CHAPTER 13

Investing in Bonds

Q: What’s the difference between a man and a bond?

A: The bond eventually matures.

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Investing in Bonds

• Bonds represent loans to…
• Companies (Corporate bonds)
• State & local municipalities (Municipal bonds, “Muni’s”)
• Federal government (Treasury bonds, “Governments”)
• Bondholders receive interest on the loan
• Loan is repaid (Bond is redeemed) in 1 to 30 years
• Bondholders are first in line for repayment if there is default on the loans (after taxes & payroll expenses)
• Bond prices are less volatile but still fluctuate (?)
• Average returns over decades – 2% to 5%
• Intermediate-term to long-term investments
• There is a way for bonds to be short-term that we learn about in BUS-123, Introduction to Investments

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Why Do Investors Buy Bonds?

• For interest income
• Investors know the interest rate
• Interest will be paid to investors twice a year
• Bond face amount will be repaid at maturity
• Although there is always the risk of default
• Normally, the risk of default is very, very small
• If the risk is high, the bonds are usually referred to as “non-investment grade bonds” (aka “junk bonds”)
• Appreciation of bond value
• You may be able to sell your bond to someone else at a higher price if the interest rate on your bond is higher than the current market rate (“Huh?” “Later…”)

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Why Sell Bonds

• To raise money to operate or expand
• Examples: Build a new factory, expand into a new country, build new or upgrade older schools, bridges, finance a war, etc. – Big ticket items
• Can get better interest rates than if they went to a bank or other money-lending entity
• Also, sometimes the bond issuer can’t go to a bank!
• (Can you imagine the Federal government asking your local credit union for a $900 billion loan to invade Iraq?)

Almost every election year in California, the voters are asked to approve a “bond proposition” for parks, schools, water projects, transportation, emergency and public safety equipment, etc. The State of California then sells the bonds to pay for the project and must pay the interest and pay back the principal over 30 years. Do you believe that most voters understand what they are voting for?

When an entity sells bonds, it is borrowing money.

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Why Sell Bonds

• In the case where the bond issuer is a corporation, sometimes it is difficult, not advantageous or impossible to sell stock
• And the interest is a tax-deductible expense for corporations
• Whereas dividends to stock shareholders are not
• To take advantage of “financial leverage”
• Use other people’s money to make your money

Bonds are debt financing. Corporations, municipalities, or the Federal government borrow for many of the same reasons that individuals borrow for – to finance their operations.

Stocks are equity financing. A corporation is selling a piece of itself to finance the operations of the company. (Governments do not issue stocks because they can not sell pieces of themselves.)

(continued)

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Characteristics of Bonds

• Written pledge to repay a specified amount (face value, par value) of money with interest
• The face value is the dollar amount that the bondholder will receive when the bond matures
• Normally in $1,000 denominations (up to $10,000)
• Bondholders receive interest payments every six months at the stated interest rate
• The legal conditions are described in the bond indenture
• The indenture is the loan agreement
• The trustee is the bondholders’ representative

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Types of Bonds

• Mortgage-backed bonds (“Secured”)
• A bond that is secured by various assets of the issuing firm
• A mortgage bond is like a homeowner’s home mortgage
• If the bond issuer does not pay, the asset is seized
• Debenture bonds (“Unsecured”)
• Most bonds are debenture bonds
• Backed only by the reputation of the issuer
• A debenture bond is like a credit card
• If the bond issuer does not pay, the bond investors must go after whatever assets or income they can find
• Convertible bonds (only corporate bonds)
• Can be exchanged, at the owner’s option, for a specified number of shares of common stock

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Call Feature of Bonds

• Corporations and municipalities can sometimes “call in” (buy back) outstanding bonds from current bondholders before the maturity date
• Treasuries (Federal bonds) have never been callable
• Most agree not to call in their bonds for the first 5 to 10 years after they are issued
• aka Deferred Call, Call Protection Period
• Bonds are called if the interest rate they are paying is higher than the going rate
• It is the same idea as when a homeowner refinances his/her home mortgage loan

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Bonds and Taxes

• Bond interest is normally taxed at your marginal tax rate
• Always true of corporate bonds
• However, municipal bonds are not subject to Federal income taxes and …
• Federal bonds are not subject to state income tax
• This is an important feature for wealthy investors
• Must look at the Taxable Equivalent Yield
• Some municipal bonds are “double-tax free”
• If from your state, also exempt from state taxes
• Careful! If you are subject to the AMT, the interest income from some municipal bonds is no longer exempt from Federal taxes

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Taxable Equivalent Yield

Tax-Exempt Yield

1.0 – Your Federal marginal tax rate

​

Example: 6% yield, 25% tax bracket

Taxable equivalent yield = 0.06

1.0 - 0.25

​

= 0.08 = 8%

Federal income tax free municipal bonds

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Taxable Equivalent Yield

Tax-Exempt Yield

1.0 - Your combined marginal tax rate

(Federal & state)

Example: 6% yield, 25% Fed, 8% state

Taxable equivalent yield = 0.06

1.0 – (0.25+0.08)

​

= 0.0895 = 8.95%

(continued)

If you purchase bonds from your state, they are usually “double tax-free.”

Federal & state income tax free.

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Making the Decision to �Buy or Sell a Bond

• Can the corporation, municipality, or Federal government...
• Pay back the face value at maturity?
• Will you receive interest payments until maturity?
• What is the bond’s rating? (Kinda’ like your credit score)
• Ratings range from AAA to D (AAA, AA, A, BBB, BB, etc., D)
• BB or below is “non-investment grade”
• Also called a “junk bond” or speculative bond
• Rated by one of the rating agencies
• Standard and Poor’s, Moody’s, Fitch’s

Think of the ratings as “idiot lights” on your car’s dashboard. By the time the agency downgrades the bond to C or D, it is already too late!

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Bonds and Interest Rates

• Inverse relationship
• As interest rates fall, bond prices rise
• As interest rates rise, bond prices fall
• Since the interest rate of your bond does not change (the interest rate is fixed), the price of the bond changes to reflect the change in interest rates within the financial industry (the price of the bond is not fixed)
• Great source of confusion and consternation to many in and out of the investment world

When interest rates fall,

…bond prices rise,

and vice-versa.

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Bonds and Interest Rates: Example

• Bond paying 10%
• The bond’s face value is $1,000
• The bond’s interest per year is $100
• 10% of $1,000 = $100
• Interest rates fall to 5%
• Now, investors have to pay $2,000 to get the same amount of interest
• 5% of $2,000 = $100
• The result is your bond is now worth more than it once was (capital gain if sold)
• The bond could be sold at a high premium

Interest rates fall?

Bond prices rise!

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• Bond paying 5%
• The bond’s face value is $1,000
• The bond’s interest per year is $50
• 5% of $1,000 = $50
• Interest rates rise to 10%
• Now, investors only have to pay $500 to get the same amount of interest
• 10% of $500 = $50
• The result is your bond is now worth less than it once was (capital loss if sold)
• The bond would be sold at a large discount

(continued)

Bonds and Interest Rates: Example

Interest rates rise?

Bond prices fall!

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Bond Pricing: Problem 1

Juan Zapata-Tyme bought a corporate bond paying 8% four years ago. Today, corporate bonds that are like Juan’s bond are paying 6%. Would Juan be able to sell his bond for more than he paid for it, less than he paid for it, or the same amount he paid for the bond?

​

1. He could sell it for more than he paid for it
2. He could sell it for less than he paid for it
3. He could sell it for the same that he paid for it

The correct answer is (A). If interest rates go down, bond prices go up. The bond would sell at a premium.

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Bond Pricing: Problem 2

L. Coco bought a Treasury bond paying 5% two years ago. Today, like Treasury bonds are paying 7%. Would Señor Coco be able to sell his bond for more than he paid for it, less than he paid for it, or the same amount he paid for it?

​

1. He could sell it for more than he paid for it
2. He could sell it for less than he paid for it
3. He could sell it for the same that he paid for it

The correct answer is (B). If interest rates go up, bond prices go down. The bond would sell at a discount.

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Bonds and Interest Rates

• The relationship of bonds and interest rates is why a bond will have different quoted rates
• Nominal Rate (aka Coupon Rate)
• This is the rate that the bond pays on the original amount of the loan (usually in $1,000 increments)
• Current Yield
• This is the true rate of interest that the bond buyer is currently getting since it reflects the premium or discount price the buyer had to pay
• Yield to Maturity
• This is the yield you would receive if you were to hold onto the bond until it matures
• If the Nominal Rate, Current Yield and the Yield to Maturity are all the same, the bond is said to be selling at par
• There is no premium or discount

(continued)

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Current % Yield of a Bond

Example: 6%, $1,100 market value

Current yield = $60

$1,100

= 0.0545454 ≅ 5.454%

A bond selling at a premium has a current yield lower than its stated nominal rate

(continued)

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Current % Yield of a Bond

Example: 6%, $900 market value

Current yield = $60

$900

= 0.06667 ≅ 6.667%

A bond selling at a discount has a current yield higher than its stated nominal rate

(continued)

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Yield to Maturity

Face value - Market value

Number of periods

Face value + Market value

2

Example: 6%, Selling at $900, 10-year maturity

$1,000 - $900

10 years

$1,000 + $900

2

= 0.073684 = 7.368%

$ Amt Annual Interest +

$60 +

¡Aye, Paquito!

This top quantity takes into account the appreciation or depreciation of the bond.

This bottom quantity is just the average of the face value and the market value.

Annual interest

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Primary and Secondary Bond Markets

• Primary bond market
• Buy via an investment bank or company representative
• www.treasurydirect.gov
• Secondary bond market
• Buy through a broker from another investor who wants to sell it, and pay a commission

Very few small investors participate in the bond markets. Bond traders normally deal in the millions of dollars and want you to pony up at least $25,000, preferably $100,000 or more. The major exceptions are Federal Treasury bonds. The small investor is welcome at www.treasurydirect.gov.

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Bond Mutual Funds

• Most small investors are better served by investing in a bond mutual fund
• Professional Money Management
• Diversification
• Bond Traders are used to buying and selling in the millions
• Smallest transactions are in the $10,000’s
• The mutual fund managers and pension fund managers can get a much better deal because of their size

Although it is very easy to buy Treasury bonds directly from the Federal government at www.treasurydirect.gov

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Bottom Line on Bonds

• Bonds are good intermediate-term investments
• Bonds are decent long-term investments
• Especially good for those who would have trouble sleeping at night if they were fully invested in stocks
• But don’t be fooled!
• Bonds have risks, too
• Especially when interest rates are very low

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