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Transcript of Bonds
What are Bonds?
-A debt instrument under which the issuer owes the holder a debt, or principal, to be paid at a certain maturity date
-Bonds are comprised of several components, including:
-The agreed upon amount to be repaid at the maturity date.
-Also called the par or nominal value
-The interest paid by the issuer to the holder, usually on a semi-annual basis
-usually fixed rate throughout life of bond
-not always a part of the bond
-longer maturity=higher coupon, lower credit rating=higher coupon
-The date the bond issuer has to repay the principal to the bond holder
-can be any length of time, usually up to 30 years
-1-5 years is considered short-term (bills)
-5-12 years is medium-term (notes)
-12+ years is long-term (bonds)
-The rate of return received by the bondholder for purchasing and holding the bond
-most useful measure of ROR is yield to maturity
-Takes into account market price, all coupon payments present and future, and the principal due on maturity
Why Buy Bonds?
It depends on your financial need
Great for portfolio diversification
Bonds pay semiannually
Can be purchased with varying maturities to fit your long term financial planning
Good in an economic downturn
Safe for first time investors nervous about losing money
Investing in debt is usually more stable than investing in equity
Debtholders have priority over shareholders
Some bonds (ex. treasury bonds) are tax-exempt
Better returns than putting money in banks
A safe and conservative investment
Bonds usually have lower yields than other investments (stock)
Some bonds must be held for a certain length of time
There are penalties for cashing them early
Doesn't adjust to inflation rates (Exception: Floating Rate Bonds)
Issuer could default, not repaying the principal
How to buy bonds:
-The amount the bondholder pays the issuer for the bond
-Market price influenced by many factors, including the credit rating of the bond, other similar bonds on the market, and market interest rates
-Par value of $1000
This is a broker who carries out orders at a reduced price, but does not offer any investment advice.
This is a broker who executes trades between bond traders. He or she communicates with traders to obtain quotes from both parties.
These brokers keep buyers and sellers anonymous in the bond market.
These brokers usually require a minimum initial deposit of $5,000.
Fidelity, Scottrade, tradeMonster, SOGOtrade, Kapitall, etc.
Bonds can bought from Treasury Direct at www.treasurydirect.gov. These are known as Treasury Bonds.
This was created by The Bureau of Public Debt so that individuals could buy bonds without seeking the help of a broker.
Treasury bonds are very stable.
These bonds are considered “risk-free” because they are backed by the US government.
The government guarantees that the interest and principal will be paid on time and in full.
Be cautious when buying bonds through a broker
He or she usually says that there is no commission on the trade.
He or she will then mark up the prices of the bond and this mark-up will act as his or her commission.
Make sure to research the latest quote for each bond and then decide whether or not the “mark up” is acceptable.
Full service broker
This is a broker who offers many services to its clients, such as research and advice, retirement planning, tax tips, etc.
Different Types of Bonds
Four main types
US Government Bonds
US Government Bonds
Bills, notes, bonds
Debt the the US government owes you
"Full faith and credit" of the US government
Safest but lowest return
IOUS from corporations
Usually multiples of $1,000 or $5,000
They use money how they wish
Debt obligations issued by states, cities, counties, etc
Help build local infrastructure
Essentially lending money to localities for the public good
Tax benefits $$$$$
A bond rating is a grade given to a bond that indicates the bond's credit quality.
Rating services provide evaluations of a bond issuer's ability to pay a bond's interest and principal in a timely manner.
Standard & Poor's, Moody's and Fitch.
Bonds are rated from AAA to C.
A bond that is rated below BB is referred to as a "junk bond"
What affects bond price and interest?
1) Bond Market
Credit of Issuer
Length of Term
Yield to Maturity
2) Interest Rates
Length of Term
Modeled by the yield curve.
Represents the Yield-to-Maturity of a class of bonds.
The longer the term to maturity, the higher the yield will be.
The longer the period of time before a cash flow is received, the more chance there is that the required discount rate (or yield) will move higher.
In general, when interest rates rise, bond prices fall. When interest rates fall, bond prices rise.
Example – You own a bond paying 3% interest. When interest rates are low – say 1% – your interest rate is higher than the going rate. This makes your bond attractive to other investors. But if interest rates rise to 5%, your bond is less attractive.
Yield to Maturity
Discount rate that can be used to make the present value of all of a bond's cash flows equal to its price.
This discount factor is the yield.
When a bond's yield rises, by definition, its price falls, and when a bond's yield falls, by definition, its price increases.
When inflation is on the rise, bond prices fall. When inflation is decreasing, bond prices rise.
Rising inflation erodes the purchasing power of what you’ll earn on your investment.
When your bond matures, the return you’ve earned on your investment will be worth less in today’s dollars.
Credit of Issuer
Credit rating agencies assign credit ratings to bond issuers and to specific bonds.
Provides information about an issuer’s ability to make interest payments and repay the principal on a bond.
The higher the credit rating, the more likely an issuer is to meet its payment obligations.
Two types of entities
1. Government Sponsored Enterprises
2. Federal Government Agencies
Government Sponsored Enterprises
Examples: Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation)
Not backed by full faith and credit of US Government
Federal Government Agencies
Examples: Small Business Association and Government National Mortgage Association (Ginnie Mae)
Backed by full faith of US Government
Thank you for listening!