What are Bonds?

• Bonds are certificates of indebtedness • Think of a Bond is as an I.O.U.• In reality a bond is nothing more than a loan• The investor is lending to the bond issuer (the

company• In return, you receive a stated interest rate• The rate is stated on the face of the bond

Who are the issuers of Bonds?

• Just as people need money, so do companies and governments

• Companies need money to expand • Stockholders don’t like it when you issue new

stock – it makes their shares worth less• Governments need money for everything

from infrastructure to social programs

What do the investors of bonds receive?

• Interest. Nobody would loan his or her money for nothing.

• The issuer of the bond must pay the investor something extra for the privilege of using his or her money.

Why would a company choose to issue bonds rather than stock?

• Bonds add “leverage” – a different kind of risk– Instead of them giving you money for the stock,

you are giving them interest for their money– This means that you are being responsible to pay

them back

• Less risky than stock for investors• Offer stable income to investors• Bond prices are related to interest rates

Different Kinds of Bonds

• Government Bonds– T-bill, T-note, T-bond

• Agency Bonds– Fannie Mae, Freddie Mac, Sallie Mae

• Corporate– Issued by individual companies

• Municipal– Issued by a county, city or state

Registered Bonds

How do bonds pay interest?

• Some bonds are bought at discount, and interest accrues over a period of years.– Savings bonds are a good example– Investors buy the bond at a reduced face value– At maturity, the investor receives one payment – The payment is equal to the principle of the bond

plus the interest that has been accumulated during the time the bond has been held by the investor

– Also called a “zero coupon bond”

Savings Bond

“Coupon” Bonds• Other bonds pay interest at periodic intervals– Coupon bonds pay out interest payment to the investor

every six months– The Principal (face value of the bond) is paid to the investor

at a specific maturity date, which can range from a few months to 30 years

– Bonds are considered to be “fixed income securities” because the amount the investor receives is set, or fixed, by the coupon rate

– The “coupons” used to be attached to the bond certificate, but most bonds are now held electronically and this is no longer the case

– So “coupon” = interest rate

Bonds Are An Old Idea

How a Coupon Works• Example: – Buy a bond with a face value of $1000– Coupon Rate 8%– Maturity 10 years

• This means you will receive a total of $80 ($1000 * 8%) of

interest per year for the next 10 years.

• Since most bonds pay out semi-annually you will receive two payments of $40 a year for 10 years.

• When the bond matures after a 10 years you will get your $1000 (Principal) back.

• What a bondholder gets: $80x10= $800 plus your $1,000 back

How do I calculate my return on investment for a bond?

• It’s not like a stock– We calculate it by the year– 8%, the stated rate, is your return on investment– Even though you are getting $800/$1000 = 80%,

you have to wait ten years

• What about taxes?– Interest is taxed as ordinary income at whatever

rate you pay for your other income, like salary

How Do I Buy a Bond in the Stock Market Game?