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Investment Basics and Evaluating Bonds
Copyright © 2006 The McGraw-Hill Companies, Inc. All rights reserved.
Explain why you should establish an investment program 2. Evaluate bonds when making an investment . growth. Identify the factors that reduce investment risk 4. income. risk.11-3 Investing Basics Chapter Objectives 1. 5. and liquidity affect your investment program 3. Describe how safety. Recognize why investors purchase bonds and other conservative investments.
11-4 Objective 1: Explain why you should establish an investment program Establishing Investment Goals Financial goals should be specific and measurable. To develop your goals ask yourself. They should be tailored to your financial needs and what you want to accomplish. What will you use the money for? How much money do you need for your goals? How will you obtain the money? How long will it take you to obtain the money? How much risk are you willing to assume in an investment program? ..
are your investment goals reasonable? Are you willing to make the sacrifices necessary to ensure that you meet your investment goals? What will the consequences be if you don’t reach your investment goals? .11-5 Establishing Investment Goals (continued) What possible economic or personal conditions could alter your investment goals? Considering your economic circumstances.
11-6 Performing a Financial Checkup Work to balance your budget. – Do you regularly spend more than you make? Pay off high interest credit card debt first. – Cash advance on your credit card. Start an emergency fund you can access quickly. Have access to other sources of cash for emergencies. Obtain adequate insurance protection. – Three to nine months of living expenses. . – Line of credit is a short-term loan approved before the money is needed.
. and windfalls. Participate in elective savings programs. Make a special savings effort one or two months each year. Take advantage of gifts. Take advantage of employer- sponsored retirement programs.11-7 Getting the Money Needed to Start an Investing Program Pay yourself first. inheritances.
11-8 The Value of Long-Term Investing Programs Many people don’t start investing because they only have a small amount to invest. you could have over $1 million by the time you are age 65—See Exhibit 11-1.000 each year (depending on the rate of return. The higher the rate of return the greater the risk. but even small amounts invested regularly grow over a long period of time. If you begin savings $2. .
and liquidity affect your investment decisions Factors Affecting the Choice of Investments Safety and risk. growth.11-9 Objective 2: Describe how safety. risk. – Safety in any investment means minimal risk of loss. – Risk means a measure of uncertainty about the outcome. – Speculative investments are high risk. – The potential return on any investment should be directly related to the risk the investor assumes. income. . made by those seeking a large profit in a short time. – Investments range from very safe to very risky.
Interest rate risk – the value of bonds or preferred stock may increase or decrease because of changes in interest rates in the economy.affects stocks and corporate bonds. Market risk .during periods of high inflation your investment return may not keep pace with the inflation rate. .prices fluctuate because of behaviors of investors. Business failure risk .11-10 Components of the Risk Factor Inflation risk .
Liquidity – . Ability to buy or sell an investment quickly without substantially affecting the investment’s value. government and corporate bonds.11-11 Investment Growth and Liquidity Income . Common stock usually offers the greatest potential for growth. and real estate offer growth potential. Mutual funds. Growth – – means investment will increase in value.An investment will provide a predictable source of income.
Asset allocation is the process of spreading your assets among several different types of investments.11-12 Objective 3: Identify the factors that can reduce investment risk. Other factors to consider include: – The time factor – Your age – Your role in the investment process .
11-13 Government Bonds and Debt Securities Sold to obtain money to finance the national debt. . Three levels of government issue bonds: – Federal. and the ongoing costs of government. – Local municipalities. – State.
Typical maturities are 2.000 units. or 26 weeks to maturity. $1. Government Treasury Bills and Notes Treasury Bills (T-Bills).000 minimum.S. Federal but no state tax on interest earned. . 4. Treasury Notes. 3. at a higher rate than T-bills. Interest paid every six months. Sold at a discount. 13. $1. and 10 years.11-14 U. 5. Federal but no state tax on interest earned.
and earn slightly higher interest than government securities issued by the treasury department. Essentially risk free.Federal Home Loan Mortgage Corporation. . Maturities range from 15 – 30 years.Government National Mortgage Association.11-15 Federal Agency Debt Issues FHA .Federal National Mortgage Association. Freddie Mac .Federal Housing Administration Fannie Mae . Average maturity is 15 years. Ginnie Mae .
Revenue bonds are repaid from money generated by the project the funds finance. . airports. and bridges. and special taxing districts. counties. school districts. General obligation bonds are backed by the state or local government that issues them.sometimes called munis. Use funds for ongoing costs and to build major projects such as schools. Issued by a state or local government. such as a toll bridge. including cities.11-16 State and Local Government Securities Municipal bonds .
0 .Your tax rate Example: 0.0.28 = 0.06 = __________ 1.083 = 8.11-17 Taxable Equivalent Yield Tax-exempt yield ___________________ 1.3% Taxable equivalent yield .0 .
The legal conditions are described in a bond indenture. . Bondholders receive interest payments every six months at the stated interest rate. The face value is the dollar amount that the bondholder will receive at the bond’s maturity date. A trustee is a financially independent firm that acts as the bondholder’s representative.11-18 Characteristics of Corporate Bonds Corporation’s written pledge to repay a specified amount of money with interest.
When it is difficult or impossible to sell stock. . To fund ongoing business activities.11-19 Why Corporations Sell Bonds To get funds for major purchases. Interest paid to bondholders is a tax deductible business expense that can be used to reduce the federal and state taxes corporations must pay. To improve financial leverage.
– Unsecured . – Most corporate bonds are debenture bonds. .11-20 Types of Corporate Bonds Debenture bond. – A corporate bond that is secured by various assets of the issuing firm.Backed only by the reputation of the issuing company. Mortgage bond. usually real estate. – Interest rate is lower because it is secured.
(continued) .11-21 Types of Corporate Bonds Convertible bond. for a specified number of shares of the corporation’s common stock. – Convertible bonds. at the owner’s option. must be carefully evaluated. the interest rate on a convertible bond is 1 to 2 percent lower than the rate paid on traditional bonds. – A special kind of corporate bond that can be exchanged. – Generally. like all potential investments.
11-22 Provisions For Repayment Call Feature of a Bond Corporation can call in or buy back outstanding bonds from current bondholders before the maturity date. Most corporate bonds are callable. They call bonds if the interest rate they are paying is much higher than the going rate. Most agree not to call bonds for the first 5 to 10 years after they are issued. .
– Bonds of a single issue that mature on different dates.11-23 Provisions For Repayment (continued) Sinking fund. – Corporations deposit money in this fund annually or semiannually and use the money to pay off the bondholders when the bond issue comes due. Serial bonds. .
Bond face amount will be repaid at maturity. – Interest will be paid to investors twice a year.11-24 Objective 4: Explain Why Investors Buy Corporate Bonds For interest income. with the payment based on the interest rate and the face value of the bond. . – 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 current interest rate. Dollar appreciation of bond value. – Investors know the interest rate.
. with information on their websites. – BB or below is called a junk (speculative) bond. – The internet – Use it for price information. trade bonds online and lastly do research on the issuing corporation and its bond issues Read the bond quotes in the newspaper. – Rated by Standard and Poors and Moodys. How is the bond rated? – Rating range from AAA to D.11-25 Objective 5: Evaluate bonds when making an investment decision The Decision to Buy or Sell a Bond – There are a number of sources of information that can be used to evaluate bond investments.
11-26 The Decision to Buy or Sell a Bond Bond Yield Calculations – Current Yield = annual income amount divided by current market value Other Sources of Information – Business Periodicals – Government Sources .