Transcript Chapter15OverheadsSpring2016

Investing in Bonds
Objectives
 Describe bonds and how they are used by
corporations and investors.
 Describe the major characteristics of
bonds.
 Differentiate among the four general types
of bonds.
Objectives
 Describe what the investor should
consider before investing in bonds,
particularly the current yield and yield to
maturity.
 List the advantages and disadvantages of
investing in bonds.
Descriptive Terms for Bond Features
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.
Language of Bond Investing
 Registered and bearer
 Zero-coupon
 Callable
 Warrants and exercise price
 Convertibility
 Sinking Funds
 General Obligation vs Revenue
 Exempt vs State and Local Exemptions
Language of Bond Investing
 Indenture
 Face value, coupon rate, maturity date
 Secured and unsecured
 Mortgage and Debenture
 Senior and subordinated
Interest Income
 Assume you purchase $1,000 corporate
bond issued by AT&T Corporation. The
interest rate for this bond is 6.70%. The
annual interest is $67 as shown below:
Dollar amount of annual return = Face value x interest rate
= 1,000 x 6.7%
= 1,000 x .067
= $67.00
Approximate Bond Value
 Assume you purchase a Verizon Communications
bond that pays 5.5% interest based on a face value
of $1,000 until maturity in 2017. Also assume new
corporate bond issues of comparable quality are
currently paying 7%. The approximate market value
of your Verizon bond is $786 calculated as follows:
Dollar amount of annual interest = $1,000 x 5.5% = $55
Approximate market value = Dollar amount of annual interest
Comparable interest rate
= $55
7%
= $786
Current Yield
Current yield = annual interest payments
current market price
= $55
$786
= 7%
Effective Yield of a Tax-Free
Investment
 Not paying tax effectively increases your rate of
return
 you get to keep all of your profits, instead of only
a portion


r
 1  taxbracket  100


 Example: 28% tax bracket, 5% rate of return
 .05 
 1  .28  100


= 6.94%
What is the Yield or Rate of Return on a
Financial Investment?
 Annualized Percentage Change:


  new  old 

  1  100
1  
old





1
n
Example: original price=$20/share, current
price=$100/share, stock held for 9 years
Comparison of Taxable vs Tax
Exempt Investments
TaxExempt
Yield
15%
Tax
Rate
25%
Tax
Rate
28%
Tax
Rate
33%
Tax
Rate
35%
Tax
Rate
4%
4.71%
5.33%
5.56%
5.97%
6.15%
5%
5.88%
6.67%
6.94%
7.46%
7.69%
6%
7.06%
8.00%
8.33%
8.96%
9.23%
7%
8.24%
9.33%
9.72%
10.45%
10.77%
What is the Yield or Rate of Return on a
Financial Investment?
Approximate
= annual int. Par value – current price
Yield to maturity
payments + # of years to maturity
par value + current price
2
Let’s look at a bond with 10 yrs. to maturity, a par value of $1,000, a current price
of $880, and a coupon interest rate of 10%:
$1,000 – $880
Approximate
= $100 +
10
Yield to maturity
$1,000 + $880
2
$120
= $100 + 10
$940
= $112/$940 = 11.91%
Bond Price Calculation
Assume that a bond has a price quote of 84. The
actual price for the bond is $840, as calculated below:
Bond price = Face value (usually $1,000) x bond quote
= $1,000 x 84 percent
= $1,000 x .84
= $840
Bond Ratings
A plus sign (“+”) following a rating indicates that it is likely to be upgraded, while a minus sign (“-“) following a rating indicates
that it is likely to be downgraded.
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Considerations Before Investing in
Bonds
 Susceptibility to certain risks
 Credit
 Callability
 Inflation
 Interest rate
Considerations Before Investing in
Bonds
 Premiums and discounts
 Current yield
 Yield to maturity
 Tax-equivalent yields
 When to sell
Bond Prices, Bond Yields, and Interest
Rates
., REVIEW BOOK: Personal Finance. Retrieved Oct 1, 2009 from http://www.flatworldknowledge.com/node/50890
.
Effective Yield of a Tax-Free
Investment
 Not paying tax effectively increases your rate of
return
 you get to keep all of your profits, instead of only
a portion


r
 1  taxbracket  100


 Example: 28% tax bracket, 5% rate of return
 .05 
 1  .28  100


= 6.94%
Advantages of Investing in Bonds
 Pay higher interest rates than savings
 Offer safe return of principle
 Have less volatility than stocks
 Offer regular income
 Require smaller initial investment
Disadvantages of Investing in Bonds
 No hedge against inflation
 Can be quite volatile
 Compounding is almost impossible
 Subject to investors tax rate
 Poor marketability