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Chapter 13

Investing in
Bonds and Other
Alternatives

Learning Objectives
1. Invest in the bond market.
2. Understand basic bond terminology and
compare the various types of bonds.
3. Calculate the value of a bond and
understand the factors that cause bond
value to change.

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Learning Objectives
4. Compare preferred stock to bonds as an
investment option.
5. Understand the risks associated with
investing in real estate.
6. Know why you shouldnt invest in gold,
silver, gems, or collectibles.

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Introduction
Bonds carry less risk than stocks.
Bonds provide steady income.
Returns from bonds are not necessarily low.

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Why Consider Bonds?


Bonds reduce risk through diversification.
Bonds produce steady income.
Bonds can be a safe investment if held to
maturity.

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Basic Bond Terminology and


Features
Par valueface value of a bond
Maturitylength of time until bond reaches
par value
Coupon Interest Rateannual interest rate
paid

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Basic Bond Terminology and


Features
Indenturea legal document that provides
specific terms of the loan agreement
It includes:

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A description of the bond.


The rights of bondholders.
The rights of the issuing firm.
The responsibilities of the bond trustees.

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Basic Bond Terminology and


Features
Call Provisiongives issuer right to
repurchase bonds from their holders prior to
maturity
Deferred callprovision stating bond cant
be called until set number of years have
passed
Sinking Fundbond issuer deposits money
to pay off bond issue
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Types of Bonds
Corporate bonds
U.S. government bonds
State and local bonds

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Corporate Bonds
Secured Corporate Debt
Secured bond is backed by collateral
Mortgage debt is secured by lien on real property

Unsecured Corporate Debt


Debenture is any unsecured long-term bond
More risky

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Treasury and Agency Bonds


Risk-free
Not callable
Lower interest rate
Most interest payments are exempt from
state and local taxes

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Treasury and Agency Bonds


Treasury-issued debt has maturities from 3
months to 10 years
Bills, notes, and bonds differ by maturity
and denomination
Agency bonds

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Treasury and Agency Bonds


Pass-Through Certificatesissued by the
Government National Mortgage Association
Ginnie Mae
Treasury Inflation Protected Securities
(TIPS)par value changes with the
consumer price index to guarantee investor
a real rate of return

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Treasury and Agency Bonds


U.S. Series EE Bonds
I Bonds

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Municipal Bonds
Munisissued by states, counties, cities, public
agencies (e.g., school districts)
General obligation bondbacked by taxing power
Revenue bondsinterest and par value are paid
with funds from a designated project or specific tax
Serial maturitiesmunicipal bonds with various
maturity dates

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Special Situation Bonds


Zero Coupon Bondsdont pay interest and
are sold at a deep discount from their par
value
Junk Bondsalso high-yield bonds, very
risk, low-rated BB or below

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Bond RatingsA Measure of


Riskiness
Moodys and Standard & Poors provide ratings
on corporate and municipal bonds.
Ratings involve a judgment about a bonds
future risk potential.
The poorer the rating, the higher the rate of
return demanded by investors.
Safest bonds receive AAA, D is extremely risky.
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Bond Yield
Current Yieldratio of annual interest
payment to the bonds market price

Yield to maturitytrue yield or return that


the bondholder receives if a bond is held to
maturitymeasure of expected return

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Equivalent Taxable Yield on


Municipal Bonds
Municipal bonds are tax-exempt
To calculate the equivalent yield to taxable
bonds, use the following formula:

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Valuation Principles
Principle 3The Time Value of Money
Principle 8Risk and Return Go Hand in
Hand
Value in todays dollars of the interest
payments and principal payments, add them
together

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Bond Valuation
The value of a bond is the present value of
the interest payments (an annuity) plus the
present value of the repayment of the
bonds par value at maturity (a single cash
flow)

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Bond Valuation
If the issuer becomes riskier, the required
rate of return should rise.
A change in general interest rates, the
required rate of return should increase.
When interest rates rise, the value of
outstanding bonds falls.

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Why Bonds Fluctuate in Value


Inverse relationship between interest rates
and bond values in the secondary market.
When interest rates rise, bond values drop,
and when interest rates drop, bond values
rise.
Longer-term bonds fluctuate in price more
than shorter-term bonds.

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What Bond Valuation Relationships


Mean to the Investor
As a bond approaches maturity, the market
value approaches its par value.
When interest rates go down, bond prices go
up, but upward price movement on bonds
with a call provision is limited by the call
price.

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What Bond Valuation Relationships


Mean to the Investor
If you expect interest rats to go up (bond
prices to fall)purchase very short-term
bonds.
If you expect interest rates to go down
(bond prices to rise)purchase bonds with
long maturities and are not callable.

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Reading Online Corporate Bond


Quotes
Selling price is quoted as percentage of par
Also expected to pay accrued interest
Invoice pricesum of the quoted or stated
price of a bond and the bonds accrued
interestprice of bond on secondary
market.

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Preferred Stock
An Alternative to Bonds
A hybrid security with features of common
stock and bonds.
Similar to common stockno fixed maturity
date, not paying dividends wont bring
bankruptcy.
Similar to bondsdividends are fixed, paid
before common and no voting rights.

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Features and Characteristics


of Preferred Stock
Multiple Issues
Cumulative Feature
Adjustable Rate
Convertibility
Callability
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Valuation of Preferred Stock


The value of a share of preferred stock is
the present value of the perpetual stream of
constant dividends.

As market interest rates rise and fall, the


value of preferred stock moves in an
opposite manner

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Risks Associated with Preferred


Stock
If interest rates rise, the value of preferred
stock drops.
If interest rates drop, the value of preferred
stock rises and it is called away.
Investor doesnt participate in the capital
gains that common stockholders receive.
Investor doesnt have the safety of bond
interest payments because preferred
dividends can be passed without the risk of
bankruptcy.
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Investing in Real Estate


Requires time, energy, and sophistication
Illiquid asset
Direct investments in real estate
Indirect investments in real estate
The bottom line: Real estate is not well suited
to the novice investor
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InvestingSpeculatingin Gold,
Silver, Gems, and Collectibles
Dont do it!
This is not investingit is speculation.
Collectibles may only have entertainment
value.
Dont expect them to provide for your
financial future.
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Summary
Bonds reduce risk, produce steady income,
and can be safe investment.
Hold bond until it maturescan get yield to
maturity.
Value of bond is the present value of the
stream of interest payments plus the
present value of the repayment of the
bonds par value at maturity.
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Summary
Preferred stock is a security with no fixed
maturity date and with dividends that are
generally set in amount and dont fluctuate.
You own property with direct real estate
investment but with indirect real estate
investment, youre an investor in a group.
Gold, silver, gems, or collectibles are not
investments but speculation.
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