Dr. Steven M. HaysBKHS

Personal Finance

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-usually $1,000.

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.

Corporations may call in, or buy, outstanding bonds from bondholders before the maturity date. 15-2

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.

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Debenture BondMortgage BondsSubordinated Debenture BondConvertible Bond

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◦Most corporate bonds are debenture bonds.◦Unsecured - Backed only by the reputation

of the issuing company.

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

◦Interest rate is lower because it is secured

An unsecured bond that gives bondholders a claim secondary to that of other designated bond holders with respect to interest payments and claim on assets.

◦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.

Issued by smaller companies who may find it costly to issue stock or bonds Typically by more speculative companies Buy a convertible bond if you are bullish on the stock Convertible bond allows you the opportunity to collect interest, semi-

annually With the option to convert to stock, the income paid will be less than a

traditional bond Offer investors the opportunity to participate in the equity market while

collecting interest

Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date.

Most agree not to call bonds for the first 5 to 10 years after they are issued.

Bonds called if their interest rate is much higher than the going rate.

Most corporate bonds are callable.

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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.

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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.

Appreciation of bond value.◦ May be able to sell a bond with a fixed

interest rate to someone else at a higher price if overall interest rates fall.

Bond face amount will be repaid at maturity.

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Registered bond: Registered in your name by the company who issued it. Interest checks will be mailed directly to you.

A bearer bond is not registered in your name. Also has detachable coupons. No longer issued by U.S. corporations.

Zero coupon bonds: Sold for below face value; it pays no interest; redeem it for face value at maturity. Interest is taxed as you earn it.

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Individuals can hold bond until maturity or sell it in the secondary market.

Success or failure of the business and changes in market interest rates will affect the price of the bond.

Interest and capital gains from selling bonds are both taxable.

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

Three levels of government issue bonds:◦Federal-no state income tax on the

interest.◦State.◦Local municipalities.

Treasury Bills (T-Bills). $1,000 minimum. 4, 13, 26, or 52 weeks to mature.

Sold at a discount.Treasury Notes (T-Notes). $1,000 units. 2, 3, 5, 7 and 10 year terms. Interest paid every six months, higher rates than T-bills.

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Pay a lower interest rate than corporate bond, but virtually risk free if chosen carefully.

Often used by investors to diversify their investment holdings.

Fannie Mae (www.fanniemae.com).◦ Federal National Mortgage Association.

Ginnie Mae - pay interest once a month.◦ Government National Mortgage Association.

Freddie Mac.◦ Federal Home Loan Mortgage Corporation.

Slightly higher risk than Treasury securities, so slightly higher interest rates.

Issued for 1-30 years, 12 year average. Minimum may be as high as $25,000.

Municipal bonds or “munis” Issued by a state or local government, such as

cities, counties, school districts Use funds for ongoing costs & 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

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 ten years.

Interest earned may be exempt from federal income tax so yield is higher.

Tax-exempt yield1.0 - Your tax rate

Example:Taxable equivalent yield = 0.06 (6%)

1.0 - 0.28

= 0.083 = 8.3%

Will the bond be repaid at maturity? Will you receive interest payments until

maturity? Read the annual report, looking for

strengths and weaknesses. Bond ratings? (see Exhibit 15-6).

◦ 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, www.standardpoor.com, www.moodys.com.

◦ www.bondsonline.com, www.bondpage.com, www.buysellbonds.com, http://bonds.yahoo.com/ are online sources of information on bonds.

Standard and Poors Moodys

Issues opinion on the general creditworthiness of an obligor, or the creditworthiness of an obligor with respect to a particular debt security or other financial obligation.

Credit ratings have achieved wide investor acceptance as convenient tools for differentiating credit quality.

http://www.standardandpoors.com/ratings/en/us/

System of rating securities was originated by John Moody in 1909

Purpose is to provide investors with a simple system of gradation by which future relative creditworthiness of securities may be gauged

Gradations of creditworthiness are indicated by rating symbols

Read bond quotes in the newspaper. ◦Bid price is the highest price offered for

the bond during a day (market value).◦Asked price is the lowest price at which

someone has offered to sell a bond during a day.

◦Look at the maturity date.◦Determine the current yield.◦A bond listed at 100 is really selling for

$1,000.

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(continued)

Example:Current yield = $75

$800 = 0.094 = 9.4%

The Investment’s Current Market Value

Dollar Amount of Income Generated Yearly

Go to one of these sites and look up information about municipal bonds in your area.

www.emuni.com www.municipalbonds.com Print the cover page of the bond that you

choose Determine the taxable equivalent yield for a

bond from the City of Rochester, Greece, Irondequoit, Gates, Chili, Webster, Penfield, Brighton, Henrietta, or other municipality in the area

What do you think of the rates these bonds are paying?