Chapter 13: Investing in Bonds and Other Alternatives

The safest bonds receive ___. ___ is extremely risky

AAA = safe D = risky

In addition to the Treasury, a number of other government agencies, such as the Federal National Mortgage Association (FNMA) and the Federal Home Loan Banks (FHLB), issue debt called ____. Although these aren't issued directly through the Treasury, they are issued by federal agencies and are authorized by Congress. They're still viewed as being virtually risk free and carry an interest rate slightly higher than that carried on Treasury securities. In general, their minimum denomination is $10,000, with maturities

Agency Bonds

When interest rates go down, bond prices go up, but the upward price movement on bonds with a call provision is limited by the___.

Call price

___ are also viewed as being more risky than secured bonds and, as a result, have a higher yield associated with them.

Debentures

(T/F) The investor participates in the capital gains that common stockholders receive

False. The investor doesn't participate in the capital gains that common stockholders receive

(T/F) The investor has safety of bond interest payments because preferred stock dividends can be passed without the risk of bankruptcy

False: The investor doesn't have the safety of bond interest payments because preferred stock dividends can be passed without the risk of bankruptcy

Bonds can be safe if ___.

Held to maturity

A change in general interest rates, the required rate of return should ___.

Increase

The ___ is the present value of the interest payments (an annuity) plus the present value of the repayment of the bond's par value at maturity (single cash flow)

The value of a bond

There's an ___ relationship between interest rates and bond values in the secondary market: When interest rates ___, bond values ___, and when interest rates ___, bond values ___.

There's an INVERSE relationship between interest rates and bond values in the secondary market: When interest rates RISE, bond values DROP, and when interest rates DROP, bond values RISE.

The coupon rate stays the same but the par value is adjusted for inflation periodically

Treasury Inflation-Protected Security (TIPS)

These bonds have a maturity of 5, 10, or 20 years and a minimum par value of $1,000. When there are changes in the Consumer Price Index (the government's measure of the effect of inflation on prices), there's a corresponding change in the par value of the bond.

Treasury Inflation-Protected Security (TIPS)

Risk-free, not callable, lower interest rate, most interest payments are exempt from state and local taxes. This describe what types of bonds?

Treasury and Agency Bonds

(T/F) Bond Payments are guaranteed

True

bonds ___ a very liquid investment.

are NOT

Without question, a bond will sell for its ___.

"Par or maturity value at maturity." We know this because at maturity the bondholder receives the par value from the issuer, and the bond is terminated. As a result, as the bond approaches maturity, the market price of the bond approaches its par value

For bonds issued by corporations, the par value is generally ___.

$1,000

If, for example, you're considering a bond with an 8 percent coupon interest rate, a par value of $1,000, and a market price of $700, it would have a current yield of...

11.4% (pg 443)

Moreover, most junk bonds are___.

Callable. That means that if the firm does do well and recovers from its difficulties, then the bond will be called. If the firm doesn't do well, it could default. Neither alternative is a good one. Prudent investors generally avoid junk bonds. Hey, they're not called junk for nothing!

__ get paid before ___

Debt holders get paid before stock holders

Preferred stock is similar to bonds in that

Dividends are fixed, paid before common, and no voting rights (voting rights in special cases)

When interest rates rise, bond values ___

Drop

The valuation of bonds has its roots in Principles ___ and ___.

Principle 3: The Time Value of Money allows us to bring the investment returns back to the present, while Principle 8: Risk and Return Go Hand in Hand tells us what discount rate to use in bringing those returns back to the present.

(T/F) Most interest payments received on federal debt are exempt from state and local taxation.1

True

(T/F) Real estate investment requires time, energy, and sophistication that the majority of us just don't have.

True

(T/F) The investor doesn't have the safety of bond interest payments because preferred stock dividends can be passed without the risk of bankruptcy

True

(T/F) The investor doesn't participate in the capital gains that common stockholders receive

True

(T/F) With bonds, interest payments and repayment of principal is guaranteed.

True

(T/F) Longer-term bonds fluctuate in price more than shorter-term bonds.

True. Remember from Chapter 3 that the further in the future a cash flow is, the more its present value will fluctuate as a result of a change in the interest or discount rate. Thus, when interest rates change, longer-term bonds fluctuate in price more than shorter-term bonds.

(T/F) Municipal bonds, or "munis," are tax exempt—interest payments aren't taxed by the federal government or, in general, by the state as long as you live in the state in which the bonds were issued.

True.. as long as you live in the state in which the bonds were issued.

If the Treasury debt has a maturity of 3, 6, or 12 months, it's referred to as a Treasury___.

bill

Any time the bond rating drops...

bond values drop like a stone.

Treasury___ are issued with maturities of 30 years.

bonds

If you expect interest rates to go down (bond prices to rise), purchase __

bonds with long maturities

A ___ entitles the bond issuer to repurchase, or "call," the bonds from their holders at a stated price prior to maturity.

call provision

Most corporate bonds are___.

callable

Some preferred stock is also___ preferred stock, which means that its holder can, at any time, exchange it for a predetermined number of shares of common stock.

convertible

___ account for about half of the bonds outstanding. Generally, these bonds are issued in denominations of $1,000 in order to appeal to smaller investors. There are several different types, with the one major difference being whether or not the bond is secured.

corporate bonds

The ___ on a bond indicates what percentage of the par value of the bond will be paid out annually in the form of interest.

coupon interest rate

Most preferred stock carries a ___, which requires that all past unpaid preferred stock dividends be paid before any common stock dividends are declared. This feature provides the preferred stock investor with some degree of protection because otherwise there would be no reason why preferred stock dividends wouldn't be omitted or passed when common stock dividends are passed.

cumulative feature

The ____ on a bond refers to the ratio of the annual interest payment to the bond's market price.

current yield

annual interest payments / MKT price of bond = ?

current yield

If interest rates rise, bond prices will___.

fall

A___ bond is secured by a lien on real property. Typically, the value of the real property is greater than that of the bonds issued, providing the investor with a margin of safety in case the market value of the secured property declines.

mortgage

As a bond approaches maturity, the market value approaches its ___

par value

The ___ of a bond is its face value, or the amount returned to the bondholder at maturity, the date when the bond comes due.

par value

A____ bond is one that's backed by collateral, which, as you remember, is a real asset that can be seized and sold if a debtor doesn't pay off his or her debt.

secured

Municipal bonds also come with many different maturities. In fact, most municipal bond offerings have ___. That is, a portion of the debt comes due, or matures, each year until the issue is exhausted. In effect, it works like a sinking fund. It's important that you choose the maturity date you want so you get the principal back when you need and expect it. (i.e. various maturity dates)

serial maturities

When a bond issuer retires parts of bond issue at certain predetermined time intervals

sinking fund

Bonds produce ___ income

steady

The ___ is the true yield or return you receive if you hold a bond to maturity. Basically, it's the measure of expected return. In effect, it is the same as solving for the annual interest rate, i, as we did in Chapter 3, where we discussed the time value of money.

yield to maturity

This measure of return considers the annual interest payments you receive, as well as the difference between the bond's current market price and its value at maturity - "measure of expected return"

yield to maturity

Bonds that don't pay interest are called___. These bonds are sold at a deep discount from their face or par value, and at maturity, they return the entire par value.

zero coupon bonds

The major disadvantage of ____ bonds is that while you don't receive any income annually, you're taxed as though you do. The IRS considers any annual appreciation in value (or as the IRS calls it, the undistributed interest) as subject to tax.

zero coupon bonds

A bond with an 8 percent coupon interest rate and a $1,000 par value will pay out ___ annually in interest until maturity, generally in semiannual installments, or $40 every 6 months.

$80 (8% * $1,000) - Interest (annually)

if the municipal bond yields 7 percent and you are in the 38 percent marginal tax bracket, the equivalent taxable yield on a municipal bond would be

0.1129, or 11.29% (pg 446)

Treasury-issued debt has maturities that range from ___.

3 months to 30 years

(T/F) Returns from bonds are higher than on stocks.

FALSE! Stocks yield higher returns

When interest rates rise, the value of outstanding bonds ___.

Falls

An____ is the legal document that provides the specific terms of the loan agreement, including a description of the bond, the rights of the bondholders, the rights of the issuing firm, and the responsibilities of the bond trustees.

Indenture

___ first began to rate bonds in 1909.

John Moody

___ are low-rated bonds, also called high-yield bonds, which are bonds rated BB or below.

Junk bonds

These ratings involve a judgment about the future risk potential of a bond—specifically, its default risk, or the chance that the issuer may not be able to meet its obligation to pay interest or repay the principal sometime in the future.

Moody's and Standard & Poor's

___ are bonds issued by states, counties, and cities, in addition to other public agencies such as school districts and highway authorities, to fund public projects.

Municipal bonds, or "munis,"

Preferred stock is similar to common stock in that

No fixed maturity date, not paying dividends won't bring bankruptcy

Real + Inflation = ?

Nominal Rate

___ has no fixed maturity date and not paying its dividends won't bring on bankruptcy. Its dividends are of a fixed size and are paid before common stock dividends are paid. And a share doesn't carry voting rights.

Preferred stock

___ is often referred to as a hybrid security because it has many of the characteristics of both common stock and bonds. From the investor's point of view, it is probably closer to bonds.

Preferred stock

Nominal - Inflation = ?

Real Rate

___bonds derive the funds to pay interest and repay the bonds from a designated project or specific tax, can pay only if a sufficient amount of revenue is generated, and are exempt from state and local taxes but not federal taxes.

Revenue Bonds

If the issuer become riskier, the required rate of return should ___.

Rise

When interest rates drop, bond values ___

Rise

The government's zero coupon bonds are called ___

STRIPS

The trade-off associated with convertible preferred stock is that...

The convertibility feature may allow the preferred stockholder to participate in the company's capital gains, but the preferred stock has a lower dividend associated with it than regular preferred stock.

The current market rate on the bond

Yield to maturity

As interest rates rise, investors demand ___ on bonds.

a higher return

With ___ preferred stock, the amount of the quarterly dividend fluctuates with interest rates under a formula that ties the dividend payment to a market interest rate. (like T-bill rate)

adjustable-rate

The term___ applies to any unsecured long-term bond. When bonds are unsecured, the earning ability of the issuing corporation is of great concern to the investor.

debenture

A provision stating the bond can't be called until a set number of years have passed.

deferred call

If the issuer experiences financial problems, bond values___

drop

If a bond has a fixed coupon interest rate, the only way the bond can increase its return to investors is to...

drop in value and sell for less.

If interest rates rise, the value of the preferred stock___.

drops

In comparing municipal bonds to taxable bonds, the comparison must be between their ___

equivalent taxable yields

A bond is a loan; when you buy a bond, you become a lender. The bond issuer—generally a corporation, the federal government and its agencies, a city, or a state—gets the use of your money and in return pays you interest, generally every 6 months, for the life of the bond. At maturity, the issuer pays you the ___, which may be more or less than what you originally paid for it.

face value of the bond

The longer the maturity, the more the bond will ___

fluctuate

A ___ is backed by the full faith and credit—that is, the taxing power

general obligation bond (G.O. Bonds)

Today, the term ___ refers to any bond with a low rating.

junk bond

The length of time until the bond reaches par value and the principal is repaid.

maturity

If, when issued, it has a maturity of 2, 3, 5, or 10 years, it's referred to as a Treasury___.

note

When reading corporate bond quotes: Selling price is quoted as ___

percentage of par

If an issuer can't make interest or principal payments, the bond will___ in value

plummet (drop)

The___ the bond rating, the higher the rate of return demanded by investors.

poorer

If interest rates go down, the issuer may call the bonds and ____.

replace them with lower-cost debt

If interest rates drop, bond prices will___.

rise

In theory, when interest rates drop, the value of a bond should ___

rise

If interest rates drop, the value of the preferred stock___.

rises

The appeal of municipal bonds is their ___.

tax-exempt status

The problem with junk bonds is...

that they haven't been around long enough for us to really know what will happen in a major recession.

The value of a share of preferred stock is...

the present value of the perpetual stream of constant dividends.

In general, the value of a bond should be approximately...

the same as its price because that's what you and other investors would be willing to pay for the bond.

If you expect interest rates to go up (bond prices to fall), purchase ____

very short term bonds

If interest rates drop, that inverse relationship between interest rates and bond prices will...

work in your favor. In that case, you'll want a long-term, noncallable bond.