Investing in Bonds

C H A P T E R
Investing in Bonds
16
Tom scratched his head for a moment. This
was something entirely new to him. His broker
was recommending a car and junk? And who
were all these people that his broker was so
friendly with? And Tom always thought it
took at least 25 to 30 years to reach the top of
the corporate ladder, not 10.
Fortunately, the broker cleared up Tom’s confusion by explaining that junk bonds were
high-risk bonds that offered higher interest
rates than other bonds, a convertible was a
type of bond that could be converted to common stock, and Fannie Maes, Ginnie Maes,
and Freddie Macs were bonds issued by agencies of the federal government. Tom was still
When Tom Sanders asked his broker for a rec-
confused about the corporate ladder, so his
ommendation regarding buying some bonds,
broker explained that a corporate bond simply
his broker told him, “Well, I recommend you
was a bond issued by a corporation, and the
buy some junk and perhaps a convertible or
ladder was the technique of staggering the
two. Of course, I really like Fannie Maes, Gin-
maturity dates of the bonds purchased so that
nie Maes, and Freddie Macs for their yield. I
a portion of the portfolio was reinvested in
would stay away from Munis, since you are in
new bonds every two years. In time Tom
a 15 percent tax bracket. And finally, I recom-
learned that investing in bonds helps build a
mend some corporates with a 10-year ladder.”
diversified portfolio.
441
442
I N V E S T I N G
I N
B O N D S
Like other investments, bonds present an array of new terminology and have unique characteristics.
As with stocks, the return and risk of bonds vary depending upon their issuer as well as current and
expected economic conditions. Once understood, however, they constitute an important investment
option. Understanding the different types of bonds and various bond investment strategies can help
you build your own investment portfolio and enhance your wealth.
The objectives of this chapter are to:
■
identify the different types of bonds,
■
explain what affects the return from investing in a bond,
■
describe why some bonds are risky, and
■
identify common bond investment strategies.
BACKGROUND ON BONDS
bonds
Long-term debt securities
issued by government
agencies or corporations.
par value
For a bond, its face value,
or the amount returned to
the investor at the
maturity date when the
bond is due.
Recall that investors commonly invest some of their funds in bonds, which are
long-term debt securities issued by government agencies or corporations. Bonds
often offer more favorable returns than bank deposits. In addition, they typically provide fixed interest payments that represent additional income each year.
The par value of a bond is its face value, or the amount returned to the investor
at the maturity date when the bond is due.
Most bonds have maturities between 10 and 30 years, although some bonds
have longer maturities. Investors provide the issuers of bonds with funds
(credit). In return, the issuers are obligated to make interest (or coupon) payments and to pay the par value at maturity. When a bond has a par value of
$1,000, a coupon rate of 6 percent means that $60 (.06 $1,000) is paid annually to investors. The coupon payments are normally paid semiannually (in this
example, $30 every six months). Some bonds are sold at a price below par value;
in this case, investors who hold the bonds until maturity will earn a return from
the difference between par value and what they paid. This income is in addition
to the coupon payments earned.
You should consider investing in bonds rather than stock if you wish to
receive periodic income from your investments. As explained in Chapter 18,
many investors diversify among stocks and bonds to achieve their desired return
and risk preferences.
BOND CHARACTERISTICS
Bonds that are issued by a particular type of issuer can offer various features
such as a call feature or convertibility.
BACKGROUND ON BONDS
call feature
A feature on a bond that
allows the issuer to
repurchase the bond from
the investor before
maturity.
443
Call Feature. A call feature on a bond allows the issuer to buy back the bond
from the investor before maturity. This feature is desirable for issuers because it
allows them to retire existing bonds with coupon rates that are higher than the
prevailing interest rates.
EXAMPLE
Five years ago, Cieplak, Inc., issued 15-year callable bonds with a coupon rate of 9
percent. Interest rates have declined since then. Today, Cieplak could issue new
bonds at a rate of 7 percent. It decides to retire the existing bonds by buying them
back from investors and to issue new bonds at a 7 percent coupon rate. By calling
the old bonds, Cieplak has reduced its cost of financing.
Investors are willing to purchase bonds with a call feature only if the bonds
offer a slightly higher return than similar bonds without a call feature. This premium compensates the investors for the possibility that the bonds may be called
before maturity.
convertible bond
A bond that can be
converted into a stated
number of shares of the
issuer’s stock if the stock
price reaches a specified
price.
Convertible Feature.
A convertible bond allows the investor to convert the
bond into a stated number of shares of the issuer’s stock if the stock price
reaches a specified price. This feature enables bond investors to benefit when
the issuer’s stock price rises. Because convertibility is a desirable feature for
investors, convertible bonds tend to offer a lower return than nonconvertible
bonds. Consequently, if the stock price does not rise to the specified trigger
price, the convertible bond provides a lower return to investors than alternative
bonds without a convertible feature. If the stock price does reach the trigger
price, however, investors can convert their bonds into shares of the issuer’s
stock, thereby earning a higher return than they would have earned on alternative nonconvertible bonds.
A BOND’S YIELD TO MATURITY
yield to maturity
The annualized return on a
bond if it is held until
maturity.
A bond’s yield to maturity is the annualized return on the bond if it is held until
maturity. Consider a bond that is priced at $1,000, has a par value of $1,000,
a maturity of 20 years, and a coupon rate of 10 percent. This bond has a yield
to maturity of 10 percent, which is the same as its coupon rate, because the price
paid for the bond equals the principal.
As an alternative example, if this bond’s price were lower than the principal amount, its yield to maturity would exceed the coupon rate of 10 percent.
The bond would also generate income in the form of a capital gain, because the
purchase price would be less than the principal amount to be received at maturity. Conversely, if this bond’s price were higher than the principal amount, its
yield to maturity would be less than the 10 percent coupon rate, because the
amount paid for the bond would exceed the principal amount to be received at
maturity.
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16.1
I N V E S T I N G
I N
B O N D S
Financial Planning Online: Your Bond’s Yield
Go to:
http://www.calcbuilder.com
/cgi-bin/calcs/BON1.cgi/
yahoo_bonds
This Web site provides:
an estimate of the yield to
maturity of your bond
based on its present price,
its coupon rate, and its
maturity. Thus, you can
determine the rate of
return that the bond will
generate for you from
today until it matures.
BOND TRADING IN THE SECONDARY MARKET
Investors can sell their bonds to other investors in the secondary market before
the bonds reach maturity. Bond prices change in response to interest rate movements and other factors. Some bonds are traded on stock exchanges such as the
New York Stock Exchange. Other bonds are traded in the over-the-counter
market. Many investors sell their bonds in the secondary market to raise funds
to cover upcoming expenses or to invest in other more attractive types of securities. Brokerage firms take orders from investors to buy or sell bonds.
TYPES OF BONDS
Bonds can be classified according to the type of issuer as follows:
■
Treasury bonds
■
Municipal bonds
■
Federal agency bonds
■
Corporate bonds
Each type is described here.
Treasury bonds
Long-term debt securities
issued by the U.S.
Treasury.
TREASURY BONDS
Treasury bonds are long-term debt securities issued by the U.S. Treasury, a
branch of the federal government. Because the payments are guaranteed by the
mad65918_c16.qxd 3/25/05 8:09 AM Page 445
TYPES OF BONDS
445
federal government, they are not exposed to the risk of default by the issuer. The
interest on Treasury bonds is subject to federal income tax, but it is exempt
from state and local taxes. Treasury bonds are very liquid because they can easily be sold in the secondary market.
MUNICIPAL BONDS
municipal bonds
Long-term debt securities
issued by state and local
government agencies.
Municipal bonds are long-term debt securities issued by state and local government agencies; they are funded with proceeds from municipal projects such as
parks or sewage plants, as well as tax revenues, in some cases. Because a state
or local government agency might possibly default on its coupon payments,
municipal bonds are not free from the risk of default. Nevertheless, most municipal bonds have a very low default risk. To entice investors, municipal bonds that
are issued by a local government with a relatively high level of risk will have to
offer a higher yield than other municipal bonds with a lower level of risk.
The interest on municipal bonds is exempt from federal income tax, which
is especially beneficial to investors who are in tax brackets of 28 percent or
more. The interest is also exempt from state and local taxes when the investor
resides in the same state as the municipality that issued the bonds. Municipal
bonds tend to have a lower coupon rate than Treasury bonds issued at the same
time. However, the municipal bonds may offer a higher after-tax return to
investors.
EXAMPLE
Mike Rivas lives in Florida, where there is no state tax on income. For federal income
tax, however, he faces a 35 percent marginal rate, meaning that he will pay a tax of
35 percent on any additional income that he earns this year. Last year, Mike invested
$100,000 in Treasury bonds with a coupon rate of 8 percent and $100,000 in municipal bonds with a coupon rate of 6 percent. His annual earnings from these two
investments are shown here:
Interest income
before taxes
Federal taxes owed
Interest income
after taxes
Treasury Bonds
Municipal Bonds
$8,000 (computed as
.08 $100,000)
$6,000 (computed as
.06 $100,000)
2,800 (computed as
.35 $8,000)
$5,200
0
$6,000
Notice that even though Mike received more interest income from the Treasury
bonds, he must pay 35 percent of that income to the federal government. Therefore,
he keeps only 65 percent of that income, or a total of $5,200. In contrast, none of
the interest income of $6,000 from the municipal bonds is taxed. Consequently,
every year Mike receives $800 more in after-tax interest income from the municipal
bonds with the 6 percent coupon rate than from the Treasury bonds with the 8 percent coupon rate.
446
16.2
I N V E S T I N G
I N
B O N D S
Financial Planning Online: Municipal Bond Quotations
Go to:
http://www.bloomberg.com
/markets/rates/index.html
This Web site provides:
quotations of yields
offered by municipal
bonds with various terms
to maturity. Review this
information when considering purchasing municipal
bonds.
FEDERAL AGENCY BONDS
federal agency bonds
Long-term debt securities
issued by federal
agencies.
Federal agency bonds are long-term debt securities issued by federal agencies.
The Government National Mortgage Association (called Ginnie Mae or abbreviated as GNMA), for example, issues bonds so that it can invest in mortgages
that are insured by the Federal Housing Administration (FHA) and by the Veteran’s Administration (VA). The Federal Home Loan Mortgage Association
(called Freddie Mac) also commonly issues bonds and uses the proceeds to purchase conventional mortgages. A third government agency that commonly issues
bonds is the Federal National Mortgage Association (Fannie Mae). Though federally chartered, it is owned by individual shareholders rather than the government. It uses the proceeds from the bonds to purchase residential mortgages.
The bonds issued by these three federal agencies are backed by the mortgages
in which the agencies invest. Thus, the bonds have a very low degree of default
risk. The income provided by these bonds is subject to state and federal taxes.
CORPORATE BONDS
corporate bonds
Long-term debt securities
issued by large firms.
Corporate bonds are long-term debt securities issued by large firms. The repayment of debt by corporations is not backed by the federal government, so corporate bonds are subject to default risk. At one extreme, bonds issued by corporations such as Coca-Cola and IBM have very low default risk because of the
companies’ proven ability to generate sufficient cash flows for many years. At
the other extreme, bonds issued by smaller, less stable corporations are subject
to a higher degree of default risk. These bonds are referred to as high-yield
RETURN FROM INVESTING IN BONDS
high-yield (junk)
bonds
Bonds issued by smaller,
less stable corporations
that are subject to a higher
degree of default risk.
447
bonds or junk bonds. Many investors are willing to invest in junk bonds
because they offer a relatively high rate of return. However, they are more likely
to default than other bonds, especially if economic conditions are poor.
Corporate Bond Quotations.
Corporate bond quotations are provided in the
Wall Street Journal, as shown in Exhibit 16.1. The quotations include the following information:
■
Coupon rate
■
Maturity
■
Current yield
■
Volume
■
Closing price
■
Net change in the price from the previous trading day
Consider bonds issued by IBM, which are highlighted in Exhibit 16.1. The
coupon rate on these bonds is 7.0 percent, listed next to the name of the firm.
Thus, the annual coupon payment is $70.00 per $1,000 bond. The bonds
mature in 2025 (listed as 25). The trading volume on this day was 2,500 bonds.
The closing price was 110.88, or 1108.80 per $1,000 of par value. The net
change from the previous trading day was 0.13, which represents a increase of
$.13 per $1,000 of par value.
RETURN FROM INVESTING IN BONDS
If you purchase a bond and hold it until maturity, you will earn the yield to
maturity specified when you purchased the bond. As mentioned earlier, however, many investors sell bonds in the secondary market before they reach maturity. Since a bond’s price changes over time, your return from investing in a
bond is dependent on the price at the time you sell it.
IMPACT OF INTEREST RATE MOVEMENTS ON BOND RETURNS
Your return from investing in a bond can be highly influenced by the interest
rate movements over the period you hold the bond. To illustrate, suppose that
you purchase a bond at par value that has a coupon rate of 8 percent. After one
year, you decide to sell the bond. At this time, new bonds being sold at par value
are offering a coupon rate of 9 percent. Since investors can purchase a new bond
that offers coupon payments of 9 percent, they will not be willing to buy your
bond unless you sell it to them for less than par value. In other words, you must
offer a discount on the price to compensate for the bond’s lower coupon rate.
If interest rates had declined over the year rather than increased, the
opposite effects would have occurred. You could sell your bond for a premium above par value, because the coupon rate of your bond would be higher
448
I N V E S T I N G
I N
Exhibit 16.1
B O N D S
An Example of Corporate Bond Quotations
Copyright © 2003 Dow Jones & Company, Inc. All Rights Reserved.
RETURN FROM INVESTING IN BONDS
449
than the coupon rate offered on newly issued bonds. Thus, interest rate movements and bond prices are inversely related. Your return from investing in
bonds will be more favorable if interest rates decline over the period you hold
the bonds.
TAX IMPLICATIONS OF INVESTING IN BONDS
When determining the return from investing in a bond, you need to account for
tax effects. The interest income that you receive from a bond is taxed as ordinary income for federal income tax purposes (except for tax-exempt bonds as
explained earlier). Selling bonds in the secondary market at a higher price than
the price you originally paid for them results in a capital gain. The capital gain
(or loss) is the difference between the price at which you sell the bond and the
initial price that you paid for it. Recall from Chapter 4 that a capital gain from
an asset held one year or less is a short-term capital gain and is taxed as ordinary income. A capital gain from an asset held for more than one year is subject to a long-term capital gains tax.
EXAMPLE
You purchase 10 newly issued bonds for $9,700. The bonds have a total par value of
$10,000 and a maturity of 10 years. The bonds pay a coupon rate of 8 percent, or
$800 (computed as .08 $10,000) per year. The coupon payments are made every
six months, so each payment is $400. Exhibit 16.2 shows your return and the tax
16.3
Financial Planning Online: Today’s Events That Could Affect Bond Prices
Go to:
http://www.businessweek
.com/investor/
Click on:
Economy and Bonds
This Web site provides:
a summary of recent
financial news related to
the bond market, which
you may consider before
selling or buying bonds.
450
I N V E S T I N G
Exhibit 16.2
I N
B O N D S
Potential Tax Implications from Investing in Bonds
Scenario
Implication
1. You sell the bonds after 8 months
at a price of $9,800.
You receive one $400 coupon payment 6 months after buying the bond, which
is taxed at your ordinary income tax rate; you also earn a short-term capital
gain of $100, which is taxed at your ordinary income tax rate.
2. You sell the bonds after 2 years
at a price of $10,200.
You receive coupon payments (taxed at your ordinary income tax rate) of $800
in the first year and in the second year; you also earn a long-term capital gain
of $500 in the second year, which is subject to the long-term capital gains tax
in that year.
3. You sell the bonds after 2 years
at a price of $9,500.
You receive coupon payments (taxed at your ordinary income tax rate) of $800
in the first year and in the second year; you also incur a long-term capital loss
of $200 in the second year.
4. You hold the bonds until maturity.
You receive coupon payments (taxed at your ordinary income tax rate) in each
year over the 10-year life of the bond. You also receive the bond’s principal of
$10,000 at the end of the 10-year period. This reflects a long-term capital
gain of $300, which is subject to a long-term capital gains tax in the year you
receive the gain.
implications for four different scenarios. Notice how taxes incurred from the investment in bonds are dependent on the change in the bond price over time and the
length of time the bonds are held.
RISK FROM INVESTING IN BONDS
Bond investors are exposed to the risk that the bonds may not provide the
expected return. The main sources of risk are default risk, call risk, and interest
rate risk.
DEFAULT RISK
risk premium
The extra yield required by
investors to compensate
for the risk of default.
default risk
Risk that the borrower of
funds will not repay the
creditors.
If the issuer of the bond (a government agency or a firm) defaults on its payments, investors do not receive all of the coupon payments that they are owed
and do not receive the principal. Investors will invest in a risky bond only if it
offers a higher yield than other bonds to compensate for its risk. The extra yield
required by investors to compensate for default risk is referred to as a risk premium. Treasury bonds do not contain a risk premium because they are free
from default risk.
To illustrate how bond prices can change due to the perceived default risk,
consider the case of various telecommunications companies that experienced
weak performance over the one-year period ending in May 2002. During that
year, investors became concerned that some of these companies might not be
capable of repaying their debt. Consequently, the price of AT&T bonds declined
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RISK FROM INVESTING IN BONDS
Exhibit 16.3
Bond Rating Classes
Risk Class
Standard & Poor’s
Moody’s
Highest quality (least risk)
AAA
Aaa
High quality
AA
Aa
High-medium quality
A
A
Medium quality
BBB
Baa
Medium-low quality
BB
Ba
Low quality
B
B
Poor quality
CCC
Caa
Very poor quality
CC
Ca
DDD
C
Lowest quality
by 8 percent, the price of Qwest bonds declined by about 24 percent, the price
of Sprint bonds declined by 11 percent, the price of WorldCom bonds declined
by 53 percent, and the price of Global Crossing bonds declined by 98 percent.
Use of Risk Ratings to Measure the Default Risk.
Investors can use ratings
(provided by agencies such as Moody’s Investor Service or Standard and Poor’s)
to assess the risk of corporate bonds. The ratings reflect the likelihood that the
issuers will repay their debt over time. The ratings are classified as shown in
Exhibit 16.3. Investors can select the corporate bonds that fit their degree of
risk tolerance by weighing the higher potential return against the higher default
risk of lower-grade debt securities.
Relationship of Risk Rating to Risk Premium.
The lower (weaker) the risk
rating, the higher the risk premium offered on a bond.
EXAMPLE
Stephanie Spratt reviews today’s bond yields as quoted in financial newspapers for
bonds with a 10-year maturity, as shown in the second column:
Risk Premium Contained
within Bond Yield
Type of Bond
Bond Yield Offered
Treasury bonds
7.0%
0.0%
AAA-rated corporate bonds
7.5
0.5
A-rated corporate bonds
7.8
0.8
BB-rated corporate bonds
8.8
1.8
CCC-rated corporate bonds
9.5
2.5
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I N V E S T I N G
I N
B O N D S
Based on the bond yields, she derives the risk
shown in the third column. Notice that since the
have no risk premium. However, the other bonds
amount by which their annualized yield exceeds
mium can change over time.
premium for each type of bond,
Treasury bonds are risk-free, they
have a risk premium, which is the
the Treasury bond yield. The pre-
Stephanie decides that she prefers Treasury bonds or AAA-rated bonds to other
types of bonds, because she believes the risk premium is not enough compensation
for the risk. However, at this point in time, she cannot afford to buy any type of bond.
Some investors would select specific CCC-rated corporate bonds that they believe
will not default. If these bonds do not default, they will provide a yield that is 2.0 percentage points above the yield offered on AAA-rated bonds and 2.5 percentage
points above the yield offered on Treasury bonds.
Impact of Economic Conditions.
Bonds with a high degree of default risk
are most susceptible to default when economic conditions are weak. Investors
may lose all or most of their initial investment when a bond defaults. They
can avoid default risk by investing in Treasury bonds or can at least keep the
default risk to a minimum by investing in government agency bonds or AAArated corporate bonds. However, they will receive a lower yield on these
bonds than investors who are willing to accept a higher degree of default
risk.
FOCUS ON ETHICS: ACCOUNTING FRAUD AND DEFAULT RISK
If a bond is issued by a firm whose financial statements become questionable,
its price can decline quickly. Firms such as Enron, Global Crossing, Qwest
Communications, and WorldCom have used misleading accounting techniques
to hide their debt or to inflate their revenue. The higher bond rating, which indicates a lower risk to investors, allows the firm to obtain funds at a lower cost
when issuing bonds.
Yet once a debt rating agency becomes aware that the financial statements
are misleading, it will lower the bond rating and investors will in turn reduce
their demand for the bonds. In addition, investors will lose trust in the firm.
Even if a bond does not default, its price will decline when the perception of its
risk is increased by credit rating agencies and investors. Under these conditions,
investors will likely earn a negative return on their investment.
The role of the Securities and Exchange Commission (SEC) is to ensure that
firms accurately disclose their financial condition. However, some firms still
provide misleading financial statements. Some bondholders who invested in the
bonds issued by Enron, WorldCom, and many other firms that recently went
bankrupt lost most or all of their investment. Therefore, you need to recognize
that a firm may default on its bonds even if its most recent financial statement
was very optimistic.
RISK FROM INVESTING IN BONDS
call (prepayment)
risk
The risk that a callable
bond will be called.
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CALL RISK
Bonds with a call feature are subject to call risk (also called prepayment risk),
which is the risk that the bond will be called. If issuers of callable bonds call
these bonds, the bondholders must sell them back to the issuer.
EXAMPLE
Two years ago, Christine Ramirez purchased 10-year bonds that offered a yield to
maturity of 9 percent. She planned to hold the bonds until maturity. Recently, interest rates declined and the issuer called the bonds. Christine could use the proceeds
to buy other bonds, but the yield to maturity offered on new bonds is lower because
interest rates have declined. The return that Christine will earn from investing in
bonds is likely to be less than the return that she would have earned if she could
have retained the 10-year bonds until maturity.
INTEREST RATE RISK
interest rate risk
The risk that a bond’s price
will decline in response to
an increase in interest
rates.
All bonds are subject to interest rate risk, which is the risk that the bond’s price
will decline in response to an increase in interest rates. A bond is valued as the
present value of its future expected cash flows. Most bonds pay fixed coupon
payments. If interest rates rise, investors will require a higher return on a bond.
Consequently, the discount rate applied to value the bond is increased, and the
market price of the bond will decline.
EXAMPLE
Three months ago, Rob Suerth paid $10,000 for a 20-year Treasury bond that has a par
value of $10,000 and a 7 percent coupon rate. Since then, interest rates have increased.
New 20-year Treasury bonds with a par value of $10,000 are priced at $10,000 and offer
a coupon rate of 9 percent. Thus, Rob would earn 2 percentage points more in coupon
payments from a new bond than from the bond he purchased three months ago. He
decides to sell his Treasury bond and use the proceeds to invest in the new bonds. He
quickly learns that no one in the secondary market is willing to purchase his bond for the
price he paid. These investors avoid his bond for the same reason that he wants to sell
it; they would prefer to earn 9 percent on the new bonds rather than earn 7 percent on
his bond. The only way that Rob can sell his bond is by lowering the price to compensate for the bond’s lower coupon rate (compared to new bonds).
The chapter appendix explains how bonds are valued and offers more
insight into the relationship between interest rate movements and bond prices
(and therefore bond returns).
Impact of a Bond’s Maturity on Its Interest Rate Risk.
Bonds with longer terms
to maturity are more sensitive to interest rate movements than bonds that have
short terms remaining until maturity. To understand why, consider two bonds.
I N V E S T I N G
I N
B O N D S
© 2003 Robert Mankoff from cartoonbank.com.
All Rights Reserved.
454
Each has a par value of $1,000 and offers a 9 percent coupon rate, but one bond
has 20 years remaining until maturity while the other has only 1 year remaining
until maturity. If market interest rates suddenly decline from 9 to 7 percent, which
bond would you prefer to own? The bond with 20 years until maturity becomes
very attractive because you would be able to receive coupon payments reflecting
a 9 percent return for the next 20 years. Conversely, the bond with one year
remaining until maturity will provide the 9 percent payment only over the next
year. Although the market price of both bonds increases in response to the decline
in interest rates, it increases more for the bond with the longer term to maturity.
Now assume that, instead of declining, interest rates have risen from their initial level of 9 percent to 11 percent. Which bond would you prefer? Each bond provides a 9 percent coupon rate, which is less than the prevailing interest rate. The
bond with one year until maturity will mature soon, however, so you can reinvest
the proceeds at the higher interest rates at that time (assuming the rates are still
high). Conversely, you are stuck with the other bond for 20 more years. Although
neither bond would be very desirable under these conditions, the bond with the
longer term to maturity is less desirable. Therefore, its price in the secondary market will decline more than the price of the bond with a short term to maturity.
Selecting an Appropriate Bond Maturity.
Since bond prices change in
response to interest rate movements, you may wish to choose maturities on bonds
that reflect your expectations of future interest rates. If you prefer to reduce your
exposure to interest rate risk, you may consider investing in bonds that have a
maturity that matches the time when you will need the funds. If you expect that
interest rates will decline over time, you may consider investing in bonds with
longer maturities than the time when you will need the funds. In this way, you
can sell the bonds in the secondary market at a relatively high price, assuming
that your expectations were correct. If interest rates increase instead of declining over this period, however, your return will be reduced.
BOND INVESTMENT STRATEGIES
455
BOND INVESTMENT STRATEGIES
If you decide to invest in bonds, you need to determine a strategy for selecting
them. Most strategies involve investing in a diversified portfolio of bonds rather
than in one bond. Diversification reduces the exposure to possible default by a
single issuer. If you cannot afford to invest in a diversified portfolio of bonds,
you may consider investing in a bond mutual fund with a small minimum
investment (such as $1,000). Additional information on bond mutual funds is
provided in Chapter 17. Whether you focus on individual bonds or bond
mutual funds, the bond investment strategies summarized here are applicable.
INTEREST RATE STRATEGY
interest rate strategy
Selecting bonds for
investment based on
interest rate expectations.
With an interest rate strategy, you select bonds based on interest rate expectations. When you expect interest rates to decline, you invest heavily in long-term
bonds whose prices will increase the most if interest rates fall. Conversely, when
you expect interest rates to increase, you shift most of your money to bonds
with short terms to maturity in order to minimize the adverse impact of the
higher interest rates.
Investors who use the interest rate strategy may experience poor performance if their guesses about the future direction of interest rate movements are
incorrect. In addition, this strategy requires frequent trading to capitalize on
shifts in expectations of interest rates. Some investors who follow this strategy
frequently sell their entire portfolio of bonds so that they can shift to bonds with
different maturities in response to shifts in interest rate expectations. The frequent trading results in high transaction costs (in the form of commissions to
brokerage firms). In addition, the high turnover of bonds may generate more
short-term capital gains, which are taxed at the ordinary federal income tax rate.
This rate is higher for most investors than the tax on long-term capital gains.
PASSIVE STRATEGY
passive strategy
Investing in a diversified
portfolio of bonds that are
held for a long period of
time.
With a passive strategy, you invest in a diversified portfolio of bonds that are
held for a long period of time. The portfolio is simply intended to generate periodic interest income in the form of coupon payments. The passive strategy is
especially valuable for investors who want to generate stable interest income
over time and do not want to incur costs associated with frequent trading.
A passive strategy does not have to focus on very safe bonds that offer low
returns; it may reflect a portfolio of bonds with diversified risk levels. The diversification is intended to reduce the exposure to default from a single issuer of
bonds. To reduce exposure to interest rate risk, a portfolio may even attempt to
diversify across a wide range of bond maturities.
One disadvantage of this strategy is that it does not capitalize on expectations of interest rate movements. Investors who use a passive strategy, however,
are more comfortable matching general bond market movements than trying to
beat the bond market and possibly failing.
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I N V E S T I N G
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B O N D S
MATURITY MATCHING STRATEGY
matching strategy
Investing in bonds that will
generate payments to
match future expenses.
The matching strategy involves selecting bonds that will generate payments to
match future expenses. For example, parents of an 8-year-old child may consider investing in a 10-year bond so that the principal can be used to pay for the
child’s college education. Alternatively, they may invest in a bond portfolio just
before retirement so that they will receive annual income (coupon payments) to
cover periodic expenses after retirement. The matching strategy is conservative,
in that it is simply intended to cover future expenses, rather than to beat the
bond market in general.
HOW BOND DECISIONS FIT WITHIN
YOUR FINANCIAL PLAN
The following are the key decisions about bonds that should be included within
your financial plan:
1. Should you consider buying bonds?
2. What strategy should you use for investing in bonds?
Exhibit 16.4 provides an example of how bond decisions apply to Stephanie
Spratt’s financial plan. Stephanie’s first concern is maintaining adequate liquidity and making her existing loan payments. She is not in a position to buy bonds
right now, but will consider bonds once her financial position improves.
Exhibit 16.4
How Bonds Fit Within Stephanie Spratt’s Financial Plan
Goals for Investing in Bonds
1. Determine if I could benefit from investing in bonds.
2. If I decide to invest in bonds, determine what strategy to use to invest in bonds.
Analysis
Strategy to Invest in Bonds
Opinion
Interest rate strategy
I cannot forecast the direction of interest rates (even experts
are commonly wrong on their interest rate forecasts), so this
strategy could backfire. This strategy would also complicate
my tax return.
Passive strategy
May be appropriate for me in many situations, and the low
transaction costs are appealing.
Maturity matching strategy
Not applicable to my situation, since I am not trying to match
coupon payments to future expenses.
INTEGRATING THE KEY CONCEPTS
457
Decisions
Decision on Whether to Invest in Bonds:
I cannot afford to buy bonds right now, but I will consider purchasing them in the future
when my financial position improves. Bonds can generate a decent return, and some bonds
are free from default risk. I find Treasury or AAA-rated bonds to be most attractive.
Decision on the Strategy to Use for Investing in Bonds:
I am not attempting to match coupon payments with future anticipated expenses. I may consider expected interest rate movements according to financial experts when I decide which
bond fund to invest in, but I will not shift in and out of bond funds frequently to capitalize
on expected interest rate movements. I will likely use a passive strategy of investing in bonds
and will retain bond investments for a long period of time.
DISCUSSION QUESTIONS
1. How would Stephanie’s bond investing decisions be
different if she were a single mother of two children?
SUMMARY
Bonds are long-term debt securities. Bonds can be
classified by their issuer. The common issuers are
the U.S. Treasury, municipalities, federal government agencies, and corporations.
A bond’s yield to maturity is the annualized return
that is earned by an investor who holds the bond
until maturity. This yield is composed of interest
(coupon) payments and the difference between the
principal value and the price at which the bond was
originally purchased.
Bonds can be exposed to default risk, which reflects
the possibility that the issuer will default on the bond
payments. Some bonds are exposed to call risk, or the
risk that the bond will be called before maturity. Bonds
are also subject to interest rate risk, or the risk of a decline in price in response to rising interest rates.
A popular bond strategy is the interest rate strategy,
where the selection of which bonds to buy is dependent on the expectation of future interest rates.
An alternative strategy is a passive strategy, in
which a diversified portfolio of bonds is maintained.
A third bond strategy is the maturity matching strat-
2. How would Stephanie’s bond investing decisions be
affected if she were 35 years old? If she were 50
years old?
egy, in which the investor selects bonds that will
mature on future dates when funds will be needed.
INTEGRATING THE KEY CONCEPTS
Your decision to invest in bonds is not only related to
your other investment decisions, but affects other
parts of your financial plan. Before investing in bonds,
you should reassess your liquidity (Part 2). Bonds that
provide periodic coupon payments offer some liquidity. However, the value of a bond is subject to an
abrupt decline, and you may not want to sell the bond
when its price is temporarily depressed.
The bond decision is related to financing (Part 3) because you should consider paying off any personal
loans before you invest in bonds. If after considering
your liquidity and your financing situation, you still
decide to invest in bonds, you need to decide
whether the investment should be for your retirement account (Part 6). There are some tax advantages to that choice, but also some restrictions on
when you have access to those funds (as explained
in more detail in Chapter 19).
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I N V E S T I N G
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B O N D S
1. Financial
Planning Tools
(Budgeting, Time
Value, Tax Planning)
2. Liquidity
Management
6. Retirement and
Estate Planning
( Retirement Planning,
Estate Planning)
Decide Whether
to Invest in Bonds
(Banking, Money
Management,
Credit Management)
5. Investing
3. Financing
( Stocks, Bonds,
Mutual Funds)
(Personal Loans,
Mortgages)
4. Protecting Your
Assets and Income
(Insurance)
A P P E N D I X
Valuing a Bond
16A
Before investing in a bond, you may wish to determine its value using time value
of money analysis. A bond’s value is determined as the present value of the
future cash flows to be received by the investor, which are the periodic coupon
payments and the principal payment at maturity. The present value of a bond
can be computed by discounting the future cash flows (coupon payments and
principal payment) to be received from the bond. The discount rate used to discount the cash flows should reflect your required rate of return. The value of a
bond can be expressed as:
n
Value of Bond [Ct /(1 k)t] Prin/(1 k)n
t1
where Ct represents the coupon payments in year t, Prin is the principal payment at the end of year n when the bond matures, and k is the required rate of
return. Thus, the value of a bond is composed of the present value of the future
coupon payments, along with the present value of the principal payment. If you
pay the price that is obtained by this valuation approach and hold the bond to
maturity, you will earn the return that you require.
EXAMPLE
Victor Kalafa is planning to purchase a bond that has seven years remaining until
maturity, a par value of $1,000, and a coupon rate of 6 percent (let’s assume the
coupon payments are paid once annually at the end of the year). He is willing to purchase this bond only if he can earn a return of 8 percent, because he knows that he
can earn 8 percent on alternative bonds.
The first step in valuing a bond is to identify the coupon payments, principal payment,
and required rate of return:
■
Future cash flows:
Coupon payment (C) .06 $1,000 $60
Principal payment (Prin) $1,000
■
Discount rate:
Required rate of return 8 percent.
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I N V E S T I N G
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The next step is to use this information to discount the future cash flows of the bond
with the help of the present value tables in the appendix at the end of the book:
Input
Function
Value of Bond Present Value of Coupon Payments Present Value of Principal
7
N
[C (PVIFA, 8%, 7 yrs)] [Prin (PVIF, 8%, 7 yrs)]
8
I
[$60 5.2064] [$1,000 .5835]
? 895.87
PV
60
PMT
1000
FV
$312.38 $583.50
$895.88.
When using a financial calculator to determine the value of the bond, the future value
will be 1,000 because this is the amount the bondholder will receive at maturity.
Based on this analysis, Victor is willing to pay $895.88 for this bond, which will provide his annualized return of 8 percent. If he can obtain the bond for a lower price,
his return will exceed 8 percent. If the price exceeds $895.88, his return would be
less than 8 percent, so he would not buy the bond.
The market price of any bond is based on investors’ required rate of return,
which is influenced by the interest rates that are available on alternative investments at the time. If bond investors require a rate of return of 8 percent as Victor does, the bond will be priced in the bond market at the value derived by Victor. However, if the bond market participants use a different required rate of
return than Victor, the market price of the bond will be different. For example,
if most investors require a 9 percent return on this bond, the bond will have a
market price below the value derived by Victor (conduct your own valuation
using a 9 percent discount rate to verify this).
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FINANCIAL PLANNING PROBLEMS
REVIEW QUESTIONS
1. What is a bond? What is a bond’s par value? What
are coupon payments, and how often are they
normally paid? What happens when investors buy
a bond below par value? When should you consider investing in bonds?
2. What is a call feature on a bond? How will a call
feature affect investor interest in purchasing the
bond?
3. What is a convertible bond? How does a bond’s
convertibility feature affect its return?
4. What is a bond’s yield to maturity? How does the
price paid for a bond affect its yield to maturity?
5. Discuss how bonds are sold on the secondary
market.
6. What are Treasury bonds? Describe their key characteristics.
7. What are municipal bonds? Why are they issued?
Are all municipal bonds free from default risk?
What characteristic makes municipal bonds especially attractive to high-income investors?
8. What are federal agency bonds? Compare and
contrast the three most common federal agency
bonds.
9. What are corporate bonds? Are corporate bonds
subject to default risk? What are junk bonds? Why
would investors purchase junk bonds?
10. List the information provided in corporate bond
quotations.
11. When an investor sells a bond in the secondary
market before the bond reaches maturity, what
determines the return on the bond? How do interest rate movements affect bond returns in general?
12. Discuss the effect of taxes on bond returns.
13. Discuss default risk as it relates to bonds. How
may investors use risk ratings? What is the relationship between the risk rating and the risk premium? How do economic conditions affect default risk?
461
14. What is the risk to investors on bonds that have a
call feature?
15. What is interest rate risk? How does a rise in interest rates affect a bond’s price?
16. How is interest rate risk affected by a bond’s maturity? How can investors use expectations of interest rate movements to their advantage?
17. Describe how the interest rate strategy for bond
investment works. What are some of the potential
problems with this strategy?
18. How does the passive strategy for bond investment work? What is the main disadvantage of this
strategy?
19. Describe the maturity matching strategy of investing in bonds. Give an example. Why is this strategy considered conservative?
Question 20 is based on the chapter appendix.
20. How is the value of a bond determined? What information is needed to perform the calculation?
FINANCIAL PLANNING PROBLEMS
1. Bernie purchased 20 bonds with par values of
$1,000 each. The bonds carry a coupon rate of 9
percent payable semiannually. How much will
Bernie receive for his first interest payment?
2. Michael has $10,000 that he wishes to invest in
bonds. He can purchase Treasury bonds with a
coupon rate of 7.0 percent or municipal bonds
with a coupon rate of 5.5 percent. Michael lives in
a state with no state income tax and has a marginal tax rate of 25 percent. Which investment will
give Michael the higher annual earnings after
taxes are considered?
3. Sandy has a choice between purchasing $5,000 in
Treasury bonds paying 7.0 percent interest or purchasing $5,000 in BB-rated corporate bonds with
a coupon rate of 9.2 percent. What is the risk premium on the BB-rated corporate bonds?
4. Bonnie paid $9,500 for corporate bonds that have
a par value of $10,000 and a coupon rate of 9 percent, payable annually. Bonnie received her first
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B O N D S
interest payment after holding the bonds for 12
months, and then sold the bonds for $9,700. If
Bonnie is in a 35 percent marginal tax bracket for
federal income tax purposes, what are the tax
consequences of her ownership and sale of the
bonds?
5. Katie paid $9,400 for a Ginnie Mae bond with a
par value of $10,000 and a coupon rate of 6.5 percent. Two years later, after having received the annual interest payments on the bond, Katie sold
the bond for $9,700. What are her total tax consequences if she is in a 25 percent marginal tax
bracket?
Questions 6 through 10 are based on the chapter
appendix.
6.
Timothy has an opportunity to buy a $1,000 par
value municipal bond with a coupon rate of 7 percent and a maturity of five years. The bond pays
interest annually. If Timothy requires a return of 8
percent, what should he pay for the bond?
7. Molly wants to invest in Treasury bonds that have
a par value of $20,000 and a coupon rate of 4.5
percent. The bonds have a 10-year maturity, and
Molly requires a 6.0 percent return. How much
should Molly pay for her bonds, assuming interest
is paid annually?
8. Emma is considering purchasing bonds with a par
value of $10,000. The bonds have an annual
coupon rate of 8 percent and six years to maturity.
The bonds are priced at $9,550. If Emma requires
a 10 percent return, should she buy these bonds?
9. Mark has a Treasury bond that has a par value of
$30,000 and a coupon rate of 6 percent. The bond
has 15 years to maturity. Mark needs to sell the
bond, and new bonds are currently carrying
coupon rates of 8 percent. What price should
Mark put on the bond?
10. What if Mark’s Treasury bond in the previous question had a coupon rate of 9 percent and new bonds
still had interest rates of 8 percent? What price
should Mark put on the bond in this situation?
FINANCIAL PLANNING
ONLINE EXERCISES
1. Go to http://www.financenter.com/products/
sellingtools/calculators/bond and click on “What is
my yield to maturity?”
a. This Web site provides an estimate of the yield
to maturity of a bond based on its present
price, coupon rate, and maturity. Enter 98 for
the percent of face value paid as price of the
bond. Enter $1,000 as the face value, a coupon
rate of 7.75 percent, 120 months to maturity,
15 percent federal tax rate, 8 percent state tax
rate, indicate that your coupon income is invested elsewhere at a rate of 4 percent, and
that the type of bond is a Treasury security.
View the results and graphs.
b. Now change the price you paid to 105 percent
of face value and keep the other values the
same as in the previous example. Compare the
yield to maturity to the yield from the previous
example. What is the reason for the differences?
c. Now change the price you paid as percent of
face value to 100 percent and keep the other
values the same as in the previous example.
How does the yield to maturity compare with
the coupon rate? How does this result differ
from the previous two examples?
d. Now enter 98 under price you paid as percent
of face value, and under type of bond, choose
municipal bond: state tax exempt. Keep the
other values the same as in the previous example. Note the yield to maturity and the return.
e. Keeping the values the same as in the previous
example, now change the type of bond to a corporate bond. Compare the yield to maturity and
the return to those from the municipal bond example. Why is the return after taxes different?
2. Go to http://money.cnn.com/markets/bondcenter/,
which allows you to monitor the performance of
the bond market.
a. Click on “Latest Rates” and you will get a listing of the current yield to maturity for several
types of fixed-income securities, including Treasury bonds, municipal bonds, and corporate
bonds. Can you explain the difference in rates
within each category and between categories?
b. Now click on “Short Term Rates.” You will receive information on the prime rate, discount
rate, and the federal funds rate. What is the
THE SAMPSONS—A CONTINUING CASE
significance of each rate, and how are they different from each other?
3. Go to http://www.bloomberg.com/markets/rates/
index.html. You will see information on municipal
bond yields for various maturities. The yields observed during the last two trading days will be
shown along with the percentage change in yields.
463
The yields from a week ago and six months ago
will also be provided. The equivalent yield on a taxable bond for an investor with a federal marginal
tax rate of 28 percent will be shown for comparison, as the interest received on municipal bonds is
exempt from federal income taxes. Why are the
yields different for the various maturities?
BUILDING YOUR OWN FINANCIAL PLAN
Based on an investor’s risk tolerance and/or timeline
for goal achievement, bonds may prove to be a useful investment instrument. Referring back to the risk
tolerance test that you took in Chapter 13 and the
goals that you established in Chapter 1, consider the
extent to which bonds may play a role in your overall financial planning. The Web sites mentioned in
the template provided with this chapter in the Financial Planning Workbook and on the CD-ROM will
assist you in the decision. Carefully consider whether
any of your financial goals can be met with bond investing; revise your goals and personal cash flow
statement to reflect any decision you make.
Bonds, like stocks, need to be reviewed as market
conditions change, although bonds are far less volatile
than stocks and, therefore, do not require daily monitoring.
THE SAMPSONS—A CONTINUING CASE
The Sampsons are considering investing in bonds as
a way of saving for their children’s college education.
They learn that there are bonds with maturities between 12 and 16 years from now, which is exactly
when they would need the funds for college expenses. Next, Dave and Sharon notice that some
highly rated municipal bonds offer a coupon rate of 5
percent, while some highly rated corporate bonds
offer a coupon rate of 8 percent. The Sampsons could
purchase either type of bond at its par value. The income from the corporate bonds would be subject to
tax at their marginal rate of 25 percent. The income
on the municipal bonds would not be subject to federal income tax. Dave and Sharon are looking to you
for advice on whether bonds are a sound investment
and, if so, what type of bond they should purchase.
1. Should the Sampsons consider investing a portion of their savings in bonds to save for their children’s education? Why or why not?
2. If the Sampsons should purchase bonds, what
maturities should they consider, keeping in mind
their investment goal?
3. If the Sampsons should consider bonds, should
they invest in corporate bonds or municipal
bonds? Factor the return they would receive after
tax liabilities into your analysis, based on the
bonds having a $1,000 par value and the Sampsons being in a 25 percent marginal tax bracket.
4. The Sampsons have read that many corporate
bonds have recently been downgraded due to
questionable financial statements. However, the
Sampsons are not concerned with this, since the
corporate bond they are considering is highly
rated. Given their financial goals, explain the
impact a downgrade of the corporate bond could
have on the Sampsons.
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IN-TEXT STUDY GUIDE
True/False:
1. Bonds are short-term debt securities that are issued
by government agencies or corporations.
2. Bonds typically provide fixed dividend payments that
represent additional income each year.
3. A call feature attached to a bond allows the issuer to
buy back the bond before maturity.
4. Investors can sell bonds before maturity to other investors in the secondary market.
5. Treasury bonds are subject to default risk.
6. Federal agency bonds are long-term debt securities
issued by federal agencies such as the Government
National Mortgage Association.
7. Bonds issued by some smaller, less stable corporations are subject to a higher degree of default risk.
They are referred to as trash bonds.
8. You can always rely on credit agencies to detect accounting gimmicks.
9. Most strategies for selecting bonds involve investing
in a diversified portfolio of bonds rather than in one
bond.
10. The matching strategy for selecting bonds involves
frequent trading to capitalize on shifts in expectations
of interest rate fluctuations.
11. Each bond has a par value (or face value) that is paid
by the issuer to the investor holding the bond until
maturity.
Question 12 is based on the chapter appendix.
12. When determining the price of a bond, cash flows
are discounted at a rate that reflects the investor’s
required rate of return.
Multiple Choice:
1. Typical maturities for bonds are
a. 1 to 2 years.
b. 2 to 5 years.
c. 5 to 10 years.
d. 10 to 30 years.
2. Bond coupon payments are usually made
a. annually.
b. semiannually.
c. quarterly.
d. monthly.
3. ____________ risk is the possibility that the bond’s
price will decline in response to an increase in interest
rates.
a. Interest rate
b. Call
c. Reinvestment rate
d. Default
4. _______ bonds allow investors to exchange the bonds
for a specified number of shares of the issuer’s stock.
a. Registered
b. Bearer
c. Callable
d. Convertible
5. ________ bonds can be bought back by the issuer
before maturity.
a. Registered
b. Bearer
c. Callable
d. Convertible
6. The __________ is the annualized yield if the bond is
held until maturity.
a. coupon rate
b. yield to maturity
c. yield to call
d. call rate
IN-TEXT STUDY GUIDE
7. If a bond’s price _______ its par value, the yield to
maturity ________ the coupon rate.
a. exceeds; is less than
b. exceeds; exceeds
c. is less than; is less than
d. none of the above
13. Investors who own callable bonds are subject to
_______ risk.
a. default
b. prepayment
c. interest rate
d. exchange rate
8. ________ bonds are bonds issued by state and local
government agencies.
a. Treasury
b. Municipal
c. Government agency
d. Corporate
14. The _______ the risk of a bond, the _________ the
yield to maturity.
a. higher; lower
b. lower; higher
c. higher; higher
d. Answers (a) and (b) are correct.
9. Grant Gable lives in a state without state income
taxes. Grant is in the 27 percent tax bracket for federal income tax purposes. This year, he generated
$7,000 in interest from a municipal bond. Grant has
to pay federal taxes in the amount of
a. $0.
b. $7,000.
c. $1,960.
d. none of the above
15. Bonds with __________ terms to maturity are
_________ sensitive to interest rate movements.
a. long; more
b. short; less
c. long; not
d. Answers (a) and (b) are correct.
10. Which of the following bonds are not exposed to
default risk?
a. A-rated corporate bonds
b. C-rated corporate bonds
c. municipal bonds
d. Treasury bonds
11. Your return from a bond that you hold until maturity is
not dependent on
a. the coupon rate.
b. the yield to maturity.
c. the price of the bond.
d. Your return from a bond is dependent on all of
the above.
12. Which of the following ratings indicates the highest
degree of default risk?
a. AA
b. B
c. CCC
d. DDD
465
16. A(n) ____________ strategy involves investing in a
diversified portfolio of bonds that are held for a long
period of time.
a. interest rate
b. passive
c. matching
d. none of the above
17. A(n) ____________ strategy involves selecting bonds
that will generate payments that equal future
expenses.
a. interest rate
b. passive
c. matching
d. none of the above
18. The _________ a bond provides credit.
a. issuer of
b. investor in
c. shareholder of
d. none of the above
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Questions 19 and 20 are based on the chapter appendix.
The following information applies to questions 19 and 20.
Peter Mangler would like to purchase a bond that has
nine years remaining until maturity, has a par value of
$1,000, and has an annual coupon rate of 11 percent.
19. If Peter requires a return of 12 percent on the bond,
he should be willing to pay _______ for this bond.
a. $947.08
b. $1,000.00
c. $1,055.37
d. none of the above
20. If Peter requires a return of 10 percent on the bond,
he should be willing to pay _______ for this bond.
a. $944.63
b. $1,057.49
c. $1,000.00
d. none of the above