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Fundamentals of Investing

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CHAPTER 11
 Investing Basics and Evaluating Bonds




                    “If a little money does not go out,
                       great money will not come in.”
                                          -- Confucius
                                  2


The Answer is…

  “A Voluntary
  Tax on Stupid
    People”
          What is the Question?
                                     3


Silly, the Question is…

“What is the
   Lottery?”
  A Voluntary Tax on Stupid People
                                                    4


What are the Odds of Winning?
    The odds of winning the California Mega
     Millions Jackpot are 176 million to 1
      “But somebody has to win, right?”
      Yes, but that somebody will not be you!
    If a person purchases 50 lottery tickets
     each week, he or she will win the Mega
     Millions Jackpot about once every 50,000
     years
      “Let’s see. $50 per week at 10% for 50,000
       years…”
                                                            5


Speaking of Odds…
   Astronomers have located an asteroid that is
    possibly on a collision course with Earth
     The asteroid could hit the Earth in 2029
        Triggering untold destruction and the end of tens of
         thousands of species, including the human race
     The odds of the asteroid hitting the Earth are
      currently set at 300 to 1
        But those odds will probably lessen as more is
        learned about the asteroid’s orbit

So Why Aren’t the Nations Preparing for This!?
                                                       6


Because it Ain’t Gonna’ Happen!

 And You Ain’t Gonna’
   Win the Lottery!
    So Start Saving Now
   But, of course, if the asteroid does hit, we will
    have plenty of warning for you to go out and
   spend all your savings on a really great time!
                           Now, let’s get serious…
                                                                  7


Establishing Investment Goals
   You already know the #1 Financial Goal:
       “Spend Less Than You Earn”
       “Live Beneath Your Means”
       “Make Love, Not Loans”    Which one is
       “Pay Yourself First”      your favorite?
       “Frugal, Frugal, Frugal!”
   If Goal #1 is followed, everything else is easy!
     For each investment goal, assess the time frame
        Is it short-term, intermediate-term, or long-term
     Choose an appropriate investment for the time frame
        This chapter gives you a thumb-nail view of each type
            With an emphasis on bond investments
         We will look at some of the others in detail later on
                                                                             8
                                                                They are
Essentials Before Investing                                important but
                                                            not essential
                          Or so says our book…
    Work to balance your budget
       Pay off high interest credit card debt first
    Start an emergency fund you can access quickly
       Three to nine months of living expenses
     I simply do not agree with the concept of an “emergency fund”
     of three to nine months of living expenses. As long as you have
     access to cash via a home equity line of credit, for example,
     there is no good reason to keep $20,000 to $30,000 or more in a
     savings account earning 0.01%. Instead, use the money to pay
     down high interest debt, especially credit card debt.
     P.S. The Wealthy Barber agrees with me. Exceptions: Salespeople
     P.P.S. You are adequately insured, right?       and the self-employed
                                                                           9


First: Some Investment Terms
    Safety – Guarantee of return of principal
    Risk – Uncertainty about an outcome
      Inflation risk
      Interest rate risk            “I am not so much concerned with
      Business failure risk            the return on my money as I am
                                          with the return of my money.”
      Market risk
                                                          -- Will Rogers
      Global investment risk
    Liquidity
      Ability to buy or sell an investment quickly without
       substantially affecting the investment’s value
 What is your tolerance for risk? (http://njaes.rutgers.edu/money/riskquiz/)
 Unfortunately, you can’t know until you have some skin in the game …
                                                  and then lose some skin!
                                                         10


“Where Do I Get the Money to Invest?”

        Pay Yourself First
  Take advantage of employer-sponsored
     retirement programs [401(k), 403(b), etc.]
      These come right out of your paycheck
  Take advantage of automatic contributions from
     your checking or savings account [Roth IRA]
      Schedule them to occur right after you normally
       receive your paycheck
    They work like a pay raise, only in reverse
                                                          11


“How Much Do I Need?”
 Start small!
   “Can you afford $50 per month?”
 Small amounts invested regularly become
  large amounts over time
 Obviously, the more the better
   But it is better to get started with a small amount
    now than to lazily dream of a day when you’ll be
    able to put away far more – Get Started Now!
 You can always increase the amount
   Try to increase the amount each year
   Especially when you get a pay raise
Regular Taxable Accounts versus                                                    12




Tax-Qualified Accounts
                                             Account Statement Examples
            Bonds “Cash”                                Bonds
     Stocks    Options                      Stocks                   “Cash”
  Margining Real Estate Futures
       Mutual Funds Shorting                         Mutual Funds


        Taxable Account                    Tax-Qualified Account
           a.k.a. Regular account               a.k.a. Retirement Account,
                                             Education Accounts, MSA  HSA
  All contributions are post-tax dollars   Most are pre-tax; Some are post-tax

         No limit on contributions               Strict limits on contributions
       No limits on investment types           Strict limits on investment types
                                                  Tax-deferred (pre-tax) or
       Pay taxes every year on gains
                                                       Tax-free (post-tax)


  Although there are many subtle and not-so-subtle differences, the
    major differences are how they are taxed by the IRS, how much
  money you can contribute, and what you can have in the account.
                                                             13


Types of Investment Accounts
   Taxable Accounts (a.k.a. Regular Accounts)
     All interest, dividends, capital gains, and rent are
     taxable each year
    Best for short-term or intermediate-term
     investments but can also be used for long-term
 Tax-Qualified Accounts (a.k.a. Retirement
  Accounts, Education Accounts, MSAs  HSAs)
    Tax-deferred – Pay no taxes until you withdraw
     the funds (normally in retirement)
    Best for intermediate-term or long-term
     investments (but mostly for long-term)
                                   Account Statement Examples
                                                               14


Types of Retirement Accounts
   Pre-tax Contributions
     401(k), 403(b) for private & public employees
     Traditional IRA for everyone
     SEP-IRA, SIMPLE IRA and Keogh for self-
      employed or those working for small business
     Tax Break Now
        Deduct contributions from income tax
        Pay taxes in retirement (when tax bracket is lower)
   Post-tax Contributions
     Roth IRA for everyone, Roth 401(k), Roth 403(b)
       Tax Break Later (Tax-Free in Retirement!)
   Annuities (pre-tax and post-tax)
 A Pre-tax Contribution Lowers Your
                                                   15



 Taxes Now Examples: IRA, 401(k) / 403(b)
           You contribute via your paycheck: $100


 Your Federal tax withholding is lowered by:     $25
Your California tax withholding is lowered by:    $8
                   Total government subsidy:     $33


     Your take home pay is only reduced by:      $67

But the whole $100 still goes into your account!
                                                                16


“So What’s the Catch?”
   You pay income tax on any amounts
    withdrawn in retirement
     But people in retirement are usually in a lower
      tax bracket
   If you withdraw the funds before retirement…
     You pay the income tax, and
     You pay a 10% penalty!
        Exceptions for first home purchase, higher
         education expenses and medical disability
   This is a long-term investment
     Don’t even think about dipping into it for a car,
      vacation, etc. (A first home or higher education? Okay)
A Post-tax Contribution Gives You No              17



Tax Break Now Examples: Roth IRA, Roth 401(k)
                You contribute to a Roth IRA: $100


  Your Federal tax withholding is lowered by:    $0
Your California tax withholding is lowered by:   $0
                   Total government subsidy:     $0


      Your disposable income is reduced by: $100

  So Why Bother Contributing to a Roth IRA?
                                                           18


“Because a Roth IRA is So Cool!”
   Tax-Free in Retirement is a Golden
    Opportunity
     No other investment choice comes close!
     Eventually, I think they will probably be gotten rid of
   Plus, you can withdraw the contributions at any
    time with no penalty
     You have already paid taxes on the contributions
 This makes the Roth IRA also an excellent
    intermediate-term investment account
     Purchase of a house or other high-ticket item
     Great for college expenses
       Currently not used in Financial Aid calculations
But Contributing to a Roth Can Be                            19



Tricky for High Income Earners
   Limitations on Roth IRAs Contributions
     Only single taxpayers with an AGI of $105,000 or
      less and married couples with an AGI of $167,000
      or less can fully contribute to a Roth IRA
        If you do not qualify, Congratulations!
     But you can contribute to a Roth IRA anyway
        If you find that you have made over the limit, you can
         “recharacterize” the contributions into a Traditional
         IRA (which does not have the same limitations)
         before you file your taxes
        And then you convert the Traditional IRA to a Roth
          I know. I know. Who voted for these bozos?
              Oh, yeah. We did …
                                                                20


Education Savings Accounts
   529 Plans                 529 plans were set to expire in
     Works like a Roth IRA    2011 but have been extended
     Post-tax dollars                          indefinitely.
     No tax on earnings as long as you use the money
    for higher education
   High penalty if you use the money for any other
    purpose
 Coverdell Education Plans (nee Education IRA)
   Like the 529 plan, only much worse
   But if you use either of these plans, then you
    can’t take advantage of the Hope and Lifelong
    Learning Educational Tax Credits (Gee, Thanks!)
Medical Savings Accounts                                  21



Health Savings Accounts
   Medical Savings Accounts (MSAs)
     Tax-deductible contributions
        Pre-tax dollars
     No tax on withdrawals as long as you use the
      money for medical purposes
       High penalty if you use the money for any other
        purposes
   Only available to self-employed and those
    working for small business
     They are now changing to …
   Health Savings Accounts (HSAs)
     Anyone can have one, not just self-employed or
      small businesses
Review: Types of Investment                                        22



Accounts
   Taxable Accounts (a.k.a. Regular Accounts)
   Tax-Qualified Accounts (a.k.a. Retirement
    Accounts, Educational Savings Accounts, MSAs, HSAs)
      Pre-tax Contributions – tax-deferred
         Traditional IRA, 401(k), 403(b), etc.
      Post-tax Contributions – tax-free
         Roth IRA, Roth 401(k), Roth 403(b)
 This is where the types of investments reside
      They are not the investments!

          Okay. Now, What Do We Invest In? (In other words, what
    investments do we put in our taxable or tax-qualified accounts?)
                                                              23


Investment Alternatives
 Stocks – “You are an Owner”
 Bonds – “You are a Loaner”
 “Cash” – “You are Guaranteed”
   a.k.a. Short-term investments
 Annuities – “Have we got a (bad) deal for you!”
 Real Estate – “Yes, but it is not without risk”
 Other Investment Alternatives…
   …That I hope you will avoid
     Unless you know what you are doing or are willing to lose
      a good chunk of your money or, preferably, both
                                                                    24


Investment Alternatives: Stocks
 Stocks represent ownership in companies
 Benefits include…
   Stockholders are owners and share in the success
    of the company (capital gains)
   Shareholders receive distribution of company’s
    earnings (dividends)          Fancy term for “You’se can
 Stock Prices are Volatile             lose a lot of yer money!”

   But you knew that already, didn’t you?
 Average returns over decades – 8% to 10%
   Best overall long-term investment returns
   Stocks are long-term investments
                                                           25


Investment Alternatives: Bonds
 Bonds represent loans to…
   Companies (Corporate bonds)
   State & local municipalities (Municipal bonds)
   Federal government (Treasury bonds)
 Bondholders receive interest on the loan
   Loan is repaid (Bond is redeemed) in 1 to 30 years
   Bondholders are first in line for repayment if there
    is default on the loans
   Bond prices are less volatile but still do fluctuate
 Average returns over decades – 4% to 8%
   Intermediate-term to long-term investments
                                                          26


Investment Alternatives: “Cash”
 Better term is “Short-term Investments”
   a.k.a. “Short-term Instruments, short-term vehicles”
 Guaranteed Return of Principal
   Savings Accounts, Certificates of Deposit (CDs),
    Money Market Accounts
   Money Market Mutual Funds
      Not guaranteed but pretty darned close
 Average returns over decades – 2% to 5%
   Currently, they are paying the lowest rates in over
    50 years – less than 1% (some paying zero!)
   Huge Opportunity Cost
   These are short-term investments
                                                                27


Investment Alternatives: Annuities
    An annuity is a financial contract written by an
     insurance company that provides you with a
     regular income for a specified time
      For the rest of your life or
      For 10-year, 20-year, etc. periods
         Guaranteed contracts that will continue to pay your
          heirs if you die before the end of the time period
    People buy annuities to supplement retirement
     income and to shelter income from taxes
                                                                      28


Investment Alternatives: Annuities
                                                       (continued)

    Those who expect to live longer than average
     benefit most from annuities
      But if you die one month after you have signed up
       for the annuity, the life insurance company keeps
       all the money! Great deal, huh?
      “No problem!” sez Mr. InsuranceMan. “You can
       choose a definite payout period … but we will pay you less.”
    Annuities are tax-deferred investment plans
      Contributions are after-tax money but earnings are
       tax-deferred
      You pay taxes on the earnings when you draw the
       money out (The contributions are returned tax-free)
                                                                29


Investment Alternatives: Annuities
                                                  (continued)

  Suffice to say that annuities are for people who
   have already put as much money as they can into
   all other retirement options, already have plenty
   of investments outside of retirement accounts and
   still have plenty of money to invest
  “Money to burn” goes into an annuity
      Even then, they are not the best investment options
    Average returns over decades
      Fixed annuities – 2% to 6% – bonds
         But they have a guaranteed minimum payout (2% to 3%)
      Variable annuities – 2% to 8% – stocks & bonds
         Can lose money – no guaranteed minimum
Investment Alternatives:                                        30




Real Estate
 Real Estate is Tricky but can be Very Profitable
   Real Estate is an illiquid investment
 Purchase and manage rental property, or
 REIT’s (Real Estate Investment Trust)
   Trade like stocks – liquid
   They manage the real estate for you
   You receive the rent and any capital gains
      Minus the REIT’s management fees, of course
 Average returns over decades – 7% to 8%
   Uh, San Diego is a notable exception
      But as we have seen, some people have literally lost
       everything after the real estate bubble of the 2000’s burst
   Intermediate-term to long-term investments
Investment Alternatives:                                       31




The “Others”
 Derivatives: Options, Futures, and Commodities
   Very, very risky
      They derive their value from another investment (?)
   These are speculations (gambling), not investments
 Precious Metals and Gems
   If you believe the global economy is going to fall apart
    anytime soon, buy these in large quantities
   Even De Beers now admits that diamonds are awful
    investments
 Collectibles, Antiques, Fine Art, Coins & Stamps
   It may be fun, but do not call it investing
   Unless you know exactly what you are doing!
 None of these are eligible for retirement accounts
   Does that tell you anything?
                                                              32


“So What Is Your Choice?”
   If the goal is long-term (example: retirement),
    then my choice is high-quality stocks
     Although some people prefer bonds because they
      are less risky than stocks (or a combination of both)
 If the goal is intermediate-term, then bonds or
  REITs make sense
 If the goal is short-term, you have no choice
  but to use a guaranteed short-term “cash”
  investment such as a money market account
     Although bonds close to maturity could also work
   The “Others” never make sense except for a
    small percentage of the population
“So I am buying stocks and bonds.                                         33



Great! How do I get started?”
    Well, actually, you don’t…
      Buy the stocks and bonds, that is…
    For the vast majority of people, the best
     investments are mutual funds that buy the
     stocks and bonds for them
      Professional money management
      Diversification
      “But you got me all excited about buying stocks and bonds all by
         myself! Besides, in their commercials on TV, Ameritrade and
       Scottrade show everyday, hard-working Americans just like me
        happily and profitably buying and selling stocks all the time.”
Let me ask you a few                                     34



questions…
   Do you have the discipline, courage and brains to buy
    when everyone else is selling and sell when everyone
    else is buying?
   Do you have a strong background in finance, business,
    marketing, economics, politics and history?
   Are you a part of a global research team stationed all
    around the world?
   Do you have the time and resources to visit in person
    the companies you intend to invest in?
      Plus their customers, competitors and suppliers?
   Do you have enough money to buy at least 20 or more
    stocks representing various sectors of the economy?
   Most importantly, do you have a knack or intuition for
    recognizing unrecognized value?
                                                                 35


    Your results?
   If the answer to two or more of the previous
    questions is, “No” (especially the last two: money
    for 20 or more stocks & an intuitive eye for value)
      Stay away from individual stocks!
      Bonds are also difficult since bond traders usually
       deal in tens of thousands of dollars per trade
        (The exceptions are government bonds bought
         directly from www.treasurydirect.gov)
   Mutual Funds are your Best Bet
     And if it means anything to you, virtually all of my
      family’s financial investments (and my clients’)
      are in mutual funds (>99%)
        I certainly can’t answer “Yes” to all those questions
Mutual Funds
                                                                 36



(a.k.a. Investment Company)

  STOCKS                 BONDS                    “CASH”
              Balanced
               mutual          Bond
  Stock        funds           mutual
  mutual                       funds
  funds                                                 Money
                                                        market
                                                        mutual
                                                        funds

                                           a “mutual” fund
                                        (investment company)


                          Professional Money Management
                                   Diversification
                                                                      37


“So, How Do I Pick a Mutual Fund?”
     Pick a Mutual Fund that…
        Invests in high-quality stocks or bonds
        Is well-diversified across several industries and
         sectors of the economy and countries of the world
        Has a long-term perspective and a manager or
         (better yet) a management team with many years
         of experience
           Avoid companies that “shuffle” their managers
            every few years (which is virtually all of them!)
        Has been around for decades and performed
         consistently well in both good and bad markets
      More about choosing a good mutual fund when we get to Chapter 13.
                                                                   38


“How Do I Purchase a Mutual Fund?”
     Normally, a little bit at a time
       Virtually all mutual funds will allow you to start an
        automatic investment plan with as little as $25 to
        $50 per month
          Either through your employer (401k, 403b, etc.)
          Or from your checking or savings accounts (IRA,
          Roth IRA)
       The ones that won’t are specialized funds that
        you normally don’t want to deal with anyway
          Minimum purchases of $1,000 to $25,000 or more

                      Investing a fixed amount ($50, $100, etc.)
                 periodically is called “dollar cost averaging.”
                                                         39


Dollar Cost Averaging
   A system of buying an investment at regular
    intervals with a fixed dollar amount
     $50 per month, $100 per month, etc.
   With Dollar Cost Averaging, there is always
    “Good News”                         Yippee!
     “The market is up! Good News!”
        Your account is worth more            Huh?!
     “The market is down! Good News!”
        Next month, you will get more shares at a
         lower price when the $50 or $100 comes out of
         your paycheck or checking account
                                                                   40


“But Now It All Sounds So Boring…”
  In the investment world, Boring is Good!
  After you have built a solid foundation of high-
   quality stock or bond investments through mutual
   funds, then you can “play the market”
      I used to call it my “Vega$ Fund”
    Take no more than 5% to 10% of your financial
     assets and choose your own stocks
      Be prepared for “volatility”
         “Volatility” is the investment world’s euphemism for large
         losses – Buy a stock for $12, sell it for 30¢
      I kept my “Vega$ Fund” to no more than 1% of our
       total portfolio, by the way
                                            41


Coming Attractions
 Chapter 11 (continued) – Bonds
 Chapter 12 – Stocks
 Chapter 13 – Mutual Funds
 Lecture Notes – Real Estate & the “Others”
  We will examine all of these in more detail
       Plus…
   Chapter 14 – Retirement & Estate
    Planning
                                                              42


Investments: What are ___?
    Investment companies that pool investors'
    money and invest in a diversified portfolio of
    securities. Investors get diversification and
    professional money management.
 A. short-term securities (a.k.a. “cash”)
 B. stocks
 C. bonds
 D. mutual funds

     The correct answer is (D). Investment company is the legal
                         term; mutual fund is the popular term.
                                                                 43


Investments: What are ___?
      Represent ownership in a corporation.
      Investors receive dividends and capital
      gains (or capital losses).

 A. real estate
 B. stocks
 C. bonds
 D. short-term securities (a.k.a. “cash”)

       The correct answer is (B). Stock investors are part-owners
                                                  of corporations.
                                                              44


Investments: What are ___?
      Fixed-income securities that represent loans
      to corporations, municipalities (state & local
      governments & agencies), and the Federal
      government. Investors receive interest and
      a promise to repay the loan.
 A.   real estate
 B.   stocks
 C.   bonds
 D.   short-term securities (a.k.a. “cash”)
The correct answer is (C). Bonds are “fixed-income” investments.
                                                             45


Investments: What are ___?
      Investments with very little risk, and
      correspondingly, very little return. They are
      usually guaranteed or pretty darned close.
      There is a huge opportunity cost if you leave
      your money here for the long-term.

 A. real estate
 B. stocks
 C. bonds
 D. short-term securities (a.k.a. “cash”)

              The correct answer is (D). Low risk, low return.
What are Reasonable                            46



Expectations?
     What are reasonable expectations of
     returns from the following investments?

A.   stocks                  8% - 10%
B.   bonds                   4% - 8%
C.   short-term securities   2% - 5%
D.   real estate             7% - 8%
E.   mutual funds              ?
F.   the “others”              -?
                                                                47


Investing in Bonds
 Bonds represent loans to…
    Companies (Corporate bonds)
    State & local municipalities (Municipal bonds, “Muni’s”)
    Federal government (Treasury bonds, “Governments”)
 Bondholders receive interest on the loan
    Loan is repaid (Bond is redeemed) in 1 to 30 years
 Bondholders are first in line for repayment if there
  is default on the loans (after taxes & payroll expenses)
 Bond prices are less volatile but still fluctuate (?)
 Average returns over decades – 4% to 8%
 Intermediate-term to long-term investments
    (But there is a way for bonds to be short-term)
                                                                         48


Why Do Investors Buy Bonds?
    For interest income
      Investors know the interest rate
      Interest will be paid to investors twice a year
    Bond face amount will be repaid at maturity
      Although there is always the risk of default
         Normally, the risk of default is very, very small
            If the risk is high, the bonds are usually referred to as
             “non-investment grade bonds” (a.k.a. “junk bonds”)

    Appreciation of bond value
      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 market rate (“Huh?” “Later…”)
                                                                            49


Why Sell Bonds                           When an entity sells bonds,
                                            it is borrowing money.

   To raise money to operate or expand
     Examples: Build a new factory, expand into a new
      country, build new or upgrade older schools,
      bridges, finance a war, etc. – Big ticket items
     Can get better interest rates than if they went to a
      bank or other money-lending entity
        Also, sometimes the bond issuer can’t go to a bank!
           (Can you imagine the Federal government asking your local
            credit union for a $900 billion loan to invade Iraq?)
       Almost every election year in California, the voters are asked to
      approve a “bond proposition” for parks, schools, water projects,
      transportation, emergency and public safety equipment, etc. The
      State of California then sells the bonds to pay for the project and
        must pay the interest and pay back the principal over 30 years.
                                                                            50


Why Sell Bonds                                           (continued)

   In the case where the bond issuer is a
    corporation, sometimes it is difficult, not
    advantageous or impossible to sell stock
     And the interest is a tax-deductible expense for
      corporations
        Whereas dividends to stock shareholders are not
   To take advantage of “financial leverage”
     Use other people’s money to make your money
     Bonds are “debt financing.” Corporations, municipalities, or the
         Federal government borrow for many of the same reasons that
                    individuals borrow for – to finance their operations.
     Stocks are “equity financing.” A corporation is selling a piece of
     itself to finance the operations of the company. (Governments do
        not issue stocks because they can not sell pieces of themselves.)
                                                         51


Characteristics of Bonds
   Written pledge to repay a specified amount
    (face value, par value) of money with interest
   The face value is the dollar amount that the
    bondholder will receive when the bond matures
     Normally in $1,000 denominations (up to $10,000)
   Bondholders receive interest payments every
    six months at the stated interest rate
   The legal conditions are described in the bond
    indenture
     The indenture is the loan agreement
   The trustee is the bondholders’ representative
                                                                       52


Types of Bonds
   Mortgage-backed bonds (“Secured”)
     A bond that is secured by various assets of the
      issuing firm
        A mortgage bond is like a homeowner’s home mortgage
           If the bond issuer does not pay, the asset is seized
   Debenture bonds (“Unsecured”)
     Most bonds are debenture bonds
     Backed only by the reputation of the issuer
        A debenture bond is like a credit card
           If the bond issuer does not pay, the bond investors must
            go after whatever assets or income they can find
   Convertible bonds (only corporate bonds)
     Can be exchanged, at the owner’s option, for a
      specified number of shares of common stock
                                                      53


Call Feature of Bonds
   Corporations and municipalities can
    sometimes “call in” (buy back) outstanding
    bonds from current bondholders before the
    maturity date
     Treasuries (Federal bonds) are never callable
   Most agree not to call in their bonds for the
    first 5 to 10 years after they are issued
     a.k.a. Deferred Call, Call Protection Period
   Bonds are called if the interest rate they are
    paying is higher than the going rate
     It is the same idea as when a homeowner
      refinances his/her home mortgage loan
                                                             54


    Bonds and Taxes
   Bond interest is normally taxed at your
    marginal tax rate
     Always true of corporate bonds
     However, municipal bonds are not subject to
      Federal income taxes and …
        Federal bonds are not subject to state income tax
     This is an important feature for wealthy investors
     Must look at the Taxable Equivalent Yield
   Some municipal bonds are “double-tax free”
     If from your state, also exempt from state taxes
     Careful! If you are subject to the AMT, the
      interest income from some municipal bonds is no
      longer exempt from Federal taxes
                                              55


Taxable Equivalent Yield
                Tax-Exempt Yield
       1.0 – Your Federal marginal tax rate

  Example: 6% yield, 25% tax bracket
  Taxable equivalent yield = 0.06
                            1.0 - 0.25
  Federal income tax free
        municipal bonds     = 0.08 = 8%
                                                             56


Taxable Equivalent Yield                       (continued)


                Tax-Exempt Yield
      1.0 - Your combined marginal tax rate
                 (Federal & state)
   Example: 6% yield, 25% Fed, 8% state
   Taxable equivalent yield = 0.06
                           1.0 – (0.25+0.08)
 If you purchase bonds from your
    state, they are usually “double
                          tax-free.”
 Federal & state income tax free.
                                       = 0.0895 = 8.95%
  Making the Decision to                                                57




  Buy or Sell a Bond
 Can the corporation, municipality, or Federal
  government...
    Pay back the face value at maturity?
    Will you receive interest payments until maturity?
 What is the bond’s rating? (Kinda’ like your credit score)
   Ratings range from AAA to D (AAA, AA, A, BBB, BB, etc., D)
   BB or below is “non-investment grade”
      Also called a “junk bond” or speculative bond
   Rated by one of the rating agencies
      Standard and Poor’s, Moody’s, Fitch’s
   Think of the ratings as “idiot lights” on your car’s dashboard. By the
   time the agency downgrades the bond to C or D, it is already too late!
                                                                     58


Bonds and Interest Rates
    Inverse relationship
       As interest rates fall, bond prices rise
       As interest rates rise, bond prices fall
    Since the interest rate of your bond does not
     change (it is fixed), the price of the bond changes to
     reflect the change in interest rates within the
     financial industry (the price of the bond is not fixed)
       Great source of confusion and consternation to many in
         and out of the investment world
     When interest
        rates fall,
                                                   …bond prices
                                                            rise,
                                                   and vice-versa.
Bonds and Interest Rates:                              59



Example
     Bond paying 10%
       The bond’s face value is $1,000
       The bond’s interest per year is $100
          10% of $1,000 = $100
     Interest rates fall to 5%
       Now, investors have to pay $2,000 to get the
        same amount of interest
          5% of $2,000 = $100
     The result is your bond is now worth more
      than it once was (capital gain if sold)
       The bond could be sold at a high premium
Bonds and Interest Rates:                                   60



Example                                       (continued)

     Bond paying 5%
       The bond’s face value is $1,000
       The bond’s interest per year is $50
          5% of $1,000 = $50
     Interest rates rise to 10%
       Now, investors only have to pay $500 to get the
        same amount of interest
          10% of $500 = $50
     The result is your bond is now worth less
      than it once was (capital loss if sold)
       The bond would be sold at a large discount
                                                                61


      Bond Pricing: Problem 1
     Juan Zapata-Tyme bought a corporate bond
     paying 8% four years ago. Today, corporate
     bonds that are like Juan’s bond are paying 6%.
     Would Juan be able to sell his bond for more
     than he paid for it, less than he paid for it, or the
     same amount he paid for the bond?
A. He could sell it for more than he paid for it
B. He could sell it for less than he paid for it
C. He could sell it for the same that he paid for it
       The correct answer is (A). If interest rates go down, bond
               prices go up. The bond would sell at a premium.
                                                                62


      Bond Pricing: Problem 2
     L. Coco bought a Treasury bond paying 5% two
     years ago. Today, like Treasury bonds are
     paying 7%. Would Señor Coco be able to sell
     his bond for more than he paid for it, less than
     he paid for it, or the same amount he paid for it?
A. He could sell it for more than he paid for it
B. He could sell it for less than he paid for it
C. He could sell it for the same that he paid for it

         The correct answer is (B). If interest rates go up, bond
           prices go down. The bond would sell at a discount.
                                                                     63


Bonds and Interest Rates                             (continued)
    The relationship of bonds and interest rates is
     why a bond will have different quoted rates
      Nominal Rate (a.k.a. Coupon Rate)
         This is the rate that the bond pays on the original
          amount of the loan (usually in $1,000 increments)
      Current Yield
         This is the true rate of interest that the bond buyer is
          currently getting since it reflects the premium or
          discount price the buyer had to pay
      Yield to Maturity
         This is the yield you would receive if you were to hold
          onto the bond until it matures
    If the Nominal Rate, Current Yield and the Yield
     to Maturity are all the same, the bond is said to
     be selling at par
      There is no premium nor is there a discount
                                                           64


Current % Yield of a Bond               (continued)




 Dollar Amount of Annual Interest

      Current Market Value

                                    A bond selling at a
 Example: 6%, $1100 market value        premium has a
 Current yield = $60                current yield lower
                $1100                    than its stated
              = 0.0545454  5.45%         nominal rate
                                                         65


Current % Yield of a Bond

 Dollar Amount of Annual Interest

      Current Market Value

                                   A bond selling at a
 Example: 6%, $900 market value        discount has a
 Current yield = $60                     current yield
                 $900                  higher than its
              = 0.06667  6.67%   stated nominal rate
                                                        66


Yield to Maturity
                        Face value - Market value
$ Amt Annual Interest +
                          Number of periods
           Face value + Market value
                        2
 Example: 6%, Selling at $900, 10-year maturity
                           $1,000 - $900
                 $60 +        10 years
                     $1000 + $900
                           2           ¡Aye, Paquito!
              = 0.074 = 7.4%
Primary and Secondary Bond                                               67




Markets
    Primary bond market
      Buy via an investment bank or company
       representative
      www.treasurydirect.gov
    Secondary bond market
      Buy through a broker from another investor
       who wants to sell it, and pay a commission
       Very few small investors participate in the bond markets. Bond
 traders normally deal in the millions of dollars and want you to pony
         up at least $25,000, preferably $100,000 or more. The major
         exceptions are Federal Treasury bonds. The small investor is
                                   welcome at www.treasurydirect.gov.
                                                                         68


Bond Mutual Funds
   Most small investors are better served by
    investing in a bond mutual fund
     Professional Money Management
     Diversification
     Bond Traders are used to buying and selling in
      the millions
        Smallest transactions are in the $10,000’s
        The mutual fund managers and pension fund
        managers can get a much better deal because of
        their size
      Although it is very easy to buy Treasury bonds directly from the
                       Federal government at www.treasurydirect.gov
                                                         69


Bottom Line on Bonds
   Bonds are good intermediate-term
    investments
   Bonds are decent long-term investments
     Especially good for those who would have trouble
      sleeping at night if they were fully invested in
      stocks
   But don’t be fooled!
     Bonds have significant risks, too
        Especially when interest rates are very low
          Like right now…

				
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