Lecture 8

Investing in
Stocks and Bonds

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 Learning Objectives
1. Describe the various types of risks to which investors are
exposed, as well as the sources of return.
2. Know how to search for an acceptable investment on the basis
of risk, total return, and yield.
3. Discuss the merits of investing in common stock and be able to
distinguish among the different types of stocks.
4. Become familiar with the various measures of performance
and how to use them in placing a value on stocks.
5. Describe the basic issue characteristics of bonds as well as how
these securities are used as investment vehicles.
6. Distinguish between the different types of bonds, gain an
understanding of how bond prices behave, and know how to
compute different measures of yield.
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Learning Objective 01.
Describe the various types of risks
to which investors are exposed, as
well as the sources of return.

3
Learning Objective 02.
Know how to search for an
acceptable investment on the
basis of risk, total return, and yield

4
 The Risks of Investing
• The basic types of investment risk are:
– business risk
– financial risk
– market risk
– purchasing power risk
– interest rate risk
– liquidity risk
– event risk

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 The Risks of Investing
• Business risk: the variability associated with a
firm’s cash flows and its subsequent ability to
meet its operating expenses.
• Financial risk: a type of risk associated with
the mix of debt and equity financing used by
the issuing firm, and its ability to meet its
financial obligations

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 The Risks of Investing

• Market risk: a type of risk associated with the

price volatility of a security.
• The more volatile the price of a security
relative to the overall market, the greater its
market risk.

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 The Risks of Investing
• Purchasing power risk: a type of risk, resulting
from possible changes in price levels, that can
significantly affect investment returns.
• Stocks or real estate are most profitable during
periods of rising prices.
• Bonds are preferred during periods of low or
declining price levels.

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 The Risks of Investing
• Interest rate risk: a type of risk, resulting from
changing market interest rates, that mainly affects
fixed-income securities.
• Fixed-income securities: securities such as bonds,
notes, and preferred stocks that offer purchasers
fixed periodic income.
• The prices of these securities fluctuate, decreasing
with rising interest rates and increasing with falling
rates.

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 The Risks of Investing
• Liquidity risk: a type of risk associated with
the inability to liquidate an investment
conveniently and at a reasonable price.
• Investments such as mutual funds, common
stocks, and U.S. Treasury securities are
generally highly liquid; others, such as raw
land, are not.

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 The Risks of Investing
• Event risk: the risk that some major,
unexpected event will occur that leads to a
sudden and substantial change in the value of
an investment.
• Fortunately, event risk is often confined to
specific companies, securities, or market
segments.

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 Returns from Investing
• 2 basic sources of return: current income and
capital gains.
• Current income: dividends on stock, interest from
bonds, or rents from real estate.
• People who invest to obtain current income look
for investments that will provide regular and
predictable patterns of cash flows.
• Preferred stocks and bonds, which are expected
to pay established amounts at specified times are
usually viewed as good income investments.
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 Returns from Investing
• Capital gains occur when selling a security for more
than the amount paid for it.
• Investments that provide greater growth potential
through capital appreciation normally have lower
levels of current income because the firm achieves
its growth by reinvesting its earnings instead of
paying dividends to the owners.
• Many common stocks are bought for their capital
gains potential.

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 Returns from Investing
• Earning interest on interest: another source
of return.
• The amount of interest on interest embedded
in a security’s return depends in large part on
the length of investment horizon.
• Long-term investments are subject to a lot
more interest on interest earnings than are
short-term investments.

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 The Risk–Return Trade-Off
• Risk-free rate of return: the rate of return on
government securities, such as Treasury bills,
that is considered free from default risk.
• It’s possible to receive a positive return for
zero risk.

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16
 What Makes a Good Investment?
• Future Return: expectations of security’s
future income and future capital appreciation.
• Computing an investment’s approximate
expected yield is a fairly easy way to obtain a
reasonably close estimation of expected
return.
• Approximate expected yield provides a
measure of the fully compounded rate of
return from an investment.

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 What Makes a Good Investment?
• Example: Given the average current income
from annual dividends of $2.15, current stock
price of $60, future stock price of $95, you
expect to hold the stock from the beginning of
2020 through the end of 2022, what is the
expected approximate yield ?
Approximate expected yield =
𝐹𝑢𝑡𝑢𝑟𝑒 𝑝𝑟𝑖𝑐𝑒 −𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑖𝑛𝑐𝑜𝑚𝑒+𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑
(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒+𝐹𝑢𝑟𝑡𝑢𝑟𝑒 𝑝𝑟𝑖𝑐𝑒)/2

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 What Makes a Good Investment?
• To determine whether the expected rate of
return on the investment will be satisfactory, you
can compare it to some benchmark. One of the
best is the rate of return you can expect from a
risk-free security such as a U.S. T-bill or a U.S. T-
bond.
• The return on a risky security should be greater
than that available on a risk-free security.

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 What Makes a Good Investment?

• Required rate of return: the minimum rate of

return an investor feels should be earned in
compensation for the amount of risk assumed.
• An investment is acceptable only if it’s expected
to generate a rate of return that meets (or
exceeds) your required rate of return.

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Learning Objective 03.
Discuss the merits of investing in
common stock and be able to
distinguish among the different
types of stocks.

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Learning Objective 04.
Become familiar with the various
measures of performance and how
to use them in placing a value on
stocks.

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• Common stockholders are really the residual
owners of the company, meaning that they’re
entitled to dividend income and a prorated
share of the company’s earnings, but only
after all the firm’s other obligations have been
met.

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 Issuers of Common Stock
• Shares of common stock can be issued by any
corporation in any line of business.
• All corporations have stockholders, but not all of
them have publicly traded shares.
• Publicly traded issues: the shares that are readily
available to the general public and that are bought
and sold in the open market.
• In a public offering, the corporation, working with
its underwriter, simply offers the investing public a
certain number of shares of its stock at a certain
price.
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 Voting Rights
• The holders of common stock normally receive
voting rights, which means that for each share
of stock held, they receive one vote.
• Because most small stockholders can’t attend
annual stockholders’ meetings, they can use a
proxy to assign their votes to another person to
become new director.
• Proxy: a written statement used to assign a
stockholder’s voting rights to another person,
typically one of the directors.
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 Basic Tax Considerations
• Common stocks provide income in the form of
dividends, usually paid quarterly, and/or capital gains.
• Qualified dividends and capital gains were taxed at a
rate between 0% and 20% based on the investor’s
income.
• There is no tax liability on any capital gains until the
stock is actually sold.
• Taxes are due on any dividends or capital gains in the
year in which the dividends are received or the stock
is sold.
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 Basic Tax Considerations
• Example: Assume you just sold 100 shares of
common stock for $50 per share. Also assume
the stock was originally purchased 2 years ago
for $20 per share and that, during each of the
past two years, you received $1.25 per share
in cash dividends. Suppose that you are in the
24% tax bracket. What is your tax liability in
this year?

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 Dividends
• Corporations pay dividends to their common
stockholders in the form of cash and/or
additional stock.
• Cash dividends, distributed quarterly in an
amount determined by the firm’s board of
directors, are most prevalent.

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 Dividends
• Dividend yield: the percentage return provided
by the dividends paid on common stock.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Dividend yield =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘

• Dividend yield measures the rate of current

income being earned on the investment.
• Example: A company that pays $2 per share in
annual dividends and has stock trading at $50 a
share. What is the dividend yield?
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 Dividends
• The directors may declare a stock dividend as a
supplement to or in place of cash dividends.
• Stock dividends: new shares of stock distributed to
existing stockholders as a supplement to or
substitute for cash dividends.
• You’ll be no better off after the stock dividend than
you were before. That’s because the total market
value of the shares owned would be roughly the
same after the stock dividend as before

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 Some Key Measures of Performance
• Book value measures the amount of stockholders’
equity in a firm.
Book value of Equity = Total Assets – Total Liabilities
Common stock book value = Book value of Equity – Preferred Stock
𝐶𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒
Book value per share =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔
• Book value per share affects the firm’s growth, so it is
necessary to see book value per share steadily
increasing over time, and look for stocks whose
market prices are comfortably above their book
values.

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 Book Value
• Example: Assume the company (DA) had assets
of $8 million, liabilities of $2 million, and
preferred stock issued at $1 million. DA had
100,000 shares of common stock outstanding.
What is the book value of the firm’s common
stock and its book value per share?

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 Some Key Measures of Performance
• Net profit margin: a key measure of profitability that
relates a firm’s net profits to its sales; shows the rate
of return the company is earning on its sales.
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
Net Profit Margin =
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
• The higher the net profit margin, the more money the
company earns.
• If you look for a relatively stable—or even better
company, an increasing—net profit margin is a good
sign.
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 Some Key Measures of Performance
• Return on equity (ROE): a measure that
captures the firm’s overall profitability; it is
important because of its impact on the firm’s
growth, profits, and dividends.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
Return on equity (ROE) =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠’ 𝑒𝑞𝑢𝑖𝑡𝑦
• As long as a firm is not borrowing too much
money, the better the ROE, the better the
company’s financial and competitive positions.

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 Some Key Measures of Performance
• Earnings per share (EPS): the return earned by
each share of common stock.
Earnings per share (EPS)
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 −𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑
=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

• This metric translates total corporate profits

into profits on a per-share basis and provides
a convenient measure of the amount of
earnings available to stockholders.
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 Earnings per share
• Example: DA reported a net profit of
$600,000, paid $100,000 in dividends to
preferred stockholders, and had 100,000
shares of common stock outstanding. What is
DA’s earnings per share?

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 Some Key Measures of Performance
• Price/Earnings Ratio (P/E ratio): a measure of
investors’ confidence in a given security.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Price/Earnings (P/E) ratio =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

• The higher the P/E ratio, the more confidence

investors are presumed to have in a given security.

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 Price/Earnings Ratio
• Example: In the case of DA, whose shares are
currently selling for $60, what is P/E ratio?

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 Some Key Measures of Performance
• A stock’s beta: an index of the price volatility
for a share of common stock; a reflection of
how the stock price responds to market forces.
• The market beta is used as a benchmark of
performance and always has a beta of 1.0.
• Beta < 1.0 → low-beta stocks → stocks have
low price volatility.
• Beta > 1.0 → high-beta stocks → stocks are
easily volatile → more risky.
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 Some Key Measures of Performance
Beta
• Other things being equal, if you’re looking for
a relatively conservative investment, then you
should stick with low-beta stocks. On the
other hand, if it’s potentially high capital gains
and price volatility you’re after, go with high-
beta securities.

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 Types of Common Stock
• Blue-chip stock: a stock generally issued by
companies expected to provide an
uninterrupted stream of dividends and good,
long-term growth prospects.
• They’re issued by large, well-established firms
that have impeccable financial credentials.
• Blue chips are particularly attractive to investors
who seek high-quality investments offering
decent dividend yields and respectable growth
potential.
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 Types of Common Stock
• Growth stock: a stock whose earnings and/or
market price have increased over time at a rate
well above average.
• A good growth stock might exhibit a sustained rate
of growth in earnings of 15% - 20% over a period
when common stocks are averaging only 6% - 8%.
• Growth stocks often reinvest a lot of their earnings.
• Because of their potential for dramatic price
appreciation, they appeal mostly to investors who
are seeking capital gains.
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 Types of Common Stock
• Value stock: shares of a company that appears
to trade at a lower price relative to
its fundamentals, such as dividends, earnings,
or sales.
• Value stocks often issue dividends as the
company has less need for capital for growth.

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 Types of Common Stock
• Tech stock: a stock that represents the
technology sector of the market.
• Tech stocks may offer the potential for
attractive, even phenomenal returns, but they
also involve considerable risk.
• Tech stocks are probably most suitable for
investors with high tolerance for such risk.

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 Types of Common Stock
• Income stock: a stock whose appeal is the
dividends it pays out; offers dividend
payments that can be expected to increase
over time.
• Income stocks are ideally suited for investors
seeking a relatively safe and high level of
current income from their investment capital.

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 Types of Common Stock
• Speculative stock: stock that is purchased on
little more than the hope that its price per
share will increase.
• The value of speculative stocks and their P/E
ratios tend to fluctuate widely as additional
information about the firm’s future is
received.
• Investors in speculative stocks should be
prepared to experience losses as well as gains
because these are high-risk securities.
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 Types of Common Stock
• Cyclical Stock: a stock whose price movements
tend to parallel the various stages of the
business cycle.
• When the economy is in an expansionary stage,
the prices of cyclical stocks tend to increase;
during a contractionary stage (recession), they
decline.
• Most cyclical stocks are found in the basic
industries—automobiles, steel, and lumber, etc.
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 Types of Common Stock
• Defensive stock: a stock whose price
movements are usually contrary to
movements in the business cycle.
• Because they’re basically income stocks, their
earnings and dividends tend to keep their
market prices up during periods of economic
decline.
• Examples: The shares of consumer goods
companies, certain public utilities, and gold
mining companies, etc.
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 Types of Common Stock
• A stock’s market cap (or market capitalization)
is found by multiplying its market price by the
number of shares outstanding.
• Large-cap: Stocks with market caps of more
than $10 billion
• Mid-cap: Stocks with market caps of $1 to $10
billion
• Small-cap: Stocks with market caps of less
than $1 billion

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 Types of Common Stock
• Mid-cap stocks offer investors some attractive
return opportunities as they provide much of
the sizzle of small-stock returns but without all
the price volatility.
• Small-cap stocks may hold the potential for
high returns, but investors should also be
aware of the high-risk exposure associated
with them.

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 Investing in Common Stock
• There are three basic reasons for investing in
common stock:
– to use the stock as a warehouse of value
– to accumulate capital
– to provide a source of income
• Investors who are more concerned about
storage of value than others tend to gravitate
toward blue chips and other low-risk
securities.

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 Investing in Common Stock
• Investors who want to accumulate capital will
use the capital gains and dividends that stocks
provide to build up their wealth.
• Some use growth stocks for such purposes;
others do it with income shares; still others
use a little of both.
• Some people use stocks as a source of income
will prefer high-yielding, good-quality income
shares.
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 Stock Ownership
• Ownership of common stock has advantages:
– the potential returns, in the form of both dividend
income and price appreciation, can be substantial.
– many stocks are actively traded and so are a highly
liquid form of investment.
– market and company information about literally
thousands of common stocks is widely published
and readily available.

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 Stock Ownership
• Ownership of common stock also has
disadvantages:
– a significant risk-return trade-off still exists.
– the uncertainty of dividends
– the problem of timing purchases and sales

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 Making Investment Decisions
• The first step in investing is to know where to
put your money.
• The second is to know when to make your
moves.
• A stock (or any other investment) should be
considered a viable investment candidate as
long as it looks likely to generate a sufficiently
attractive rate of return and fully compensates
for the risks taken.

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 Putting a Value on Stock
• The value of a stock depends on its expected stream
of future income, expected future market price
appreciation, and the associated risk.
• If the expected return from the investment exceeds
your required rate of return, then you should make
the investment.
• If the expected return is less than your required rate
of return, then you should not buy the stock because
it’s currently “overpriced,” and you won’t be able to
earn your required rate of return.
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 Putting a Value on Stock
• First, find a company you like and then take a
look at how it has performed over the past 3-5
years.
• Find out what kind of growth in sales it has
experienced (strong ROE, able to maintain or
improve its profit margin, how much
dividends paid, etc.)
• Don’t forget the expected future performance
of a stock.

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 Timing Your Investments
• Don’t invest in stocks under the following
conditions:
– If you’re confident the market’s in for a big fall (or
will continue to fall, if it’s already doing so), then
wait until the market drops and buy the stock
when it’s cheaper.
– Market lacks direction, or there’s way too much
price volatility to suit you. Once again, wait for the
market to settle down before buying stocks.

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 Be Sure to Reinvest Your Dividends
• The basic investment objective: to earn an
attractive, fully compounded rate of return.
→requires regular reinvestment of dividend
income.
• Dividend reinvestment plan (DRP): a program
whereby stockholders can choose to take their
cash dividends in the form of more shares of
the company’s stock.

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 Be Sure to Reinvest Your Dividends
• Partial participation: rather than committing all
their cash dividends to these plans, participants
may specify a portion of their shares for dividend
reinvestment and receive cash dividends on the
rest.
• Even though these dividends take the form of
additional shares of stock, reinvested dividends
are taxable, in the year they’re received, just as if
they had been received in cash.

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• Example: According to several financial reporting
services, Apple Inc., has strong financials; its sales
have been growing at about 20% per year for the past
5 years, its net profit margin in 2018 was projected to
be about 21.5%, and its ROE about 38%. In the
summer of 2018, the stock was trading at around
$185 a share. Value Line was projecting dividends to
be $2.72 a share in 2018, $3.06 in 2019, and an
average of about $4.40 a share between 2021 and
2023. It was also estimating that the price of the stock
could rise to an average of $277.50 a share over that
period. Calculate the Expected Return on Apple’s
Stock.
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Learning Objective 05.
Describe the basic issue
characteristics of bonds as well as
how these securities are used as
investment vehicles.

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Learning Objective 06.
Distinguish between the different
types of bonds, gain an
understanding of how bond prices
behave, and know how to compute
different measures of yield.

63
 Why Invest in Bonds?
• Bonds provide investors with two kinds of
income: current income and substantial
capital gains.
• The current income comes from the interest
payments received periodically over the life of
the issue. → draws investors to bonds.
• Bonds can also produce capital gains, which
occurs whenever market interest rates fall.

64
 Why Invest in Bonds?
• A basic trading rule in the bond market is that
interest rates and bond prices move in opposite
directions: when interest rates rise, bond prices
fall.
• Because of the general high quality of many
bonds, they can also be used for the preservation
and long-term accumulation of capital.

65
 Bonds versus Stocks

• Bonds: lower risk and attractive levels of

current income, along with desirable
diversification properties, but their downside
is their comparative returns.

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 Bonds versus Stocks

• Income tax tends to favor investing in stocks

over bonds.
• This is because a major component of the
return on bonds is interest, and interest is
taxed as ordinary income.
• Qualified dividend income is taxed at the
same rate as capital gains.

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 Basic Issue Characteristics
• U.S. bonds typically pay interest every 6
months. The amount of interest paid depends
on the coupon.
• Coupon: a bond feature that defines the
annual interest income that the issuer will pay
the bondholder.
• The principal amount of a bond, also known
as its par value, specifies the amount of
capital that must be repaid at maturity.

68
 Basic Issue Characteristics
• Issues with market values lower than par are
known as discount bonds and carry coupons
that are less than those on new issues.
• Issues with market values above par are called
premium bonds and have coupons greater
than those currently being offered on new
issues.

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 Basic Issue Characteristics

• Example: a $1,000 bond with an 8% coupon

would pay how much interest every year?
How much is par value?

70
 Types of Issues
• Bonds can be differentiated from one another
by the type of collateral behind them.
• Senior bonds are secured obligations because
they’re backed by a legal claim on some
specific property of the issuer that acts as
collateral for the bonds.
• Such issues include mortgage bonds, and
equipment trust certificates.

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 Types of Issues
• Mortgage bonds: a bond secured by a claim
on real assets, such as a manufacturing plant.
• Equipment trust certificates: a bond secured
by certain types of equipment, such as
railroad cars and airplanes.

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 Types of Issues

• Junior bonds (unsecured bonds) are backed

only with a promise by the issuer to pay
interest and principal on a timely basis.
• Debenture: an unsecured bond issued on the
general credit of the firm, issued as either
notes (with maturities of 2 to 10 years) or
bonds (maturities of more than 10 years).

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 Sinking Fund
• Sinking fund: a bond provision specifying the
annual repayment schedule to be used in
paying off the issue.
• Sinking fund requirements generally begin one
to five years after the date of issue and
continue annually thereafter until all or most
of the issue has been paid off.

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 Call Feature
• Call feature: a bond feature that allows the issuer
to retire the security prior to maturity.
• Three types of call features:
– A bond can be freely callable, which means the issuer
can retire the bond prematurely at any time.
– A bond can be noncallable, which means the issuer is
prohibited from retiring the bond prior to maturity.
– The issue could carry a deferred call, which means
the issue cannot be called until after a certain length
of time has passed from the date of issue.
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 Call Feature
• Call features are normally used to retire a bond
before full maturity and replace it with one that
carries a lower coupon. → an advantage for
issuer to reduce its annual interest costs.
• In order to at least partially compensate investors
who have their bonds called out, a call premium
(usually equal to about 6 months to 1 year of
interest) is tacked onto the par value of the bond
and paid to investors at the time the bond is
called.
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 Call Feature

• Example: a company decides to call its 7%

bonds some 15 years before they mature, and
a call premium equal to nine months’ interest.
How much the company might have to pay to
investors?

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 Treasury Bonds
• Treasury bonds (Treasuries or governments): a
bond issued by and backed by the full faith
and credit of the government.
• The Treasury issues bonds, notes, and other
types of debt securities (such as the T-bills) as
a means of meeting the federal government’s
ever-increasing borrowing needs.
• All Treasury obligations are high quality

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 Treasury Bonds
• Treasury notes are issued with maturities of 2,
3, 5, and 10 years.
• Treasury bonds carry 20- and 30-year
maturities.
• All Treasury notes and bonds are sold in
minimum denominations of $1,000.
• Although interest income is subject to normal
federal income tax, it is exempt from state and
local taxes.
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 Treasury Bonds
• The newest type of Treasury issue is the Treasury
inflation-indexed bond, or TIPS (Treasury
inflation-protected securities).
• Treasury inflation-indexed bond: a bond issued by
the U.S. government that has principal payments
that are adjusted to provide protection again
inflation, as measured by the Consumer Price
Index (CPI).
• These securities are issued with maturities of 5,
10, or 20 years but coupons on these securities
are set very low, only 1.5%
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 Treasury Bonds

• Example: Assume inflation is running at an

annual rate of 3%. At the end of the year, the
par (or maturity) value of your bond will
increase by 3% (actually, adjustments to par
value are made every six months).

81
Today’s bond market offers securities to meet just
about any type of investment objective and suit
virtually any type of investor.

82
 Agency and Mortgage-Backed Bonds
• Agency bond: an obligation of a political
subdivision of the U.S. government, but are
not obligations of the U.S. Treasury.
• They customarily provide yields that are
comfortably above the market rates for
Treasuries and thus offer investors a way to
increase returns with little or no real
difference in risk.

83
 Agency and Mortgage-Backed Bonds

• Mortgage-backed securities: securities that

are a claim on the cash flows generated by
mortgage loans; bonds backed by mortgages
as collateral.

84
 Municipal Bonds
• Municipal bond: a bond issued by state or local
governments; interest income is usually exempt
from federal taxes. → tax-free bonds
• The yields on municipal bonds are lower than the
returns available from otherwise comparable
fully taxable issues.
• Unless the tax effect is sufficient to raise the yield
on a municipal to a level that equals or exceeds
the yields on taxable issues, it is not necessary to
buy municipal bonds.
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 Municipal Bonds
• Fully taxable equivalent yield: the return a
fully taxable bond must provide in order to
match the after-tax return on a lower-yielding
tax-free bond.
• The higher the individual’s tax bracket, the
more attractive municipal bonds become.
𝑌𝑖𝑒𝑙𝑑 𝑜𝑛 𝑀𝑢𝑛𝑖𝑐𝑖𝑝𝑎𝑙 𝑏𝑜𝑛𝑑
Fully taxable equivalent yield =
1 −𝑇𝑎𝑥 𝑟𝑎𝑡𝑒

86
 Municipal Bonds
• Municipal bonds are generally issued as serial
obligations.
• Serial obligation: an issue that is broken down
into a series of smaller bonds, each with its own
maturity date and coupon rate.
• Investors should be especially cautious when
investing in revenue bonds, which are municipal
bonds serviced from the income generated by
specific income-producing projects.

87
 Municipal Bonds
• Unlike issuers of so-called general obligation
bonds—which are backed by the full faith and
credit of the municipality—the issuer of a
revenue bond is obligated to pay principal and
interest only if a sufficient level of revenue is
generated.
• General obligation municipal bonds, in contrast,
are required to be serviced in a prompt and
timely fashion regardless of the level of tax
income generated by the municipality.
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 Municipal Bonds

• Example: If a municipal bond offered a yield of

6%, an individual in the 32% federal tax
bracket. What is fully taxable bond yield ?

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 Corporate Bonds
• Corporate bond: a bond issued by a corporation
• The market for corporate bonds is industrials (the
most diverse of the group), public utilities (the
dominant group in terms of the volume of new
issues), rail and transportation bonds, and
financial issues (banks and finance companies).
• Interest on corporate bonds is paid semiannually

90
 Convertible Bonds
• Convertible bonds are found only in the
corporate market. They are a hybrid security
that possesses the features of both corporate
bonds and common stocks.

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 Convertible Bonds
• Conversion privilege: the provision in a
convertible issue that stipulates the conditions
of the conversion feature, such as the
conversion period and conversion ratio.
• Conversion ratio: a ratio specifying the
number of shares of common stock into which
a convertible bond can be converted.

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 Convertible Bonds
• Conversion value: a measure of what a
convertible issue would trade for if it were
priced to sell based on its stock value.
Conversion value = Conversion ratio x Market price of common stock
• Conversion premiums: the difference
between a convertible security’s market price
and its conversion value.
Conversion premium = Market price of convertible security – Conversion value

93
 Bond Ratings
• Bond ratings: a letter grade is assigned to each
bond that designates its investment quality.
• The two largest and best-known rating
agencies are Moody’s and Standard & Poor’s
(S&P).
• Bond rating at the time of issue that indicates
the ability of the issuing organization to
service its debt in a prompt and timely
manner.

94
 Bond Ratings
• Junk bonds: also known as high-yield bonds,
these are highly speculative securities that have
received low ratings from Moody’s or Standard
& Poor’s.
• Most issues will carry a single rating to
maturity, but ratings can change over time as
new information becomes available.
• Other things being equal, the higher the rating,
the lower the yield of an obligation.

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96
 Pricing a Bond
• All bonds are priced as a percentage of par.
• In the bond market, 1 point = $10; hence a
quote of 85 does not mean $85 but rather
$850.
• Note: Market convention assumes that bonds
carry par values of $1,000.
• The price of any bond is related to the issue’s
coupon and maturity.

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 Bond Prices and Accrued Interest
• Accrued interest: the amount of interest that’s
been earned since the last coupon payment date
by the bond holder/seller, but which will be
received by the new owner/buyer of the bond at
the next regularly coupon payment date.
• When a bond is sold between coupon payment
dates, the buyer pays the seller for the accrued
interest, which is the prorated share of the
upcoming coupon payment.
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 Bond Prices and Accrued Interest
Clean price = quoted price – accrued interest

Dirty (full) price = quoted price + accrued interest

• The commonly cited prices in the financial
press and on the Internet are typically clean
bond prices.
• The relevant sale or invoice price of a bond to
the buyer is the dirty price.
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 Bond Prices and Yields
• The price of a bond depends on its coupon,
maturity, and the movement of market interest
rates.
• When interest rates go down, bond prices go up,
and vice versa.
• Premium bond: a bond whose market value is
higher than par.
• Discount bond: a bond whose market value is
lower than par.

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 Bond Prices and Yields
• Bonds with lower coupons and/or longer
maturities will respond more vigorously to
changes in market rates and undergo greater price
swings.
• If interest rates are moving up, then the investor
should seek high coupon bonds with short
maturities because this will cause minimal price
variation and preserve as much capital as possible.
• If you’re a speculator looking for a lot of capital
gains, then go with long-term, low coupon bonds.
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 Current Yield and Yield to Maturity
• Current yield: the amount of current income a
bond provides relative to its market price.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
Current yield =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑜𝑛𝑑

• This measure would be of interest to investors

seeking current income.
• The higher the current yield, the more
attractive the bond would be.
102
 Current Yield and Yield to Maturity
• Example: Calculating the Current Yield on a
Bond A 6% bond with a $1,000 face value is
currently selling for $910.

103
 Current Yield and Yield to Maturity
• Yield to maturity: the fully compounded rate
of return that a bond would yield if it were
held to maturity.

Approximately YTM =
$1,000−𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑢𝑝𝑜𝑛 𝑖𝑛𝑐𝑜𝑚𝑒+( )
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
(𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒+$1,000)/2

104
 Current Yield and Yield to Maturity

• Example: Assume you’re contemplating the

purchase of a $1,000, 6 percent annual
coupon income bond with 15 years remaining
to maturity and that the bond is trading at a
price of $910. What will be the approximate
yield to maturity on this bond?

105
 Current Yield and Yield to Maturity

• The higher the yield to maturity, the more

attractive the investment.
• If a bond provided a yield to maturity that
equaled or exceeded an investor’s desired rate
of return, then it would be considered a
worthwhile investment candidate.

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