Chapter 12 Investing In Bonds

1
Chapter 12Investing In Bonds
12-1
Kapoor Dlabay Hughes Ahmad
Prepared by Cyndi Hornby, Fanshawe College
? 2009 McGraw-Hill Ryerson Ltd.
2
Learning Objectives - Chapter 12
12-2

1. Describe the characteristics of corporate bonds.
2. Discuss why corporations issue bonds.
3. Explain why investors purchase corporate bonds.
4. Discuss why federal, provincial and municipal
   governments issue bonds and why investors
   purchase government bonds.
5. Evaluate bonds when making an investment.

3
Learning Objective 1Describe the
characteristics of corporate bonds.
12-3
4
Characteristics of Corporate Bonds
12-4

• Corporations written pledge to repay a specified
  amount of money along with interest.
• The face value is the dollar amount that the
  bondholder will receive at the bonds maturity
  date.
• Maturity date is the date on which the
  corporation is to repay the borrowed money.
• The legal conditions are described in a bond
  indenture.
• Bond indenture is a legal document that details
  all the conditions relating to a bond issue.
• A trustee is the bondholders representative.

5
Characteristics of Corporate Bonds
12-5

• Between time of issue and maturity, corporations
  pay interest to bondholders, usually
  semi-annually, at stated rate (coupon rate)

Dollar Amount of Face Value x Interest
Annual Interest (Coupon) Rate
6
Learning Objective 2Discuss why corporations
issue bonds.
12-6
7
Why Corporations Sell Bonds
12-7

• To borrow money to pay for major purchases.
• Difficult or impossible to sell stock.
• Finance ongoing business activities.
• To get money to operate or expand.
• The interest paid to bondholders is a tax
  deductible business expense.

8
Four Types of Corporate Bonds
12-8

• Debenture Bond.
• Most corporate bonds are debenture bonds.
• Backed only by the reputation of the issuing
  company.
• Mortgage Bond.
• A corporate bond that is secured by various
  assets of the issuing firm.

9
Four Types of Corporate Bonds
12-9

• Subordinated Debenture Bond.
• An unsecured bond that gives bondholders a claim
  secondary to that of other designated bond
  holders with respect to interest payments and
  assets.
• Convertible Bond.
• Can be exchanged, at the owners option, for a
  specified number of shares of common stock.

10
Provisions for Repayment
12-10

• Call Feature
• 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.
• They call bonds if the interest rate they are
  paying you is very much higher than the going
  rate.
• Most corporate bonds and municipal bonds are
  callable.

11
Provisions For Repayment
12-11

• Sinking fund
• A fund to which annual or semi-annual deposits
  are made for the purpose of redeeming a bond
  issue.
• Serial bonds
• One issue of bonds that mature at different dates.

12
Other Types of Bonds
12-12

• Domestic, Foreign Eurobonds
• Issued in the country and currency of the issuer
• Units
• Two or more corporate securities bundled by an
  investment dealer and sold at an overall price
• Strip Bonds
• Coupons and bonds are sold separately at
  significant discounts

13
Learning Objective 3Explain why investors
purchase corporate bonds.
12-13
14
Why Investors Buy Corporate Bonds?
12-14

• For interest income.
• Investors know the interest rate.
• Interest will be paid to investors twice a year.
• Appreciation of bond value.
• May be able to sell the bond to someone else at a
  higher price if the interest rate on the bond is
  higher than the market rate.
• Bond face amount will be repaid at maturity.

15
Interest Income
12-15

• Method used to pay bondholders their interest
  depends on how the bond is registered.
• A registered bond is registered in your name by
  the company or government who issued it.
• A registered coupon bond is registered for
  principal only and not for interest.
• A bearer bond is not registered in the investors
  name.
• A zero coupon bond is sold well below face value,
  pays no interest, but is redeemed for face value
  at maturity.

16
Changes In Bond Value
12-16

• Price of corporate bond may fluctuate until
  maturity
• Usually caused by changes in interest rates
• If interest rates fall, price of bond will
  increase since its coupon rate is higher (selling
  at a premium)
• If interest rates rise, price of bond will fall
  (selling at a discount)

17
Changes in Bond Value
12-17

• Approximate Market Dollar Amount of
• Value Annual Interest
• Comparable
  Interest Rate
• Dollar Amount of Annual Interest 100 x 4.875
• 
  48.75
• Approximate Market Value 48.75
• 7
• 696.00
  

18
Bond Repayment At Maturity
12-18

• You may keep bond until maturity and then redeem
  it
• You may sell bond at anytime to another investor
• Value of bond closely tied to corporations
  ability to repay
• Other investors will pay more money for a quality
  bond

19
Comparison of Bonds to GICs
12-19

• Bonds included in portfolio to generate steady
  income, stabilize returns and provide security
• GIC similar except lending to bank
• Offer better protection as value guaranteed by
  bank and insured by CDIC
• Bonds higher risk of default therefore higher
  interest paid
• Can be sold at market to take advantage of market
  fluctuations

20
A Typical Bond Transaction
12-20

• Bonds are sold through full-service or discount
  brokerage firms or the Internet
• Bond market is an over-the-counter exchange
• Bond or investment dealers are paid a fee

21
Learning Objective 4Discuss why federal,
provincial and municipal governments issue bonds
and why investors purchase government bonds.
12-21
22
Government Bonds and Debt Securities
12-22

• Federal government sells bonds and securities to
  finance national debt and ongoing activities
• Considered low risk investments
• Offer lower interest rates than corporate bonds
• Types of Bonds
• Government of Canada securities
• Marketable bonds
• Specific maturity date, interest rate and are
  transferable
• Treasury Bills
• Discounted securities
• Canada Savings Bonds
• Regular or compound interest
  

23
Government Bonds and Debt Securities
12-23

• Provincial governments issue bonds to fund
  program spending and fund deficits
• Municipal bonds
• Installment Debentures

24
Learning Objective 5Evaluate bonds when
making an investment.
12-24
25
The Decision to Buy or Sell Bonds
12-25

• Can the corporation, government or
  municipality...
• Pay back the face value at maturity?
• Will you receive interest payments until
  maturity?
• Read the annual report.

26
The Decision to Buy or Sell Bonds
12-26

• Look for signs of financial strengths and
  weaknesses
• Is firm profitable?
• Are sales revenues increasing?
• Are long term liabilities increasing?
• How is bond rated?
• AAA (the highest) to D (the lowest)
• Junk Bond
• a type of bond that offers a very high return but
  is very risky as bond is nearing or currently in
  default

27
Bond Yield Calculations
12-27
Current Yield
Current Yield Dollar Amount of Annual Interest
Current Market
Value
Yield is the rate of return earned by an investor
who holds a bond for a stated period of time.
28
Bond Yield Calculations
12-28
Yield to Maturity
Takes into account the relationship among the
bonds maturity value, the time to maturity, the
current price and the dollar amount of interest
Dollar Amount of Annual Interest Face Value
Market Value
Number of Periods
Market Value Face Value
2
29
Summary of Learning Objectives
12-29

• Describe the characteristics of corporate bonds
• A written pledge to repay a specified amount of
  money with interest
• All of the details are contained in the bond
  indenture
• Face value, interest rate, maturity date,
  repayment
• Trustee is the bondholders representative

30
Summary of Learning Objectives
12-30

• Discuss why corporations issue bonds
• Help finance their ongoing activities
• Bonds may be debentures, mortgage bonds,
  subordinated bonds or convertible bonds
• To ensure money is available to repay bonds
  corporations establish a sinking fund
• Ca also issue serial bonds that mature on
  different dates

31
Summary of Learning Objectives
12-31

• Explain why investors purchase corporate bonds
• For interest income, possible increase in value
  and repayment at maturity
• Method used to pay interest depends on how bonds
  are registered
• Possible to purchase a bond at a discount and
  hold it until is appreciates in value
• Changes in interest rates are prime cause of bond
  price fluctuations

32
Summary of Learning Objectives
12-32

• Explain why investors purchase corporate bonds
• If you pay too much for a bond and it decreases
  in value, you lose money on your investment
• Hold bond until maturity and corporation pays you
  the face value
• Bonds can be bought or sold through brokerage
  firms

33
Summary of Learning Objectives
12-33

• Discuss why federal, provincial and municipal
  governments issue bonds and why investors
  purchase government bonds
• Federal government sells bonds to finance
  national debt and ongoing activities
• Three principal types of bonds
• Treasury Bills, marketable bonds and Canada
  Savings Bonds

34
Summary of Learning Objectives
12-34

• Discuss why federal, provincial and municipal
  governments issue bonds and why investors
  purchase government bonds
• Provincial and local governments issue bonds to
  finance ongoing activities and special projects
• Schools, roads, toll bridges
• Can be purchased through banks, trust companies,
  other financial institutions or through account
  executives

35
Summary of Learning Objectives
12-35

• Evaluate bonds when making an investment
• Newspapers provide information to evaluate a bond
  issue
• As does a copy of the corporations annual report
  or its Web site
• Bonds can be traded online and researched over
  the Internet
• Study to rating provided by the CBRS and DBRS

36
Summary of Learning Objectives
12-36

• Evaluate bonds when making an investment
• Current Yield is determined by dividing the
  amount of annual interest of the bond by its
  current market value
• The Yield to Maturity takes into account the
  relationship among a bonds maturity value, the
  time to maturity, the current price and the
  dollar amount of interest