Chapter 11. Section 2: Bonds & Other Financial Assets

Transcription

1 Chapter 11 Section 2: Bonds & Other Financial Assets

2 Bonds as Financial Assets Bonds are basically loans, or IOUs, that represent debt that the government or a corporation must repay to an investor. Typically pay the investor a fixed amount of interest at regular intervals for a fixed amount of time Bonds are generally a lower risk investment, but the rate is usually lower too

3 Bonds have three basic components: 1. The coupon rate the interest rate that the issuer will pay the bondholder. 2. The maturity the time when payment to the bondholder is due. - Typically 10, 20, or 30 years 3. The par value the amount that an investor pays to purchase the bond and that will be repaid to the investor at maturity. - aka face value or principal

4 Not all bonds are held to maturity. Sometimes bonds are traded or sold and their price may change. Economists therefore refer to a bond s yield, which is the annual rate of return on the bond if the bond were held to maturity.

5 Buying Bonds at a Discount Investors earn interest on the bonds they buy. They can also earn money by buying bonds at a discount from par. Discounts from Par 1. Sharon buys a bond with a par value of $1,000 at 5% interest. Bond purchase without discount from par 2. Interest rates go up to 6% 3. Sharon needs to sell her bond. Nate wants to buy it, but is unwilling to buy a bond at 5% interest when the current rate is 6% 4. Sharon offers to discount the bond, taking $40 off the price and selling it for $ Nate accepts the offer. He now owns a $1,000 bond paying 5% interest, which he purchased at a discount from par. = = Bond purchase with discount from par

6 Bond Ratings Investors can check bond quality through 2 firms: Standard & Poor s and Moody s Rate bonds on a number of factors, including the issuer s ability to make future payments and to repay the principal when the bond matures.

7 Highest AAA (S & P) or Aaa (Moody) D generally means that the bond is in default (issuer has not kept up with interest payment or has defaulted on paying principal) A high bond rating usually means that the bond will sell at a higher price, and that the firm will be able to issue the bond at a lower interest rate.

8 Bond Ratings Standard & Poor s Moody s Highest investment grade High grade Upper medium grade Medium grade Lower medium grade Speculative Vulnerable to default Subordinated to other debt rated CCC AAA AA A BBB BB B CCC CC Best quality High quality Upper medium grade Medium grade Possesses speculative elements Generally not desirable Poor, possibly in default Highly speculative, often in default Aaa Aa A Baa Ba B Caa Ca Subordinated to CC debt Bond in default C D Income bonds not paying income Interest and principal payments in default C D

9 Holders of bonds with high ratings who keep their bonds until maturity face relatively little risk of losing their investment Holders of bonds with lower ratings, take on more risk in return for potentially higher interest payments

10 Advantages & Disadvantages to the Issuer Bonds are desirable from the issuer s point of view for two main reasons: 1. Once the bond is sold, the coupon rate for that bond will not go up or down. 2. Unlike stock, bonds are not shares of ownership in a company, so it doesn t have to share profits

11 Bonds also pose two main disadvantages to the issuer: 1. The company must make fixed interest payments, even in bad years when it does not make money. 2. If the issuer does not maintain financial health, its bonds may be downgraded to a lower bond rating. - This makes it harder to sell future bonds unless a discount or higher interest rate is offered.

12 Types of Bonds Savings Bonds Low-denomination ($50 to $10,000) bonds issued by the United States government. Purchased below par value (a $100 savings bond costs $50 to buy) and interest is paid only when the bond matures.

13 Government uses funds from the sale of bonds to help pay for public works projects like buildings, roads, & dams Virtually no risk of default

14 Treasury Bonds, Bills, and Notes These investments are issued by the United States Treasury Department. Backed by the full faith & credit of the U.S. government Offer different lengths of maturity One of the safest investments in terms of default risk

15 Temporarily stopped selling 30 year bonds in 2001, upsetting many investors with like safe, long term investments

16 Municipal Bonds aka Munis Issued by state or local governments to finance such improvements as highways, state buildings, libraries, and schools. Because state & local governments have the power to tax, investors can assume that these governments will be able to keep up with interest payments & repay the principle at maturity Tax exempt!!

17 Corporate Bonds A bond that a corporation issues to raise money to expand its business. Issued in fairly large denominations such as $1,000, $5,000, & $10,000 Interest is taxed as ordinary income

18 Corporations have no tax base to help guarantee their ability to repay their loans, so they have moderate level of risk Depends on the success of the corporation's sales of goods & services to generate enough income to pay interest & principle

19 Junk Bonds Lower-rated, potentially higherpaying bonds.

20 Other Types of Financial Assets Certificates of Deposit One of the most common forms of investment Available through banks, which use the funds deposited for a fixed amount of time. Attractive to small investors because they costs of little as $100 Various terms of maturity, allowing investors to plan for future financial needs.

21 Money Market Mutual Funds Special types of mutual funds. Businesses collect money from individual investors & then buy stocks, bonds, & other financial assets to form a mutual fund Investors receive higher interest on a money than they would receive from a savings account or a CD. Assets are not FDIC insured.

22 Financial Asset Markets One way to classify financial asset markets is according to the length of time for which the funds are lent. Capital markets are markets in which money is lent for periods longer than a year. Long term CDs & corporate & government bonds

23 Money markets are markets in which money is lent for periods of less than a year. Short-term CDs & Treasury bills & money market mutual funds

24 Markets can also be classified according to whether assets can be resold to other buyers. Primary markets involve financial assets that cannot be transferred from the original holder, such as savings bonds & small CDs Secondary markets involve financial assets that can be resold, such as stocks. Provides liquidity to investors

25 If there is a strong secondary market for an asset, the investor knows that the asset can be resold fairly quickly without penalty, thus providing the investor with ready cash Also makes possible the lively trade in Stock