Download callable bond

Characteristics of Bonds
1
GOALS
 Discuss the features and types of corporate
bonds
 Explain how to calculate earnings and
percentage yield on a corporate bond
 Describe federal and municipal government
securities, and zero-coupon bonds
2
Corporate Bonds
Corporations can use two financing methods:
STOCKS
BONDS
Important distinctions between the two:
1st - Bond are LOANS that must be repaid
- Stocks are shares of OWNERSHIP – not repaid
2nd - Interest payments on bonds are MANDATORY
- Dividends on stocks are NOT MANDATORY
3
Corporate Bonds
MATURITY DATE – bond becomes due for
payment
-- varies (1-30+ years)
-- most common = 10 yrs.
FACE VALUE - amount bondholder will be
repaid at maturity
-- most common = $1,000
4
Features of Corporate Bonds
Sold on the open
market just like
stocks
Only find a fraction of
bonds issued listed in
the newspaper
Referred to as “fixedincome investments”
BOND’s INTEREST RATE – percentage of face value that
will be paid in interest to the holder each year
5
Interest Rate on Bonds
Bond = $1,000
Purchased Jan. 1
Interest 5%
June 30
$25 Paid to holder
Dec. 31
$25 Paid to holder
6
7
Interest on Bonds
Taxed on bond interest paid throughout year
Taxed as ordinary income
2 Types of Bonds:
Registered
Coupon
Registered – Interest check mailed directly to
holder
Coupon – Present coupon at bank
 Only “older” bonds are Coupon Bonds
8
Corporate Bonds
Major Disadvantage: Few less than $1,000
Most sold in units of $5,000
Large outlay of cash by individuals 
CALLABLE BOND - bond that issuer has
the right to pay off before its maturity date
Date Bond can be called - identified at time it
is offered for sale
9
CALLABLE BOND
Example:
10-Year Bond issued in 2000
Maturity Date: 2010
Callable: 2005
Interest rates   issuer will
probably C A L L
Re-issue at lower interest rate
10
CALLABLE BOND
 Corporations usually agree NOT to call
bonds for the first five years
 Interest rate drops 2% or more
 When a corporation elects to exercise its
right to call a bond, it generally pays the
bondholders a slight premium-an amount above the face value of the bond
i.e. $1,000 bond might be called for $1,020
11
Types of Corporate Bonds
DEBENTURES - corporate bond not backed
by collateral but only by the general credit
standing of the corporations
-- no pledge of any specific assets to assure
repayment of the loan
-- holder must rely on the full faith and credit
of the issuer for repayment (reputation)
12
Mortgage Bonds
 a/k/a - secured bond - corporate bond
backed by specific assets as collateral to
assure repayment of the debt.
 Corporation fails to repay debt - holder may
claim the property used as security for the
debt
 Collateral --> typically real estate
13
Convertible Bonds
 Corporate bond that can be exchanged, at
the owner’s option, for a specified number
of shares of the corporation’s common stock
 If holder converts, cannot redeem at bond
maturity
14
Convertible Bonds Example
Purchase $1,000 convertible to 50 shares of
common stock
Convert when stock is
($1,000/50 shares = $20) or higher
Market price rises to $22
$22 X 50 = $1,100
15
Earnings on Corporate Bonds
All Bonds are issued with a
--> stated face value
--> interest rate
--> maturity date
i.e. Bond is issued January 1, 2000
Bond must be paid in 10 years (Jan. 1, 2010)
Yield --> 6%
16
Parts of a US Savings Bond
17
Earnings on Corporate Bonds
 No compounding
 Market Value may rise/fall once issued
i.e. $10,000 bond may sell higher if interest
rates are falling
-- investors would be willing to pay more for
the bond because it pays an interest rate
higher than current market rate
18
Earnings on Corporate Bonds
 Bonds selling for MORE than face value =
Selling at a PREMIUM
i.e. $10,000 bond selling for $10,000 – price,
is at 100% of its face value
But if bond sells for “104”, it would have a
premium of 4%
At 104, the market price would be $10,400.
$10,000 X .04 = $400 premium
$10,000 + $400 = $10,400 market price
19
Earnings on Corporate Bonds
In the previous example, the YIELD would be lower
than 6% because the buyer had to pay more than
face value to buy the bond
Bond can also sell BELOW face value
(investors are not willing to pay face value for a
bond yielding 6% when interest rates are rising)
Bond would then sell at a DISCOUNT to entice
buyers
20
Earnings on Corporate Bonds
Bond sold for 96 -- sold at a 4% discount
Bond purchaser would pay $9,600 for a $10,000.
$10,000 X .04 = $400.00 discount
$10,000 - $400 = $9,600. market price
In this case, buyer’s yield would be higher
than 6% because the buyer paid less than
the face value
21
Yield on a 6% Corporate Bond Purchased at a
Premium and at a Discount
Interest
Yield
Buy $10,000 at
face value--100
$600
6%
Buy at 104
$600
5.8%
Buy at 96
$600
6.3%
($600/$10,400 and $600/$9,600) annual dollar amt. / current
market price
22
1
2
3
$5,000
$5,000
$5,000
BOND
BOND
BOND
Interest 4%
$200
Interest 4%
$200
Interest 4%
$200
Price 100
Price 103
Price 96
($5,000)
($5,150)
($4,800)
4%
3.9%
4.15%
23
Yield vs. Interest Rate
 YIELD is NOT the same thing as the
interest rate
 YIELD can be higher or lower than the
bond’s stated interest rate
24
25
Government Bonds
 Loan money to the Government
Five major types of government bonds:
1) municipal
2) general obligation
3) treasury
4) savings
5) federal agency bonds
26
MUNICIPAL BONDS
Bond issued by state and local governments
Most attractive to residents of states with state
income taxes
Minimum Investment - $5,000
Also called “munis”
backed by specific projects
or by the general taxing authority of a governmental
unit
27
REVENUE BONDS
Municipal bond issued to raise money for a
public-works project
-- revenues (income) generated by the project
are used to pay the interest and repay the
bonds at maturity
Major projects financed:
28
GENERAL OBLIGATION BONDS
Municipal bond backed by the power of the
issuing state or local government to levy
taxes and borrow.
 No federal or state taxes
School District - build new school
City - new police / administrative center
State - new college campus
29
GENERAL OBLIGATION BONDS
 Repaid with general revenue & borrowings
 Compare to Revenue bonds – repaid from
revenue of the the specific facility built
with borrowed funds
How bonds – Cities pay off the bonds from - city income
and sales taxes collected, fees, fines
are paid
back 
– Schools and colleges pay off bonds from –
property taxes collected, tuition, fees
30
MUNICIPAL BONDS
 Although municipal bonds generally pay a
lower interest rate than corporate bonds, the
interest is exempt from federal taxes = so
the effective rate is higher than the stated
rate.
 Municipal bonds are also generally exempt
from state and local taxes in the state where
they are issued
• See example on next slide
31
Comparing Taxable and Tax-Exempt Bonds
Corporate Bond Municipal Bond
Face Value
$10,000
$10,000
Rate of Interest
6%
5%
Amt. Annual
Interest
Tax on Interest
Earned (28%)
Net Interest
$600
$500
168
0
$432
$500
32
SAVINGS BONDS & TREASURIES
 Purchase from:
• Commercial banks
• Payroll deduction
• Directly from a Federal Reserve Bank
 Allowed up to $15,000. / year
 Series EE [ $50 - $10,000 ]
 Postpone paying federal tax on interest on
matured Series EE by converting to HH
bonds
33
SAVINGS BONDS & TREASURIES
 TREASURIES – no longer engraved
certificates, rather in bookkeeping entries in
the records of the U.S. Treasury Dept. itself
or in the records of commercial banks
 Not rated – US Government backing makes
rating unnecessary
 Exempt from state and local taxes
 Usually not callable
34
AGENCY BONDS
 Loaning money to one of the following
agencies:
–
–
–
–
–
Federal Home Loan Mortgage Corporation
Federal National Mortgage Association
Federal Land Bank
Federal Housing Administration
Tennessee Valley Authority
 Although very low risk, they offer a slightly
higher yield than securities issued by the
Treasury
 Purchased directly through Banks / Brokers
35
ZERO COUPON BONDS
 Bond that is sold at a deep discount, makes no
interest payments , and is redeemable for its face
value at maturity
 Issued by
– U.S. Government
– Corporations
– Municipalities
Sold at as much as 50-75% below face value
 Bondholders often make money by selling before
maturity at a higher price than they paid
– Some hold to maturity and receive face value
36
ZERO COUPON BONDS
 Pay taxes on any interest earned (even
though you don’t actually receive it) until
bond is paid at maturity
 Zero-coupon municipal bonds – not subject
to taxation
 Prices on zero-coupon bonds can fluctuate
widely
– Should you need to sell the bond before
maturity, you may face a loss
37
Bond Ratings – Moody’s Investor
Service Bond-Rating









Aaa
Aa
A
Baa
Ba
B
Caa
Ca
C









Highest quality
High quality
Upper medium quality
Medium grade
Somewhat speculative
Low grade, speculative
Low grade, default possible
Low grade, partial recovery possible
Default, recovery unlikely
Determines creditworthy of the issuer
38
Characteristics of Bonds
Section 13.2
39
How to Buy/Sell Bonds
 Full-Service Brokers
 Discount Brokers
 Treasury Securities –
– Federal Reserve Banks + 25 Regional branches
40

41
Treasury Securities –
• www.treasurydirect.gov
42
43
Savings Bonds
 Through payroll deductions
– Employer withholds money as authorized
 Banks
44
Municipal Bonds
 Through Banks
 Brokers
 minimum $1,000.
45
Evaluating Bonds
 Earn a return on bonds in three ways:
– Interest each day
– Redeem the bond at face value
– Bond price may increase and holder can sell
before maturity for a higher price
46
Evaluating Bonds
 Rated for Safety - Moody’s / S&P
 AAA – highest
 D – lowest (bond in default)
• Issuer cannot meet interest and/or principal
payments [investor loses money]
47
Evaluating Bonds
 Bonds rated Baa or higher = Investment
Grade
– Safe because the issuers are stable &
dependable
– Letters stand for:
• stability
• bond security
• general industry risk
48
Evaluating Bonds
 Bonds rated Ba/BB or lower = Junk Bond
 highly speculative
 Issuing companies not usually financially
sound
 Read Bond Quote – pg. 370
49
Charles Schwab & Co. Inc., is pleased to announce the availability of the following new issue Taxable Offering
JP Morgan Chase Capital XVI
Issuer Name: JP Morgan Chase Capital XVI
Type Of Instrument: Hybrid Preferred Security
Moody's Expected Credit Rating*: A1
S&P Expected Credit Rating*: A-
Expected Bond Maturities*: 30 years
Anticipated Yield to Maturity: 6.25% Area
Issuer Description: J.P. Morgan Chase & Co.
provides global financial services under the J.P.
Morgan brand and retail banking under the Chase
brand. The Company provides services such as
investment banking, treasury and securities
services, asset management, private banking,
cardmember services, commercial banking, and
home finance. J.P. Morgan Chase serves business
enterprises, institutions, and individuals. This hybrid
security is an indirect obligation of JP Morgan.
Payment Frequency: Quarterly
Expected Call Features: Noncallable for 5 years
Select Benchmark Reference Rates
U.S. Treasuries
Maturity
Yield
6 Month
3.16%
2 year
3.58%
5 year
3.81%
10 year
4.12%
Data as of 5:24 PM ET 5/17/2005
Fixed income investments are subject to various risks including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and othe
50