CHAPTER 11 Investing Basics and Evaluating Bonds “If a little money does not go out, great money will not come in.” -- Confucius.
Download ReportTranscript CHAPTER 11 Investing Basics and Evaluating Bonds “If a little money does not go out, great money will not come in.” -- Confucius.
C
HAPTER
11
Investing Basics and Evaluating Bonds
1
“If a little money does not go out, great money will not come in.” -- Confucius
The Answer is…
“A Voluntary Tax on Stupid People”
2
What is the Question?
Silly, the Question is…
“What is the Lottery?”
3
A Voluntary Tax on Stupid People
What are the Odds of Winning?
The odds of winning the California Mega Millions Jackpot are 176 million to 1
“But somebody has to win, right?”
Yes, but that somebody will not be you!
If a person purchases 50 lottery tickets each week, he or she will win the Mega Millions Jackpot about once every 50,000 years
“Let’s see. $50 per week at 10% for 50,000 years…”
4
Speaking of Odds…
Astronomers have located an asteroid that is possibly on a collision course with Earth The asteroid could hit the Earth in 2029 Triggering untold destruction and the end of tens of thousands of species, including the human race The odds of the asteroid hitting the Earth are currently set at 300 to 1 But those odds will probably lessen as more is learned about the asteroid’s orbit
So Why Aren’t the Nations Preparing for This!?
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Because it Ain’t Gonna’ Happen!
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And You Ain’t Gonna’ Win the Lottery!
So Start Saving Now
But, of course, if the asteroid does hit, we will have plenty of warning for you to go out and spend all your savings on a really great time!
Now, let’s get serious…
Establishing Investment Goals
You already know the #1 Financial Goal:
“Spend Less Than You Earn” “Live Beneath Your Means” “Make Love, Not Loans” “Pay Yourself First” “Frugal, Frugal, Frugal!”
Which one is your favorite?
If Goal #1 is followed, everything else is easy!
For each investment goal, assess the time frame Is it short-term, intermediate-term, or long-term Choose an appropriate investment for the time frame This chapter gives you a thumb-nail view of each type With an emphasis on bond investments We will look at some of the others in detail later on 7
Essentials Before Investing
Or so says our book… They are important but not essential
8 Work to balance your budget Pay off high interest credit card debt first Start an
emergency fund
you can access quickly Three to nine months of living expenses
I simply do not agree with the concept of an “emergency fund” of three to nine months of living expenses. As long as you have access to cash via a home equity line of credit, for example, there is no good reason to keep $20,000 to $30,000 or more in a savings account earning 0.01%. Instead, use the money to pay down high interest debt, especially credit card debt.
P.S. The Wealthy Barber agrees with me. P.P.S. You are adequately insured, right?
Exceptions: Salespeople and the self-employed
First: Some Investment Terms
Safety – Guarantee of return of principal Risk – Uncertainty about an outcome Inflation risk Interest rate risk
“I am not so much concerned with
Business failure risk the return on my money as I am Market risk with the return of my money.”
- Will Rogers
Global investment risk Liquidity Ability to buy or sell an investment quickly without substantially affecting the investment’s value 9
What is your tolerance for risk? ( http://njaes.rutgers.edu/money/riskquiz/ ) Unfortunately, you can’t know until you have some skin in the game … and then lose some skin!
“Where Do I Get the Money to Invest?”
10
Pay Yourself First
Take advantage of employer-sponsored retirement programs [401(k), 403(b), etc.] These come right out of your paycheck Take advantage of automatic contributions from your checking or savings account [Roth IRA] Schedule them to occur right after you normally receive your paycheck They work like a pay raise, only in reverse
“How Much Do I Need?”
Start small!
“Can you afford $50 per month?”
Small amounts invested regularly become large amounts over time
Obviously, the more the better
But it is better to get started with a small amount now than to lazily dream of a day when you’ll be able to put away far more –
Get Started Now!
You can always increase the amount
Try to increase the amount each year Especially when you get a pay raise 11
Regular Taxable Accounts
versus
Qualified Accounts Tax-
12
Account Statement Examples
Stocks Margining Bonds Options “Cash” Futures Real Estate Mutual Funds Shorting Stocks Bonds Mutual Funds “Cash” Taxable Account a.k.a. Regular account All contributions are post-tax dollars No limit on contributions No limits on investment types Pay taxes every year on gains Tax-Qualified Account a.k.a. Retirement Account, Education Accounts, MSA HSA Most are pre-tax; Some are post-tax Strict limits on contributions Strict limits on investment types Tax-deferred (pre-tax)
or
Tax-free (post-tax)
Although there are many subtle and not-so-subtle differences, the major differences are how they are taxed by the IRS, how much money you can contribute, and what you can have in the account.
Types of Investment Accounts
Taxable Accounts (a.k.a. Regular Accounts)
All interest, dividends, capital gains, and rent are taxable each year
Best for short-term or intermediate-term investments but can also be used for long-term Tax-Qualified Accounts (a.k.a. Retirement Accounts, Education Accounts, MSAs HSAs) Tax-deferred – Pay no taxes until you withdraw the funds (normally in retirement) Best for intermediate-term or long-term investments (but mostly for long-term)
Account Statement Examples
13
Types of Retirement Accounts
Pre-tax Contributions 401(k), 403(b) for private & public employees Traditional IRA for everyone SEP-IRA, SIMPLE IRA and Keogh for self employed or those working for small business Tax Break Now Deduct contributions from income tax Pay taxes in retirement (when tax bracket is lower) Post-tax Contributions Roth IRA for everyone, Roth 401(k), Roth 403(b) Tax Break Later
(Tax-Free in Retirement!)
Annuities (pre-tax and post-tax) 14
A Pre-tax Contribution Lowers Your Taxes Now
Examples: IRA, 401(k) / 403(b)
15 You contribute via your paycheck: $100 Your Federal tax withholding is lowered by: Your California tax withholding is lowered by: Total government subsidy: $25 $8 $33 Your take home pay is only reduced by: $67
But the whole $100 still goes into your account!
“So What’s the Catch?”
You pay income tax on any amounts withdrawn in retirement But people in retirement are usually in a lower tax bracket If you withdraw the funds
before
You pay the income tax, and retirement… You pay a 10% penalty!
Exceptions for first home purchase, higher education expenses and medical disability This is a long-term investment Don’t even
think
about dipping into it for a car, vacation, etc. (A first home or higher education? Okay) 16
A Post-tax Contribution Gives You No Tax Break Now
Examples: Roth IRA, Roth 401(k)
17 You contribute to a Roth IRA: $100 Your Federal tax withholding is lowered by: Your California tax withholding is lowered by: Total government subsidy: $0 $0 $0 Your disposable income is reduced by: $100
So Why Bother Contributing to a Roth IRA?
“Because a Roth IRA is So Cool!”
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Tax-Free in Retirement
Opportunity is a Golden No other investment choice comes close!
Eventually, I think they will probably be gotten rid of Plus, you can withdraw the contributions
at any time
with no penalty You have already paid taxes on the contributions This makes the Roth IRA also an excellent intermediate-term investment account Purchase of a house or other high-ticket item Great for college expenses Currently not used in Financial Aid calculations
19
But Contributing to a Roth Can Be Tricky for High Income Earners
Limitations on Roth IRAs Contributions Only single taxpayers with an AGI of $105,000 or less and married couples with an AGI of $167,000 or less can fully contribute to a Roth IRA If you do not qualify,
Congratulations!
But you can contribute to a Roth IRA anyway If you find that you have made over the limit, you can “recharacterize” the contributions into a Traditional IRA (which does not have the same limitations) before you file your taxes And then you convert the Traditional IRA to a Roth I know. I know. Who voted for these bozos?
Oh, yeah. We did …
Education Savings Accounts
529 Plans Works like a Roth IRA Post-tax dollars
529 plans were set to expire in 2011 but have been extended indefinitely.
No tax on earnings as long as you use the money for higher education High penalty if you use the money for any other purpose Coverdell Education Plans (nee Education IRA) Like the 529 plan, only much worse But if you use either of these plans, then you can’t take advantage of the Hope and Lifelong Learning Educational Tax Credits (
Gee, Thanks!
) 20
Medical Savings Accounts Health Savings Accounts
Medical Savings Accounts (MSAs) Tax-deductible contributions Pre-tax dollars No tax on withdrawals as long as you use the money for medical purposes High penalty if you use the money for any other purposes Only available to self-employed and those working for small business They are now changing to … Health Savings Accounts (HSAs) Anyone can have one, not just self-employed or small businesses 21
Review: Types of Investment Accounts
Taxable Accounts (a.k.a. Regular Accounts) Tax-Qualified Accounts (a.k.a. Retirement Accounts, Educational Savings Accounts, MSAs, HSAs) Pre-tax Contributions – tax-deferred Traditional IRA, 401(k), 403(b) , etc.
Post-tax Contributions – tax-free Roth IRA, Roth 401(k), Roth 403(b) This is where the types of investments reside
They are not the investments!
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Okay. Now, What Do We Invest In? (In other words, what investments do we put in our taxable or tax-qualified accounts?)
Investment Alternatives
Stocks
– “You are an Owner”
Bonds
– “You are a Loaner”
“Cash”
– “You are Guaranteed” a.k.a. Short-term investments Annuities – “Have we got a
(bad)
deal for you!”
Real Estate
– “Yes, but it is not without risk” Other Investment Alternatives… …That I hope you will avoid Unless you know what you are doing or are willing to lose a good chunk of your money or, preferably, both 23
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Investment Alternatives:
Stocks
Stocks represent ownership in companies Benefits include… Stockholders are owners and share in the success of the company (capital gains) Shareholders receive distribution of company’s earnings (dividends)
Stock Prices are Volatile Fancy term for “You’se can lose a lot of yer money!”
But you knew that already, didn’t you?
Average returns over decades – 8% to 10% Best overall long-term investment returns Stocks are long-term investments
Investment Alternatives:
Bonds
Bonds represent loans to… Companies (Corporate bonds) State & local municipalities (Municipal bonds) Federal government (Treasury bonds) Bondholders receive interest on the loan Loan is repaid (Bond is redeemed) in 1 to 30 years Bond prices are less volatile
but still
do fluctuate Average returns over decades – 4% to 8% Bondholders are first in line for repayment if there is default on the loans Intermediate-term to long-term investments 25
Investment Alternatives:
“Cash”
Better term is “Short-term Investments” a.k.a. “Short-term Instruments, short-term vehicles” Guaranteed Return of Principal Savings Accounts, Certificates of Deposit (CDs), Money Market Accounts Money Market Mutual Funds Not guaranteed but pretty darned close Average returns over decades – 2% to 5% Currently, they are paying the lowest rates in over 50 years – less than 1% (some paying zero!)
Huge Opportunity Cost
These are short-term investments 26
Investment Alternatives: Annuities
An annuity is a financial contract written by an insurance company that provides you with a regular income for a specified time For the rest of your life
or
For 10-year, 20-year, etc. periods Guaranteed contracts that will continue to pay your heirs if you die before the end of the time period People buy annuities to supplement retirement income and to shelter income from taxes 27
Investment Alternatives: Annuities
(continued) Those who expect to live longer than average benefit most from annuities
But
if you die one month after you have signed up for the annuity,
the life insurance company keeps all the money! Great deal, huh?
“No problem!” sez Mr. InsuranceMan. “You can choose a definite payout period … but we will pay you less.
” 28 Annuities are tax-deferred investment plans Contributions are after-tax money but earnings are tax-deferred You pay taxes on the earnings when you draw the money out (The contributions are returned tax-free)
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Investment Alternatives: Annuities
(continued) Suffice to say that annuities are for people who have already put as much money as they can into all other retirement options, already have plenty of investments outside of retirement accounts and still have plenty of money to invest “Money to burn” goes into an annuity Even then, they are not the best investment options Average returns over decades Fixed annuities – 2% to 6% – bonds But they have a guaranteed minimum payout (2% to 3%) Variable annuities – 2% to 8% – stocks & bonds Can lose money – no guaranteed minimum
Investment Alternatives:
Real Estate
Real Estate is Tricky but can be
Very Profitable
Real Estate is an illiquid investment Purchase and manage rental property,
or
REIT’s (Real Estate Investment Trust) Trade like stocks – liquid They manage the real estate for you You receive the rent and any capital gains Minus the REIT’s management fees, of course Average returns over decades – 7% to 8% Uh, San Diego is a notable exception But as we have seen, some people have literally lost everything after the real estate bubble of the 2000’s burst Intermediate-term to long-term investments 30
Investment Alternatives: The
“Others”
Derivatives: Options, Futures, and Commodities Very, very risky They derive their value from another investment (?) These are
speculations
(gambling) , not
investments
Precious Metals and Gems If you believe the global economy is going to fall apart anytime soon, buy these in large quantities Even De Beers now admits that diamonds are awful investments Collectibles, Antiques, Fine Art, Coins & Stamps It may be fun, but do not call it investing Unless you know exactly what you are doing!
None of these are eligible for retirement accounts Does that tell you anything?
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“So What Is
Your
Choice?”
If the goal is long-term (example: retirement) , then
my
choice is high-quality stocks Although some people prefer bonds because they are less risky than stocks (or a combination of both) If the goal is intermediate-term, then bonds or REITs make sense If the goal is short-term, you have no choice but to use a guaranteed short term “cash” investment such as a money market account Although bonds close to maturity could also work The
“Others”
never make sense except for a small percentage of the population 32
“So I am buying stocks and bonds. Great! How do I get started?”
Well, actually, you don’t… Buy the stocks and bonds, that is… For the vast majority of people, the best investments are
mutual funds
that buy the stocks and bonds for them Professional money management Diversification
“But you got me all excited about buying stocks and bonds all by myself! Besides, in their commercials on TV, Ameritrade and Scottrade show everyday, hard-working Americans just like me happily and profitably buying and selling stocks all the time.”
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Let me ask you a few questions…
Do you have the discipline, courage and brains to buy when everyone else is selling and sell when everyone else is buying? Do you have a strong background in finance, business, marketing, economics, politics and history?
Are you a part of a global research team stationed all around the world?
Do you have the time and resources to visit in person the companies you intend to invest in?
Plus their customers, competitors and suppliers?
Do you have enough money to buy at least 20 or more stocks representing various sectors of the economy?
Most importantly, do you have a knack or intuition for recognizing unrecognized value?
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Your results?
If the answer to two or more of the previous questions is, “No” (especially the last two: money for 20 or more stocks & an intuitive eye for value)
Stay away from individual stocks!
Bonds are also difficult since bond traders usually deal in tens of thousands of dollars per trade (The exceptions are government bonds bought directly from www.treasurydirect.gov) Mutual Funds are your Best Bet And if it means anything to you, virtually all of my family’s financial investments (and my clients’) are in mutual funds (>99%) I certainly can’t answer “Yes” to all those questions 35
Mutual Funds
(a.k.a. Investment Company)
STOCKS
Stock mutual funds Balanced mutual funds
BONDS
Bond mutual funds
“CASH”
Money market mutual funds
a “mutual” fund (investment company)
36
Professional Money Management Diversification
“So, How Do I Pick a Mutual Fund?”
Pick a Mutual Fund that… Invests in high-quality stocks or bonds Is well-diversified across several industries and sectors of the economy and countries of the world Has a long-term perspective and a manager or (better yet) a management team with many years of experience Avoid companies that “shuffle” their managers every few years (which is virtually all of them!) Has been around for decades and performed consistently well in both good
and
bad markets
More about choosing a good mutual fund when we get to Chapter 13.
37
“How Do I Purchase a Mutual Fund?”
38 Normally, a little bit at a time Virtually all mutual funds will allow you to start an automatic investment plan with as little as $25 to $50 per month Either through your employer (401k, 403b, etc.) Roth IRA) The ones that won’t are specialized funds that you normally don’t want to deal with anyway Or from your checking or savings accounts (IRA, Minimum purchases of $1,000 to $25,000 or more
Investing a fixed amount ($50, $100, etc.) periodically is called “dollar cost averaging.”
Dollar Cost Averaging
A system of buying an investment at regular intervals with a fixed dollar amount $50 per month, $100 per month, etc.
With Dollar Cost Averaging, there is always “Good News”
Yippee!
“The market is up! Good News!”
Your account is worth more
“The market is down! Good News!” Huh?!
Next month, you will get more shares at a lower price when the $50 or $100 comes out of your paycheck or checking account 39
“But Now It All Sounds So
Boring
…”
In the investment world,
Boring is Good!
After you have built a solid foundation of high quality stock or bond investments through mutual funds, then you can “play the market” I used to call it my “Vega
$
Fund” Take no more than 5% to 10% of your financial assets and choose your own stocks Be prepared for “volatility” “Volatility” is the investment world’s euphemism for large losses – Buy a stock for $12, sell it for 30¢ I kept my “Vega
$
Fund” to no more than 1% of our total portfolio, by the way 40
Coming Attractions
Chapter 11 (continued) – Bonds
Chapter 12 – Stocks
Chapter 13 – Mutual Funds
Lecture Notes – Real Estate & the “
Others”
We will examine all of these in more detail
Plus…
Chapter 14 – Retirement & Estate Planning
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Investments:
What are ___?
A.
Investment companies that pool investors' money and invest in a diversified portfolio of securities. Investors get diversification and professional money management.
short term securities (a.k.a. “cash”) B.
C.
stocks bonds D.
mutual funds
The correct answer is (D). Investment company is the legal term; mutual fund is the popular term.
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Investments:
What are ___?
Represent ownership in a corporation. Investors receive dividends and capital gains (or capital losses).
A.
B.
real estate stocks C.
D.
bonds short term securities (a.k.a. “cash”)
The correct answer is (B). Stock investors are part-owners of corporations.
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Investments:
What are ___?
Fixed-income securities that represent loans to corporations, municipalities (state & local governments & agencies) , and the Federal government. Investors receive interest and a promise to repay the loan.
A.
B.
real estate stocks C.
D.
bonds short term securities (a.k.a. “cash”)
The correct answer is (C). Bonds are “fixed-income” investments.
44
Investments:
What are ___?
Investments with very little risk, and correspondingly, very little return. They are usually guaranteed or pretty darned close. There is a huge opportunity cost if you leave your money here for the long-term.
45 A.
B.
C.
D.
real estate stocks bonds short term securities (a.k.a. “cash”)
The correct answer is (D). Low risk, low return.
What are Reasonable Expectations?
What are reasonable expectations of returns from the following investments?
A.
B.
C.
D.
E.
F.
stocks bonds short-term securities real estate mutual funds the “others”
8% - 10% 4% - 8% 2% - 5% 7% - 8% ?
-?
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Investing in Bonds
Bonds represent loans to… Companies (Corporate bonds) State & local municipalities (Municipal bonds, “Muni’s”) Federal government (Treasury bonds, “Governments”) Bondholders receive interest on the loan Loan is repaid (Bond is redeemed) in 1 to 30 years Bondholders are first in line for repayment if there is default on the loans (after taxes & payroll expenses) Bond prices are less volatile
but still fluctuate
(?) Average returns over decades – 4% to 8% Intermediate-term to long-term investments (But there is a way for bonds to be short-term) 47
Why Do Investors Buy Bonds?
For interest income Investors know the interest rate Interest will be paid to investors twice a year Bond face amount will be repaid at maturity Although there is always the risk of default Normally, the risk of default is very, very small If the risk is high, the bonds are usually referred to as “non-investment grade bonds” (a.k.a. “junk bonds”) 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
(“Huh?” “Later…”)
48
Why Sell Bonds
When an entity sells bonds, it is borrowing money.
49 To raise money to operate or expand Examples: Build a new factory, expand into a new country, build new or upgrade older schools, bridges, finance a war, etc. – Big ticket items Can get better interest rates than if they went to a bank or other money-lending entity Also, sometimes the bond issuer can’t go to a bank!
(Can you imagine the Federal government asking your local credit union for a $900 billion loan to invade Iraq?)
Almost every election year in California, the voters are asked to approve a “bond proposition” for parks, schools, water projects, transportation, emergency and public safety equipment, etc. The State of California then sells the bonds to pay for the project and must pay the interest and pay back the principal over 30 years.
Why Sell Bonds
(continued) In the case where the bond issuer is a corporation, sometimes it is difficult, not advantageous or impossible to sell stock And the interest is a tax-deductible expense for corporations Whereas dividends to stock shareholders are not To take advantage of “financial leverage” Use other people’s money to make your money
Bonds are “debt financing.” Corporations, municipalities, or the Federal government borrow for many of the same reasons that individuals borrow for – to finance their operations. Stocks are “equity financing.” A corporation is selling a piece of itself to finance the operations of the company. (Governments do not issue stocks because they can not sell pieces of themselves.)
50
Characteristics of Bonds
Written pledge to repay a specified amount (face value, par value) of money with interest The face value is the dollar amount that the bondholder will receive when the bond matures Normally in $1,000 denominations (up to $10,000) Bondholders receive interest payments every six months at the stated interest rate The legal conditions are described in the
bond indenture
The indenture is the loan agreement The trustee is the bondholders’ representative 51
Types of Bonds
Mortgage-backed bonds (“Secured”) A bond that is secured by various assets of the issuing firm A mortgage bond is like a homeowner’s home mortgage If the bond issuer does not pay, the asset is seized Debenture bonds (“Unsecured”) Most bonds are debenture bonds Backed only by the reputation of the issuer A debenture bond is like a credit card If the bond issuer does not pay, the bond investors must go after whatever assets or income they can find Convertible bonds (only corporate bonds) Can be exchanged, at the owner’s option, for a specified number of shares of common stock 52
Call Feature of Bonds
Corporations and municipalities can sometimes “call in” (buy back) outstanding bonds from current bondholders before the maturity date Treasuries (Federal bonds) are never callable Most agree not to call in their bonds for the first 5 to 10 years after they are issued a.k.a. Deferred Call, Call Protection Period Bonds are called if the interest rate they are paying is higher than the going rate It is the same idea as when a homeowner refinances his/her home mortgage loan 53
Bonds and Taxes
Bond interest is normally taxed at your marginal tax rate Always true of corporate bonds However,
municipal bonds are not subject to Federal income taxes and …
Federal bonds are not subject to state income tax
This is an important feature for wealthy investors Must look at the Taxable Equivalent Yield Some municipal bonds are “double-tax free” If from your state, also exempt from state taxes Careful! If you are subject to the AMT, the interest income from some municipal bonds is no longer exempt from Federal taxes 54
Taxable Equivalent Yield
Tax-Exempt Yield 1.0 – Your Federal marginal tax rate
Example: 6% yield, 25% tax bracket
Taxable equivalent yield = 0.06
1.0 - 0.25
Federal income tax free municipal bonds
= 0.08 = 8% 55
Taxable Equivalent Yield
(continued) Tax-Exempt Yield 1.0 - Your combined marginal tax rate (Federal & state)
Example: 6% yield, 25% Fed, 8% state
Taxable equivalent yield = 0.06
1.0 – (0.25+0.08)
If you purchase bonds from your state, they are usually “double tax-free.” Federal & state income tax free.
= 0.0895 = 8.95% 56
Making the Decision to Buy or Sell a Bond
Can the corporation, municipality, or Federal government...
Pay back the face value at maturity?
Will you receive interest payments until maturity?
What is the bond’s rating?
(Kinda’ like your credit score)
Ratings range from AAA to D (AAA, AA, A, BBB, BB, etc., D) BB or below is “non-investment grade” Also called a “junk bond” or speculative bond Rated by one of the rating agencies Standard and Poor’s, Moody’s, Fitch’s
Think of the ratings as “idiot lights” on your car’s dashboard. By the time the agency downgrades the bond to C or D, it is already too late!
57
Bonds and Interest Rates
Inverse relationship
As interest rates fall, bond prices rise
As interest rates rise, bond prices fall
Since the interest rate of your bond does not change (it is fixed) , the price of the bond changes to reflect the change in interest rates within the financial industry (the price of the bond is not fixed) Great source of confusion and consternation to many in and out of the investment world
When interest rates fall, …bond prices rise, and vice-versa.
58
Bonds and Interest Rates:
Example Bond paying 10% The bond’s face value is $1,000 The bond’s interest per year is $100 10% of $1,000 = $100 Interest rates fall to 5% Now, investors have to pay $2,000 to get the same amount of interest 5% of $2,000 = $100 The result is your bond is now worth
more
than it once was (capital gain if sold) The bond could be sold at a high
premium
59
Bonds and Interest Rates:
Example (continued) Bond paying 5% The bond’s face value is $1,000 The bond’s interest per year is $50 5% of $1,000 = $50 Interest rates rise to 10% Now, investors only have to pay $500 to get the same amount of interest 10% of $500 = $50 The result is your bond is now worth
less
than it once was (capital loss if sold) The bond would be sold at a large
discount
60
Bond Pricing: Problem 1
Juan Zapata-Tyme bought a corporate bond paying 8% four years ago. Today, corporate bonds that are like Juan’s bond are paying 6%. Would Juan be able to sell his bond for
more
than he paid for it,
less
than he paid for it, or the
same
amount he paid for the bond?
A.
He could sell it for
more
than he paid for it B.
He could sell it for
less
than he paid for it C.
He could sell it for the
same
that he paid for it
The correct answer is (A). If interest rates go down, bond prices go up. The bond would sell at a premium.
61
Bond Pricing: Problem 2
L. Coco bought a Treasury bond paying 5% two years ago. Today, like Treasury bonds are paying 7%. Would Señor Coco be able to sell his bond for
more
than he paid for it,
less
than he paid for it, or the
same
amount he paid for it?
A.
He could sell it for
more
than he paid for it B.
He could sell it for
less
than he paid for it C.
He could sell it for the
same
that he paid for it 62
The correct answer is (B). If interest rates go up, bond prices go down. The bond would sell at a discount.
Bonds and Interest Rates
(continued) The relationship of bonds and interest rates is why a bond will have different quoted rates Nominal Rate (a.k.a. Coupon Rate) This is the rate that the bond pays on the original amount of the loan (usually in $1,000 increments) Current Yield This is the true rate of interest that the bond buyer is currently getting since it reflects the premium or discount price the buyer had to pay Yield to Maturity This is the yield you would receive if you were to hold onto the bond until it matures If the Nominal Rate, Current Yield and the Yield to Maturity are all the same, the bond is said to be selling at
par
There is no premium nor is there a discount 63
Current % Yield of a Bond
(continued) 64
Dollar Amount of Annual Interest Current Market Value
Example: 6%, $1100 market value
Current yield = $60 $1100 = 0.0545454 5.45%
A bond selling at a premium has a current yield lower than its stated nominal rate
Current % Yield of a Bond Dollar Amount of Annual Interest Current Market Value
Example: 6%, $900 market value
Current yield = $60 $900 = 0.06667 6.67%
A bond selling at a discount has a current yield higher than its stated nominal rate
65
Yield to Maturity
Face value - Market value $ Amt Annual Interest + Number of periods Face value + Market value 2
Example: 6%, Selling at $900, 10-year maturity
$60 + $1,000 - $900 10 years $1000 + $900 2 = 0.074 = 7.4%
¡Aye, Paquito!
66
Primary and Secondary Bond Markets
Primary bond market Buy via an investment bank or company representative www.treasurydirect.gov
Secondary bond market Buy through a broker from another investor who wants to sell it, and pay a commission
Very few small investors participate in the bond markets. Bond traders normally deal in the millions of dollars and want you to pony up at least $25,000, preferably $100,000 or more. The major exceptions are Federal Treasury bonds. The small investor is welcome at www.treasurydirect.gov.
67
Bond Mutual Funds
Most small investors are better served by investing in a bond mutual fund Professional Money Management Diversification Bond Traders are used to buying and selling in the millions Smallest transactions are in the $10,000’s The mutual fund managers and pension fund managers can get a much better deal because of their size
Although it is very easy to buy Treasury bonds directly from the Federal government at www.treasurydirect.gov
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Bottom Line on Bonds
Bonds are good intermediate-term investments Bonds are decent long-term investments Especially good for those who would have trouble sleeping at night if they were fully invested in stocks
But don’t be fooled!
Bonds have significant risks, too Especially when interest rates are very low
Like right now…
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