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FIN 200: Personal Finance
Topic 19–BondsLawrence Schrenk, Instructor
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Learning Objectives
1. Explain the features basic common to all bonds. ▪
2. Compare and contrast the bonds issued by different government levels and agencies.
3. Describe the various features found in corporate bonds. ▪
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Bond Cash Flows
Bonds are loans. Regular Interest Payments (Coupons) Principle Repaid at End
Example: Three year annual bond with a principal or $1,000 and coupon rate of 10%.
Year 1 Year 2 Year 3Coupon $100 $100 $100Principal $1,000TOTAL $100 $100 $1,100
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Bond Terminology
Principal, Par Value, Face Value Coupon, Coupon Rate Maturity Discount Rate Periods
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Bond Valuation
Example: Three year annual bond with a principal of $1,000 and coupon rate of 10% (r = 8%).
Year 1 Year 2 Year 3
Coupon $100 $100 $100
Principal $1,000
TOTAL $100 $100 $1,100
2 3
100 100 1,100Price = + + = $1,051.54
1.08 1.08 1.08
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Bond Price Movement
Interest Rate Risk Interest Rates and Bond Prices
Inversely Related
Interest Rates ↑ Bond Prices ↓
Interest Rates ↓ Bond Prices ↑
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More Complicated Bonds
‘Straight’ Bond Premium versus Discount Bonds Features
Callable Bonds Convertible Bonds Sinking Funds
Debt Covenant Financial Ratios Technical Default
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Government Bonds
US Treasury Bills, Notes and Bonds Savings Bonds Inflation-Adjusted Bonds
TIPS I-Bonds
Other Agencies
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Why do Investors Purchase Government Bonds?
Government bonds are written pledge to repay a specified sum of money along with interest
Sold to obtain money to finance the national debt, and the ongoing costs of government.
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U.S. Treasury Bills, Notes and Bonds
Treasury Bills (T-Bills) 4, 13, or 26 weeks to maturity Sold at a discount Federal but no state tax on interest earned
Treasury Notes Typical maturities are 2, 3, 5, and 10 years Interest paid every six months, at a higher rate than T-bills Federal but no state tax on interest earned
Treasury Bonds 30 year maturity dates Interest rates higher than the notes and bills Interest paid every six month
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U.S. Savings Bonds.
U.S. Savings Bonds. Series EE sold at half of face value, with potential tax
advantages if used to pay tuition and fees. Series HH pays interest every six months. I bonds which earns a fixed rate plus an inflation rate which
changes twice a year See www.savingsbonds.gov for rates.
Advantages Exempt from state and local income taxes. You don’t have to pay federal income tax on earnings until
you redeem the bonds.
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Treasury Inflation-Protected Securities (TIPS) Treasury Inflation-Protected Securities
(TIPS) started in 1997 Provide protection against inflation
Principal increases with inflation (CPI) When a TIPS matures, the investor is paid the
inflation-adjusted principal or original principal, whichever is greater
Interest paid semiannually at a fixed rate The rate is applied to the adjusted principal; so, like
the principal, interest payments rise with inflation and fall with deflation
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Payments in TIPS Consider a 3-year TIPS, par value of $1,000, and a coupon rate of
4%. Assume that the inflation turns out to be 2%, 3%, and 4% in the next
3 years Returns in the first year
Real = Nominal - Inflation = 6.08 - 4 = 4.08%
Interest + Price Appreciation 40.80 + 20.00Nominal = = = 6.08%
Initial Price 1,000
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TIPS versus Regular Bonds
I ncrease in TIPS Regular Bonds
Expected Inflation 0 -
Realized Inflation + 0
Real Yields - -
Risk of I nflation 0 -
Price Response of
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Federal Agency Debt Issues
Agencies, examples… Government National Mortgage Association (GNMA) Export-Import Bank Farmers Housing Administration (FHA)
Higher interest than government securities issued by the treasury department.
Minimum investment may be as high as $25,000 Maturities range from 15-30 years. Average maturity is 15 years.
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State and Local Government Securities Municipal Bonds (Muni’s) Issued by a state or local government, including
cities, counties, school districts, and special taxing districts.
Use funds for ongoing costs and to build major projects such as schools, airports, and bridges.
Tax Status Two Types:
General obligation bonds are backed by the state or local government that issues them.
Revenue bonds are repaid from money generated by the project the funds finance, such as a toll bridge.
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Corporate Bonds
Corporation’s written pledge to repay a specified amount of money with interest.
The face value is the dollar amount that the bondholder will receive at the bond’s maturity date.
Bondholders receive interest payments every six months at the stated interest rate.
The legal conditions are described in a bond indenture (or covenant).
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Major Classifications
Collateral Secured Debt (Mortgage) versus Unsecured Debt (Debenture)
Seniority Senior Debt versus Subordinated Debt
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Why Corporations Sell Bonds To get funds for major purchases. To fund ongoing business activities. As an alternate to selling stock. Interest Payments are tax deductible
Versus dividend payments, which are not.
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Types of Corporate Bonds
1. Unsecured (Debenture) Bond Most corporate bonds are debenture bonds. Unsecured - Backed only by the reputation of the
issuing company.
2. Secured (Mortgage) Bond A corporate bond that is secured by various
assets of the issuing firm, usually real estate. Interest rate is lower because it is secured.
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Types of Corporate Bonds (cont’d)
3. Convertible Bond A special kind of corporate bond that can be
exchanged for a specified number of shares of the corporation’s common stock.
Generally, the interest rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds.
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Provisions for Repayment
Call Feature of a Bond Corporation can call in or buy back outstanding
bonds from current bondholders before the maturity date.
Most corporate bonds are callable. Most agree not to call bonds for the first 5 to 10
years after they are issued. They call bonds if the interest rate they are paying
is much higher than the going rate.
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Provisions for Repayment (cont’d)
Sinking Fund Corporations deposit money in this fund annually
or semiannually and use the money to pay off the bondholders when the bond issue comes due.
Serial Bonds Bonds of a single issue that
mature on different dates.
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Bond Rating Agencies
Standard & Poor's (S&P) Moody's Fitch
NOTE: There are similar to the ratings given insurance companies.
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‘Junk’ Bonds
Alternate Names/Different Spin High Yield Bonds Non-investment Grade Bonds Speculative Grade Bonds Junk Bonds
Higher Risk of Default, Higher Yield
