Personal finance 6th madura chapter 16 investing in bonds

Personal Finance
SIXTH EDITION

Chapter 16
Investing in
Bonds

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Chapter Objectives (1 of 2)
16.1 Provide a background on bonds
16.2 Identify the different types of bonds
16.3 Identify factors that affect the return (yield)
from investing in a bond
16.4 Describe how bonds are valued
16.5 Discuss why some bonds are risky

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Chapter Objectives (2 of 2)
16.6 Describe common bond investment strategies
16.7 Explain how investing in bonds can fit within
your financial plan

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Background on Bonds (1 of 5)
• Bonds: long-term debt securities issued by

government agencies or corporations
• Par value: for a bond, its face value, or the amount
returned to the investor at the maturity date when
a bond is due
• Most bonds have maturities between 10–30 years

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Background on Bonds (2 of 5)
• Issuers required to make interest payments and
repay par value
• Bond Characteristics
– Call feature: a feature on a bond that allows the issuer
to repurchase the bond from the investor before
maturity
 These bonds offer a slightly higher return

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Background on Bonds (3 of 5)
– Convertible bond: a bond that can be converted into a
stated number of shares of the issuer’s stock if the
stock price reaches a specified price
 These bonds tend to offer a slightly lower return

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Background on Bonds (4 of 5)
• A bond’s yield to maturity: the annualized return on
a bond if it is held to maturity
– If a bond sells at par value, its yield to maturity equals
the coupon rate
– If a bond sells below par value, its yield to maturity
would exceed the coupon rate
– If a bond sells above par value, its yield to maturity
would be less than the coupon rate

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Financial Planning Online (1 of 3)
• Go to and then go
to the section on bond calculators
• This web site provides an estimate of the yield to
maturity of your bond based on its present price,
its coupon rate, and its maturity.

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Background on Bonds (5 of 5)
• Bond trading in the secondary market
– Investors sell their bonds to other investors before they
reach maturity
– Bond prices change in response to interest rates
– Brokerage firms also take orders to buy or sell bonds

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Types of Bonds (1 of 4)
• Treasury bonds: long-term debt securities issued
by the U.S. Treasury
– Payments guaranteed by federal government
– Interest is subject to federal income tax, but exempt
from state and local taxes
– Can easily be sold in the secondary market

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Types of Bonds (2 of 4)
• Municipal bonds: long-term debt securities issued
by state and local government agencies
– Low risk
– Interest exempt from federal income tax

• Federal agency bonds: long-term debt securities
issued by federal agencies
– Low default risk
– Interest is taxable

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Financial Planning Online (2 of 3)
• Go to the markets section of http://

www.bloomberg.com
• This Web site provides quotations of yields offered
by municipal bonds with various terms to maturity.
Review this information when considering
purchasing municipal bonds.

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Types of Bonds (3 of 4)
• Corporate bonds: long-term debt securities issued
by large firms
– Subject to default risk
– High-yield (junk) bonds: bonds issued by smaller, less
stable corporations that are subject to a higher degree
of default risk

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Types of Bonds (4 of 4)
• Corporate bond quotations
–
–
–
–
–
–

Coupon rate

Maturity
Current yield
Volume
Closing price
Net change in the price from the previous day

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Exhibit 16.1 An Example of Corporate
Bond Quotations
EXHIBIT 16.1 An Example of Corporate Bond Quotations
Company

Coupon

Maturity

Price

Yield

Estimated Volume (in $1,000s)

Zugle Co.

5.00%

Dec. 1, 2018

100.00

5.00%

4,000

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Return from Investing in Bonds (1 of 3)
• Impact of interest rate movements on bond returns
– If interest rates rise, the value of your bond decreases
– If interest rates fall, the value of your bond increases

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Return from Investing in Bonds (2 of 3)
• Tax implications of investing in bonds
– Interest is taxed as ordinary income (unless tax
exempt)
– Selling bonds at a price higher than you paid also
results in a capital gain

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Return from Investing in Bonds (3 of 3)
EXHIBIT 16.2 Potential Tax Implications from Investing in Bonds
Scenario

Implication

1. You sell the bonds after eight months

You receive one $400 coupon payment six months after
buying the bond, which is taxed at your ordinary income tax
rate. You also earn a short-term capital gain of $100, which is
taxed at your ordinary income tax rate.

at a price of $9,800.
2. You sell the bonds after two years at a
price of $10,200.

3. You sell the bonds after two years at a
price of $9,500.
4. You hold the bonds until maturity.

You receive coupon payments (taxed at your ordinary income
tax rate) of $800 in the first year and in the second year. You
also earn a long-term capital gain of $500 in the second year,
which is subject to the long-term capital gains tax for that
year.
You receive coupon payments (taxed at your ordinary income
tax rate) of $800 in the first year and in the second year. You
also incur a long-term capital loss of $200 in the second year.
You receive coupon payments (taxed at your ordinary income
tax rate) each year over the 10-year life of the bond. You also
receive the bond’s principal of $10,000 at the end of the 10year period. This reflects a long-term capital gain of $300,
which is subject to the long-term capital gains tax for that

year.

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Valuing a Bond
• Uses time value of money
– Present value of the future coupon payments
– Present value of the principal payment

• Economic impact on bond values
– Higher rate of return is only realized if firms are healthy
enough to make payments
– This may not be true in unfavorable economic
conditions

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Financial Planning Online (3 of 3)
• Go to the markets section of http://
www.bloomberg.com
• This Web site provides a summary of recent
financial news related to the bond market, which
you may consider before selling or buying bonds.

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Risk from Investing in Bonds (1 of 4)

• Default risk: risk that the borrower of funds will not
repay the creditors
– Risk premium: the extra yield required by investors to
compensate for the risk of default
– Use of risk ratings to measure the default risk
 Ratings reflect likelihood that issuers will repay their debt over
time
 Moody’s Investors Service, or Standard & Poor’s are two
common bond rating agencies

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Risk from Investing in Bonds (2 of 4)
– Impact of the financial crisis on default risk
 Many firms experienced financial problems and were unable to
make bond payments

– Relationship of risk rating to risk premium
 The lower the risk rating, the higher the risk premium offered
on a bond

– Impact of economic conditions
 Higher risk of default when economic conditions are weak

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Exhibit 16.3 Bond Rating Classes
EXHIBIT 16.3 Bond Rating Classes

Risk Class

Standard & Poor’s

Moody’s

AAA

Aaa

AA

Aa

A

A

BBB

Baa

BB

Ba

Low quality

B

B

Poor quality

CCC

Caa

CC

Ca

DDD

C

Highest quality (least risk)
High quality
High-medium quality
Medium quality
Medium-low quality

Very poor quality
Lowest quality

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Risk from Investing in Bonds (3 of 4)
• Call (prepayment) risk: the risk that a callable

bond will be redeemed by the issuer
• Interest rate risk: the risk that a bond’s price will
decline in response to an increase in interest rates
– Impact of a bond’s maturity on its interest rate risk
 Bonds with longer terms more sensitive to interest rate
movements

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Risk from Investing in Bonds (4 of 4)
– Selecting an appropriate bond maturity
 Choose maturities that reflect your expectations of future
interest rates
 Consider investing in bonds that have a maturity that matches
the time you will need the funds

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