COA Ch. 13: Bonds

What is a major advantage of corporate bonds?

*A major advantage of bonds is the lower risk they offer, plus contractual periodic interest payments*.

What does it mean to *default*?

*Default* refers to the failure of a debtor to make on-time payments & principal as they come due. Bonds with high ratings are the least likely to default.

What are *government bonds*?

*Government bonds* are written pledges of a government or municipality to repay a specified sum of money along with interest.

What are *treasury bills (T-bills)*?

*Treasury bills (T-bills)* are U.S. securities that mature in *1 year or less*. They are sold in minimum units of *$1,000*, and can be issued up to $1 million.

What are agency bonds?

- Government agencies besides the Treasury Department offer bonds. - These include *Fannie Mae (Federal Mortgage Association)* and *Ginnie Mae (Government National Mortgage Association)*. - They offer higher risk & higher interest than federal bonds.

Which type of bond is not rated?

- Government bonds, issued by the U.S. Treasury, are not rated because their interest & principal payments are backed by the full faith & credit of the U.S. Government. - They are considered some of the safest investments that exist.

Where can investors check a bond's rating? What is the highest rating?

- Investors can check a bond's rating from Standard & Poor's Corporation or Moody's Investor Service. *The highest rating are Aa in Moody's and AAA in Standard & Poor's*.

What are *debentures*?

A *debenture* (unsecured bond) is the most common type of bond. It is a debt obligation backed by the earning power of the borrower & documented by an indenture (a formal agreement between an issuer of bonds & the bondholder).

What is a bond also called? When did bonds begin?

A bond is a debt instrument issued by a corporation or the government. They began in 1935 with Roosevelt.

How do corporate bonds differ from stocks?

Bonds differ from stocks in that they must be repaid. In the event of company bankruptcy, bondholders will be paid before stockholders.

What are the tax consequences of government bonds?

Investors in high tax brackets are attracted to government bonds because many are tax-exempt or tax-deferred. - Federal government-issued bonds are exempt from state & local taxes, but not federal taxes. - Municipal bonds are exempt from local, state, & federal taxes.

Discuss the liquidity of bonds.

Investors like bonds because they offer better yields than money market funds & less risk than stocks. However, *one of the drawbacks of bonds is that they are less liquid than money market funds or stocks. Usually, you buy a bond with the intention of holding it until it matures*.

What are *bonds*?

- *Bonds* are an investment in which money is lent to an organization for a period of time. In other words, bonds are "loans". - Govt. units or corporations issue bonds to borrow money for expansion, construction, & other purposes. In return for the loan, investors (*bondholders*) receive interest payments twice per year, and at the end of their term, they get their principal back. - Bonds can be purchased from the govt., corporations, or a third party (bank, broker).

What are *callable bonds*?

- *Callable bonds* allow corporations to call in or buy back outstanding bonds before their maturity dates. - *Because investors whose bonds are called in must then reinvest usually at less favorable rates, issuers must offer "call premiums" (which increase the purchase value above the normal face value) in order to compensate*.

What are *convertible bonds*?

- *Convertible bonds* are bonds that can be exchanged for stock shares instead of getting cash back. - If it is a growth company, this can be an attractive feature. However, you may receive lower interest rates.

What is the *coupon rate*? What is the *market value*?

- *Coupon rate* - the interest rate, expressed as an annual percentage of face value, that the issuer promises to pay the bondholder until maturity. - *Market value* (corporate bonds only) - the price of the bond, which is determined by net asset value, yield, and the investor's expectation of future earnings.

What are *junk bonds*?

- *Junk bonds* (high-yield bonds) are bonds with ratings of BB or lower. - They are issued by companies with long track records of sales & earnings, or by those with questionable credit strength. - They are more volatile & pay higher yields than investment grade bonds.

What is *laddering*?

- *Laddering* means buying issues of varying maturities so that bonds will expire at different intervals, providing cash when you need it. - This is a good strategy for saving for a goal (e.g. downpayment on a house, retirement), for investment income, or if you aren't ready to commit to stocks.

What are *municipal bonds*?

- *Municipal bonds (munis)* are issued by cities, local govt., and state govt. to support activities such as building roads, bridges, & schools. - *They are usually exempt from state & federal income taxes*. - The starting price is usually $5,000, the maturation dates range from 30 days - 30 years, and the interest rate is lower than other types of bonds.

What is one of the main advantage of bonds? What is one of the disadvantages?

- *One the main advantages of bonds is that they serve as an attractive means to diversify a portfolio*. They provide a balance during rocky economic times.

What are *secured bonds*?

- *Secured bonds* are backed by the pledge of collateral (assets), a mortgage, or some other lien. They are often called "mortgage bonds". - Because of the increased security, you receive lower interest rates.

What are *subordinated debentures*?

- *Subordinated debentures* are unsecured bonds that give bondholders a claim secondary to that of their "designated bondholders". - Because of the increased risk, you receive higher interest rates.

What are *treasury bonds*?

- *Treasury bonds* are U.S. securities that mature in *10-30 years*. They are sold in minimum units of *$1,000*. - Interest rates are usually higher than T-bills or treasury notes (due to the longer maturation period). - They are also referred to as "long bonds".

What are *treasury notes*?

- *Treasury notes* are U.S. securities that mature in *1-10 years*. They range from *$1,000 to $1 million* or more. - Interest rates are slightly higher than T-bills.

What is the *yield*? What is the *current yield*?

- *Yield* is the rate of return earned by a bondholder who holds a bond for a stated period of time (a.k.a. how much you can expect to earn from a bond). - *Current yield* is the rate of return determined by dividing a bond's annual income amount by it's current market value. The higher the current yield, the better.

Describe the relationship between interest rates & bond prices.

- As interest rates *rise*, the price of existing bonds *decrease*; people are attracted to newly issued bonds with higher interest rates. - As interest rates *drop*, the market price of existing bonds *increase* because of their higher interest rates.

Discuss treasury bills, notes, and bonds. How secure are they? Where can they be purchased? Do you need to fill out an application?

- Because they are backed by the government, these instruments are considered to be very secure. - They can be purchased from the 12 Federal Reserve banks or their branches. You must fill out a *tender form* (application to purchase U.S. Treasury securities). - *No commission is charged on bonds if they are purchased directly from the government*, but they can be purchased at work, from banks, or from the Internet.

Where do investors purchase corporate bonds? How do you buy a stock in a bond exchange?

- Bonds are bought like stocks through primary markets (through banks, account executives, companies) or secondary markets (through bond exchanges). - *In a secondary market*: If you buy a stock through an account executive, you will pay a commission. When you place an order, the account executive sends it to a Wall Street broker-dealer. He buys a bond from one investor & sells it to you, profiting on the *spread* (the difference between buying & selling prices).

Compare stocks and bonds.

- Bonds are known for sustaining price swings in the overall economy, but they do not beat inflation as well as stocks do. - *Since 1925, stocks have beaten inflation by 7% points, while bonds have beaten inflation by 2% points*.

Discuss bonds as part of an investment strategy. What are the factors in a bond purchase?

- Bonds play an important role in an overall investment strategy (a plan to allocate assets among diverse investment choices, such as stocks, mutual funds, & real estate). - Factors in a bond purchase: ● General state of the economy ● Financial strengths & weakness of the bond source ● Investor's age (as one ages, they should decrease the percentage of stocks & increase the percentage of bonds).

What does it mean when a bond is *investment grade*? What does it mean when a bond is speculative?

- Bonds rated BBB (Baa) and above are *investment grade*, meaning that the risk of default is fairly low. - Bonds rated BB (Ba) or lower are considered speculative, meaning that their futures cannot be assured.

How do interest rates affect short-term and long-term bonds? Who may benefit from interest payments?

- Short-term bonds are usually less affected by changes in interest rate than long-term bonds. Also, long-term bonds are less predictable, because it's difficult to predict interest rate changes over long periods of time. - Individuals on fixed incomes, such as retirees, may use interest payments to supplement their retirement. Bonds are also useful to people with an income gap (e.g. teachers on a 9-month contract).

What is the *maturity date (redemption date)*? How long are short-term, intermediate term, and long-term bonds held?

- The *maturity date (redemption date)* is the date when the borrower must repay the maturity value of a bond. For the promised rate of return (yield), a person should not sell a bond before it reaches maturity. - Maturity dates can be short-term (1-5 years); intermediate term (5-10 years); or long-term (10-20 years).

What are *corporate bonds*?

-*Corporate bonds* are written pledges of a corporation to repay a specified sum of money along with interest. - A typical face value is $1,000, but corporate bonds can be $10,000+. - Corporations sell bonds to support ongoing business activities, expansion, & as a tax-reduction measure.

What are the 3 methods to receive interest income?

1. *Registered bond* - The bond is recorded in the name of the holder, & only be transferred to another owner when endorsed by the registered owner. 2. *Coupon bond* - The bond is issued with detachable coupons that must be presented for interest payments. Whoever presents the coupon is entitled to interest. 3. *Zero-coupon bond* - These bonds are sold at a deep discount of their face value. They are more volatile than other bonds, but they are popular because they are tax-sheltered. *Zero-coupon bondholders don't collect interest*; instead, the bond reaches its full value when it matures.

What are the 5 types of corporate bonds?

1. Debentures 2. Secured bonds 3. Subordinated debentures 4. Convertible bonds 5. Callable bonds

Why do investors purchase corporate bonds (3 reasons)?

1. To provide interest income. 2. To provide capital gains. 3. For the bond repayment at maturity.

What are the 3 types of government bonds?

1. U.S. treasury bills, notes, & bonds 2. Agency bonds 3. Municipal bonds

What are the tax consequences of corporate bonds?

Capital gains & interest from corporate bonds are taxable by state & federal governments.

What are the two types of brokerage firms that sell corporate bonds?

Corporate bonds are sold through: - Full-service brokerage firms (You get advice & information about the bond.) - Discount brokers on the Internet (You are on your own.)

When the stock market is slow, _______.

The bond market grows. For example, the people who had bonds in 2009 were at an advantage.

What 3 things does the issuer of the bond promise the bondholder?

The issuer of the bond promises the bondholder (1) *a fixed rate of return* (the coupon rate), (2) *over a specified period of time* or at specified intervals, and (3) *repayment of the face or par value* at maturity.