Chapter 14.5

U.S. government securities are classified into two groups:

(1) Treasury bills, notes, and bonds and (2) federal agency issue notes, bonds, and certificates.

Premiums and Discounts When a bond is first issued, it is sold in one of three ways:

(1) at its face value (the value of the bond stated on the certificate and the amount the investor will receive when the bond matures), (2) at a discount below its face value, or (3) at a premium above its face value. After a bond is issued, its market price changes in order to provide a competitive effective rate of return for anyone interested in purchasing it from the original bondholder.

Four Decisions for Bond Investors

1.Decide on credit quality. Consider Treasury/agency, investment-grade corporate and municipal, and below investment-grade corporate and municipal bonds. 2.Decide on maturity. Consider the time schedule of your financial needs: short, intermediate, or long term. Bonds with a short maturity have the lowest current yield but excellent price stability. Intermediate maturity bonds pay close to the higher rates earned on long-term bonds and enjoy greater price stability. 3.Determine the after-tax return. Assuming equivalent risk, choose the bond that provides the better after-tax return because tax-exempt securities may offer a higher after-tax return than taxable alternatives. To compare the after-tax returns of investments in Chapter 4. 4.Select the highest yield to maturity. Given similar bond securities with comparable risk, maturity, and tax equivalency, investors are wise to choose the one that offers the highest yield to maturity, as calculated by Equation (14.5).

Three generalizations can be made about the yield to maturity:

1.If a bond is purchased for exactly its face value, the YTM is the same as the coupon rate printed on the certificate. 2.If a bond is purchased at a premium, the YTM will be lower than the coupon rate. 3.If a bond is purchased at a discount, the YTM will be higher than the coupon rate.

End of

14.5

end of

14.5a

end of

14.5b

end of

14.5c

Interest Rate/Bond Price Relationship

14.5d

value of bond (or bond selling price) formula

14.5d

bond premium

A sum of money paid in addition to a regular price.

bond rating

An impartial outsider's opinion of the quality—or creditworthiness—of the issuing organization. - It reflects the likelihood that the issuing organization will be able to repay its debt. -Ratings for each bond issue are continually re-evaluated, and they often change after the original security has been sold to the public.

default risk

An impartial outsider's opinion of the quality—or creditworthiness—of the issuing organization. -uncertainty associated with not receiving the promised periodic interest payments as well as the principal amount when it becomes due at maturity

This decline in value ensures that an older bond and a newly issued bond will offer potential investors approximately the same yield.

Bonds generally have a fixed yield (the interest income payment remains the same) but a variable value.

market interest rates

Current long- and short-term interest rates paid on various types of corporate and government debts that carry similar levels of risk.

Corporate bonds

Interest-bearing certificates of long- term debt issued by a corporation. -represent a needed source of funds for corporations. -The dollar value of newly issued bonds is three times the dollar value of newly issued stocks.

current yield Equals the bond's fixed annual interest payment divided by its bond price.

It is a measure of the current annual income (the total of both semiannual interest payments in dollars) expressed as a percentage when divided by the bond's current market price.

Treasury securities

Known as Treasuries, securities issued by the U.S. government, including bills, notes, and bonds.

Municipal government bonds "minus"

Long-term debts (bonds) issued by local governments (cities, states, and various districts and political subdivisions) and their agencies.

Speculative-grade bonds "junk bonds"

Long-term, high-risk, high-interest-rate corporate (or municipal) IOUs issued by companies (or municipalities) with poor or no credit ratings. Also called junk bonds or high-yield bonds. -The interest rates paid investors on junk bonds are 3.5 to 8 percentage points more than those of Treasury bonds.

zeros or deep discount bonds

Municipal, corporate, and Treasury bonds that are issued at a sharp discount from face value and pay no annual interest but are redeemed at full face value upon maturity. -For example, a 4 percent, $10,000 zero-coupon bond to be redeemed 15 years from now might sell today for $5,550. -Zeros pay no current income to investors, so investors do not have to be concerned about where to reinvest interest payments. -Parents often invest in zero-coupon bonds to help pay for their children's college education, and they wisely establish ownership of the zeros in the child's name.

investment-grade bonds

Offer investors a reasonable certainty of regularly receiving periodic income (interest) and retrieving the amount originally invested (principal). -High quality -only about 0.001 percent of the 23,000 largest U.S. companies that issue bonds meet the highest investment-grade rating standards for a AAA credit rating (3 total companies). -Bonds are usually issued at a par value (also known as face value) of $1,000, and they pay interest semi-annually, which is known as a coupon rate.

Because of tax regulations, corporations often finance major projects by issuing long-term bonds instead of selling stocks.

One reason they do so is that payments of dividends to common and preferred stockholders are not tax deductible for corporations, unlike interest paid to bondholders. -State laws require corporations to make bond interest payments on time. Therefore, companies in financial difficulty are required to pay bondholders before paying any short-term creditors.

interest rate risk

Risk that interest rates will rise and bond prices will fall, thereby lowering the prices on older bond issues.

Long-term rates largely reflect bond investors' buying and selling decisions, primarily based on their expectations of future inflation.

Short-term interest rates are manipulated by the Federal Reserve Board, which is popularly known as the "Fed."

-The higher the rating, the greater the probable safety of the bond and the lower the default risk. -The lower the rating of the bond the higher the stated, or effective interest rate. -When bonds are reduced in price from their face amount, more risk is involved. -Higher ratings denote confidence that the issuer will not default and, if necessary, that the bond can readily be sold before its maturity date.

Summary of Bond Ratings

Yields on high-quality municipal bonds are normally about 85 percent of those of Treasuries of equal maturity.

The investor's interest income on municipal bonds is not subject to federal income taxes. This is because the U.S constitution requires that municipal bond interest be exempt from federal income taxes.

Yield to maturity (YTM)

Total annual effective rate of return earned by a bondholder on a bond if the security is held to maturity—takes into consideration both the price at which the bond sold and the coupon interest rate to arrive at effective rate of return.

The federal government uses these debt instruments to finance the public national debt.

Treasury securities have excellent liquidity and are simple to acquire and sell.

-When inflation rises, the Fed often raises interest rates to discourage borrowing, which reduces consumer and business spending. -When the economy slows, the Fed often lowers the interest rates on short-term Treasury issues in an attempt to stimulate economic activity by making it cheaper for companies and consumers to borrow and expand. -Again to stimulate the economy, the Fed sometimes puts more money into the economy by buying long-term mortgage securities and Treasury bonds and notes and related debt for autos and credit cards.

U.S. Government Treasury Securities and Municipal Bonds

U.S. Treasury securities issued by the federal government are the world's safest investment because it has never intentionally defaulted on its debt.

U.S. Treasury securities are backed by the "full faith, credit, and taxing power of the U.S. government," and this all but guarantees the timely payment of principal and interest.

high-yield bonds,

carry investment ratings that are below traditional investment grade and carry a higher risk of default (not repaying the bond investors). -Keep in mind that higher returns require greater risk

Unique Characteristics of Bonds

coupon rate, serial or sinking fund, secured or unsecured, registered and issued, book entry, callable

Investors can utilize the standard factors to evaluate bond prices and potential returns:

interest rates, premiums and discounts, current yield, and yield to maturity.

bond's price, or its value on any given day, is affected by a host of factors:

its type, coupon rate, and availability in the marketplace; demand for the bond; prices for similar bonds; the underlying credit quality of the issuer; and the number of years before it matures.

Bonds also can be a safe investment if held to

maturity.

You should consider investing in bonds if you wish to

receive steady income from a portion of your investments.

bonds usually offer a lower return to investors than

stocks, there are good reasons to include bonds in one's portfolio.

The default risk varies with

the issuer.

obtaining a regular source of predictable although low income,

the likelihood of profiting from possible future increases in the value of bonds if you own a bond and interest rates decline, and matching some of one's assets to one's investment time horizon

The risks and potential rewards of bond investments, independent advisory services, such as Moody's Investors Service, Standard & Poor's, and Fitch, grade bonds for credit risk.

unbiased ratings of the financial conditions of corporations and municipalities that issue bonds.

bonds diversify your investments

which reduces market risk.