Personal Finance Chapter 15
STUFF ABOUT SOVEREIGN BOND CRISIS of 2011
United States of America - S&P downgrade in August 2011 Greece - Receiving loans from EU based on their ability to pass austerity measures Italy - In better shape than Greece, but current cost of borrowing not sustainable Spain, Portugal, Ireland, Cyprus, Belgium ...
Treasury Bonds
Units of $100 like T-Bills - 20-30 year maturity - Interest rates are generally higher than those of T-Bills and T-Notes - Interest paid every 6 months - Held until maturity or sold before maturity
What companies provide bond ratings
Moody's Investor Service Inc., Standard & Poor's Corporation, and Fitch Ratings
Current yield on corporate bond = Annual income amount/ Current market value
$55 / $1105 = 4.977%
Mortgage bond
- A corporate bond that is secured by various assets, usually real estate - Interest rate lower because it's secured by the collateral and corporate assets.
What are the 3 levels of government bonds?
- Federal: No state or local income tax on interest - State: Usually only fed tax - Local Municipalities: No tax at any level
Why investors purchase corp bonds: Interest income
- Investors receive interest every 6 months - The annual interest is computed by multiplying the interest rate by the face value of the bond
General obligation bonds
Bonds backed by the state or local government that issues them
What is Serial Bonds?
Bonds of a single issue that mature on different dates
Fannie Mae - Federal National Mortgage Association Ginnie Mae - pay interest once a month. Government National Mortgage Association Freddie Mac - Federal Home Loan Mortgage Corporation
Fannie Mae - Federal National Mortgage Association Ginnie Mae - pay interest once a month. Government National Mortgage Association Freddie Mac - Federal Home Loan Mortgage Corporation
What are the characteristics of corporate bonds?
- It is a corporation's written pledge to repay a certain amount of money, with interest - The face value (which is usually $1000) is the dollar amount that the bondholder will receive at the bond's maturity date. - Bondholders receive interest payments every 6 months at the stated interest rate (coupon rate) - The legal conditions described within the BOND INDENTURE
Debenture bond
- Most corporate bonds are debenture bonds. - Unsecured - backed only by the reputation of the issuing company.
How can the internet be used to evaluate a bond?
- Obtain the price info - Trade bonds online for a lower commission - Research information on the corp or government bond issues online
Features of a municipal bond
- People like to invest in projects close to home - They like insured municipal bonds, or states that guarantee payment - May be callable, but usually not until after the first 5 to 10 years - Interest earned may be exempt from federal income tax, so yield is higher
Federal Agency Debt Issues
- Slightly higher risk than Treasury securities, so slightly higher interest rates paid - Issued for 1-30 years with 12 year average duration - Minimum denominations may be as high as $10k-25k - Agency debt is callable before maturity
Call Feature
- This is when a corp can call in or buy back bonds from current bondholders before maturity date - Most agree to not call bonds for the first 5 to 10 years after issued - Bonds typically called if the interest rate is higher than the market rate - Most corporate bonds are callable - Pay a higher coupon rate to investor for "call" risk
How to obtain annual reports
- Write or call the corporation to receive the annual report - Corporations maintain a website that provides access to annual reports
What do bond ratings range from?
AAA to D
What is Sinking Fund?
Corporations deposit money into this fund annually or semiannually and use the money to pay off bondholders when the bond issue is due
What are bond ratings?
They are ratings that provide quality and risk information associated with bond issues
Treasury Bills (T-Bills)
- $100 minimum @ $100 increments - 4, 13,26, or 52 weeks to mature - Sold at a discount
Treasury Notes (T-Notes)
- $100 units like T-Bills - 2, 3, 5, 7 and 10 year terms - Interest paid every 6 months
Subordinated debenture bond
- An unsecured bond that gives bondholders a claim secondary to that of mortgage or debenture bond holders. - This is more risky for the investor so the coupon rate is higher.
High yield bond
- Bond that pays at a higher rate of interest but has a higher risk of default - "Junk bonds"
What are the mechanics of a bond transaction?
- Bonds can be held until maturity or sold in secondary market - Most bonds sold through full-service brokerage firms, discount brokerage firms or the internet - Generally a minimum commission of $5-35 on a $1,000 bond - Interest and capital gains from selling bonds are both taxable
Why investors purchase corp bonds: Dollar Appreciation of Bond Value
- Can sell the bond to someone else at higher price if interest rate on bond is higher than the comparable market rate - Approx Market Value = $annual interest/ comparable interest rate
Why do corporations issue bonds?
- To get funds for major purchases. - To finance ongoing business activities. - When it is difficult or impossible to sell stock. - To improve financial leverage, which increases ROI. - Interest paid to bondholders is a tax-deductible business expense that can be used to reduce the federal and state taxes corporations must pay. - Bonds must be repaid and interest is mandatory. - Superior claim to corporate assets over stockholders.
TIPS (Treasury Inflation-Protected Securities)
- Units of $100 like T-Bills - Sold in 5, 10, and 30 year terms - Value based upon CPI - When CPI rises, principal adjusts upward - Interest paid every 6 months and will vary - Held until maturity or sold before maturity
Why investors purchase corp bonds: Bond Face Amount Repaid at Maturity
- You can keep bond until maturity or sell it at any time to another investor - Bond ladders (just like CD ladders) balance risk and return through maturity diversification
Municipal bonds
- issued by a state or local government, such as cities, counties, school districts - Use funds for ongoing costs and to build major projects such as schools, airports, and bridges
What are the three reasons investors purchase corporate bonds?
1. Interest Income 2. Dollar Appreciation of Bond Value 3. Bond Face Amount Repaid at Maturity
Tax-Exempt Yield = Tax Equivalent Yield x (1.0 - Your MTR)
8.3% x (1.0- .28) = 6% AKA the after-tax yield
Revenue bonds
Bonds repaid from money generated by the project the funds finance, such as a toll bridge
Taxable equivalent yield = Tax-exempt yield/ (1.0 - Your MTR) MTR = Municipal tax rate
EX: .06 / (1.0 - .28) = .083 = 8.3% - You are indifferent between an 8.3% taxable bond and a 6% tax-free bond
Why are government bonds sold?
They are sold to obtain money in order to finance the national debt and ongoing costs of government.
Registered bonds
This is a bond registered in the owner's name
Registered Coupon bonds
This is a coupon bond where the registered owner collects principal, while anyone with coupon can collect interest.
What is a trustee?
This is a financially independent firm that acts as the bondholder's representative.
Convertible bond
This is a special kind of corporate bond that can be exchanged for shares or common stock - has lower interest rate coupon - Attracts more investors, yet most don't convert - If converted, corp doesn't have to repay bond at maturity
Zero-coupon bonds
This is sold at a deep discount, makes zero coupon payments and is redeemed for its face value at maturity
What is yield?
This is the rate of return earned by an investor who holds a bond for a stated period
Bearer bonds
This is when the person in physical possession collects
Treasury bills, notes and bonds are considered risk-free investments
Treasury bills, notes and bonds are considered risk-free investments
Yield-To-Maturity = ($coupon + (FV-MV) / Remaining Period)/ (MV + FV) / 2
YTM = [$55 + ($1000 -$1105) / 6.167] / [($1105 + $1000) /2] = YTM = [55 - 17.0261] / 1052.50 = YTM = 3.608%
