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Chapter 16
Investing in Bonds
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Chapter Objectives
• Identify the different types of bonds
• Explain what affects the return (yield) from investing in a bond
• Describe how bonds are valued
• Describe why some bonds are risky
• Identify common bond investment strategies
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Background on Bonds
• Bonds: long-term debt securities issued by government agencies or corporations
• Par value: for a bond, its face value, or the amount returned to the investor at the maturity date when a bond is due
• Most bonds have maturities between 10–30 years
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Background on Bonds (cont’d)
• Issuers required to make interest payments and repay par value
• Bond Characteristics
– Call feature: a feature on a bond that allows the issuer to repurchase the bond from the investor before maturity
• These bonds offer a slightly higher return
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Background on Bonds (cont’d)
– Convertible bond: a bond that can be converted into a stated number of shares of the issuer’s stock if the stock price reaches a specified price
• These bonds tend to offer a slightly lower return
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Background on Bonds (cont’d)
• A bond’s yield to maturity: the annualized return on a bond if it is held to maturity
– If a bond sells at par value, its yield to maturity equals the coupon rate
– If a bond sells below par value, its yield to maturity would exceed the coupon rate
– If a bond sells above par value, its yield to maturity would be less than the coupon rate
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Financial Planning Online
• Go to www.calculatorweb.com/calculators/bondcalc.shtml
• This web site provides an estimate of the yield to maturity of your bond based on its present price, its coupon rate, and its maturity.
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Background on Bonds (cont’d)
• Bond trading in the secondary market
– Investors sell their bonds to other investors before they reach maturity
– Bond prices change in response to interest rates
– Brokerage firms also take orders to buy or sell bonds
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Types of Bonds
• Treasury bonds: long-term debt securities issued by the U.S. Treasury– Payments guaranteed by federal government
– Interest is subject to federal income tax, but exempt from state and local taxes
– Can easily be sold in the secondary market
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Types of Bonds (cont’d)
• Municipal bonds: long-term debt securities issued by state and local government agencies– Low risk– Interest exempt from federal income tax
• Federal agency bonds: long-term debt securities issued by federal agencies– Low default risk– Interest is taxable
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Financial Planning Online
• Go to www.bloomberg.com/markets/rates/index
.html
• This Web site provides quotations of yields offered by municipal bonds with various terms to maturity. Review this information when considering purchasing municipal bonds.
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Types of Bonds (cont’d)
• Corporate bonds: long-term debt securities issued by large firms– Subject to default risk
– High-yield (junk) bonds: bonds issued by smaller, less stable corporations that are subject to a higher degree of default risk
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Types of Bonds (cont’d)
• Corporate bond quotations– Coupon rate– Maturity– Current yield– Volume– Closing price– Net change in the price from the previous day
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Return from Investing in Bonds
• Impact of interest rate movements on bond returns
– If interest rates rise, the value of your bond decreases
– If interest rates fall, the value of your bond increases
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Return from Investing in Bonds (cont’d)
• Tax implications of investing in bonds– Interest is taxed as ordinary income
(unless tax exempt)
– Selling bonds at a price higher than you paid also results in a capital gain
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Return from Investing in Bonds (cont’d)
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Valuing a Bond
• Uses time value of money– Present value of the future coupon payments– Present value of the principal payment
• Economic impact on bond values– Higher rate of return is only realized if firms are
healthy enough to make payments– This may not be true in unfavorable economic
conditions
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Financial Planning Online
• Go to www.bloomberg.com/news/markets/bonds.html
• This Web site provides a summary of recent financial news related to the bond market, which you may consider before selling or buying bonds.
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Risk from Investing in Bonds
• Default risk: risk that the borrower of funds will not repay the creditors
– Risk premium: the extra yield required by investors to compensate for the risk of default
– Use of risk ratings to measure the default risk• Ratings reflect likelihood that issuers will repay their
debt over time
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Risk from Investing in Bonds (cont’d)
– Impact of the financial crisis on default risk• Many firms experienced financial problems and were
unable to make bond payments
– Relationship of risk rating to risk premium• The lower the risk rating, the higher the risk premium
offered on a bond
– Impact of economic conditions• Higher risk of default when economic conditions are
weak
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Copyright ©2014 Pearson Education, Inc. All rights reserved. 16-23
Risk from Investing in Bonds (cont’d)
• Call (prepayment) risk: the risk that a callable bond will be redeemed by the issuer
• Interest rate risk: the risk that a bond’s price will decline in response to an increase in interest rates– Impact of a bond’s maturity on its interest
rate risk• Bonds with longer terms more sensitive to interest rate
movements
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Risk from Investing in Bonds (cont’d)
– Selecting an appropriate bond maturity
• Choose maturities that reflect your expectations of future interest rates
• Consider investing in bonds that have a maturity that matches the time you will need the funds
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Bond Investment Strategies
• Interest rate strategy: selecting bonds for investment based on interest rate expectations– Purchase long-term bonds if you expect interest
rates to fall
• Passive strategy: investing in a diversified portfolio of bonds that are held for a long period of time
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Bond Investment Strategies (cont’d)
• Maturity matching strategy: investing in bonds that will generate payments to match future expenses
– For example, parents might invest in a bond that will mature at the right time to pay for their child’s college education
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How Bond Decisions Fit within Your Financial Plan
• Key decisions about bonds for your financial plan are:– Should you consider buying bonds?
– What strategy should you use for investing in bonds?
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