 6% would have the same income as someone
investing in a taxable fund that pays 8.3%.
Municipal Bonds
„
„
Corporate Bonds
General Obligation
Revenue Bonds
Risk/Reward
Convertible Bonds
„ Zero Coupon Bonds
„
Slide 7
Municipal bonds are debt instruments of state and
local governments, or government-related entities
(bridge or highway authorities). General obligation
municipal bonds are backed by the full taxing ability
of the issuer and are considered the safest. Revenue
bonds are backed by some revenue-generating source
„
Slide 9
Corporate bonds are debt instruments issued by forprofit companies to raise capital for expansion or
ongoing operations. They are generally sold in
$1,000 increments and pay taxable interest twice a
year. Corporate bonds generally pay higher interest
5
rates than government bonds with comparable credit
ratings and maturities. Investing in a corporation is a
greater risk than a government entity that has the
ability to raise revenue through taxes. Thus, investors
must be compensated accordingly.
The least risky of all corporate bonds is a mortgage
bond because it is backed by the company’s land and
buildings. Bonds backed by non-real estate assets
(e.g., airplanes, securities) have more risk. The
highest risk corporate bond is a debenture, which is
a corporate bond backed only by a company’s future
earnings and promise to repay. Conservative investors will want to select mortgage bonds issued by
investment grade (i.e., highly rated) companies.
Convertible bonds are a type of corporate bond that
allows investors to “have their cake and eat it too” —
almost. They provide the upside potential of stocks
(the opportunity to participate in company earnings)
with the downside protection of bonds (a fixed return
and repayment of principal at maturity).Convertible
bonds can be exchanged for a specified number of
shares of common stock of the issuing company. As
the price of the company stock increases, the convertible bond price also increases because the option to
convert becomes more valuable. This correlation is
true whether or not an investor chooses to convert.
The trade-off is that convertible bonds generally
convert to fewer shares of stock than you could buy
for the cost of a bond. Almost all convertible bonds
are callable. Even though they are a “hybrid” investment, convertibles (like all bonds) are sensitive to
interest rate fluctuations. They can be purchased as
individual securities in $1,000 increments or through
convertible bond mutual funds.
Zero-coupon bonds pay no (zero) annual interest.
Instead, they are sold at a deep discount and eventually grow to full face value ($1,000). An investor
might pay only $200 or $300, for example, for a bond
that matures in 15 or 20 years. Brokers may require a
$5,000 purchase, however, or five times the initial
cost. For example, an 8% zero-coupon bond with 15
6
years to maturity would cost $308. To purchase five
such bonds ($5,000 face value) would cost $1,540 (5
x $308). In this example, if you invest $1,540 now,
you know you’ll receive $5,000 in 15 years. This
return might be suitable for a goal you want to
achieve in 15 years (e.g., future education expenses
for a young child).
Many investors like zero-coupon bonds for their
relatively low upfront cost and predictability. An
investor knows exactly how much they’ll have at
maturity. Two disadvantages of zero-coupon bonds
are their extreme volatility with interest rate changes
and the fact that annual increases in value are considered taxable income.Immediate taxation can be
avoided, however, by using zero-coupon bonds for
tax-deferred retirement plans, such as IRAs, or by
buying tax-exempt (e.g., municipal) zero-coupon
municipal bonds.
Other Types of Bonds
Bond Mutual Funds
Mortgage Backed Securities
„ Collateralized Mortgage Obligations
„ Unit Investment Trusts
„ Annuities
„
„
Slide 10
Bond Mutual Funds offer investors another way to
invest in the bond market. Investors can diversify
risks using a professionally managed and selected
portfolio of securities.
Mortgage Backed Securities are debt obligations
backed by a pool of mortgages (Ginnie Mae, Freddie
Mac, and Fannie Mae are common types of MBS).
Collateralized Mortgage Obligations are derivative
debt securities that are backed by a portfolio of
mortgage loans, offering a wider range of investment
time frames and greater cash flow certainty than was
typically available with original mortgage-backed
securities.
Unit Investment Trusts are fixed portfolios of
professionally selected investments in government,
municipal, mortgage-backed or corporate bonds.
Credit Quality - Bonds range from highest credit
quality (U.S. Treasury Securities) to bonds considered speculative.
Annuities are contracts that provides for a series of
payments to be made or received at regular intervals.
A bond annuity would be based on investments in
bonds.
Credit Rating - Assigned ratings based on in-depth
analysis of issuer’s financial condition and management, economic and debt characteristics, and specific
revenue sources securing the bond. Rating companies
include Moody’s Investor Service, Stand & Poor’s
Corporation, and Fitch. Highest ratings are AAA (S
&P/Fitch) and Aaa (Moody’s). BBB category stocks
are also considered investment grade, BB and below
are considered speculative.
Learning the Lingo
„
„
„
„
„
„
„
„
„
„
Interest Rate
Maturity
Redemption Features
Call Provisions
Puts
Average Life
Principal Payments
Credit Quality
Credit Rating
Bond Insurance
„
„
„
„
„
„
„
„
„
„
Price
Yield
Market Fluctuations
Tax Status
Diversification
Inflation Risk
Laddering
Volatility
Bearer Bond
Par
Slide 11
Definitions (Use your own judgment as to which
ones should be covered. Optional activities suggestions are included at end of this section):
Interest Rate - bond interest rate can be fixed,
floating (adjust to current market rates) or payable at
maturity.
Maturity - the specific future date when investor’s
principal will be repaid.
Redemption Features - some bonds have structures
called redemption features that can substantially
change the expected life of the investment.
Call Provisions - provisions allowing or requiring
issuer to repay investor’s principal at a specific date
before maturity.
Puts - Provisions allowing investor the option of
requiring issuer to repurchase bonds prior to
maturity.
Average Life - Basis of pricing for mortgage-backed
securities (rather than maturity).
Bond Insurance - specialized firms that offer
insurance to guarantee timely repayment of principal
and interest.
Price - cost of the bond, based on many factors, such
as interest rates, supply and demand, credit quality,
maturity and tax status. Newly issued bonds normally
sell at or close to face value.Bonds selling at above
face value are said to be selling at a premium. Those
selling below are selling at a discount.
Yield - return on the price you paid and the interest
payment you received. Current yield is annual return
on dollar amount paid for the bond. Yield to maturity
and yield to call are more meaningful, refer to total
return if held to maturity or call, and includes
interest, gain or loss.
Market Fluctuations - Changes in the level of
interest rates typically have an immediate and
predictable effect on the price of bonds. When
interest rates rise, outstanding bond prices fall. When
prevailing interest rates fall, prices of outstanding
bonds rise. Due to market fluctuations, the value of a
bond will likely be higher or lower than its original
face value if you sell before maturity.
Tax Status - certain bonds offer tax deferred or tax
exempt statusDiversification- even within the bond
class, it makes sense to diversify – corporate bonds,
municipal bonds, government bonds, etc.
Principal Payments - the method principal will be
repaid; an important consideration in choosing best
bond for your needs.
7
Inflation Risk - the risk that the return on a bond
may not provide a real return great than the loss of
principal due to inflation.
Laddering - purchasing bonds with a range of
different maturities to reduce a portfolio’s sensitivity
to interest rate risk.
Bearer Bond - No identification on bond as to
owner; illegal since 1982 in the U. S. to issue in the
corporate and municipal market.
Par - Value at maturity.
The first rule of becoming
wealthy is not to lose money.
The second rule is not to
forget the first rule.
Warren Buffet
Slide 13
If maintaining your capital is a primary objective for
you, bonds may be a valuable addition to your
investments. As Warren Buffet, successful American
investor, would say. . . not losing money is basic to
becoming wealthy.
Optional Activity
Using some of the ideas presented in the I
bond section, use these terms for an activity.
Evaluation
Please fill out the evaluation form provided
with the lesson.
Are Bonds for YOU?
Your Goals
Your Timeline
„ Your Risk Tolerance
„
„
Slide 12
Bonds are a good way to diversify your portfolio and
to help meet your income and savings objectives.
Only you, however, know your level of risk tolerance.
If you do want to learn more about U. S. Savings
Bonds, the new publication, “Investing in U. S.
Government Bonds” may be useful (Hand out
publication).Thanks for your attention . . . and
happy investing!
This program is part of NDSU Extension’s
Financial Security in Later Life program
effort. This is also part of a larger national
effort. The evaluation results you provide
will allow us to track the success of this
initiative, and plan for future educational
materials. Thank you in advance for helping
with this challenge!
Links for more information
http://www.publicdebt.treas.gov/sav/savbond.htm
http://www.publicdebt.treas.gov/sav/sbkwdsch.htm
http://www.publicdebt.treas.gov/sav/sbkscram.htm
NDSU Extension Service, North Dakota State University of Agriculture and Applied Science, and U.S. Department of Agriculture cooperating. Sharon D. Anderson,
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