Download Chapter 11

11-1
11
McGraw-Hill/Irwin
Investment Basics and Evaluating
Bonds
Copyright © 2006 The McGraw-Hill Companies, Inc. All rights reserved.
11-3
Investing Basics
Chapter Objectives
1. Explain why you should establish an
investment program
2. Describe how safety, risk, income, growth,
and liquidity affect your investment program
3. Identify the factors that reduce investment
risk
4. Recognize why investors purchase bonds
and other conservative investments.
5. Evaluate bonds when making an investment
11-4
Objective 1: Explain why you should establish
an investment program
Establishing Investment Goals
 Financial goals should be specific and measurable.
They should be tailored to your financial needs and
what you want to accomplish. To develop your goals
ask yourself..
 What will you use the money for?
 How much money do you need for your goals?
 How will you obtain the money?
 How long will it take you to obtain the money?
 How much risk are you willing to assume in an
investment program?
11-5
Establishing Investment Goals
(continued)
 What possible economic or personal
conditions could alter your investment goals?
 Considering your economic circumstances,
are your investment goals reasonable?
 Are you willing to make the sacrifices
necessary to ensure that you meet your
investment goals?
 What will the consequences be if you don’t
reach your investment goals?
11-6
Performing a Financial Checkup
 Work to balance your budget.
– Do you regularly spend more than you make?
 Pay off high interest credit card debt first.
 Obtain adequate insurance protection.
 Start an emergency fund you can access quickly.
– Three to nine months of living expenses.
 Have access to other sources of cash for
emergencies.
– Line of credit is a short-term loan approved before the
money is needed.
– Cash advance on your credit card.
11-7
Getting the Money Needed to Start an Investing
Program
 Pay yourself first.
 Take advantage of employer-
sponsored retirement programs.
 Participate in elective savings programs.
 Make a special savings effort one or two
months each year.
 Take advantage of gifts, inheritances, and
windfalls.
11-8
The Value of Long-Term Investing Programs
 Many people don’t start investing because
they only have a small amount to invest, but
even small amounts invested regularly
grow over a long period of time.
 If you begin savings $2,000 each year
(depending on the rate of return, you could
have over $1 million by the time you are age
65—See Exhibit 11-1.
 The higher the rate of return the greater the
risk.
11-9
Objective 2: Describe how safety, risk, income, growth,
and liquidity affect your investment decisions
Factors Affecting the Choice of Investments
 Safety and risk.
– Safety in any investment means
minimal risk of loss.
– Risk means a measure of
uncertainty about the outcome.
– Investments range from very safe to very risky.
– The potential return on any investment should be
directly related to the risk the investor assumes.
– Speculative investments are high risk, made by
those seeking a large profit in a short time.
11-10
Components of the Risk Factor
 Inflation risk - during periods of high inflation your
investment return may not keep pace with the
inflation rate.
 Interest rate risk – the value of bonds or preferred
stock may increase or decrease because of
changes in interest rates in the economy.
 Business failure risk - affects stocks and corporate
bonds.
 Market risk - prices fluctuate because of behaviors
of investors.
Investment Growth and Liquidity
11-11

Income
- An investment will provide a predictable source of
income.

Growth
–
–

means investment will increase in value.
Common stock usually offers the greatest
potential for growth.
Mutual funds, government and corporate bonds,
and real estate offer growth potential.
Liquidity
–
Ability to buy or sell an investment quickly without
substantially affecting the investment’s value.
11-12
Objective 3: Identify the factors that can reduce
investment risk.
 Asset allocation is the process of spreading your
assets among several different types of
investments. Other factors to consider include:
– The time factor
– Your age
– Your role in the investment process
11-13
Government Bonds and Debt Securities
 Sold to obtain money to finance the national
debt, and the ongoing costs of government.
 Three levels of government issue bonds:
– Federal.
– State.
– Local municipalities.
U.S. Government Treasury Bills and Notes
11-14
Treasury Bills (T-Bills).




$1,000 minimum.
4, 13, or 26 weeks to maturity.
Sold at a discount.
Federal but no state tax on interest earned.
Treasury Notes.




$1,000 units.
Typical maturities are 2, 3, 5, and 10 years.
Interest paid every six months, at a higher rate than T-bills.
Federal but no state tax on interest earned.
11-15
Federal Agency Debt Issues
 FHA - Federal Housing Administration
 Fannie Mae - Federal National Mortgage Association.
 Ginnie Mae - Government National Mortgage
Association.
 Freddie Mac - Federal Home Loan Mortgage
Corporation.
 Essentially risk free, and earn slightly higher interest
than government securities issued by
the treasury department.
 Maturities range from 15 – 30 years.
 Average maturity is 15 years.
11-16
State and Local Government Securities
 Municipal bonds - sometimes called munis.
 Issued by a state or local government, including cities,
counties, school districts, and special taxing districts.
 Use funds for ongoing costs and 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.
11-17
Taxable Equivalent Yield
Tax-exempt yield
___________________
1.0 - Your tax rate
Example:
Taxable equivalent yield
0.06
= __________
1.0 - 0.28
= 0.083 = 8.3%
11-18
Characteristics of Corporate Bonds
 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.
 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.
Why Corporations Sell Bonds
11-19





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.
11-20
Types of Corporate Bonds
Debenture bond.
– Most corporate bonds
are debenture bonds.
– Unsecured - Backed only by
the reputation of the issuing company.
Mortgage bond.
– A corporate bond that is secured by various
assets of the issuing firm, usually real estate.
– Interest rate is lower because it is secured.
11-21
Types of Corporate Bonds
(continued)
Convertible bond.
– 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.
– Generally, the interest rate on a convertible bond is
1 to 2 percent lower than the rate paid on traditional
bonds.
– Convertible bonds, like all potential investments,
must be carefully evaluated.
11-22
Provisions For Repayment
Call Feature of a Bond
 Corporation can call in or buy back outstanding bonds
from current bondholders before the maturity date.
 Most corporate bonds are callable.
 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 is
much higher than the going rate.
11-23
Provisions For Repayment
(continued)
 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.
11-24
Objective 4: Explain Why Investors Buy Corporate
Bonds
 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.
 Dollar 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 current interest rate.
 Bond face amount will be repaid at maturity.
11-25
Objective 5: Evaluate bonds when making an
investment decision
 The Decision to Buy or Sell a Bond
– There are a number of sources of information that
can be used to evaluate bond investments.
– The internet
– Use it for price information, trade bonds online and
lastly do research on the issuing corporation and its
bond issues
 Read the bond quotes in the newspaper.
 How is the bond rated?
– 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.
11-26
The Decision to Buy or Sell a Bond
 Bond Yield Calculations
– Current Yield = annual income amount divided by
current market value
 Other Sources of Information
– Business Periodicals
– Government Sources