11-1

McGraw-Hill/Irwin Copyright © 2006 The McGraw-Hill Companies, Inc. All rights reserved.

11 Investment Basics and Evaluating Bonds

11-3 Investing Basics

1. Explain why you should establish an investment program

2. Describe how safety, risk, income, growth, and liquidity affect your investment program

3. Identify the factors that reduce investment risk

4. Recognize why investors purchase bonds and other conservative investments.

5. Evaluate bonds when making an investment

Chapter Objectives

11-4Objective 1: Explain why you should establish an investment programEstablishing Investment Goals

Financial goals should be specific and measurable. They should be tailored to your financial needs and what you want to accomplish. To develop your goals ask yourself..

What will you use the money for? How much money do you need for your goals? How will you obtain the money? How long will it take you to obtain the money? How much risk are you willing to assume in an

investment program?

11-5 Establishing Investment Goals

What possible economic or personal conditions could alter your investment goals?

Considering your economic circumstances, are your investment goals reasonable?

Are you willing to make the sacrifices necessary to ensure that you meet your investment goals?

What will the consequences be if you don’t reach your investment goals?

(continued)

11-6 Performing a Financial Checkup

Work to balance your budget.– Do you regularly spend more than you make?

Pay off high interest credit card debt first. Obtain adequate insurance protection. Start an emergency fund you can access quickly.

– Three to nine months of living expenses. Have access to other sources of cash for emergencies.

– Line of credit is a short-term loan approved before the money is needed.

– Cash advance on your credit card.

11-7 Getting the Money Needed to Start an Investing Program

Pay yourself first. Take advantage of employer-

sponsored retirement programs. Participate in elective savings programs. Make a special savings effort one or two

months each year. Take advantage of gifts, inheritances, and

windfalls.

11-8 The Value of Long-Term Investing Programs

Many people don’t start investing because they only have a small amount to invest, buteven small amounts invested regularly grow over a long period of time.

If you begin savings $2,000 each year (depending on the rate of return, you could have over $1 million by the time you are age 65—See Exhibit 11-1.

The higher the rate of return the greater the risk.

11-9Objective 2: Describe how safety, risk, income, growth, and liquidity affect your investment decisions

Factors Affecting the Choice of Investments Safety and risk.

– Safety in any investment means minimal risk of loss.

– Risk means a measure of uncertainty about the outcome.

– Investments range from very safe to very risky.– The potential return on any investment should be

directly related to the risk the investor assumes. – Speculative investments are high risk, made by

those seeking a large profit in a short time.

11-10 Components of the Risk Factor

Inflation risk - during periods of high inflation your investment return may not keep pace with the inflation rate.

Interest rate risk – the value of bonds or preferred stock may increase or decrease because of changes in interest rates in the economy.

Business failure risk - affects stocks and corporate bonds.

Market risk - prices fluctuate because of behaviors of investors.

11-11 Investment Growth and Liquidity Income - An investment will provide a predictable source of

income. Growth - means investment will increase in value.

– Common stock usually offers the greatest potential for growth.

– Mutual funds, government and corporate bonds, and real estate offer growth potential.

Liquidity– Ability to buy or sell an investment quickly without

substantially affecting the investment’s value.

11-12Objective 3: Identify the factors that can reduce investment risk.

Asset allocation is the process of spreading your assets among several different types of investments. Other factors to consider include:– The time factor– Your age– Your role in the investment process

11-13 Government Bonds and Debt Securities

Sold to obtain money to finance the national debt, and the ongoing costs of government.

Three levels of government issue bonds:– Federal.– State.– Local municipalities.

11-14 U.S. Government Treasury Bills and Notes

Treasury Bills (T-Bills).

$1,000 minimum. 4, 13, or 26 weeks to maturity. Sold at a discount. Federal but no state tax on interest earned.

Treasury Notes.

$1,000 units. Typical maturities are 2, 3, 5, and 10 years. Interest paid every six months, at a higher rate than T-bills. Federal but no state tax on interest earned.

11-15 Federal Agency Debt Issues FHA - Federal Housing Administration Fannie Mae - Federal National Mortgage Association. Ginnie Mae - Government National Mortgage

Association. Freddie Mac - Federal Home Loan Mortgage

Corporation. Essentially risk free, and earn slightly higher interest

than government securities issued by the treasury department.

Maturities range from 15 – 30 years. Average maturity is 15 years.

11-16 State and Local Government Securities

Municipal bonds - sometimes called munis. Issued by a state or local government, including cities,

counties, school districts, and special taxing districts. Use funds for ongoing costs and to build major projects

such as schools, airports, and bridges. General obligation bonds are backed by the state or

local government that issues them. Revenue bonds are repaid from money generated by

the project the funds finance, such as a toll bridge.

11-17 Taxable Equivalent Yield

Tax-exempt yield___________________

1.0 - Your tax rate

Example: 0.06

Taxable equivalent yield = __________

1.0 - 0.28

= 0.083 = 8.3%

11-18 Characteristics of Corporate Bonds

Corporation’s written pledge to repay a specified amount of money with interest.

The face value is the dollar amount that the bondholder will receive at the bond’s maturity date.

Bondholders receive interest payments every six months at the stated interest rate.

The legal conditions are described in a bond indenture.

A trustee is a financially independent firm that acts as the bondholder’s representative.

11-19 Why Corporations Sell Bonds

To get funds for major purchases. To fund ongoing business activities. When it is difficult or impossible to sell stock. To improve financial leverage. Interest paid to bondholders is a tax deductible

business expense that can be used to reduce the federal and state taxes corporations must pay.

11-20 Types of Corporate Bonds

Debenture bond.– Most corporate bonds

are debenture bonds.– Unsecured - Backed only by

the reputation of the issuing company.Mortgage bond.

– A corporate bond that is secured by various assets of the issuing firm, usually real estate.

– Interest rate is lower because it is secured.

11-21 Types of Corporate Bonds

Convertible bond.– A special kind of corporate bond that can be

exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock.

– Generally, the interest rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds.

– Convertible bonds, like all potential investments, must be carefully evaluated.

(continued)

11-22 Provisions For Repayment

Call Feature of a Bond Corporation can call in or buy back outstanding bonds

from current bondholders before the maturity date. Most corporate bonds are callable. Most agree not to call bonds for the first 5 to 10 years

after they are issued. They call bonds if the interest rate they are paying is

much higher than the going rate.

11-23 Provisions For Repayment

Sinking fund.– Corporations deposit money in this fund annually or

semiannually and use the money to pay off the bondholders when the bond issue comes due.

Serial bonds.– Bonds of a single issue that

mature on different dates.

(continued)

Bond

11-24Objective 4: Explain Why Investors Buy Corporate Bonds

For interest income.– Investors know the interest rate. – Interest will be paid to investors twice a year, with the

payment based on the interest rate and the face value of the bond.

Dollar appreciation of bond value.– May be able to sell the bond to someone else at a

higher price if the interest rate on the bond is higher than the current interest rate.

Bond face amount will be repaid at maturity.

11-25 Objective 5: Evaluate bonds when making an investment decision

The Decision to Buy or Sell a Bond–There are a number of sources of information that

can be used to evaluate bond investments.–The internet–Use it for price information, trade bonds online and

lastly do research on the issuing corporation and its bond issues

Read the bond quotes in the newspaper. How is the bond rated?

–Rating range from AAA to D.–BB or below is called a junk (speculative) bond.–Rated by Standard and Poors and Moodys, with

information on their websites.

11-26 The Decision to Buy or Sell a Bond

Bond Yield Calculations– Current Yield = annual income amount divided by

current market value Other Sources of Information

– Business Periodicals– Government Sources