CH-15 Investing in Bonds – Personal Finance : Chapter Notes

15 INVESTING IN BONDS CHAPTER OVERVIEW This chapter describes bonds as an investment alternative. Initially, we examine important characteristics that pertain to bond investments. Then, we discuss the topics of why corporations sell bonds and why investors buy those bonds. Next, the differences between corporate and government bonds, and the factors that investors use to evaluate bond investments are presented. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: LO 15-1 Describe the characteristics of corporate bonds. A corporate bond is a corporation’s written pledge to repay a specified amount of money, with interest. All of the details about a bond (face value, interest rate, maturity, repayment, etc.) are contained in the bond indenture. The trustee is the bondholder’s representative. LO 15-2 Discuss why corporations issue bonds. Corporations issue bonds and other securities to pay for major purchases and help finance their ongoing activities. Firms also issue bonds when it is difficult or impossible to sell stock, to improve a corporation’s financial leverage, and to reduce taxes paid to federal and state governments. Bonds may be debentures, mortgage bonds, subordinated debentures, convertible bonds, or high-yield (junk) bonds. Most bonds are callable. A call provision can be used to buy back bonds before the maturity date. To ensure the money will be available when needed to repay bonds, many corporations establish a sinking fund. Corporations can also issue serial bonds that mature on different dates. LO 15-3 Explain why investors purchase corporate bonds. Investors purchase corporate bonds for three reasons: (1) interest income, (2) possible increase in value, and (3) repayment at maturity. They are also an excellent way use asset allocation to diversify your investment portfolio. The method used to pay bondholders their interest depends on whether they own registered bonds, registered coupon bonds, or bearer bonds. Because bonds can increase or decrease in value, it is possible to purchase a bond at a discount and hold the bond until it appreciates in value. Changes in overall interest rates in the economy and changes in the financial condition of the corporation are the primary causes of most bond price fluctuations. You can lose money on a bond investment if your bond decreases in value. You can also choose to hold the bond until maturity and the corporation will repay the face value of the bond. Corporate bonds are sold by full-service and discount brokerage firms and online 15-1 LEARNING OBJECTIVES CHAPTER SUMMARY LO 15-4 Discuss why federal, state, and local governments issue bonds and why investors purchase government bonds. Bonds issued by the U.S. Treasury are used to finance the national debt and the ongoing activities of the federal government. Currently, the U.S. Treasury issues five principal types of bonds and securities: Treasury bills, Treasury notes, Treasury bonds, Treasury Inflation-Protected Securities (TIPS), and savings bonds. Federal agencies, government-sponsored enterprises, and state and local governments also issue bonds to finance their ongoing activities and special projects. Typical activities and projects include home mortgage financing, airports, schools, toll roads, and toll bridges. U.S. Treasury securities can be purchased through Treasury Direct, brokerage firms, and other financial institutions. Municipal bonds are generally sold through the government entity that issued them or account executives. One of the most important features of municipal bonds is that interest on them may be exempt from federal taxes. LO 15-5 Evaluate bonds when making an investment. Today it is possible to trade bonds online and obtain research information via the Internet. Some local newspapers and The Wall Street Journal and Barron’s provide bond investors with information needed to evaluate a bond issue. Detailed financial information can also be obtained by requesting a printed copy of the corporation’s annual report or accessing its Website. To determine the quality of a bond issue, most investors study the ratings provided by Standard & Poor’s, Moodys, and Fitch Bond Ratings. Investors can also calculate a current yield and the yield to maturity to evaluate a decision to buy or sell bond issues. The current yield is determined by dividing the annual income amount by its current market value. The yield to maturity takes into account the relationship among a bond’s maturity value, the time to maturity, the current price, and the dollar amount of interest. 15-2 INTRODUCTORY ACTIVITIES • Ask students to comment on the My Life feature: Why Bonds? (p. 521) • Point out the learning objectives (p. 521) in an effort to highlight the key points in the chapter. • Ask students to express opinions they may have about investing in corporate and government bonds. . • Discuss how different investment objectives can be achieved with various types of bond investments. WHAT’S NEW Selected Topics Benefits for the Teaching and Learning Environment New Example: Convertible bonds Updated Did You Know New material: The psychology of investing in bond Revised Example: Interest calculation New boxed feature: Financial Planning Calculations Updated Example: Dollar appreciation for a bond Updated Exhibit 15-2: Sample Corporate Bond Transaction Revised Content: Government securities Updated Did You Know Revised Exhibit 15-4: Tax-exempt yields Revised Exhibit 15-5: Bond information Includes information about Ford Motor Company’s convertible corporate note issue. Provides updated information for the yields on high-quality corporate bonds. Adds a new section on the psychology of investing in bonds and specific reasons why investors choose bonds. Shows students how to calculate the interest for a $1,000 AT&T bond that pays 5.50 percent annual interest. Illustrates how reinvesting annual interest amounts can make a difference because of the time value of money. Shows how a bond’s value can change because of changes in overall interest rates in the economy. Describes how bond investors can make money with an investment in a DuPont bond. Addresses the quality of securities issued by the U.S. government. Provides information about yields for 10-year treasury notes from 1990 to February 2013. Includes equivalent yields for all tax brackets including the recently added 39.6 percent bracket. Gives information from the Yahoo! Finance website about an American Express bond. 15-3 Revised Exhibit 15-6: Bond Ratings Revised Examples: Yields Revised box feature: Financial Planning Calculations New Dashboard feature Revised Financial Planning Case Provides revised information about the bond ratings provided by Moody’s and Standard and Poor’s. Includes current dollar values for all the examples in the section Bond-Yield Calculations. Gives current financial information for AT&T that can be used to calculate the times interest earned ratio. Explains the reasons why people—even young investors— choose bonds for their investment program. Includes current prices for the possible investments provided in the case. I. Characteristics of Corporate Bonds II. Why Corporations Sell Corporate Bonds A. Types of Bonds 1. Convertible Bonds and Notes 2. High-Yield Bonds B. Provisions for Repayment III. Why Investors Purchase Corporate Bonds A. The Psychology of Investing in Bonds B. Interest Income C. Dollar Appreciation of Bond Value D. Bond Repayment at Maturity E. A Typical Bond Transaction F. The Mechanics of a Bond Transaction IV. Government Bonds and Debt Securities A. Treasury Bills, Notes, and Bonds 1. Treasury Bills 2. Treasury Notes 3. Treasury Bonds 4. Treasury Inflation-Protected Securities (TIPS) B. Federal Agency Debt Issues C. State and Local Government Securities V. The Decision to Buy or Sell Bonds A. The Internet B. Financial Coverage for Bond Transactions C. Annual Reports 15-4 D. Bond Ratings E. Bond Yield Calculations F. Other Sources of Information 15-5 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions • Although stocks have traditionally returned more than other investment alternatives, bonds are often considered a safer investment. In fact, bonds can be a “safe harbor” during an economic crisis. They, along with other investment alternatives, are also are an excellent way to diversify an investment portfolio and apply the concept of asset allocation. Investors also pick bonds because they need current income. I. CHARACTERISTICS OF CORPORATE BONDS (p. 522) • A corporate bond is a corporation’s written pledge that it will repay a specified amount of money, with interest. • The usual face value (sometimes referred to as par value) of a corporate bond is $1,000. The total face value of all bonds issued usually runs into the millions of dollars. • Between the time of purchase and the maturity date, the corporation pays interest to the bondholder— usually every six months. • Note: The interest rate for a bond is sometimes referred to as the coupon rate in some financial publications. • The maturity date of a corporate bond is the date on which the corporation is to repay the borrowed money. Maturity dates for bonds generally range from 1 to 30 years. • The actual legal conditions for a corporate bond are described in a bond indenture. • Use PPT slides 15-1 and 15-2. • Text Highlight: You may want to use the My Life feature to review the important terms bond investors should know--see page 522. • Use PPT slides 15-3 and 15-4. • Since corporate bond indentures are very difficult for the average person to read and understand, a corporation issuing bonds appoints a trustee to act as the bondholder’s representative. • Practice Quiz 15-1 (p. 523) 15-6 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions II. WHY CORPORATIONS SELL CORPORATE BONDS (p. 523) • Corporations sell corporate bonds to pay for major purchases or to help finance their ongoing business activities. The following factors should be considered: 1. They usually sell bonds when it is difficult or impossible to sell stock. 2. The sale of bonds can also improve a corporation’s financial leverage—the use of borrowed funds to increase the corporation’s return on investment. 3. Finally, the interest paid on corporate bonds is a tax-deductible expense and thus can be used to reduce the taxes that a corporation must pay. • Corporate bonds are often referred to as the “workhorse” of corporate finance. • Discussion Question: Why would a corporation sell corporate bonds? • Use PPT slide 15-5. • Corporate bonds are a form of debt financing, whereas stock is a form of equity financing. 1. Bonds must be repaid at a future date. 2. Interest payments on bonds are required. 3. In case of bankruptcy, bondholders have a claim to assets of the corporation prior to that of stockholders. 4. Finally, many financial managers prefer selling bonds because they retain control of the corporation. Types of Bonds (p. 523) • A debenture is a bond that is backed only by the reputation of the issuing corporation. • To make a bond issue more appealing to investors, a corporation may issue a mortgage bond. A mortgage bond (sometimes called a secured bond) is a corporate bond that is secured by various assets of the issuing firm. • A subordinated debenture is an unsecured bond that gives bondholders a claim secondary to that of mortgage or debenture bondholders with respect to interest payments, repayment, and assets. • Use PPT slides 15-6 and 15-7. • Text Highlight: You may want to discuss the “Did You Know feature about historical bond yields for high-quality corporate bonds on page 524. Convertible Bonds and Notes (p. 524) • A convertible bond is a bond that can be exchanged, at the owner’s option, for a specified number of shares of the corporation’s common stock. A convertible note is a legal debt that is convertible to shares of • Text Highlight: You may want to discuss the calculations related to the Ford Motor Company convertible note that are described on page 524. 15-7 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions common stock at the investor's option. There are three reasons why corporations sell convertible bonds or notes: 1. Interest rates on convertible bonds and notes are lower when compared to traditional bonds. 2. The conversion feature attracts investors who are interested in speculative investments. 3. If the bondholder converts a convertible bond or note to stock, the corporation doesn’t have to repay the bond at maturity. High-Yield Bonds (p. 524) • High-yield bonds are corporate bonds that pay higher interest, but also have a higher risk of default. • High-yield (junk) bonds are sold by companies with poor earnings history, companies with a questionable credit record, or newer companies with unproven ability to increase sales and earn profits. • They are often used in connection with leveraged buyouts—a situation where investors acquire a company and sell high-yield bonds to pay for the company. • While high-yield bonds do pay more interest than typical corporate bonds, the corporation’s inability to pay interest each year and the risks of default and nonpayment at maturity is real. • Discussion Question: As an investor, why would you purchase a convertible bond? • Use PPT slide 15-8. • Caution: You may want to warn students about the risk associated with high-yield (junk) bonds at this point in your lecture. Provisions for Repayment (p. 525) • Today, most corporate bonds are callable. A call feature allows the corporation to call in or buy outstanding bonds from current bondholders before the maturity date. • For bondholders who purchased bonds for income, a problem is often created when a bond paying high interest is called. • The money needed to call a bond may come from the firm’s profits, the sale of additional stock, or the sale of a new bond issue that has a lower interest rate. • In most cases, corporations issuing callable bonds agree not to call them for the first 5 to 10 years after the bonds have been issued. • When a call feature is used, the corporation may have to pay the bondholders a premium, an additional amount above the face value of the bond. • A corporation may use one of two methods to ensure that it has sufficient funds available to redeem a bond issue. • Use PPT slide 15-9. • Text Highlight: Use the My Life feature to reinforce the concept of why corporations issue bonds--see page 525. • Use PPT slide 15-10. 15-8 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions 1. A sinking fund is a fund to which annual or semiannual deposits are made for the purpose of redeeming a bond issue. • Text Highlight: You may want to discuss how Union Pacific established a sinking fund to retire a bond issue—see page 525. 2. Serial bonds are bonds of a single issue that mature on different dates. • Practice Quiz 15-2 (p. 526) 15-9 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions III. WHY INVESTORS PURCHASE CORPORATE BONDS (p. 526) • Although stocks have returned more than corporate bonds, there are reasons why investors choose bonds. The Psychology of Investing in Bonds (p. 526) • There are at least three reasons why investors choose bonds in place of stocks. • First, bond investments are often chosen by investors who want to diversify and use the concept of asset allocation. • Second, investors consider government and corporate bonds a safer investment when compared to stocks, mutual funds that invest in stocks, or other investments because bonds represent a debt that must be repaid. • Third, bonds may offer more potential return than savings accounts, certificates of deposit, money market accounts, and savings bonds. • Investors purchase corporate bonds for three reasons: (1) interest income, (2) possible increase in value, and (3) repayment at maturity. Interest Income (p. 527) • Bondholders normally receive interest payments every six months. • The method used to pay bondholders their interest depends on whether they own registered bonds, registered coupon bonds, or bearer bonds. 1. A registered bond is registered in the owner’s name by the issuing company. Interest checks for registered bonds are mailed directly to the bondholder of record. 2. A registered coupon bond is registered for principal only, not for interest. To collect interest payments on a registered coupon bond, the owner must present one of the detachable coupons to the issuing corporation or the paying agent. 3. A bearer bond is a bond that is not registered in the investor’s name. Note: U.S. corporations no longer issue bearer bonds, but they are generally issued by corporations in foreign countries. Dollar Appreciation of Value (p. 528) • Corporate bonds may increase or decrease in value until the maturity date. • Changes in overall interest rates in the economy are • Discussion Question: Why do investors purchase corporate bonds? • Use PPT slide 15-11. • The Did You Know feature describes information currently available about bond investing available on the SEC Web site at www.sec.gov. • Text Highlight: You may want to review Exhibit 15.1 (Financial Suggestions for Bond Investors). • Use PPT slide 15-12. • Text Highlight: You may want to review the interest calculation for the AT&T bond on page 527 with your students at this point in your lecture. • Text Highlight: The Financial Planning Calculations feature describes how the time value of money can be used to maximize interest payments from bond investments--see page 528. • Use PPT slide 15-13. • For a different example than the one in the textbook, use Transparency Master 15-1. 15-10 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions the primary cause of most bond price fluctuations. If overall interest rates fall, then a corporate bond with a fixed interest rate will go up in value. On the other hand, if overall interest rates rise, then a corporate bond with a fixed interest rate will go down in value. • While the interest rate for corporate bonds is fixed, the market value and the yield for a bond are not. The yield is the rate of return earned by an investor who holds a bond for a stated period of time--usually a 12- month period. • The financial condition of the corporation and the probability of its repaying the bond at maturity also affect the bond’s value. Bond Repayment at Maturity (p. 529) • Corporate bonds are repaid at maturity. • When you purchase a bond, you have two options: You may keep the bond until maturity and then redeem it, or you may sell the bond at any time to another investor. • It is also possible to build a bond ladder to balance risk and return in an investment portfolio. A bond ladder is a strategy where investors divide their investment dollars among bonds that mature at regular intervals in order to balance risk and return. • Text Highlight: You may want to discuss the formula for determining the Approximate Market Value of a bond and the example on page 529 at this point in your lecture. • Text Highlight: You may want to discuss the My Life to reinforce the advantages of investing in bonds--see p. 530. A Typical Bond Transaction (p. 530) • Exhibit 15-2 details a typical bond transaction that involves an investor who purchased a DuPont bond and then later resold it for a profit. The Mechanics of a Bond Transaction (p. 531) • Most bonds are sold through full-service brokerage firms, discount brokerage firms, or the Internet. • Generally, if you purchase one $1,000 bond through an account executive, you should expect to pay a minimum commission of between $5 and $25. If you purchase more bonds, the commission usually drops to $1 to $10 per bond. • Use PPT slide 15-14. • Text Highlight: You may want to discuss the material in Exhibit 15-2 (Sample Corporate Bond Transaction for DuPont) at this point in your lecture. • Text Highlight: You may want to discuss the boxed feature “Are Bond Funds Right for You” on page 531. • You should also expect to pay commission when you sell bonds. • Some brokerage firms have begun charging a flat commission charge regardless of how many bonds you buy or sell. • Practice Quiz 15-3 (p. 532) 15-11 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions IV. GOVERNMENT BONDS AND DEBT SECURITIES (p. 532) • In addition to corporations, the U.S. government and state and local governments issue bonds to obtain financing. A government bond is a written pledge of a government or a municipality to repay a specified sum of money, along with interest. Treasury Bills, Notes, and Bonds (p. 532) • The federal government sells bonds and securities to finance both the national debt and the government’s ongoing activities. • Even with concerns about default and the nation's economic problems, the main reason why investors in the United States and around the globe choose U.S. government securities is that most investors consider them to be a safe investment with little risk. • Treasury bills, notes, bonds, TIPS, and savings bonds can be purchased through Treasury Direct at www.treasurydirect.gov . 1. If investors bid competitively, they must specify the rate or interest yield that they are willing to accept. 2. If they bid noncompetitively, they are willing to accept the average interest rate or yield determined by auction. • Treasury securities may also be purchased through banks or brokers, which charge a commission. • Be Warned: Interest rates for securities issued by the U.S. Treasury are at record low levels. And yet, investors often choose these securities because of the decreased risk of default and in an attempt to use asset allocation to lessen overall risk. • Interest paid on U.S. government securities is taxable for federal income tax purposes but is exempt from state and local taxation. Note: For more information about savings bonds, see the material in Chapter 5. • Use PPT slide 15-15. • Discussion Question: Do you consider U.S. government bonds to be risk-free investments? • Text Highlight: You may want to discuss Exhibit 15.3 which provides information about Treasury Direct (www.treasurydirect.gov)--see page 533. • U.S. government securities include: 1. Treasury bills, sometimes called T-bills, are issued in minimum units of $100 with additional increments of $100 above the minimum. The maturities for T-bills may be as short as a few days or as long as 1 year. Currently, maturities are 4 weeks, 13 weeks, 26 weeks, or 52 weeks. T- bills are discounted securities, and the actual purchase price is less than the maturity value of • Use PPT slide 15-16. • Text Highlight: You may want to discuss the example that determines the purchase price for a discounted T-bill—see page 533. • Text Highlight: You may want to discuss the example that describes how to calculate the 15-12 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions the T-bill. When T-bills reach maturity, you are paid the maturity value or full amount. 2. Treasury notes are issued in $100 units with maturities that are more than 1 year but not more than 10 years. Interest is paid every six months until maturity. Typical maturities are 2, 3, 5, 7, and 10 years. At maturity, the face value of the note is paid to the owner. Notes can also be sold before maturity. 3. Treasury bonds are issued in minimum units of $100 with a 30-year maturity. Interest is paid every six months. When a bond matures, the owner is paid the face value of the bond. Bonds can also be sold before maturity. 4. Treasury Inflation-Protected Securities (TIPS) are sold in minimum units of $100 with additional increments of $100 above the minimum. Currently, TIPS are sold with 5, 10, or 30 year maturities. The principal of TIPS securities increases with inflation and decreases with deflation, as measured by the consumer price index. When TIPS mature, you are paid the adjusted principal or original principal, whichever is greater. TIPS also pay interest twice a year, at a fixed rate. The rate is applied to the adjusted principal, so, like the principal, interest payments rise with inflation and fall with deflation. yield for a discounted T-bill— see page 534. • The Did You Know feature on page 534 provides information on yields for U.S. Government 10-year treasury notes. • Use PPT slide 15-17. • Use PPT slide 15-18. Federal Agency Debt Issues (p. 535) • In addition to the bonds and securities issued by the Treasury Department, debt securities are issued by federal agencies and government sponsored enterprises which include the Federal National Mortgage Association, the Government National Mortgage Association, and the Federal Home Loan Mortgage Corporation. • While some federal agencies or enterprises may be government sponsored, strictly speaking they are not actually part of the U.S. government and the securities they issue do not have the same guarantees that bills, notes, bonds, and TIPS issued by the U.S. Treasury have. As a result, agency debt issues often have a slightly higher interest rate than securities issued by the Treasury Department. • Federal agencies generally issue securities with a minimum denomination that may be as high as $5,000 to $25,000 with maturities that range up to 30 years with an average life of 5 to 12 years. • Use PPT slides 15-19 and 15- 20. 15-13 CHAPTER 15 LECTURE OUTLINE Instructional Suggestions • Often brokers and account executives recommend federal agency debt because the interest rate is 0.50 to 1 percent higher than Treasury securities. State and Local Government Securities (p. 535) • A municipal bond, sometimes called a muni, is a debt security issued by a state or local government. There are two types of municipal bonds. 1. A general obligation bond is a bond backed by the full faith, credit, and unlimited taxing power of the government that issued it. • Use PPT slides 15-21 and 15- 22. 2. A revenue bond is a bond that is repaid from the income generated by the project it is designed to finance. • If the risk of default worries you, you can purchase insured bonds. Even if a municipal bond issue is insured, however, financial experts worry about the insurer’s ability to pay off in the event of default on a large bond issue. • Most experts advise investors to determine the underlying quality of a bond whether or not it is insured. • Like a corporate bond, a municipal bond may be callable by the government unit that issued it. • One of the most important features of municipal bonds is that the interest on them may be exempt from federal taxation—a factor especially important for wealthy investors. And these bonds are generally exempt from state and local taxes only in the state where they are issued. • Text Highlight: Use the My Life feature to reinforce why many investors choose government bonds--see p. 536. • Text Highlight: You may want to review the procedure for calculating the tax-equivalent yield with your students—see page 536. • Text Highlight: You may want to discuss Exhibit 15-4 (Yields for Tax-Exempt Investments) at this point in your lecture--see p. 537. • Use PPT slide 15-23. • Because of their tax-exempt status, their interest rates are lower than those of taxable bonds. It is possible to calculate the taxable-equivalent yield by dividing the tax-exempt yield by the result of 1.0 minus your current tax rate. • Once you have calculated the taxable equivalent yield, you can compare the return on tax-exempt securities with the return on taxable investments. • Practice Quiz 15-4 (p. 537) 15-14 CHAPTER 15 LECTURE OUTLINE INSTRUCTIONAL SUGGESTIONS V. THE DECISION TO BUY OR SELL BONDS (p. 537) • One basic principle that we have stressed throughout this text is the need to evaluate any potential investment. Certainly, corporate and government bonds are no exception. The Internet (p. 537) • By accessing a corporation’s Web page and locating the topics “financial information,” “annual report,” or “investor relations,” you can find many of the answers relating to the financial strength of a company. • When investing in bonds, you can also use the Internet in three other ways. You can 1. Obtain price information. 2. Trade bonds online. 3. Research a corporation and its bond issues by accessing bond Web sites. Be Warned: Bond Web sites are not as numerous as Web sites that provide information on stocks, mutual funds, or personal financial planning. • Use PPT slides 15-24 and 15-25. Financial Coverage for Bond Transactions (p. 538) • It is possible to obtain detailed information about bonds including current prices by using the Internet. • Not all local newspapers contain bond quotations, but The Wall Street Journal, Barron’s, and some metropolitan newspapers publish information on bonds. • Detailed information available by accessing the Yahoo! bond site is provided in Exhibit 15-5. • In bond quotations, prices are given as a percentage of the face value, which is usually $1,000. Thus to find the actual price paid, you must multiply the face value ($1,000) by the newspaper quote. • In the United States, the clean price for a bond represents the price of a bond with no accrued or earned interest. The dirty price for a bond represents the price of the bond plus accrued interest earned by the bond owner since the last interest payment date. • For government bonds, two price quotations are included in most financial publications. 1. The first price quotation, or the bid price, is the price a dealer or buyer is willing to pay for a government security. • Use PPT slide 15-26. • Use Transparency Master 15-2 for a different example than the one on PPT slide 15-26. • Text Highlight: You may want to discuss the bond information provided by the Yahoo! Bond site—see Exhibit 15-5 on page 539. • Text Highlight: You may want to discuss the example of determining the current price for a corporate bond illustrated on page 538 15-15 2. The second price quotation, or the asked price, represents the price at which a dealer or seller is willing to sell the government security. Annual Reports (p. 540) • As pointed out earlier in this chapter, bondholders must be concerned about the financial health of the corporation or government unit that issues bonds. • The information contained in a firm’s annual report is a logical starting point when evaluating the financial health of a corporation. • Today, there are two ways to obtain a corporation’s annual report. 1. You can write or telephone the corporation and request an annual report. 2. Most corporations maintain an Internet Web page that provides access to annual reports and detailed information about its financial performance. • Regardless of how you obtain an annual report, you should look for signs of financial strength or weakness. • Use PPT slide 15-27. Bond Ratings (p. 540) • To determine the quality and risk associated with bond issues, investors rely on the bond ratings provided by Moody’s Investors Service, Inc., Standard & Poor’s Corporation, and Fitch Bond Ratings. • As illustrated in Exhibit 15-6, bond ratings generally range from AAA (the highest) to D (the lowest) for Standard & Poor’s and Aaa (the highest) to C (the lowest) for Moodys. • Generally, U.S. government securities issued by the Treasury Department and various federal agencies are not graded because they are risk free for practical purposes. • The rating of long-term municipal bonds is similar to that of corporate bonds. • Use PPT slide 15-28. • Text Highlight: You may want to discuss the bond ratings illustrated in Exhibit 15-6 at this point in your lecture—see page 541. • Text Highlight: You may want to point out the How To . . . Evaluate Corporate, Government, and Municipal Bonds feature at this point in your class discussion—see page 542. Bond Yield Calculations (p. 540) • Two methods are used to measure the yield on a bond investment. As defined earlier in the chapter, the yield is the rate of return earned by an investor who holds a bond for a stated period of time. 1. The current yield is determined by dividing the annual income amount by the bond’s current market value. 2. The yield to maturity is a yield calculation that takes into account the relationship among a • Use PPT slide 15-29. • Text Highlight: You may want to review the examples for current yield and yield-to-maturity calculations on pages 541-543. • Use PPT slide 15-30. 15-16 bond’s maturity value, the time to maturity, the current price, and the dollar amount of interest. • Before making a decision to choose a bond because of a high current yield, keep in mind there are other factors t consider. • One very important factor is the risk associated with a potential bond investment. Other Sources of Information (p. 544) • Investors can use two additional sources of information to evaluate potential bond investments. 1. Business periodicals and publications can provide information about the economy and interest rates and detailed financial information about a corporation or government entity that issues bonds. • The Did You Know feature provides information about bond calculators available from the U.S. Treasury—see page 543. • Text Highlight: The My Life feature stresses the importance of evaluating bond investments--see p. 543. • Text Highlight: You may want to review the Financial Planning Calculations feature entitled “The Times Interest Earned Ratio” on page 544. 2. A number of federal agencies provide information that may be useful to bond investors. • Practice Quiz 15-5 (p. 544) CONCLUDING ACTIVITIES • Point out the Dashboard and My Life Stages for Investing in Bonds features, chapter summary, and key terms. (p. 545) • Discuss selected end-of-chapter key formulas, financial planning problems, financial planning activities, and financial planning case. • Use the Chapter Quiz in the Instructor’s Manual. WORKSHEETS FROM PERSONAL FINANCIAL PLANNER FOR USE WITH CHAPTER 15 Sheet 60 Corporate Bond Evaluation CHAPTER 15 QUIZ ANSWERS True-False Multiple Choice 1. F (p. 523) 6. A (p. 533) 2. T (p. 523) 7. D (p. 536) 3. T (p. 523) 8. B (p. 541) 4. T (p. 525) 9. D (p. 531) 5. F (p. 535) 10. B (p. 522) 15-17 Name ________________________________________ Date ____________________________ CHAPTER 15 QUIZ TRUE-FALSE _____1. A bond debenture is a legal document that details all of the conditions relating to a bond issue. _____2. One reason corporations sell corporate bonds is to help finance their ongoing business activities. _____3. A mortgage bond is sometimes referred to as a secured bond. _____4. A sinking fund is a fund to which annual or semiannual deposits are made for the purpose of redeeming a bond issue. _____5. A revenue bond is a bond backed by the full faith, credit, and unlimited taxing power of the government that issued it. MULTIPLE CHOICE _____6. A government security issued in minimum units of $100 with maturities that may be as long as one year is called a a. treasury bill. b. treasury note. c. treasury bond. d. municipal bond. _____7. A bond that may provide tax-free interest income is called a a. corporate debenture bond. b. corporate indenture bond. c. Federal T-bill. d. municipal bond. _____8. The current yield for a bond a. is stated on the bond certificate. b. is determined by dividing the annual income amount by a bond’s current market value. c. is not a factor when evaluating a bond investment. d. takes into account the relationship among a bond’s maturity value, the time to maturity, the current price, and the dollar amount of interest. _____9. Which of the following statements is true? a. You must own a bond for ten years before selling it to another investor. b. You must own a bond for five years before selling it to another investor. c. Bonds cannot be resold, and must be held until maturity. d. Generally, commissions to purchase a $1,000 bond are between $5 and $25. _____10. The usual face value for a corporate bond is a. $100. b. $1,000. c. $5,000. d. $10,000 15-18 SUPPLEMENTARY LECTURE The information in this supplemental lecture can be used to reinforce the material in the sections entitled “A Typical Bond Transaction,” “Bond Ratings,” “The Internet,” and “Financial Coverage for Bond Transactions.” Introduction Recently, a number of corporations have sold bonds to provide debt financing for expansion, research and development, debt retirement, or just about any other reason. From the investor’s standpoint, these new bond issues range from very conservative to very speculative investments. One Possible Bond Investment One such investment is a bond issued by General Electric, Inc. The face value of the bond is $1,000 with a maturity date of October, 2022. The interest rate is 2.70 percent. The rating for the General Electric bond is AA. Activities You may want to use the following either as a class activity or as an outside assignment. All questions and activities are designed to enhance the material in Chapter 15. If you decide to use this as an outside assignment, you may want to suggest the Yahoo bond website (http://finance.yahoo.com/bonds) as a source of information. Questions 1. How important is the AA rating for the General Electric bond? 2. What does the AA rating mean? 3. The market value for this bond was $1,038 in August 2013. What is the current value of this bond? 4. Based on your answer to question number three, would this have been a good investment? 15-19 ANSWERS TO PRACTICE QUIZ QUESTIONS, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, FINANCIAL PLANNING CASE, AND CONTINUING CASE. PRACTICE QUIZZES Practice Quiz 15-1 (p. 523) 1. What is the usual face value for a corporate bond? The usual face value of a corporate bond is $1,000, although the face value of some corporate bonds may be as high as $50,000. (p. 522) 2. In your own words, define maturity date and bond indenture. The maturity date for a corporate bond is the date on which the corporation is to repay the borrowed money. A bond indenture is a legal document that details all of the conditions relating to a bond issue. (p. 522) 3. How does a trustee evaluate the provisions contained in a bond indenture? A trustee is a financially independent firm or individual that acts as the bondholders’ representative. Usually, the corporation must report to the trustee periodically regarding its ability to make interest payments and eventually redeem the bonds. In turn, the trustee transmits this information to the bondholders along with its own evaluation of the corporation’s ability to pay. If the corporation fails to live up to all the provisions contained in the indenture agreement, the trustee may bring legal action to protect the bondholders’ interest. (p. 522) Practice Quiz 15-2 (p. 526) 1. Why do corporations sell bonds? Corporations sell corporate bonds to help pay for major purchases or to finance their ongoing business activities. They often sell bonds when it is difficult or impossible to sell stock or preferred stock. The sale of bonds can also improve a corporation’s financial leverage. Finally, the interest paid to bond holders is a tax-deductible business expense (p. 523) 2. What are the differences among a debenture, a mortgage bond, and a subordinated debenture? A debenture is a bond that is backed only by the reputation of the issuing corporation. A mortgage bond is a corporate bond that is secured by various assets of the issuing firm. A subordinated debenture is an unsecured bond that gives bondholders a claim secondary to that of other designated bondholders with respect to income, repayment, and assets. (p. 523) 3. Why would an investor purchase a convertible bond or a high-yield bond? By investing in a convertible bond, you obtain the safety of a bond, but you also have the potential for speculative gains offered by conversion to common stock. The Ford Motor Company convertible note described on page 524 can be converted to 108.6957 shares of the company’s common stock. This means you could choose to convert the bond to common stock whenever the price of the company’s common stock is $9.20 or higher ($1,000 ÷ 108.6957 = $9.20). 15-20 Investors purchase high-yield bonds because they provide additional income when compared to more conservative bond issues. Note: In order to obtain increased income, investors must be willing to accept a greater risk associated with high-yield bonds. (p. 524) 4. Describe three reasons a corporation would sell convertible bonds. The corporation gains three advantages by issuing convertible bonds. First, the interest rate on a convertible bond is often lower than that on traditional bonds. Second, the conversion feature attracts investors who are interested in the speculative gain that conversion to common stock may provide. Third, if the bondholder converts to common stock, the corporation no longer has to redeem the bond at maturity. (p. 524) 5. Explain the methods that corporations can use to repay a bond issue. A corporation may use one of two methods to ensure that it has sufficient funds available to redeem a bond issue. A sinking fund is a fund to which annual or semiannual deposits are made for the purpose of redeeming a bond issue. A corporation can also issue serial bonds. Serial bonds are bonds of a single issue that mature on different dates. (p. 525) Practice Quiz 15-3 (p. 532) 1. Describe the three reasons why investors purchase bonds. Investors purchase corporate bonds for three reasons: (1) interest income, (2) possible increase in value, and (3) repayment at maturity. (p. 527) 2. What are the differences among a registered bond, a registered coupon bond, and a bearer bond? A registered bond is registered in the owner’s name by the issuing company. A registered coupon bond is registered for principal only and not for interest. To collect interest payments on a registered coupon bond, the owner must present one of the detachable coupons to the issuing corporation or the paying agent. A bearer bond is a bond that is not registered in the investor’s name. Note: While U.S. corporations no longer issue bearer bonds, they are generally issued by corporations in foreign countries. (p. 527) 3. In what ways can interest rates in the economy affect the price of a corporate bond? Changes in overall interest rates in the economy are an example of the concept of interest rate risk and market risk discussed in Chapter 13. If overall interest rates fall, then a corporate bond with a fixed interest rate will go up in value because of the bond’s higher interest rate. On the other hand, if overall interest rates rise, the market value of a corporate bond with a fixed interest rate will go down because of the bond’s lower interest rate. (p. 528) 4. Why is the value of a bond closely tied to the issuing corporation’s ability to repay its bond indebtedness? You should always remember that the value of a bond is tied to the ability of the corporation to repay the bond at maturity or make interest payments until maturity. If the corporation that issued the bond does incur financial problems, the value of a bond will go down. (p. 529) 5. How are corporate bonds bought and sold? Most bonds are sold through full-service brokerage firms, discount brokerage firms, or the Internet. Generally, if you purchase a 1,000 bond through an account executive or brokerage firm, you should expect to pay a commission of between $5 and $25. If you purchase more bonds, the commission usually drops to $1 to $10 per bond. (p. 531) 15-21 Practice Quiz 15-4 (p. 537) 1. What are the maturities for a Treasury bill, Treasury note, and Treasury bond? Treasury bills are issued with maturities as long as one year although typical maturities are 4 weeks, 13 weeks, 26 weeks, or 52 weeks. Treasury notes are issued with maturities of more than one year but not more than ten years. Typical maturities are 2, 3, 5, 7, and 10 years. Treasury bonds have a 30-year maturity. (pp. 533-534) 2. What is the difference between a general obligation bond and a revenue bond? A general obligation bond is a bond backed by the full faith, credit, and unlimited taxing power of the government that issued it. A revenue bond is a bond that is repaid from the income generated by the project it is designed to finance. (p. 535) 3. What are the risks involved when investing in municipal bonds? Although municipal bonds are relatively safe, there have been defaults in recent years. Bondholders should be concerned about continued interest payments and eventual repayment. (p. 535) Practice Quiz 15-5 (p. 544) 1. What type of information is contained in a corporation’s Website? How could this information be used to evaluate a bond issue? Information about the firm’s finances is contained on a corporation web site. By clicking on the topics “investor relations” or “financial information,” an investor should find the answers to the following questions: (1) Is the firm profitable? (2) Are sales revenues increasing? (3) Are the firm’s long-term liabilities increasing? In fact, there are many questions that bondholders should ask before making a decision to buy a bond and many of the answers are available on the firm’s web site. (p. 537) 2. What is the market value for a bond with a face value of $1,000 and a newspaper quotation of 77? The market value for the above bond is $770 as illustrated below. (p. 538) Bond price = Face Value x bond quote = $1,000 x 77 percent = $1,000  .77 = $770 market value 3. How important are bond ratings when evaluating a bond issue? To determine the quality and risk associated with bond issues, investors rely on the bond ratings provided by Moody’s Investors Service, Standard & Poor’s, and Fitch Bond Ratings. All three companies rank thousands of corporate and municipal bonds. Although bond ratings may be flawed or inaccurate, most investors regard the work of Moody’s, Standard & Poor’s, and Fitch as highly reliable. (p. 540) 4. Why should you calculate the current yield and yield to maturity on a bond investment? Yield calculations allow investors to compare bond investments with the yields of other investment alternatives, which include certificates of deposit, common stock, preferred stocks, and mutual funds. Naturally, the higher the yield, the better. (p. 540) 5. How can business periodicals and government publications help you evaluate a bond issue? Both business periodicals and government publications provide more information that may be needed to evaluate a bond investment. (p. 544) 15-22 FINANCIAL PLANNING PROBLEMS (p. 549) 1. Calculating Interest. Calculate the annual interest and the semiannual interest payment for the following corporate bond issues with a face value of $1,000. Annual Interest Rate Annual Interest Amount Semiannual Interest Payment 4.20% $42.00 $21.00 5.10% $51.00 $25.50 5.00% $50.00 $25.00 4.70% $47.00 $23.50 Learning Objective: 15-1 Topic: Characteristics of Corporate Bonds Level of Difficulty: Easy Bloom’s Tag: Application 2. Analyzing convertible bonds. Jackson Metals, Inc. issued a $1,000 convertible corporate bond. Each bond is convertible to 40 shares of the firm’s common stock. a. What price must the common stock reach before investors would consider converting their bond to common stock? In order for investors to convert this bond to common stock, the stock price must be $25 or higher. $1,000 ÷ 40 shares = $25. b. If you owned a bond in Jackson Metals, would you convert your bond to common stock if the stock’s price did reach the conversion price? Explain your answer. Even when common stock values increase, investors are often reluctant to exchange a convertible bond for a corporation’s common stock. The reason is quite simple. As the market value of the common stock increases, the market value of the convertible bond also increases. By not converting to common stock, bondholders enjoy the added safety of the bond and interest income in addition to the increased market value of the bond caused by the price movement of the common stock. Learning Objective: 15-2 Topic: Why Corporations Sell Corporate Bonds Level of Difficulty: Easy 15-23 Bloom’s Tag: Application; Analysis 3. Determining the Approximate Market Value for a Bond. Approximate the market value for the following $1,000 bonds. Interest Rate When Issued Dollar Amount of Interest for the Existing Bond Interest Rate for Comparable Bonds Issued Today Approximate Market Value 5% 4% 5.1% 6.2% 7% 6% Approximate annual value = Dollar amount of annual interest / Comparable interest rate (.05 x $1,000) / .04 = $1,250 (.051 x $1,000) / .062 = $822.58 (.07 x $1,000) / .06 = $1,166.67 Learning Objective: 15-3 Topic: Why Investors Purchase Corporate Bonds Level of Difficulty: Hard Bloom’s Tag: Application 4. Calculating Total Return. Jean Miller purchased a $1,000 corporate bond for $910. The bond pays 5 percent annual interest. Three years later, she sold the bond for $1,010. Calculate the total return for Ms. Miller’s bond investment. The total return is $250, calculated as follows: Annual interest = $1,000 x 0.05 = $50 Three years interest = $50 x 3 = $150 Dollar gain = $1,010 – $910 = $100 Total return = $150 Three years interest + $100 Dollar gain = $250 Learning Objective: 15-3 Topic: Why Investors Purchase Corporate Bonds Level of Difficulty: Hard Bloom’s Tag: Application 5. Calculating Total Return. Mark Crane purchased a $1,000 corporate bond five years ago for $1,060. 15-24 The bond pays 4.5 percent annual interest. Five years later, he sold the bond for $950. Calculate the total return for Mr. Crane’s bond investment. The total return is $115.00, calculated as follows: Annual interest = $1,000 x 0.045 = $45.00 Five years interest = $45.00 x 5 = $225.00 Capital loss on investment = $950 - $1,060 = $110 Total return = $225.00 Five years interest - $110 Capital loss = $115.00 Learning Objective: 15-3 Topic: Why Investors Purchase Corporate Bonds Level of Difficulty: Hard Bloom’s Tag: Application 6. Calculating Bond Yield for a T-Bill. Sandra Waterman purchased a 52-week, $1,000 T-bill issued by the U.S. Treasury. The purchase price was $996. a. What is the amount of the discount? The discount amount is $4. $1,000 maturity value - $996 purchase price = $4 b. What is the amount Ms. Waterman will receive when the T-bill matures? Ms. Waterman will receive $1,000--the face value of the T-bill. c. What is the current yield for the 52-week T-bill? The current yield for the T-bill is o.40% $4 discount amount ÷ $996 = 0.0040 = 0.40% Learning Objective: 15-4 Topic: Government Bonds and Debt Securities Level of Difficulty: Medium Bloom’s Tag: Synthesis 7. Calculating Total Return. James McCulloch purchased a 30-year U.S. Treasury bond four years ago for $1,000. The bond paid 3.125 percent annual interest. Four years later, he sold the bond for $1,040. a. What is the annual interest amount for the bond? The annual interest amount is $31.25. $1,000 × 0.03125 = $31.25 b. What is the total interest Mr. McCulloch earned during the four-year period? $31.25 annual interest × 4 = $125 15-25 c. What is the total return for Mr. McCulloch's bond investment? Step 1: $31.25 annual interest x 4 years = $125 total interest Step 2: $1,040 Price when sold - $1,000 purchase price = $40 Step 3: $125 total interest + $40 capital gain = $165 total return Learning Objective: 15-3 Topic: Government Bonds and Debt Securities Level of Difficulty: Difficult Bloom’s Tag: Synthesis 8. Calculating the purchase price for a T-Bill. Calculate the purchase price for a 52-week $1,000 treasury bill with a stated interest rate of 0.60 percent. Step 1: Discount amount for one year = Maturity value x interest rate = $1,000 x 0.0060 = $6 Step 2: Purchase price = $1,000 – $6 = $994 Learning Objective: 15-4 Topic: Government Bonds and Debt Securities Level of Difficulty: Hard Bloom’s Tag: Application 9. Calculating Tax-Equivalent Yields. Assume that you are in the 39.6 percent tax bracket and you purchase a 3.35 percent tax-exempt municipal bond. Use the formula presented in this chapter to calculate the taxable equivalent yield for this investment. Tax equivalent yield = Tax-exempt yield / (1 – Tax rate) Tax equivalent yield = 3.35 percent / (1 – 0.396) = 5.5464 percent Learning Objective: 15-4 Topic: Government Bonds and Debt Securities Level of Difficulty: Medium Bloom’s Tag: Application 10. Calculating Tax-Equivalent Yield. Assume you are in the 33 percent tax bracket and purchase a 4.20 percent, tax-exempt municipal bond. Use the formula presented in this chapter to calculate the taxable equivalent yield for this investment. 15-26 Tax equivalent yield = Tax-exempt yield / (1 – Tax rate) Tax equivalent yield = 4.20 percent / (1 - 0.33) = 6.2687 percent Learning Objective: 15-4 Topic: Government Bonds and Debt Securities Level of Difficulty: Medium Bloom’s Tag: Application 11. Determining Bond Prices. What is the current price for a $1,000 bond that has a price quote of 87? $1,000 x 87 percent $1,000 x 0.87 = $870 Learning Objective: 15-5 Topic: The Decision to Buy or Sell Bonds Level of Difficulty: Easy Bloom’s Tag: Application 12. Calculating Current Yields. Calculate the interest amount and current yield for the following $1,000 bonds. Interest Rate Interest Amount Current Market Value Current Yield 6% $60 $1,020 5.88% 5.3% $53 $1,170 4.53% 5.10 $51 $930 5.48% Learning Objective: 15-5 Topic: The Decision to Buy or Sell Bonds Level of Difficulty: Medium Bloom’s Tag: Application 13. Calculating Yields. Assume you purchased a high-yield corporate bond at its current market price of $850 on January 2, 2004. It pays 9 percent interest and it will mature on December 31, 2013, at which time the corporation will pay you the face value of $1,000. a. Determine the current yield on your bond investment at the time of purchase. b. Determine the yield to maturity on your bond investment. a. The current yield = interest income ÷ market value 15-27 The current yield = $90 ÷ $850 = 0.1059 = 10.59 percent b. The yield to maturity = Interest amount + Face Value - Market Value Number of Periods Market Value + Face Value 2 Yield to maturity = $90 $1, $850 ,    000 850 10 1 000 2 Yield to maturity = 0.1135 = 11.35 percent Learning Objective: 15-5 Topic: The Decision to Buy or Sell Bonds Level of Difficulty: Hard Bloom’s Tag: Application 14. Calculating Yields. Assume that ten years ago you purchased a $1,000 bond for $820. The bond pays 6.75 percent interest and will mature this year. a. Calculate the current yield on your bond investment at the time of the purchase. b. Determine the yield to maturity on your bond investment. a. The current yield = interest income ÷ market value The current yield = $67.50 ÷ $820 = 0.0823 = 8.23 percent b. The yield to maturity = Interest amount + Face Value - Market Value Number of Periods Market Value + Face Value 2 Yield to maturity = 2 $820 1,000 10 $1,000 820 $67.50    Yield to maturity = 0.0940 =9.40 percent Learning Objective: 15-5 Topic: The Decision to Buy or Sell Bonds Level of Difficulty: Hard 15-28 Bloom’s Tag: Application FINANCIAL PLANNING ACTIVITIES (p. 551) 1. Explaining Why Corporations Sell Bonds. Prepare a two-minute oral presentation that describes why corporations sell bonds. (LO15-1) Corporations issue bonds and other securities to pay for major purchases and to help finance their ongoing activities. Firms also issue bonds when it is difficult or impossible to sell stock to improve a corporation’s financial leverage, and to reduce taxes paid to federal and state governments. 2. Analyzing Why Investors Purchase Bonds. In your own words, explain how each of the following factors is a reason to invest in bonds. (LO15-3) a. Interest Income. Interest income is a primary reason why investors choose to invest in either corporate or government bonds. Interest is calculated on the face value of the bond and is usually paid every six months. b. Possible Increase in Value. Generally, bonds are issued with a stated face value. Once issued, the price may be higher or lower than the face value. Financial returns for comparable investments and interest rates in the economy are two factors that may cause the market value of a bond to increase or decrease. Also if a corporation experiences financial difficulties for any reason, the value of a corporate bond can decrease. c. Repayment at Maturity. Whenever you purchase a bond, you have two options: you may keep the bond until maturity and then redeem it, or you may sell the bond at any time to another investor. In either case, the value of your bond is closely tied to the corporation’s ability to repay its bond indebtedness. 3. Using the Internet to Obtain Investment Information. Use the Internet to locate the website for Treasury Direct (www.treasurydirect.gov). Then prepare a report that summarizes the information provided on Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation-Protected Securities (TIPS). (LO15-4) This website provides a wealth of information about Treasury bills, Treasury notes, Treasury bonds, and TIPS. Specifically, information is included describing the nature of these investments, how investors can buy government securities, and a detailed history of interest rates. 4. Using the Internet. Use the information at the bond site on Yahoo! Finance to answer the following questions about a corporate bond. To complete this activity, follow these steps: (LO15-5) a. Go to http://finance.yahoo.com/bonds and click on Bond Screener. b. Click on Corporate and enter the information requested in the section "Select Bond Criteria." then click Find Bonds. c. Choose one of the issues listed. d. Using the information on the Yahoo! bond website, determine the current yield for this bond issue. What does the current yield calculation measure? e. Using the information on the Yahoo! bond website, what is the yield to maturity for this bond issue? What does the yield to maturity calculation measure? f. What is the rating for this bond? What does this rating mean? g. Based on your answer to the above questions, would you choose this bond for your investment portfolio? Explain your answer. 15-29 Student answers will vary depending on the bond they choose. You may want to use this exercise to review the type of information that is available on the Yahoo! Finance website and similar websites. 5. Evaluating a Bond Transaction. Choose a corporate bond that you would consider purchasing. Then, using information obtained in the library or on the Internet, answer the questions on the evaluation form presented in the Personal Financial Planner Sheet 60 “Evaluating Corporate Bonds” at the end of the text. Based on your research, would you still purchase this bond? Explain your answer. (LO15- 5) Answers will vary depending on the bond that students choose and the source of the information used for evaluation purposes. FINANCIAL PLANNING CASE A Lesson From The Past (p. 551) 1. According to Mary Goldberg, the chance to invest in New World Explorations was “too good to pass up.” Unfortunately, it was too good to be true, and she lost $10,000. Why do you think so many people are taken by get-rich-quick schemes? For most people, the lure of “big” profits encourages them to invest without thinking. At this point, you may want to remind students of the old adage, “If it’s too good to be true, it probably is.” 2. Over the past 5 to 8 years, investors have been forced to look for ways to squeeze additional income from their investment portfolios. Do you think investing in corporate bonds or quality stocks is the best way to increase income? Why or why not? Although answers will vary, bonds and quality stocks can provide increased income that results from bond interest or dividend income. 3. Using information obtained in the library or on the Internet, answer the following questions about Peter Manning’s investment suggestions. a. What does the rating for the AT&T Broadband bond mean? b. What does the rating for the Deere corporate note mean? c. How would you describe the common stock issued by Procter & Gamble? a. At the time of publication, the rating for the AT&T Broadband bond was BBB. Bonds with a “BBB” rating are medium-grade obligations. b. At the time of publication, the rating for the Deere bond was A. Bonds with an “A” rating are upper medium-grade obligations. c. The common stock issued by Procter & Gamble has been a solid “conservative” stock through the years while maintaining a degree of safety. It also has a long history of paying dividends. 4. Based on your research, which investment would you recommend to Mary Goldberg? Why? Although student answers will vary, all three investments may be appropriate for an investor who is now in her mid-40s. Given that Ms. Goldberg will probably work another 20 plus years, the Procter & Gamble investment could provide a measure of growth. On the other hand, the two bond investments would pay better interest than potential investments in certificate of deposits. 5. Using a current newspaper, The Wall Street Journal, Barron’s, or the Internet, determine the current market value for each of the three investments suggested in this case. Based on this information, would these investments have been profitable if Mary had purchased the AT&T Broadband bond for $1,530, the Deere note for $1,190, or Procter & Gamble stock for $76 a share? 15-30 Depending on the source of information and the date when students answer this question, answers will vary. CONTINUING CASE Investing in Bonds (p. 553) 1. What types of financial goals might include an investment in bonds for the Lawrences? Bonds are generally chosen by conservative investors seeking interest income and a higher degree of safety than offered by other investment alternatives. They are also chosen by investors who want to diversify their investment portfolio (asset allocation) and reduce risk. 2. If the Lawrences were interested in a particular bond, describe the bond ratings that would help them evaluate its quality and risk. Bond ratings are available from Moody’s, Standard & Poors, and Fitch Ratings. Corporate bonds rated BBB or higher (See Exhibit 15.6 on page 541) may be appropriate choices for the Lawrences. 3. Explain how Shelby and Mark might use the Personal Financial Planner sheet Corporate Bond Evaluation. Personal Financial Planner sheet 60—Corporate Bond Evaluation provides a number of questions that can be used to evaluate a bond issue. 15-31 TM 15-1 Sample Corporate Bond Transaction 15-32 TM 15-2 Bond Information available by accessing the Yahoo! bond site (http://finance.yahoo.com/bonds) 15-33 Name ______________________________________ Cha pt er 15: I nv est ing in Bonds 2. A bond that is registered for principal only, and not for interest. 3. A feature that allows the corporation to call in or buy outstanding bonds from current bondholders before the maturity date. 6. A bond that can be exchanged, at the owner's option, for a specified number of shares of the corporation's common stock. 7. A fund to which annual or semiannual deposits are made for the purpose of redeeming a bond issue. 8. Determined by dividing the yearly dollar amount of income generated by an investment by the investment's current market value. 11. A bond that is not registered in the investor's name. 15. An unsecured bond that gives bondholders a claim secondary to that of other designated bondholders with respect to interest payments, repayment, and assets. 18. A financially independent firm that acts as the bondholders' representative. 19. Bonds of a single issue that mature on different dates. 20. For a corporate bond, the date on which the corporation is to repay the borrowed money. 21. A bond that is registered in the owner's name by the issuing company. 1. A bond backed by the full faith, credit, and unlimited taxing power of the government that issued it. 4. A legal document that details all of the conditions relating to a bond issue. 5. The rate of return earned by an investor who holds a bond for a stated period of time. 6. A corporation's written pledge to repay a specified amount of money with interest. 9. A yield calculation that takes into account the relationship among a bond's maturity value, the time to maturity, the current price, and the dollar amount of interest. 10. A corporate bond secured by various assets of the issuing firm. 12. A bond that is backed only by the reputation of the issuing corporation. 13. A debt security issued by a state or local government. 14. A bond that is sold at a price far below its face value, makes no annual or semiannual interest payments, and is redeemed for its face value at maturity. 16. The dollar amount the bondholder will receive at the bond's maturity. 17. A bond that is repaid from the income generated by the project it is designed to finance. Across Down S U B O R D I N A T E D D E B E N T U R E G E N E R A L O B L I G A T I O N B O N D R E G I S T E R E D C O U P O N B O N D Y I E L D T O M A T U R I T Y C O N V E R T I B L E B O N D Z E R O C O U P O N B O N R E G I S T E R E D B O N DD M U N I C I P A L B O N D C O R P O R A T E B O N D B O N D I N D E N T U R E M O R T G A G E B O N D M A T U R I T Y D A T E C U R R E N T Y I E L D S I N K I N G F U N D S E R I A L B O N D S R E V E N U E B O N D C A L L F E A T U R E B E A R E R B O N D F A C E V A L U E D E B E N T U R T R U S T EE E Y I E L D 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 Instructor Manual for Personal Finance Jack R. Kapoor, Les R. Dlabay , Robert J. Hughes, Melissa M. Hart 9780077861643, 9781260013993