Bonds and Mutual FundsBonds and Mutual Funds

Chapter 10Chapter 10

Corporate and Government BondsCorporate and Government Bonds

Section 10.1Section 10.1•Describe the characteristics of corporate Describe the characteristics of corporate bondsbonds•Identify the reasons corporations sell bondsIdentify the reasons corporations sell bonds•Explain why investors buy corporate bondsExplain why investors buy corporate bonds•Discuss the reasons governments issue Discuss the reasons governments issue bondsbonds•Identify the types of government bondsIdentify the types of government bonds

What is Corporate Bond?What is Corporate Bond?

When purchased, basically loaning money to When purchased, basically loaning money to corporation corporation

Maturity date – date when paid is repaid, 1 to 30 Maturity date – date when paid is repaid, 1 to 30 years normallyyears normally Less than 5 short term, 5 to 15 intermediate, more Less than 5 short term, 5 to 15 intermediate, more

than 15 long-termthan 15 long-term Face value - $ amount bondholder will receive at Face value - $ amount bondholder will receive at

maturitymaturity Typically $1,000, as high as $50,000Typically $1,000, as high as $50,000 Get paid interest semiannually until maturityGet paid interest semiannually until maturity

Types of Corporate BondsTypes of Corporate Bonds

DebenturesDebenturesMortgage bondsMortgage bondsSubordinate debenturesSubordinate debenturesConvertible bondsConvertible bonds

DebenturesDebentures

Most corporate bonds are this kindMost corporate bonds are this kindBacked by reputation of company, not Backed by reputation of company, not

assetsassets Investors buy on belief that company is on Investors buy on belief that company is on

solid financial groundsolid financial ground Investors expect full repayment and Investors expect full repayment and

regular interest paymentsregular interest payments

Mortgage BondsMortgage Bonds

Often referred to as a “secure bond”Often referred to as a “secure bond”Backed by company assets like real estate Backed by company assets like real estate

or equipment or equipment Equipment and assets can be sold to Equipment and assets can be sold to

repay bond if neededrepay bond if neededSafer than debenture, but pays less Safer than debenture, but pays less

interest because risk is lowerinterest because risk is lower

Subordinated DebenturesSubordinated Debentures

Unsecured bond, only paid after all other Unsecured bond, only paid after all other bonds paidbonds paid

Considered more risky, but higher interest Considered more risky, but higher interest paymentspayments

Convertible BondsConvertible Bonds

Can be traded for shares of common stockCan be traded for shares of common stock1 to 2% lower than rates on other bonds1 to 2% lower than rates on other bondsAs the company’s stock value increases, As the company’s stock value increases,

so does the convertible bonds valueso does the convertible bonds value Investors choose not to convert to stock Investors choose not to convert to stock

because bonds are safer than stock and because bonds are safer than stock and pay interest incomepay interest income

Repaying BondsRepaying Bonds

Most bonds are callable, meaning Most bonds are callable, meaning corporations can buy back bonds before corporations can buy back bonds before maturity which would save company maturity which would save company having to pay interest incomehaving to pay interest income

Get money to call bonds byGet money to call bonds bySelling stockSelling stockUsing profitsUsing profitsSelling new bonds at lower interest rateSelling new bonds at lower interest rate

Methods to Repay BondsMethods to Repay Bonds

Premiums – paid if bonds called back Premiums – paid if bonds called back early, additional amount above face valueearly, additional amount above face value

Sinking Funds – corporation makes Sinking Funds – corporation makes deposits to fund to pay back bond issuedeposits to fund to pay back bond issue

Serial Bonds – issued at same time, but Serial Bonds – issued at same time, but mature on different dates so company mature on different dates so company buys back a chunk of bonds at a timebuys back a chunk of bonds at a time

Why Corporations Sell BondsWhy Corporations Sell Bonds

When it is hard to sell stockWhen it is hard to sell stockFinance business activitiesFinance business activitiesCan reduce tax liabilities (bond interest is Can reduce tax liabilities (bond interest is

tax deductible)tax deductible)

Responsibility to BondholdersResponsibility to Bondholders

Bondholders must be repaid, stockholders Bondholders must be repaid, stockholders do notdo not

Interest must be paid on bonds, can Interest must be paid on bonds, can choose to pay on stockschoose to pay on stocks

In cases of bankruptcy, bondholders In cases of bankruptcy, bondholders claims paid firstclaims paid first

Why Invest in Bonds?Why Invest in Bonds?

Stocks result in greater profits than bonds, Stocks result in greater profits than bonds, so why invest in them?so why invest in them?Safer than stockSafer than stockProvide interest incomeProvide interest incomeMay increase in valueMay increase in valueFace value repaid at maturityFace value repaid at maturity

Interest IncomeInterest Income

Registered Bonds – only owner can collect Registered Bonds – only owner can collect interestinterest

Coupon Bonds – has detachable coupons that Coupon Bonds – has detachable coupons that any holder can collect interest, only owner can any holder can collect interest, only owner can collect face valuecollect face value

Bearer Bonds – no name, so whoever has Bearer Bonds – no name, so whoever has physical possession of bonds can collect (no physical possession of bonds can collect (no longer issued)longer issued)

Zero-Coupon Bonds – no interest payments Zero-Coupon Bonds – no interest payments made, but sold below face valuemade, but sold below face value

Market Value of BondMarket Value of Bond Overall economy interest rates affect market Overall economy interest rates affect market

valuevalue Bond sold at 7.5%, then interest rates fall, the bond is Bond sold at 7.5%, then interest rates fall, the bond is

worth more money on marketworth more money on market Bond sold at 7.5%, then interest rates rise, the bond Bond sold at 7.5%, then interest rates rise, the bond

is worth less money on marketis worth less money on market Financial conditions, as well as supply and Financial conditions, as well as supply and

demand, may affect market valuedemand, may affect market value Selling at discount – selling for less than face Selling at discount – selling for less than face

valuevalue Selling at premium – selling more than face Selling at premium – selling more than face

valuevalue

Maturity RepaymentMaturity Repayment

Two choices after bond purchaseTwo choices after bond purchaseKeep it to maturityKeep it to maturitySell it at anytimeSell it at anytime

Value of bond tied to corporation’s ability Value of bond tied to corporation’s ability to repay itto repay it

Where Can You Purchase?Where Can You Purchase?

Full-service brokerageFull-service brokerageDiscount brokerageDiscount brokerageOnlineOnlinePrimary market – directly from companyPrimary market – directly from companySecondary market – NYBE, ABESecondary market – NYBE, ABE

Government Bonds and SecuritiesGovernment Bonds and Securities

Treasury BillsTreasury BillsTreasury NotesTreasury NotesTreasury BondsTreasury BondsUS Savings BondsUS Savings BondsKeep in mind you must pay federal income Keep in mind you must pay federal income

tax on interest from these, however you tax on interest from these, however you are exempt from state and local taxesare exempt from state and local taxes

Treasury BillsTreasury Bills

Sold in units of 1,000Sold in units of 1,000Mature in 4, 13, 26, or 52 weeksMature in 4, 13, 26, or 52 weeksDiscounted security – actual purchase Discounted security – actual purchase

price less than maturity valueprice less than maturity valueReceive the full face value at maturityReceive the full face value at maturity

Treasury NotesTreasury Notes

Issued in $1,000 unitsIssued in $1,000 unitsMaturity one to ten yearsMaturity one to ten years Interest rates slightly higher than t-bills b/c Interest rates slightly higher than t-bills b/c

investors wait longer to get moneyinvestors wait longer to get money

Treasury BondsTreasury Bonds

No longer issued, but can be bought on No longer issued, but can be bought on secondary marketsecondary market

Issued in $1,000, with 10 to 30 years Issued in $1,000, with 10 to 30 years maturitymaturity

Interest rates usually highest among T-Interest rates usually highest among T-bills, and treasury notesbills, and treasury notes

Series EE Savings BondsSeries EE Savings Bonds

Purchase price half of face valuePurchase price half of face valueCan redeem 6 months to 30 years of Can redeem 6 months to 30 years of

purchasepurchaseCan receive interest up to 30 yearsCan receive interest up to 30 yearsNot taxed by local or state govt., and no Not taxed by local or state govt., and no

federal until bond is cashedfederal until bond is cashed

Series I Savings BondSeries I Savings Bond

Pay fixed interest rate lower than Pay fixed interest rate lower than traditional bondstraditional bonds

Also pay a variable interest rate that Also pay a variable interest rate that increases with inflationincreases with inflation

Recalculated twice a yearRecalculated twice a year

State and Local Govt. BondsState and Local Govt. Bonds

Municipal bond Municipal bond Issued by state or local govt. to pay for Issued by state or local govt. to pay for

ongoing activities or major projectsongoing activities or major projectsClassified as:Classified as:

General obligation bonds – backed by full faith and General obligation bonds – backed by full faith and credit of govt. that issued itcredit of govt. that issued it

Revenue bonds – repaid by income generated by Revenue bonds – repaid by income generated by project its designed to financeproject its designed to finance

Govts. have defaulted on rare occasionsGovts. have defaulted on rare occasions

Section 10.2Section 10.2

Determining Bond Determining Bond Investment ValueInvestment Value

Bond Price QuotationsBond Price QuotationsSources of Information on BondsSources of Information on BondsBond RatingsBond RatingsYield of Bond InvestmentYield of Bond Investment

Bond Price QuotationBond Price Quotation

In metropolitan newspapers, The Wall In metropolitan newspapers, The Wall Street Journal, and Barron’sStreet Journal, and Barron’s

Bond quotation is a % of face value Bond quotation is a % of face value (usually $1000)(usually $1000)

If price quotation is 84, current market If price quotation is 84, current market value is $840 ($1000 * 84% = $840)value is $840 ($1000 * 84% = $840)

Sources of Information on BondsSources of Information on Bonds

Need to know financial stability of issuer: Need to know financial stability of issuer: Will it be repaid at maturity?Will it be repaid at maturity?Will you receive interest payments until Will you receive interest payments until

maturity?maturity?Annual reportsAnnual reports InternetInternetBusiness magazinesBusiness magazinesGovt. reports and researchGovt. reports and research

Bond RatingsBond Ratings

Companies that assign ratings on quality Companies that assign ratings on quality and risk based on financial stability of and risk based on financial stability of issuerissuer

Moody’s Bond SurveyMoody’s Bond SurveyStandard & Poor’s Stock and Bond GuideStandard & Poor’s Stock and Bond GuideTypes of Types of ratings

Yield of a Bond InvestmentYield of a Bond Investment

Current Yield = Current Yield = $ of Annual Interest Income$ of Annual Interest IncomeCurrent Market Current Market

ValueValueCan compute yield and compare to other Can compute yield and compare to other

securitiessecuritiesHigher the yield the betterHigher the yield the better

Section 10.3Section 10.3

What are mutual funds?What are mutual funds?

Investment alternative where investors Investment alternative where investors pool money togetherpool money togetherBuy stocks, bonds, and other securitiesBuy stocks, bonds, and other securitiesProfessionals managers at investment Professionals managers at investment

companies make selectionscompanies make selectionsAllows for a diverse portfolio with people Allows for a diverse portfolio with people

with limited resourceswith limited resources

Why buy mutual funds?Why buy mutual funds?

Professional management – be sure to Professional management – be sure to monitor and review funds regularlymonitor and review funds regularly

Diversification – reduces risk, some may Diversification – reduces risk, some may lose, but some may gainlose, but some may gain

1970 – 361 mutual funds1970 – 361 mutual funds2003 – 8,300 mutual funds2003 – 8,300 mutual funds

Types of Mutual FundsTypes of Mutual Funds

Closed-end fundsClosed-end fundsOpen-end fundsOpen-end fundsLoad fundsLoad fundsNo-load fundsNo-load fundsManagement fees and other chargesManagement fees and other charges

Closed-End FundsClosed-End Funds

About 6% of all mutual fundsAbout 6% of all mutual funds Investment company only issues fixed Investment company only issues fixed

number of shares when first organizednumber of shares when first organizedAfter all original shares have been issued, After all original shares have been issued,

investors can only buy from one anotherinvestors can only buy from one another

Open-End FundsOpen-End Funds

Most mutual are these typeMost mutual are these typeUnlimited number of shares issued and Unlimited number of shares issued and

redeemedredeemedCan be bought and sold on any business Can be bought and sold on any business

dayday

Load FundsLoad Funds

Mutual fund that you pay commission on Mutual fund that you pay commission on every time you buy or sellevery time you buy or sell

Can be as high as 8.5%, but average is 3 Can be as high as 8.5%, but average is 3 to 5%to 5%

Supposed advantage is high commission Supposed advantage is high commission means better advice and guidancemeans better advice and guidance

No-Load FundsNo-Load Funds

Has no commission feeHas no commission feeShould choose of load-fundsShould choose of load-funds

Management Fees and Management Fees and Other ChargesOther Charges

Management fees are fixed % of funds Management fees are fixed % of funds asset values – usually 0.5 to 1.25%asset values – usually 0.5 to 1.25%

Back-end load – 1 to 5% fee charged for Back-end load – 1 to 5% fee charged for withdrawing moneywithdrawing money

12b-1 fee – charged to pay for marketing 12b-1 fee – charged to pay for marketing and advertising of mutual fund – 1% of and advertising of mutual fund – 1% of assetsassets

Categories of Mutual FundsCategories of Mutual Funds

Stock Mutual Funds – made up of stocks Stock Mutual Funds – made up of stocks and most mutual funds are thisand most mutual funds are this

Bond Mutual Funds – made up of only Bond Mutual Funds – made up of only mutual fundsmutual funds

Mixed Mutual Funds – mix of stocks and Mixed Mutual Funds – mix of stocks and bonds and other securitiesbonds and other securities

Section 10.4Section 10.4

Considering Your Financial GoalsConsidering Your Financial GoalsWhen You Deal With Mutual FundsWhen You Deal With Mutual FundsHow old are you?How old are you?What is your family situation?What is your family situation?How much risk do you want to take?How much risk do you want to take?How much money do you make now?How much money do you make now?How much money are you likely to make How much money are you likely to make

in the future?in the future?

Information On Mutual FundsInformation On Mutual Funds

NewspapersNewspapersQuotationsQuotationsProspectusesProspectusesAnnual ReportsAnnual ReportsFinancial PublicationsFinancial PublicationsProfessional AdviceProfessional Advice InternetInternet

Return on InvestmentReturn on Investment

Gain income in one of three ways from Gain income in one of three ways from mutual fundsmutual funds Income dividends – earnings from your Income dividends – earnings from your

mutual fund mutual fund Capital gain distributions – payments made to Capital gain distributions – payments made to

shareholders that result from the sale of shareholders that result from the sale of securities in the fund’s portfoliosecurities in the fund’s portfolio

Capital gains - buying shares at a low price Capital gains - buying shares at a low price and selling after a price increaseand selling after a price increase

Taxes and Mutual FundsTaxes and Mutual Funds

Receive a Receive a 1099DIV which is a statement which is a statement from brokerage firm showing distributions from brokerage firm showing distributions and dividendsand dividends

How they are taxed:How they are taxed:Dividends – taxed as regular incomeDividends – taxed as regular incomeDistributions – reported on federal income tax Distributions – reported on federal income tax

returnreturnGains/losses – reported on Gains/losses – reported on

federal income tax return

Purchase OptionsPurchase Options

Regular Account TransactionsRegular Account TransactionsVoluntary Savings PlansVoluntary Savings PlansPayroll Deduction PlansPayroll Deduction PlansContractual Savings PlansContractual Savings PlansReinvestment PlansReinvestment Plans

Regular Account TransactionsRegular Account Transactions

Most popularMost popularLeast complicatedLeast complicatedDecide how much $ and when, and buy as Decide how much $ and when, and buy as

many shares as possiblemany shares as possible

Voluntary Savings PlansVoluntary Savings Plans

Make smaller purchases than the Make smaller purchases than the minimum required by regular account minimum required by regular account transactionstransactions

Must commit to regular purchases from Must commit to regular purchases from $25 to $100 generally$25 to $100 generally

Payroll Deduction PlansPayroll Deduction Plans

Comes right out of checkComes right out of checkCan also come from 401(k) and 403(b) Can also come from 401(k) and 403(b)

retirement plans or IRAsretirement plans or IRAs

Contractual Savings PlansContractual Savings Plans

Required to make purchases over 10 to 20 Required to make purchases over 10 to 20 yearsyears

May pay penalties if purchases not madeMay pay penalties if purchases not madeNot good choice because many investors Not good choice because many investors

lose money with these planslose money with these plans

Reinvestment PlansReinvestment Plans

Income dividends and capital gain Income dividends and capital gain distributions are automatically reinvesteddistributions are automatically reinvested

No additional sales charges or No additional sales charges or commissions charged to investorcommissions charged to investor

Withdrawal OptionsWithdrawal Options

Investment Period WithdrawalInvestment Period Withdrawal Investment Period LiquidationInvestment Period LiquidationAsset Growth WithdrawalAsset Growth WithdrawalDividend and Distribution WithdrawalDividend and Distribution Withdrawal

Investment Period WithdrawalInvestment Period Withdrawal

May withdraw certain amount each period May withdraw certain amount each period (3 months) until fund exhausted(3 months) until fund exhausted

Requires a minimum withdrawal amount, Requires a minimum withdrawal amount, usually $50usually $50

Investment Period LiquidationInvestment Period Liquidation

Liquidate or “sell off” certain number of Liquidate or “sell off” certain number of shares each periodshares each period

Asset Growth WithdrawalAsset Growth Withdrawal

Allows a prearranged % of investment’s Allows a prearranged % of investment’s asset growthasset growth

If no growth, no paymentIf no growth, no paymentPrincipal remains untouchedPrincipal remains untouched

Dividend and Distribution Dividend and Distribution WithdrawalWithdrawal

Allows withdrawal of all income from Allows withdrawal of all income from dividends and capital growthdividends and capital growth

This option also allows principal to remain This option also allows principal to remain untoucheduntouched