BONDS

Savings and

Investing

Characteristics of Bonds• Bonds are debt instruments offered by

the federal, state or local government and corporations

• Bonds are loans that are repaid at maturity

• Most bonds mature in 10 years• Face value is the amount the

bondholder will be repaid at maturity– AKA par value because that is the value

printed on the certificate

Difference Between Stocks and Bonds

• The bond purchaser is loaning the company or government money

• If the bond issuer goes bankrupt, the bond holder is a creditor and will be repaid during liquidation

• A stock holder has no claim on the company assets and can lose their entire investment

Corporate Bonds

• Sold by corporations on the open market, like stocks

• Fixed income instruments – pay a specified amount of interest at regular intervals– Usually twice per year

• Contract rate = interest rate (APR)• Usually have a face value of at least $1,000– $5,000 is a common denomination

Corporate Bonds (cont’d)• Coupon bonds (bearer bonds) require owner to

clip the interest coupon and present it to a bank for payment.

• Registered bond – interest payments are mailed semiannually to registered owner

• Callable bond – issuer has the right to pay off (call back) prior to maturity date– Corporations can take advantage of drop in interest

rates– Corporation usually pays a small premium when a bond

is called

Types of Corporate Bonds

• Debenture – backed only by the general credit standing of the corporation

• Mortgage bond (secured bond) – specific assets serve as collateral to assure repayment of the debt

• Convertible bond – can be exchanged for a specific number of shares of common stock at a specific price (or higher)

Earnings on Corporate Bonds

• Since APR is fixed and there is no compounding return on bonds (yield) should equal APR

• Market price of bonds fluctuate, which effects yield– If price is higher than purchase price, the bond is

selling at a premium– If price is lower than purchase price, the bond is selling

at a discount

Yield

Yield = Annual interest dollar amount/Market Price

• Yield < APR when bond is at a premium• Yield > APR when bond is at a discount

Price of a 6% $10,000 bond

Yield Calculation Yield

Face value $600/$10,000 6%

Premium (104) $600/$10,400 5.8%

Discount (96) $600/$9,600 6.3%

Municipal Bonds• Munis have a minimum investment of $5,000• Revenue bond is issued to raise money for a

specific public works project (airports, hospitals)– Revenue from the project is used to pay the interest

and repay the principal

• General obligation bond – backed by the power of the issuer to levy taxes

• Munis carry a lower interest rate than corporate bonds, but are exempt from federal and some state taxes

Other Types of Bonds

• Savings bonds and Treasury Bonds– Low yield, tax free investment– Considered risk free

• Agency bonds – debt securities issued by other Federal agencies– Slightly higher yield than treasury securities

• Zero coupon bonds – sold at a deep discount, no interest payments, redeemable for face value at maturity (can be Corporate or Municipal)

Buying and Selling Bonds

• Full service and discount brokers• Savings bonds and Treasury securities can be

purchased through the Federal Reserve System or online through Treasury Direct– Can purchase at a bank, but will pay a commission– Payroll deduction option, but it is slow

Evaluating Bonds

• Considered a safe investment– Fixed payment, debt obligation

• Earn return on bonds by earning interest, redeeming at face value, and through appreciation

• Bond prices are impacted by interest rates– As interest rate rise, the value of bonds decrease– Bond prices are listed in financial tables of

newspapers and online

Bond Ratings• Rating agencies include Moody’s and Standard

& Poor’s– Ratings reflect the relative risk level of the bond– Highest rating is AAA or Triple A – Lowest rating is D, which indicates default

• Investment-grade bonds have a minimun rating of Baa in Moody’s or BBB in S&P

• Junk bonds are highly risky– Ba/BB or lower