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1
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…
