Bonds from SmartMoney'com

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Bondsfrom SmartMoney.com
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What is a Bond?

• A bond is a loan,
• and you are the lender

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What is a Bond?

• If I am the lender, who is the borrower?
• US Government
• State Government
• Local Government (municipality)
• Big Companies

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Why would the government borrow money?

• To build roads or bridges
• To fund the federal deficit

Why would a big company borrow money?

• To build factories
• To purchase equipment

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Who buys Bonds?

• Individuals
• Banks
• Mutual Funds
• .. Any investor who is adverse to risk

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Bond Terminology

• I loan the State of Pennsylvania 1,000 to help
  with the costs of a new road. The State, then,
  promises to pay me an interest rate of 5, and
  repay the loan in 10 years.
• 1,000 Face Value
• 5 interest Coupon Rate
• 10 years Maturity Date

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Whats the difference between a stock and a bond?

• Bonds
• 1) Loan is guaranteed
• 2) Interest is guaranteed

• Stocks
• 1) Initial Investment is not guaranteed
• 2) Dividends are not guaranteed

Thats why Bonds are called Fixed-Income
Investments
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So, what makes Bonds so complicated?

• Because bonds can be traded.
• That is, investors buy and sell bonds on the open
  market until they reach maturity.

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Example

• Face Value 1,000
• Coupon Rate 6
• Maturity Date 30 years
• So, Interest 1,000 6 60
• What if the price of the bond falls to 800?
• You still get 60 per year in interest.
• 60
• ---------------------- 7.5
  This is called Yield
• 800

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Yield

• Face Value 1,000
• Coupon Rate 6
• Maturity Date 30 years
• So, Interest 1,000 6 60
• 1) What if the price of the bond falls to 800?
  You still get 60 per year in interest
• 60 / 800 7.5 Yield
• 2) What if the price of the bond increases to
  1,200? You still get 60 per year in interest
• 60 / 1,200 5.0 Yield

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Yield

• So
• If the price of the bond decreases, the yield
  increases.
• If the price of the bond increases, the yield
  decreases.

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Yield

• Consequently.
• A bond SELLER wants a high price on the bond.
• A bond BUYER wants a high yield on the bond.

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So, whats the risk?

• Answer Inflation
• When prices go up, the bond becomes less and less
  valuable.

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Why do bond prices change?

• Compare the bond that you purchased 2 years ago
  to a bond that you could purchase today.
• Is the coupon rate higher? Or lower?

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Why do bond prices change?Example 1

• Suppose you purchased Bond 1 in 2005
• Face Value 1,000
• Coupon Rate 6
• Maturity Date 5 years
• Suppose you could purchase Bond 2 in 2008
• Face Value 1,000
• Coupon Rate 4
• Maturity Date 5 years
• Today, is your 2005 bond worth more, or less than
  the 2008 bond? Answer More
• Could you sell your bond for a higher or lower
  price? Answer Higher

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Class Example

• Bond 1
• vs
• Bond 2
• vs
• Bond 3

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Inflation / Interest Rates

• When interest rates increase, bond prices
  decrease
• When interest rates decrease, bond prices increase