Download Bonds

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CHAPTER 11
Investing Basics and Evaluating Bonds
“If a little money does not go out,
great money will not come in.”
-- Confucius
The Answer is…
“A Voluntary
Tax on Stupid
People”
What is the Question?
2
Silly, the Question is…
“What is the
Lottery?”
A Voluntary Tax on Stupid People
3
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!?
Because It Ain’t Gonna’ Happen!
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And You Ain’t Gonna’
Win Da’ 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…
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Establishing Investment Goals

You already know the #1 Financial Goal:






“Spend Less Than You Earn”
“Live Beneath Your Means”
Which one is
“Make Love, Not Loans”
your favorite?
“Pay Yourself First”
“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
Essentials Before Investing
Or so says our book…

They are
important but
not essential
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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
and the self-employed
P.P.S. You are adequately insured, right?
First: Some Investment Terms


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Safety – Guarantee of return of principal
Risk – Uncertainty about an outcome
 Inflation risk
 Interest rate risk
“I am not so much concerned with
the return on my money as I am
with the return of my money.”
-- Will Rogers
 Business failure risk
 Market risk
 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!
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“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
“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
11
Regular Taxable Accounts versus TaxQualified Accounts
12
Account Statement Examples
Bonds “Cash”
Stocks Options Hard Assets
Margining Real Estate Futures
Mutual Funds Shorting
Bonds
Stocks
“Cash”
Mutual Funds
Taxable Account
Tax-Qualified Account
a.k.a. Regular account
a.k.a. Retirement Accounts,
Education Accounts, MSA  HSA
All contributions are post-tax dollars
Most are pre-tax; Some are post-tax
No limit on contributions
No limits on investment types
Pay taxes every year on gains
Strict limits on contributions
Strict limits on investment types
Tax-deferred (pre-tax) or
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.
Major Investment Alternatives
 Stocks
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Dividends & Capital Gains – 8%-10% – long-term
 Bonds Interest & Principal – 4%-8% – long/intermediate
 “Cash” Interest & Principal – 2%-5% – short-term
 a.k.a. Short-term investments, guaranteed, safety of principal
 Annuities
Fixed 2%-6%, Variable 2%-8% – BOHICA!
 Real Estate
Rent & Capital Gains – 7%-8% – long-term
 Other Investment Alternatives…
 …That I hope you will avoid …
 Unless you know exactly what you are doing or are willing to
lose a good chunk of your money or, preferably, both
 Derivatives (options, futures, etc.), hard assets, precious
metals, art & collectibles, etc.
“So What Is Your Choice?”

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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.
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.”
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Let me ask you a few
questions…






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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?
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
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Mutual Funds
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(a.k.a. Investment Company)
STOCKS
Stock
mutual
funds
BONDS
Balanced
mutual
funds
“CASH”
Bond
mutual
funds
Money
market
mutual
funds
a “mutual” fund
(investment company)
Professional Money Management
Diversification
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“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.
“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.”
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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
Yippee!
“Good News”
 “The market is up! Good News!”
Huh?!
 Your account is worth more
 “The market is down! Good News!”
 Next month, you will get more shares at a
lower price when the $50 or $100 comes out of
your paycheck or checking account
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“But Now It All Sounds So Boring…”

In the investment world, Boring is Good!
 After you have built a solid foundation of highquality stock or bond investments through mutual
funds, then you can “play the market”
 I used to call it my “Vega$ 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
Coming Attractions
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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
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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.
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Investments: What are ___?
Represent ownership in a corporation.
Investors receive dividends and capital
gains (or capital losses).
real estate
B. stocks
C. bonds
D. short-term securities (a.k.a. “cash”)
A.
The correct answer is (B). Stock investors are part-owners
of corporations.
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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.
B.
C.
D.
real estate
stocks
bonds
short-term securities (a.k.a. “cash”)
The correct answer is (C). Bonds are “fixed-income” investments.
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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.
real estate
B. stocks
C. bonds
D. short-term securities (a.k.a. “cash”)
A.
The correct answer is (D). Low risk, low return.
What are Reasonable
Expectations?
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What are reasonable expectations of
returns from the following investments?
A.
B.
C.
D.
E.
F.
stocks
bonds
short-term securities
real estate
mutual funds
the “others”
8% - 10%
4% - 8%
2% - 5%
7% - 8%
?
-?
Investing in Bonds
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 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)
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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…”)
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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.
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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.)
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

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The trustee is the bondholders’ representative
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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
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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
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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
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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%
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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
Buy or Sell a Bond
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 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!
Bonds and Interest Rates

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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 (the interest rate 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: Example

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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
Interest rates fall?
Bond prices rise!
Bonds and Interest Rates: 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
Bond prices fall!
Interest rates rise?
42
43
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?
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
A.
The correct answer is (A). If interest rates go down, bond
prices go up. The bond would sell at a premium.
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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?
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
A.
The correct answer is (B). If interest rates go up, bond
prices go down. The bond would sell at a discount.
Bonds and Interest Rates

45
(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
46
Current % Yield of a Bond
(continued)
Dollar Amount of Annual Interest
Current Market Value
Example: 6%, $1100 market value
Current yield = $60
$1100
= 0.0545454  5.45%
A bond selling at a
premium has a
current yield lower
than its stated
nominal rate
47
Current % Yield of a Bond
Dollar Amount of Annual Interest
Current Market Value
Example: 6%, $900 market value
Current yield = $60
$900
= 0.06667  6.67%
A bond selling at a
discount has a
current yield
higher than its
stated nominal rate
48
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
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.
49
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
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Bottom Line on Bonds


Bonds are good intermediate-term
investments
Bonds are decent long-term investments
 Especially good for those who would have trouble
sleeping at night if they were fully invested in
stocks

But don’t be fooled!
 Bonds have significant risks, too
 Especially when interest rates are very low
 Like right now…
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