15 INVESTING IN BONDS CHAPTER OVERVIEW This chapter describes bonds as an investment alternative. Initially, we examine important characteristics that pertain to bond investments. Then, we discuss the topics of why corporations sell bonds and why investors buy those bonds. Next, the differences between corporate and government bonds, and the factors that investors use to evaluate bond investments are presented. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: Obj. 1 Describe the characteristics of corporate bonds. A corporate bond is a corporation’s written pledge that it will repay a specified amount of money, with interest. All of the details about a bond (face value, interest rate, maturity, repayment, etc.) are contained in the bond indenture. The trustee is the bondholder’s representative. Obj. 2 Discuss why corporations issue bonds. Corporations issue bonds and other securities to pay for major purchases and help finance their ongoing activities. Bonds may be debentures, mortgage bonds, subordinated debentures, or convertible bonds. Most bonds are callable. To ensure the money will be available when needed to repay bonds, most corporations establish a sinking bond. Corporations can also issue serial bonds that mature on different dates. A call provision can also be used to buy back bonds before the maturity date. Obj. 3 Explain why investors purchase corporate bonds. Investors purchase corporate bonds for three reasons: (1) interest income, (2) possible increase in value, and (3) repayment at maturity. They are also an excellent way to diversify your investment portfolio. The method used to pay bondholders their interest depends on whether they own registered bonds, bearer bonds, or zero-coupon bonds. Because bonds can increase or decrease in value, it is possible to purchase a bond at a discount and hold the bond until it appreciates in value. Changes in overall interest rates in the economy are the primary causes of most bond price fluctuations. If your bond decreases in value, you can lose money on a bond investment. You can also choose to hold the bond until maturity and the corporation will repay the face value of the bond. Corporate bonds can be bought or sold through bond exchanges or account executives who represent brokerage firms. Bonds can also be bought and sold online. Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 517 LEARNING OBJECTIVES CHAPTER SUMMARY Obj. 4 Discuss why federal, state, and local governments issue bonds and why investors purchase government bonds. Bonds issued by the U.S. Treasury and federal agencies are used to finance the national debt and the ongoing activities of the federal government. Currently, the U.S. Treasury issues three principal types of bonds and securities: Treasury bills, Treasury notes, and savings bonds. State and local governments issue bonds to finance their ongoing activities and special projects such as airports, schools, toll roads, and toll bridges. U.S. Treasury securities can be purchased through Treasury Direct, brokerage firms, and other financial institutions. Municipal bonds are generally sold through the government entity that issued them or account executives. One of the most important features of municipal bonds is that interest on them may be exempt from federal taxes. Obj. 5 Evaluate bonds when making an investment. Today it is possible to trade bonds online and obtain research information via the Internet. Some local newspapers and The Wall Street Journal and Barron’s provide bond investors with information needed to evaluate a bond issue. Detailed financial information can also be obtained by requesting a printed copy of the corporation’s annual report or accessing its Website. To determine the quality of a bond issue, most investors study the ratings provided by Standard & Poor’s and Moody’s. Investors can also calculate a current yield and the yield to maturity to evaluate a decision to buy or sell bond issues. The current yield is determined by dividing the annual interest amount by its current market value. The yield to maturity takes into account the relationship among a bond’s maturity value, the time to maturity, the current price, and the dollar amount of interest. 518 Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. INTRODUCTORY ACTIVITIES Ask students to comment on the opening case for the chapter (p. 481). Point out the learning objectives (p. 480) in an effort to highlight the key points in the chapter. Ask students to express opinions they may have about investing in corporate and government bonds (p. 481). Discuss how different investment objectives can be achieved with various types of bond investments (p. 481). CHAPTER 15 OUTLINE I. Characteristics of Corporate Bonds II. Why Corporations Sell Corporate Bonds A. Types of Bonds B. Convertible Bonds C. Provisions for Repayment III. Why Investors Purchase Corporate Bonds A. Interest Income B. Dollar Appreciation of Bond Value C. Bond Repayment at Maturity D. A Typical Bond Transaction E. The Mechanics of a Bond Transaction IV. Government Bonds and Debt Securities A. Treasury Bills, Notes, and Bonds 1. Treasury Bills 2. Treasury Notes 3. Treasury Bonds B. Federal Agency Debt Issues C. State and Local Government Securities V. The Decision to Buy or Sell Bonds A. The Internet B. How to Read the Bond Section of the Newspaper C. Annual Reports D. Bond Ratings E. Bond Yield Calculations F. Other Sources of Information Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 519 CHAPTER 15 LECTURE OUTLINE Although stocks have traditionally returned more than other investment alternatives, bonds are often considered a safer investment. In fact, bonds and other investment alternatives are an excellent way to diversify an investment portfolio and apply the concept of asset allocation. Investors also pick bonds because they need current income. I. CHARACTERISTICS OF CORPORATE BONDS (p. 482) A corporate bond is a corporation’s written pledge that it will repay a specified amount of money, with interest. The usual face value of a corporate bond is $1,000. The total face value of all bonds issued usually runs into the millions of dollars. Between the time of purchase and the maturity date, the corporation pays interest to the bondholder—usually every six months. The maturity date of a corporate bond is the date on which the corporation is to repay the borrowed money. Maturity dates for bonds generally range from 1 to 30 years. The actual legal conditions for a corporate bond are described in a bond indenture. Since corporate bond indentures are very difficult for the average person to read and understand, a corporation issuing bonds appoints a trustee to act as the bondholder’s representative. CHAPTER 15 LECTURE OUTLINE II. WHY CORPORATIONS SELL CORPORATE BONDS (p. 483) Corporations sell corporate bonds to pay for major purchases and to help finance their ongoing business activities. The following factors should be considered: 1. They usually sell bonds when it is difficult or impossible to sell common or preferred stock. 2. The sale of bonds can also improve a corporation’s financial leverage—the use of borrowed funds to increase the corporation’s return on investment. 3. Finally, the interest paid on corporate bonds is a tax-deductible expense and thus can be used to reduce the taxes that a corporation must pay. Corporate bonds are often referred to as the “work horse” of corporate finance. Corporate bonds are a form of debt financing, whereas stock is a form of equity financing. 1. Bonds must be repaid at a future date. 2. Interest payments on bonds are required. 3. In case of bankruptcy, bondholders have a claim to assets of the corporation prior to that of stockholders. 4. Finally, many financial managers prefer selling bonds because they retain control of the corporation. Types of Bonds (p. 484) 520 A debenture is a bond that is backed only by the reputation of the issuing corporation. To make a bond issue more appealing to investors, a corporation may issue a mortgage bond. A mortgage bond (sometimes called a secured bond) is a corporate bond that is secured by various assets of the issuing firm. 1. A first mortgage bond may be backed up by a lien on a specific asset, usually real estate. 2. A general mortgage bond is secured by all the fixed assets of the firm that are not pledged as collateral for other financial obligations. A subordinated debenture is an unsecured bond that gives bondholders a claim secondary to that of other designated bondholders with respect to both interest payments and assets. Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 15 LECTURE OUTLINE Convertible Bonds (p. 484) A convertible bond is a bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock. There are three reasons why corporations sell convertible bonds: 1. Interest rates on convertible bonds are lower when compared to traditional bonds. 2. The conversion feature attracts investors who are interested in speculative investments. 3. If the bondholder converts, the corporation doesn’t have to repay the bond at maturity. Provisions for Repayment (p. 485) Today, most corporate bonds are callable. A call feature allows the corporation to call in or buy outstanding bonds from current bondholders before the maturity date. For bondholders who purchased bonds for income, a problem is often created when a bond paying high interest is called. A corporation may use one of two methods to ensure that it has sufficient funds available to redeem a bond issue. 1. A sinking fund is a fund to which annual or semiannual deposits are made for the purpose of redeeming a bond issue. 2. Serial bonds are bonds of a single issue that mature on different dates. CHAPTER 15 LECTURE OUTLINE IV. GOVERNMENT BONDS AND DEBT SECURITIES (p. 493) In addition to corporations, the U.S. government and state and local governments issue bonds to obtain financing. Treasury Bills, Notes, and Bonds (p. 493) The federal government sells bonds and securities to finance both the national debt and the government’s ongoing activities. The main reason why investors choose U.S. government securities is that most investors consider them risk free. Because they are backed by the full faith and credit of the U.S. government, they offer lower interest rate than corporate bonds. U.S. Treasury securities are also used by some investors to allocate their investment assets and lessen overall risk. Treasury bills, notes, and savings bonds can be purchased through Treasury Direct. 1. If investors bid competitively, they must specify the rate or interest yield that they are willing to accept. 2. If they bid noncompetitively, they are willing to accept the average interest rate or yield determined by action. U.S. government securities may also be purchased through banks or brokers, which charge a commission. Interest paid on U.S. government securities is taxable for federal income tax purposes but is exempt from state and local taxation. U.S. government securities include: 1. Treasury bills, sometimes called T-bills, are issued in minimum units of $1,000 with additional increments of $1,000 above the minimum. Currently, maturities are 4 weeks, 13 weeks, or 26 weeks. T-bills are discounted securities, and the actual purchase price is less than the maturity value of the T-bill. Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 521 CHAPTER 15 LECTURE OUTLINE 2. Treasury notes are issued in $1,000 units with maturities that are more than 1 year but not more than 10 years. Interest is paid every six months. Like T-bills, treasury notes may be purchased from the U.S. Treasury by placing a competitive or noncompetitive bid. 3. The Treasury department no longer issues Treasury bonds. However, many are still in existence and sold in the secondary markets. Therefore, here are the basics. Treasury bonds are issued in minimum units of $1,000 with maturities ranging from 10 to 30 years. Interest is paid every six months. Federal Agency Debt Issues (p. 495) In addition to the bonds and securities issued by the Treasury Department, debt securities are issued by federal agencies which include the Federal Housing Administration, the Federal National Mortgage Association, the Government National Mortgage Association, and the Federal Home Loan Mortgage Corporation. Federal agencies generally issue securities with a minimum denomination that may be as high as $25,000 with maturities that range from one year to 30 years with an average life of 12 years. Often brokers and account executives recommend federal agency debt because the interest rate is 0.5 to 1 percent higher than Treasury securities, but there are important differences. State and Local Government Securities (p. 495) A municipal bond, sometimes called a muni, is a debt security issued by a state or local government. There are two types of municipal bonds. 1. A general obligation bond is a bond backed by the full faith, credit, and unlimited taxing power of the government that issued it. 2. A revenue bond is a bond that is repaid from the income generated by the project it is designed to finance. If the risk of default worries you, you can purchase insured bonds. Like a corporate bond, a municipal bond may be callable by the government unit that issued it. One of the most important features of municipal bonds is that the interest on them may be exempt from federal taxation. And these bonds are generally exempt from state and local taxes in the state where they are issued. Because of their tax-exempt status, their interest rates are lower than those of taxable bonds. It is possible to calculate the taxable-equivalent yield by dividing the tax-exempt yield by the result of 1.0 minus your current tax rate. V. THE DECISION TO BUY OR SELL BONDS (p. 497) One basic principle that we have stressed throughout this text is the need to evaluate any potential investment. Certainly, corporate and government bonds are no exception. The Internet (p. 498) By accessing a corporation’s Web page and locating the topics “financial information,” “annual report,” or “investor relations,” you can find many of the answers relating to the financial strength of a company. When investing in bonds, you can also use the Internet in three other ways. You can 1. Obtain price information. 2. Trade bonds online. 3. Research a corporation by accessing bond Web sites. How to Read the Bond Section of the Newspaper 522 Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. CHAPTER 15 LECTURE OUTLINE (p. 498) Not all local newspapers contain bond quotations, but The Wall Street Journal and Barron’s publish complete and thorough information on this subject. Detailed information on how to read bond quotations is provided in Exhibit 15-5. In bond quotations, prices are given as a percentage of the face value, which is usually $1,000. Thus to find the actual price paid, you must multiply the face value ($1,000) by the newspaper quote. For government bonds, two price quotations are included in most financial publications. 1. The first price quotation, or the bid price, is the highest price a dealer is willing to pay for a government security. 2. The second price quotation, or the asked price, represents the lowest price at which a dealer is willing to sell the government security. Annual Reports (p. 499) As pointed out earlier in this chapter, bondholders must be concerned about the financial health of the corporation or government unit that issues bonds. The information contained in a firm’s annual report is a logical starting point when evaluating the financial health of a corporation. Today, there are three ways to obtain a corporation’s annual report. 1. You can write or telephone the corporation and request an annual report. 2. Most corporations maintain an Internet Web page that contains detailed information about its financial performance. 3. Some financial publications provide a reader’s service that allows investors to use a toll-free telephone number or a postcard to obtain an annual report. Regardless of how you obtain an annual report, you should look for signs of financial strength or weakness. Bond Ratings (p. 500) To determine the quality and risk associated with bond issues, investors rely on the bond ratings provided by Moody’s Investors Service, Inc., and Standard & Poor’s Corporation. As illustrated in Exhibit 15-6, bond ratings generally range from AAA (the highest) to D (the lowest). Generally, U.S. government securities issued by the Treasury Department and various federal agencies are not graded because they are risk free for practical purposes. The rating of long-term municipal bonds is similar to that of corporate bonds. In addition, Moody’s rates short-term municipal bonds maturing in less than one year. Bond Yield Calculations (p. 500) Two methods are used to measure the yield on a bond investment. 1. The current yield is determined by dividing the annual income amount by the bond’s current market value. 2. The yield to maturity is a yield calculation that takes into account the relationship among a bond’s maturity value, the time to maturity, the current price, and the dollar amount of interest. Other Sources of Information (p. 503) Investors can use two additional sources of information to evaluate potential bond investments. 1. Business periodicals and publications can provide information about the economy and interest rates and detailed financial information about a corporation or government entity that Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved. 523 CHAPTER 15 LECTURE OUTLINE issues bonds. 2. A number of federal agencies provide information that may be useful to bond investors. 524 Copyright © 2007 The McGraw-Hill Companies, Inc. All rights reserved.