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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. But 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 value
Maturity Coupon Interest Rate

Indenture

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Basic Bond Terminology and Features


Indenture a legal document that provides specific terms of the loan agreement. It includes:
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 Provision
Deferred call Sinking Fund

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Corporate Bonds
Corporate bonds
Secured corporate debt
Mortgage bond

Unsecured corporate debt


Debenture

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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 certificates issued 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 bond Revenue Bonds Serial maturities
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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 Ratings A 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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Table 14.1

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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 Equivalent taxable yield on municipal bonds
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Valuation Principles
Principle 3time 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 plus the present value of the repayment of the bonds par value at maturity

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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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Figure 14.1

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Figure 14.2

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Why Bonds Fluctuate in Value


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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Figure 14.3

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Table 14.2

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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 Corporate Bond Quotes in the Wall Street Journal Online


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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Figure 14.4

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Preferred StockAn 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. Value of preferred stock

= annual preferred stock dividend required rate of return


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.

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Risks Associated with Preferred Stock


Investor does not participate in the capital gains that common stockholders receive.
Investor doesnt have the safety of bond interest payments, preferred dividends can be passed without the risk of bankruptcy.

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Investing in Real Estate


Requires time, energy and sophistication. Direct investments in real estate

Indirect investments in real estate


Investing in real estate: the bottom line

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Investing Speculating in Gold, Silver, Gems, and Collectibles


Dont do it!
This is not investing it 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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