PERSONAL

FINANCIAL MANAGEMENT
INVESTING IN BONDS

Stocks have traditionally returned more than other investment alternatives but bonds are often
considered a safer investment. Bond can be a safe investment during an economic crisis. They
are also an excellent way to diversify an investment portfolio and apply the concept of asset
allocation. Investors choose bond for the current income when the annual coupon payment is
made. Some bonds are chosen on their maturity to coincide with planned expenditure.

CHARACTERISTICS OF CORPORATE BONDS

A corporate bond is a corporations written pledge that it will repay a specified amount of
money, with interest. The specified sum or face value is the sum that the bondholder will
receive at maturity date. Between the time of purchase and date of maturity, bondholders
receive interest or coupon payments every six months at the stated interest/coupon rate.

A bond indenture is a legal document that details all of the conditions relating to a bond issue.
To facilitate the administration of bonds, corporations appoint trustee to manage them. Trustee
(usually commercial bank or financial institution) is a financially independent firm that acts as
the bondholders representatives. Corporations report to trustee regarding its ability to pay
coupon payment and eventually redeem the bond at maturity. Trustee then transmits the
information to the bondholders. If corporation fails to meet the terms of the bond indenture,
trustee may bring legal action to protect the bondholders.

WHY CORPORATIONS SELL CORPORATE BONDS

Corporations issue bonds as a mean of borrowing fund when they:

do not have enough money to pay for major purposes
need to finance a corporations ongoing business activities
find it difficult or impossible to sell stock
want to improve a corporations financial leverage - the use of borrowed funds to increase the
firms return on investment
use the interest paid to bondholders as a tax-deductible expense that reduces the taxes the
corporation pays.

Raising bonds for capital costs less than to issue new stocks. Bonds are debt financing in which
the face value and coupon interest need to be paid while stock is equity financing in which the
stock need not be paid and dividend need not be declared. in the event of bankruptcy, the bond
has priority over stocks to claim the firms assets. Selling bond retain control of the corporation
with bondholders do not have the right to vote while issuing stock technically transfer the
ownership of the corporation to the stockholders. Further, stockholders have voting right which
determine the policies of the corporation including to elect the Board.

Types of Bonds

1. Debentures



Most corporate bonds are debentures, unsecured and backed only by the reputation of
the issuing corporation. If corporation fails to pay coupon payments and face value, the

debenture bondholders become general creditors and on bankruptcy can claim any assets

not only those used as specific collateral for a loan or other financial obligation.

1. Mortgage Bond/Secured Bond


A corporate bond that is secured by various assets of the issuing firm; usually real
estate. Should the corporation default, the corporate assets used as collateral can be
sold to repay the bondholders. This bond is safer than debentures. However, its interest
rate is lower because it is secured by the collateral and corporate assets.

Subordinated Debentures


An unsecured bond that gives bondholders a claim secondary to that of mortgage or
debenture bondholders with respect to interest payments and claim on assets. It pays
higher interest rate due to higher risk associated with it.

1. Convertible Bonds


A special kind of corporate bond that can be exchanged, at the owners option, for a

specified number of share of the corporations common stock. The conversion
feature allows investors to enjoy the lower risk of a corporate bond but also take
advantage of the speculative nature of common stock. Example,


ABCs $1,000 bond issue with a 2015 maturity date is convertible. Each bond can be
converted to 35.6125 shares of ABCs common stock. It means you can convert the bond
to stock at $28.08 ($1,000/35.6125) per stock or higher.

Bondholders may not convert convertible bond to common stock because if the market
value of common stock increases, the market value of convertible bond also increase.

There are three reasons why corporations sell convertible bonds:

Interest rates on convertible bonds are lower when compared to traditional bonds.
The conversion feature attracts investors who are interested in speculative investments.
If the bondholder converts a convertible bond to stock, the corporation does not have to repay
the bond at maturity.

1. High - Yield Bond/Junk Bond

Corporate bonds that pay higher interest but also have a higher risk of default. High-yield
bonds or junk bonds are sold by companies with a poor earnings history, having
questionable credit record or new company with unproven ability to increase sales or
earnings.

They are often used in connection with leveraged buyout; a situation where investors

 acquire a company and sell high-yield bonds to pay for the company. High-yield bond pay
more interest than typical bond but the inability to pay annual interest and face value at
maturity is real. These bonds are considered too risky for most financial institution or
even individual investors.








Provisions For Repayment

Today, most corporate bonds have 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 replacement may be a bond with lower interest or if the interest is the same, the risk
will be higher.

A bond is called if the market interest rate is lower than the bonds interest rate. The money
needed to call a bond may come from the firms profit, 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 namely sinking fund and serial bonds.

Sinking fund - a fund to which regular deposits are made for the purpose of redeeming a bond
issue when the bond issue comes due.

Serial bonds - bonds of a single issue that matures on different dates. The dates of maturity
normally coincide with the dates when the redemption of bonds come due.

WHY INVESTORS PURCHASE CORPORATE BONDS

Bond investments are often chosen by investors who want to diversify and use the concept of
asset allocation. Asset allocation is the process of spreading your money among several
different types of investments to lessen risk especially during troubled economic times when
bond is a safe investment.

Basically, investors purchase corporate bond for three reasons (1) interest income, (2) possible
increase in value and (3) repayment at maturity.


Interest Income

Bondholders received interest payment normally every six months. The amount of
interest is
determined by multiplying the interest rate by the face value of the bond.
Since the interest is received twice a year, the amount is divided by two.



The method used to pay bondholders their interest depends on whether it is a registered
bonds, registered coupon bonds, bearer bonds or zero-coupon bonds.

Registered bond - the bond is registered in the owners name by the issuing company.
Interests for registered bond are mailed directly to the bondholder of record.
Registered coupon bond - the bond is registered for principal only, not for interest. To
collect interest on registered coupon bond, the owner must present one of the
detachable coupons to the issuing corporations or the paying agent.
Bearer bond - a bond that is not registered in the investors name. They are generally issued
by corporation outside United States.
Zero-coupon bond - a bond that does not pay interest but is sold at a price far below its face
value and is redeemed for its face value at maturity.

Possible increase in bond value


Corporate bonds increase or decrease in value in opposite to the market interest rate.
The financial condition of the corporation and the probability of its repaying the bond
also affect the bonds value. Possible increase in bond value when you can sell the bond
to someone else at a higher price if the interest rate on the bond is higher than the
market interest rate.


Approximate Market Value = Amount of Annual Interest/Comparable Interest Rate


Example,


You purchase ABC bond that pay 5.5% interest on a face value of $1,000 until its maturity
in 2017. Assume a new corporate bond of comparable quality are currently paying 7.0%.
The approximate market value of your bond,



Annual interest = 5.5% x $1,000 =$55

Approximate market value = $55/7% = $55/0.07 = $786


Possible increase in bond is $214 = $1,000 - $786

Bond Repayment at Maturity


Bond face amount will be repaid at maturity. When you purchase a bond, you have two
options; keep the bond until maturity 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 value among bonds that mature at regular intervals in order to balance
risk and return.

A TYPICAL OF BOND TRANSACTION

Assume that on January 4, 2000, you purchased a 6.5% corporate bond issued by ABC Company
that has a maturity date in 2028. Your cost for the bond was $860 plus a $10 commission
charge, for a total investment of $870. You hold on to the bond until January 4, 2010, when you
sold it at its current market value of $1,080. Show the return on your investment.

THE MECHANICS OF A BOND TRANSACTION

Most bonds are sold through full-service brokerage firms, discount brokerage firms or the
Internet. You have to pay commission when you buy and sell bonds.

GOVERNMENT BONDS AND DEBT SECURITIES

In addition to corporations, governments issue bond to obtain financing for the national debt
and the on goings costs of government.

Treasury Bills, Notes and Bonds

Why investors choose government securities is that most investors consider them safe
investment with little risk. Government securities are backed by the full faith and credit of the
government, hence they offer lower interest rates than corporate bonds. Treasury bills are used
for asset allocation and lessen overall risk.

Federal Agency Debt Issues

In the United States, debt securities can also be issued by federal agencies. As agencies are not
actually part of the government, agency debt issues often have slightly higher interest rate than
government securities.

States and Local Government Securities

A United States municipal bond or muni, is a debt security issued by a state or local government.
There are two types of municipal bonds:

A general obligation bond - a bond backed by the full faith, credit and unlimited taxing power of
the states/ municipal that issued it.
A revenue bond - a bond that is repaid from the income generated by the project it is
designated to finance.


THE DECISION TO BUY OR SELL BONDS

Evaluate bonds when making an investment. Ways to evaluate bond include:

Usage of the Internet
The Internet can be used to obtain the bond price information, trade bond online for a
lower commission and obtain research information on the corporation or government
bond issues online.

Obtaining Annual Reports
Get the issuing corporations annual report to assess their financial health; strength or
weaknesses.

Bond Ratings
Bond ratings provide quality and risk associated with bond issues.












1. Bond Yield Calculations
Yield is the rate of return earned by an investor who holds a bond for a stated period,

1.
Current yield on corporate bond = Annual income amount/Current market value

1.
Yield to Maturity,

Amount of Annual Interest + (Face value - Market value)/Number of periods


(Market value + Face value)/2


example,



$60 + ($1,000 - $900)/10 = $60 + $100/10 = $70/$950 = 0.074 = 7.4%

($900 + $1,000)/2 $950