11-1 chapter 11 investing basics and evaluating bonds copyright © 2013 by the mcgraw-hill...

11-11-11

Chapter 11

Investing Basics and Evaluating Bonds

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

11-11-22

Investing Basics and Evaluating Bonds

Chapter Learning ObjectivesLO11.1 Explain why you should establish an

investment program.LO11.2 Describe how safety, risk, income, growth, and

liquidity affect your investment program.LO11.3 Identify the factors that reduce investment

risk.LO11.4 Understand why investors purchase

government bonds.LO11.5 Recognize why investors purchase corporate

bonds.LO11.6 Evaluate bonds when making an investment.

11-11-33

Learning Objective LO11.1Explain Why You Should Establish an

Investment Program

Establishing Investment Goals

• Financial goals should be:– Specific

– Written Down

– Measurable

– Tailored to your financial needs

– Aimed at what you want to accomplish

11-11-44


1. How much money do you need to satisfy your investment goals?

2. How will you obtain the money?

3. How long will it take you to obtain the money?

4. How much risk are you willing to assume in an investment program?

11-11-55


5. What possible economic or personal conditions could alter your investment goals?

6. Considering your current and

anticipated economic circumstances,

are your investment goals easonable?

7. Are you willing to make the sacrifices

necessary to ensure that you meet

your investment goals?

11-11-66

Performing a Financial Checkup

• Pay your bills on time• Work to balance your budget

• Manage your credit card debt – Pay in full each month– Do not use credit for small purchases– Do not use the cash advance option– Think about the number of cards you need– Get help if you are in trouble

11-11-77

Performing a Financial Checkup

• Start an emergency fund you can access quickly– At least three months of living expenses

• Have access to other sources of cash for emergencies– Pre-approved line of credit – Cash advance on your credit card– Home equity

11-11-88

Managing an Economic Crisis

1. Establish a larger than usual emergency fund2. Know what you owe

• Identify debts that must be paid

3. Reduce spending4. Notify credit card companies and lenders if

you are unable to make payments5. Monitor the value of your investment and

retirement accounts.6. Consider converting investments to cash to

preserve value.

11-11-99

Getting the Money Needed to Start an Investing Program

11-11-1010

How the Time Value of Money Affects Your Investments

• Even small amounts invested regularly grow over a long period of time. The value of one cup of coffee per day invested over 40 years grows to $390,000.

• Use the Time Value of Money calculation methods in the Chapter 1 Appendix to calculate future values.

• The higher the rate of return the greater the risk

11-11-1111

Learning Objective LO11.2 Factors Affecting the Choice of

Investments

• Safety and risk– Risk = uncertainty about the outcome

– Investment Safety = minimal risk of loss

– Risk-Return Trade-Off• The potential return on any investment should

be directly related to the risk the investor assumes

– Speculative investments are high risk, made by those seeking a large profit in a short time

11-11-1212

Components of the Risk Factor

• Inflation risk during periods of high inflation your investment return may not keep pace with inflation

• Interest rate risk the value of bonds or preferred stock may increase or decrease with changes in interest rates

• Business failure risk affects stocks and corporate bonds

• Market risk the risk of being in the market versus in a risk-free asset

11-11-1313

Investment Income

• Investment Income – A predictable source of income (dividends or

interest)– Most conservative = passbook savings, CDs and

government securities– Other choices:

• Municipal and corporate bonds• Preferred stock • Utility stocks• Selected common stocks• Selected Mutual funds• Rental real estate

11-11-1414

Investment Income, Growth and Liquidity

• Investment Growth – Growth in value (price appreciation)– Common stock usually offers the greatest potential

for growth– Mutual funds, ETFs and real estate offer growth

potential

• Investment Liquidity– 2 dimensions

• Ability to buy or sell an investment quickly • Without substantially affecting the

investment’s value

11-11-1515

Learning Objective LO11.3Factors that Reduce Investment Risk

Asset Allocation and Diversification• Asset allocation

= The process of spreading your assets among several different types of

investments = Diversification

• Stocks• Bonds• Risk-free assets• Real-estate

11-11-1616

Traditional Investment Evaluation Factors

11-11-1717

Asset Allocation and Diversification

• Other factors to consider:– Your age

• Growth versus income• Recovery time if investments nosedive

– Your investment objectives– How much can you save and invest each year?– The dollar value of your current investments– The economic outlook for the economy– Your tolerance for risk

• At what point can you no longer sleep easily?

– Your investment horizon • When will you need the money?• How long can your money continue to grow?

11-11-1818

Portfolio Investing

Brokerage firms frequently construct sample portfolios for client consideration. A suggested asset allocation for a

young investor is shown below.

11-11-1919

Investment Pyramid

11-11-2020

Your Role in the Investment Process

1. Evaluate potential investments

2. Monitor the value of your investments

3. Keep accurate records

4. Other factors Seek help from personal financial

planner Consider the tax consequences of

selling your investments

11-11-2121

Learning Objective LO11.4Conservative Investment Options:

Government Bonds

• Government bonds = written pledge to:– Repay a specified sum of money (face value) – At maturity – Along with periodic interest payments

• Sold to fund the national debt and the ongoing costs of government at all levels

• Three levels of government issues:– Federal– State– Local municipalities

11-11-2222

U.S. Treasury Bills, Notes and Bonds

Treasury Bills (T-Bills)• $100 minimum• 4, 13, 26 and 52 weeks to maturity• Sold at a discount• Federal but no state tax on interest earned

Treasury Notes• $100 units• Typical maturities = 2, 3, 5, 7, and 10 years• Interest paid every six months• Higher rate than T-bills• Federal but no state tax on interest earned

11-11-2323

U.S. Treasury Bills, Notes and Bonds

Treasury Bonds• Issued in minimum units of $100• 30 year maturity dates• Interest rates higher than notes and bills• Interest paid every six months

Treasury Inflation-Protected Securities (TIPS)

• Sold in minimum units of $100• Sold with 5, 10, or 30 year maturities• Principal changes with inflation • Pays interest twice a year at a fixed rate

11-11-2424

Treasury Securities

11-11-2525

State and Local Government Securities

Municipal Bonds (“munis”)• Issued by a state or local government

– Cities– Counties– School districts– Special taxing districts

• Funds used for ongoing costs and to build major projects such as schools, airports, and bridges

11-11-2626


Municipal Bonds (“munis”)

• General obligation bonds – Backed by the full faith, credit, and taxing

authority of the issuing state or local government

• Revenue bonds – Repaid from money generated by the

project the funds finance, such as a toll bridge

11-11-2727


Municipal Bonds (“munis”)• Key characteristic:

– Interest may be exempt from federal taxes– Capital gains may NOT be tax exempt– Usually exempt from state and local taxes in

state where issued– Exempt status determined by use of funds

• Insured municipal bonds– Private insurance to reduce risk

11-11-2828

Taxable Equivalent Yield

%94.60694..28 - 1

.05 Yield Equivalent Taxable

:Example

rate tax Your - 1

ldexempt yie-Tax Yield Equivalent Taxable

Used to compare tax exempt and taxable bonds

11-11-2929

Learning Objective LO11.5Conservative Investment Options:

Corporate Bonds

Corporate Bonds

• A corporation’s written pledge to repay a

specified amount of money with interest

• An interest-only loan

• Considered safer than stocks

• A “fixed-income” security

• A form of debt financing

11-11-3030

Corporate Bonds

• Face value: – Dollar amount bondholder receives at

bond’s maturity date– Usually $1,000

• Coupon rate – Stated interest rate

– Interest payments made every six months

• Maturity date = date on which face value repaid

11-11-3131

Corporate Bonds

• Bond Indenture

– Legal document describing conditions of

the bond issue

• Trustee

– Financially independent firm that acts as

the bondholder’s representative

– Usually a commercial bank or other

financial institution

11-11-3232

Why Corporations Sell Bonds

• To raise funds for major purchases

• To fund ongoing business activities

• When difficult or impossible to sell stock

• To improve financial leverage

• Interest paid to bondholders is tax

deductible for the firm

11-11-3333

Types of Corporate Bonds

• Debenture– Unsecured, > 10 yr maturity

– Backed only by the reputation of the issuing company

• Mortgage bond– Secured by various assets of the issuing

firm, usually real estate

– Lower interest (coupon) rate since debt is secured

11-11-3434

Types of Corporate Bonds

• Convertible bond– Can be exchanged, at the owner’s option,

for a specified number of shares of the

corporation’s common stock

– Generally, the coupon rate on a convertible

bond is 1 to 2 percent lower than the rate

paid on traditional bonds

11-11-3535

Provisions For Repayment

Call Feature of a Bond • Corporation can “call in” or buy back

outstanding bonds before the maturity date

• Most corporate bonds are callable

• Usually call protected for the first 5 to 10 years after issue

• A firm may call a bond issue if the coupon rate they are paying is much higher than the market rate

11-11-3636

Provisions For Repayment

• Sinking fund

– Corporations deposit money annually

– Trustee uses the money to retire the bond

issue prior to maturity

• Serial bonds

– Bonds of a single issue that

mature on different dates

Bond

11-11-3737

Why Investors Purchase Corporate Bonds

1. Interest income - “fixed income”– Registered bond

• Interest and principal paid to registered owner

– Registered coupon bond• Registered for principal only

• Coupon must be presented to obtain payment

11-11-3838

Why Investors Purchase Corporate Bonds

2. Dollar appreciation of bond value– Bond values change with market interest

rates in the economy• Bond value vs. Interest rates = inverse

relationship

– Bond values change with the financial condition of the issuing company or government unit

3. Bond repayment at maturity– Face value repaid on maturity date– Bondholders may keep till maturity or sell

11-11-3939

Learning Objective LO11.6Evaluate Bonds When Making an

Investment

• Sources of information – The Internet– The issuing firm’s website– www.bondsonline.com– www.bondsearch123.com– http://bonds.yahoo.com

• Price information (quotes)• Trade bonds online • Research on the issuing corporation

• Financial coverage of bond transactions– Wall Street Journal, Barrons, Internet

11-11-4040

Corporate Bond Quotes

CurrentYield(%)

HOME DEPOT INC 93.51 5.875 16-Dec-36 6.365 6.283 AA

HOME DEPOT INC 95.81 5.400 1-Mar-16 6.027 5.636 AA

HOME DEPOT INC 98.70 5.250 16-Dec-13 5.492 5.319 AA

Issue Price Coupon(%) Maturity YTM(%)Fitch

Ratings

The first bond in the list:

• Matures in 2036

• Current price = 93.51% of par (discount) = $935.10

• Pays an annual coupon rate of 5.875% = $58.75

• Yield-to-Maturity = 6.365%

• Current yield = 6.283% = 58.75/935.10

11-11-4141

Bond Ratings Measure Default Risk

11-11-4242

Bond Yield Calculations

• Yield = rate of return earned by an investor who holds the bond to maturity

Current Yield = Annual interest amount Current Price

• Other Sources of Information– Business Periodicals– Federal Agencies

• www.federalreserve.gov• www.treasury.gov• www.commerce.gov• www.sec.gov

11-11-4343

Chapter SummaryLearning Objective LO11.1

• Investment goals must be specific and measurable. • Make sure your personal financial affairs are in

order. • Accumulate an emergency fund equal to at least

three months’ living expenses. – Increase the amount in your emergency fund if you think

you may lose your job or the nation is experiencing an economic crisis.

• Then, it is time to save the money needed to establish an investment program.

• Use the time value of money concept to help you achieve your goals—especially if you start sooner rather than later.

11-11-4444


• All investors must consider the factors of safety, risk, income, growth, and liquidity.

• Especially important is the relationship between safety and risk.

• Basically, this relationship can be summarized as follows:

– The potential return for any investment should be directly related to the risk the investor assumes.

– In addition to safety and risk, investors choose investments that provide income, growth, or liquidity.

11-11-4545


• Before making the decision to invest, you should consider:– Asset allocation = the process of spreading your

assets among several different types of investments to lessen risk.

– The amount of time before you need your money. – Your age is a factor that influences investment

choices. • Younger investors tend to invest a large percentage of

their nest egg in growth-oriented investments. • Older investors tend to be more conservative.

11-11-4646


• Improve your investment returns by:– Evaluating all potential investments– Monitoring the value of your investments– Keeping accurate and current records

• Professional help and your tax situation may also affect your investment decisions.

11-11-4747


• Conservative investments include:– Savings accounts– Certificates of deposit– Money market accounts– Savings bonds– Government securities.

• Generally, most investors consider U.S. government securities to be a safe harbor in troubled economic times.

• Municipal bonds are conservative investments and may provide tax-exempt income.

11-11-4848


• Bonds are issued by corporations to raise capital. Investors purchase corporate bonds for three reasons:

(1) interest income

(2) possible increase in value

(3) repayment at maturity

• Bonds also can be an excellent way to diversify a portfolio.

11-11-4949


• The method used to pay bondholders interest depends on whether they own registered bonds or registered coupon bonds.

• Most corporate bonds are bought and sold through full-service brokerage firms, discount brokerage firms, or the Internet.

• Investors pay commissions when bonds are bought and sold.

11-11-5050


• The internet can be used to obtain information and trade bonds online.

• Study the ratings provided by Standard & Poor’s, Moody’s, and Fitch Ratings to determine the quality of a bond issue.

• Calculate a bond’s current yield to evaluate a decision to buy or sell a bond issue.

• Business periodicals and government sources provide valuable information.

11-1 chapter 11 investing basics and evaluating bonds copyright © 2013 by the mcgraw-hill...

Documents

investment risk

risk slide

investment program

risk risk

investment goals easonable

outcome investment safety

investing program slide

short time slide