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Chapter 11 second half
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11B Investing Basics and Evaluating Bonds #2
Recall the concept of asset allocation
11-1
One Effect of Asset Allocation: A Weighted Total
Return
Ultraconservative “Investors” Are Really Just
“Savers”• People who invest very conservatively
• They do not get ahead financially over the long term because taxes and inflation offset most of their interest earnings
• Remember “The Rule of 72”?
– 72/4% = 18 years
– 72/8% = 9 years (money doubles much faster)
Identify the Types of Investments You Want to
MakeDo You Want to Lend Your Money or Own an Asset?
– Debts – “loanership” (lending) investments.
• Fixed Maturity – the borrower agrees to repay the principal to the investor on a specific date.
• Fixed Income – the borrower agrees to pay the investor a specific rate of return for use of the principal.
– Equities – “ownership” investments.
• Potential for a higher return by sharing in profits
The Risk Pyramid Reveals the Trade-offs Between Investment Risk and
Return
Inflation
• To beat inflation, one must invest money so that it earns a higher after-tax return than the inflation rate
• Real Rate of Return – the return after subtracting the effects of both inflation and income taxes.
Example:
10% return, 7.5% after taxes (25% tax bracket), 4% inflation, real rate of return of 3.5% after taxes and inflation
Objective 5Recognize Why Investors Purchase
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 co. stocks
• A “fixed-income” security
• A form of debt financing (bond owners repaid in future)
11-7
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 – Example: $1,000 x 5.8% = $58 (in two $29
payments)
• Maturity Date = date on which face value repaid; generally 1 to 30 years
11-8
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
11-9
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
11-10
Types of Corporate Bonds
• Debenture
– Unsecured debt
– Investors become “creditors” if company fails
– Backed only by the reputation of the issuing
company; most corporate bonds are this type
• Mortgage Bond
– Secured by various assets of the issuing firm,
such as real estate and property
– Lower interest (coupon) rate since debt is secured
11-11
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, coupon rate on a convertible bond is 1%
to 2% lower than the rate paid on traditional bonds
– Would only want to convert when stock price gets
higher than the bond’s equivalent value in stock
11-12
Provisions For Repayment
Call Feature of Bonds
• Corporation can “call in” or buy back outstanding bonds before the maturity date
• Most corporate bonds are callable
• Call-protected for first 5 to 10 years after issue
• A firm calls a bond issue if the coupon rate they are paying is much higher than the market rate
– Like consumers refinancing to lower-rate mortgage
11-13What is the effect of called back bonds on investors?
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
– Example: After first 10 years, over the next 10
years, 10% of bonds mature each year
Bond
11-14
Why Investors Purchase Corporate Bonds
1. Interest Income - “Fixed Income”– Registered Bond- tracked electronically
• Coupon and principal paid to registered owner (check or direct deposit)
– Registered Coupon Bond• Registered for principal only• Coupon must be presented to obtain
payment– Zero-Coupon Bond
• Pays no interest• Sold at a discount from face value• Redeemed at face value at maturity 11-15
Bond
Why Investors Purchase Corporate Bonds
2. Dollar Appreciation of Bond Value
– Bond values change with market interest rates
• Bond value vs. Interest rates = inverse relationship
• If Market rate< Coupon rate Price > Face value
• If Market rate > Coupon rate ← Price < Face value
– 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 (will be worth less due to inflation)
– Bondholders may keep till maturity or sell
4. Portfolio diversification beyond stock and cash assets
11-16
Approximate Bond Value Formula
• 5.875% interest on ($1,000 bond) = $58.75• New issues paying 5% (decrease in coupon rate)
• Dollar amount of interest $58.75
Comparable interest rate = 5% (.05) = $1,175
• Bond worth more than face value because it pays interest rate higher than current market rate
• New issues paying 6.5% (increase in coupon rate)
• Dollar amount of interest $58.75
Comparable interest rate = 6.5% (.065) = $903.85
• Bond worth less than face value because it pays interest rate lower than current market rate
Premiums and Discounts
When a bond is first issued, it is sold in one of three ways:
– at its face value
– at a discount below its face value or
– at a premium above its face value.
Price Changes for Bonds
What does this graph tell you?
Objective 6Evaluate Bonds When Making an
Investment• Sources of Information – The Internet
– The issuing firm’s website
– www.bondsonline.com
– http://bonds.yahoo.com
• Financial coverage of bond transactions– Wall Street Journal, Barrons, Internet
• Other Sources of Information– Business Periodicals– Federal Agencies
• www.federalreserve.gov• www.treasury.gov• www.sec.gov
11-20
Corporate Bond QuotesCurrentYield(%)
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
HOME DEPOT INC 100.32 5.200 1-Mar-11 5.101 5.183 AA
Maturity YTM(%)Fitch
RatingsIssue Price Coupon(%)
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% (considers bond maturity date)
• Current yield = 6.283% = 5.875/93.51 (interest/price)
11-21
Bond Ratings Measure Default Risk
11-22
Decisions Bond Investors Must Make
• Decide on risk level.
– Investment grade bonds: top 4 grades (BBB, A, AA, AAA)
– Junk bonds (a.k.a., high yield bonds): lower rated and higher risk
• Decide on maturity.
– Match to financial goals
• Determine the after-tax return.
– Taxable versus tax-exempt
Wrap Up
• Chapter Quiz
• Concept Check 11-5- Calculate Semi-annual Interest and Reasons That Investors Buy Bonds
• Concept Check 11-6- Current Value of Bonds; Explain Bond Ratings