© 2013 pearson education, inc. all rights reserved.14-1 chapter 14 investing in bonds and other...

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Chapter 14

Investing in Bonds and Other

Alternatives

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Introduction

• Bonds carry less risk than stocks.

• Bonds provide steady income.

• But returns from bonds are not necessarily low.

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Why Consider Bonds?

• Bonds reduce risk through diversification.

• Bonds produce steady income.

• Bonds can be a safe investment if held to maturity.

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Basic Bond Terminologyand Features

• Par value

• Maturity

• Coupon Interest Rate

• Indenture

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Treasury and Agency Bonds

• Risk-free

• Not callable

• Lower interest rate

• Most interest payments are exempt from state and local taxes.

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Treasury and Agency Bonds

• Treasury-issued debt has maturities from 3 months to 10 years.

• Bills, notes, and bonds differ by maturity and denomination.

• Agency bonds

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Treasury and Agency Bonds

• Pass-through certificates issued by the Government National Mortgage Association “Ginnie Mae”

• Treasury Inflation Protected Securities (TIPS)—par value changes with the consumer price index to guarantee investor a real rate of return

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Municipal Bonds

• “Munis”—issued by states, counties, cities, public agencies e.g. school districts

• General obligation bond

• Revenue Bonds

• Serial maturities

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Special Situation Bonds

• Zero Coupon Bonds—don’t pay interest and are sold at a deep discount from their par value

• Junk Bonds—also high-yield bonds, very risk, low-rated BB or below

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Bond Ratings – A Measureof Riskiness

• Moody’s and Standard & Poor’s provide ratings on corporate and municipal bonds.

• Ratings involve a judgment about a bond’s future risk potential.

• The poorer the rating, the higher the rate of return demanded by investors.

• Safest bonds receive AAA, D is extremely risky.

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Table 14.1 Interpreting Bond Ratings

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Bond Yield

• Current Yield—ratio of annual interest payment to the bond’s market price

• Yield to maturity—true yield or return that the bondholder receives if a bond is held to maturity—measure of expected return

• Equivalent taxable yield on municipal bonds

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Bond Valuation

• The value of a bond is the present value of the interest payments plus the present value of the repayment of the bond’s par value at maturity.

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Bond Valuation

• If the issuer becomes riskier, the required rate of return should rise.

• A change in general interest rates, the required rate of return should increase.

• When interest rates rise, the value of outstanding bonds falls.

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Why Bonds Fluctuate in Value

• Inverse relationship between interest rates and bond values in the secondary market.

• When interest rates rise, bond values drop, and when interest rates drop, bond values rise.

• Longer-term bonds fluctuate in price more than shorter-term bonds.

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Why Bonds Fluctuate in Value

• As a bond approaches maturity, the market value approaches its par value.

• When interest rates go down, bond prices go up, but upward price movement on bonds with a call provision is limited by the call price.

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Figure 14.3 The Price Path of a 12 Percent Coupon Bond over Its Life

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What Bond Valuation Relationships Mean to the Investor

• If you expect interest rates to go up (bond prices to fall)—purchase very short-term bonds.

• If you expect interest rates to go down (bond prices to rise)—purchase bonds with long maturities and are not callable.

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Figure 14.4 How to Read Online Corporate Bond Listings

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Preferred Stock—An Alternative to Bonds

• A hybrid security with features of common stock and bonds.

• Similar to common stock—no fixed maturity date, not paying dividends won’t bring bankruptcy.

• Similar to bonds—dividends are fixed, paid before common and no voting rights.

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Investing in Real Estate

• Requires time, energy, and sophistication

• Direct investments in real estate

• Indirect investments in real estate

• Investing in real estate: the bottom line

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Investing – Speculating in Gold, Silver, Gems, and Collectibles

• Don’t do it!

• This is not investing—it is speculation.

• Collectibles may only have entertainment value.

• Don’t expect them to provide for your financial future.