Hace 3200 1nd Edition Exam 4 Study Guide Lectures 25 32 Lecture 25 Chapter 14 Investing in bonds and other investments o What are bonds Similar to an I O U When you purchase a bond you are lending money to a government Municipality corporation federal agency or other entity known as the issuer The issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond the principal when it matures or comes due Why consider bonds o Bonds reduce risk through diversification o Bonds produce steady current income o Bonds can be a safe investment if held to maturity Basic Bond Terminology and Features o Par Value face value the amount returned to the holder at maturity o Coupon interest indicates the percentage of the face value that will be paid annually to the holder in the form of interest o Indenture a document that outlines the terms of the loan agreement Basic Bond Terminology and Features o Call Provision allows the issues to repurchase the bonds before the maturity date o Sinking Fund money set aisde annually ti pay off the bonds at maturity Bond Investment Considerations o Interest rate Fixed floating or payable at maturity o Redemption features Call provisions when rates drop Puts you make issuer buy back bond when rates increase o Tax Status Interest may or may not be taxable Different Types of Bonds o Corporate bonds o Treasury and agency bonds o Municipal bonds Corporate Bonds o Corporations borrow by issuing bonds o Secured corporate debts are secured bu collateral or real property liens o Unsecured corporate debts are not secured by collateral and pay higher return Treasury and Agency Bonds o Treasury T bonds US treasury Bills notes and bonds Treasury inflation indexed bonds o Savings bonds US treasury U S Series EE bonds I bonds o Agency bonds Pass through certificates mortgages Treasury Bills Bonds o Bills mature in 3 6 or 12 months o Bonds mature in 10 to 30 years o All are sold in denominations of 1000 Agency Bonds o Issued by the government agencies authorized by congress o Low risk with interest rates slightly higher than treasury issues o Minimum denomination of 25 000 with maturities from 1 to 40 years Agency Bonds o As a savvy investor you should be familiar with three key members of the government agency bond family Ginnie Mae issued by the Government National Mortgage Association GNMA Fannie Mae issued by the Federal National Mortgage Association FNMA and Freddie Mac issued by the federal Home Loan Mortgage Corporation FHLMC Fannie Mae Freddie Mac o The Federal National Mortgage Association stockholder owned corporation chartered by Congress in 1968 as a government sponsored enterprise but founded in 1938 during the Great Depression The Corporation s purpose is to purchase and securitize mortgages in order to ensure that funds are consistently available to the institutions that lend money to home buyers o The Federal Home Loan Mortgage Corporation known as Freddie Mac was created in 1970 to expand the secondary market for mortgages in the US This secondary mortgage market increases the supply of money available for mortgage lending and increases the money available for new home purchases o The two GSEs have outstanding more than US 5 trillion in mortgage backed securities MBS and debt the debt portion alone is 1 6 trillion Fannie Mae Freddie Mac o On September 7 2008 the Federal Housing Finance Agency FHFA announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA The action is one of the most sweeping government interventions in private financial markets in decades As of 2008 Fannie Mae and the Federal Home Loan Mortgage Corporation Freddie Mac owned or guaranteed about half of the U S 12 trillion mortgage market o In 2003 the Bush Administration sought to create an agency to oversee Fannie Mae and Freddie Mac While Senate and House Leaders voiced their intention to bring about the needed legislation no reform bills materialized o Poor loans were made economy is paying the price Pass Through Certificates o Issued by the government National Mortgage Association Ginnie Mae o Minimum 25 000 certificate for pool of mortgages o Principal and interest repaid monthly Pass Through Certificates o Mortgage backed cetrtificates are the most common type of pass through where homeowner s payments pass from the original bank through a government agency or investment bank to investors Treasury Inflation indexed Bonds o Maturities of 10 years and a minmum par value of 1 000 o Inflation increases the face value of the bond guaranteeing the investor of a real return o Tax compilation must pay taxes annually on par value adjustments interest U S Series EE Bonds o Purchases price is one half of the face value ranging from 50 to 10 000 o Rate of return varies with the market rate o Have a guaranteed minimum interest rate based on treasury securities o High level of liquidity but cashing in before maturity may reduce yield Municipal Bonds Muni s o Issued by to find public projects o Interest earnings are federal tax exempt o Can be exempt from state taxes if you live in the state where the bonds issued o Not very liquid due to lack of a secondary market Zero Coupon Bonds o Issued by corporations municipalities and the treasury e g STRIPS o Do not pay interest each year o Are sold at a discount from face value o The price at maturity includes interest payments in lump sum How to invest in bonds o Most sold on the OTC Usually sold in 5 000 denominations o Bond funds Diversify across a broad range of bonds o Bond Unity Investment Trusts Government municipal and mortgage bonds Bond Yield o o o Current Yield o o Is the total return on a bond investment Is not the same as the interest rate Is affected by the bond price which may be more or less than face value Ratio of annual interest payments to the bond s market price Current yield Annual interest payments market price of the bond o Consider a bond with an 8 coupon interest rate a par value of 1 000 and a market price of 700 the current yield would be An example o Current yield 0 08 1 000 annual interest payments 700 market price of bond current yield 80 700 11 4 percent Yield to Maturity o True yield received if the bond is held to maturity o Approximate yield to maturity Annual interest payments par value current price years to maturity par value current price 2 N years to maturity PMT coupon rate par value FV Par Value PV Market Value must be