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1.
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Examine the introduction to this section, above.
Explain what you expect to
learn in this section
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How do borrowers raise money for
investment?
One of the most important
ways is by selling bonds. As you read in
Chapter 8, bonds are
certificates sold by a
company or government to finance projects
or expansion.
For
example, starting in 1942, the United
States Department of Treasury launched
bond drives to
encourage Americans to
buy “war bonds”—government savings
bonds that helped
finance World War II.
Movie stars and war heroes urged the
public to buy bonds. Even school
children
brought their dimes and quarters to school
each week, buying defense stamps
that
would eventually add up to the price of a
war bond.
During World War Two school
children bought “savings stamps,” which they pasted in a book. When the book was full it
could be traded for a War Bond. Mr Schneemann still has one of those books with a few stamps in
it. |
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2.
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What was the purpose of War Bonds.
a. | prevent inflation | c. | provide bank liquidity | b. | end the
depression | d. | finance the
war |
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Bonds as Financial Assets
Bonds are basically
loans, or IOUs, that
represent debt that the government or a
corporation must repay to an
investor.
Bonds typically pay the investor a fixed
amount of interest at regular intervals for
a
fixed amount of time. Bonds are generally
lower-risk investments. As you might
expect from
your reading about the relationship between risk and return, the rate
of return on bonds is
usually also lower
than for other investments.
The Three
Components of Bonds
Bonds have three basic components:
• Coupon rate
The coupon rate is the
interest rate that the bond issuer will pay
to the
bondholder.
• Maturity is the time at which
payment to the bondholder
is due.
Different bonds have different lengths of
maturity. Bonds typically mature in
10,
20, or 30 years.
• Par value A bond’s par value is
the
amount that an investor pays to purchase
the bond and that will be repaid to
the
investor at maturity. Par value is also
called face value or
principal.
| Suppose that you buy a $1,000
bond
from the corporation Jeans, Etc. The
investor who buys the bond is called
the
“holder.” The seller of a bond is the
“issuer.” You are therefore
the holder of
the bond, and Jeans, Etc. is the issuer. The
components of this bond are as
follows:
• Coupon rate: 5 percent, paid to the
bondholder annually
•
Maturity: 10 years
• Par Value: $1,000
How much money will you earn
from
this bond, and over what period of time?
The coupon rate is 5 percent of $1,000
per
year. This means that you will receive a
payment of $50 (.05 times $1,000) each
year for
ten years, or a total of $500 in
interest. In ten years, the bond will have
reached maturity,
and Jeans, Etc. will retire
the debt. This means that the company’s
debt to you will have
ended, and that Jeans,
Etc. will pay you the par value of the bond,
or $1,000. Thus, for your
$1,000 investment,
you will have received $1,500 over a
period of ten years.
Not all
bonds are held to maturity. Over
their lifetime they might be bought or
sold, and their price
may change. Because
of these shifts in price, buyers and sellers
are interested in a
bond’s yield, or yield to
maturity. Yield is the annual rate of return
on the bond
if the bond were held to
maturity (5 percent in the example above
involving Jeans,
Etc.). | | |
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3.
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What are bonds?
a. | Loans made mostly to individuals | c. | Loans made to corporations
only | b. | Loans made to governments only | d. | Loans made to corporations and
governments |
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4.
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The city of Chula Vista is selling bonds to build a new library. What is the
discount rate?
a. | The amount of money that Chula Vista will save by selling bonds | c. | The amount of
interest the bond holder must pay to Chula Vista | b. | The savings (discount) Chula Vista will receive
on building supplies | d. | The
amount of interest Chula Vista must pay to the bond holder |
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5.
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You own a bond that you purchased to help the city of Chula Vista build a new
library. What is the face value of the bond called?
a. | the discount rate | c. | the sub-prime rate | b. | the par value | d. | the yield |
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6.
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When will the city of Chula Vista be required to repay the money you gave them
by purchasing a bond?
a. | the maturity date of the bond | c. | they will never be required to
repay the bond | b. | immediately after the bond was purchased | d. | when the library
opens |
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7.
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In our library bond scenario, the city of Chula Vista is called the _____ and
you are called the _____ .
a. | holder - issuer | c. | bank - bond holder | b. | issuer - holder | d. | bond holder -
bank |
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8.
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The bond you purchased from the city of Chula Vista has a par value of $1000, a
coupon rate of 7% and a maturity date of 10 years. At the end of 10 years you cash in your bond. How
much money will you receive?
a. | $1,000 | c. | $1,700 | b. | $ 1,500 | d. | $ 700. |
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9.
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Your library bond does not have to be held to maturity.If you sell it after 5
years, how much would your receive?
a. | $ 1,350 | c. | $ 1,700 | b. | $ 1,500 | d. | $ 1,000 |
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Buying Bonds at a Discount
Investors earn
money from interest on the
bonds they buy. They can also earn money
by buying bonds at a
discount, called a
discount from par. In other words, if Nate
were buying a bond with a par
value of
$1,000, he may be able to pay only $960
for it. When the bond matures, Nate
will
redeem the bond at par, or $1,000. He will
thus have earned $40 on his investment,
in
addition to interest payments from the
bond issuer.
Why would someone sell a bond for
less
than its par value? The answer lies in the
fact that interest rates are always
changing.
For example, suppose that Sharon buys a
$1,000 bond at 5 percent interest, which
is
the current market rate. A year later, she
needs to sell the bond to help pay for a
new
car. By that time, however, interest rates
have risen to 6 percent. No one will
pay
$1,000 for Sharon’s bond at 5 percent
interest when they could go elsewhere
and
buy a $1,000 bond at 6 percent interest.
For Sharon to sell her bond at 5 percent,
she
will have to sell it at a discount. (See
Figure 11.3.) | 
Investors can earn money by buying bonds
at a discount, called a discount from par.
Interest Rates
How do interest rates affect bond prices? | | |
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10.
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If you purchase your Chula Vista library bond at a discount rate, what will you
pay for the bond?
a. | more than the par value | c. | less than the maturity
rate | b. | less than the par value | d. | more than the interest rate |
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11.
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Why would Chula Vista want to sell its bonds at a discount?
a. | To make more money available for the library | c. | Interest rates change so its bonds
would be less desirable | b. | To lower the investment
rate | d. | Interest rates change
so its bonds would be more desirable |
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Bond Ratings
How does an investor decide which
bonds
to buy? Investors can check bond quality
through two firms that publish bond
ratings.
Standard & Poor’s and Moody’s
rate bonds on a number of factors,
including the
issuer’s ability to make future
interest payments and to repay the principal
when the
bond matures. These
companies rating systems rank bonds
from the highest investment grade (AAA
in
the Standard & Poor’s system or Aaa in
the Moody’s rating system) to the
lowest
(D in both systems). A bond rating of D
generally means that the bond is
in
default—that is, the issuer has not kept up
with interest payments or has defaulted
on
paying principal.
The higher the bond rating, the lower the
interest rate the company
usually has to
pay to get people to buy its bonds. For
example, a AAA bond may be issued at
a
5 percent interest rate. A BBB bond,
however, may be issued at a 7.5 percent
interest
rate. The buyer of the AAA bond
trades off a lower interest rate for lower
risk. The buyer of
the BBB bond trades
greater risk for a higher interest rate.
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Similarly, the higher the bond rating, the
higher the price at which the bond will
sell.
For example, a $1,000 bond with an AAA (or “triple A”) rating may sell at
$1,100. A
$1,000 bond with a BBB rating may sell for
only $950 because of the increased
risk
that the seller could default.
In essence, holders of bonds with high
ratings who
keep their bonds until
maturity face relatively little risk of losing
their investment. Holders
of bonds with
lower ratings, however, take on more risk
in return for potentially higher
interest
payments. | | |
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12.
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What does Standard & Poor’s and Moody’s do?
a. | They rank bonds based on the risk to sellers | c. | They make funds available to
investors | b. | They rank bonds based on the risk to investors | d. | They make funds available to
sellers |
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13.
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A few years ago Moody’s lowered the bond ranking of the United States. Why
would they do that?
a. | They believed that the value of the dollar was too low | c. | They believed that the United
States was not conducting its financial affairs in a responsible manner | b. | They believed that
the United States was not providing enough goods and services to its citizens | d. | They believed that the value of the dollar was
too high |
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14.
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Which statement is true?
a. | The lower the rating the higher the risk | c. | The higher the risk the higher the
rating | b. | The lower the rating the lower the risk | d. | The higher the rating the higher the
risk |
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Advantages and Disadvantages
to the
Issuer
From the point of view of the investor,
bonds are good investments because
they
are relatively safe. Bonds are desirable
from the issuer’s point of view as well,
for
two main reasons:
1. Once the bond is sold, the coupon rate
for that bond
will not go up or down.
For example, when Jeans, Etc. sells
bonds, it knows in advance that it
will be
making fixed payments for a specific
length of time.
2. Unlike
stockholders, bondholders do not
own a part of the company. Therefore,
the company does not
have to share
profits with its bondholders if the
company does particularly well.
| On the other hand, bonds also pose two
main disadvantages to
the issuer:
1. The company must make fixed interest
payments, even in bad years when
it does
not make money. In addition, it cannot
change its interest payments even
when
interest rates have gone down.
2. If the firm does not maintain
financial
health, its bonds may be downgraded to
a lower bond rating and thus may be
harder
to sell unless they are offered at a
discount.
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15.
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What are two advantages to the seller of bonds? (pick 2)
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Types of Bonds
Despite these risks to the
issuer, when
corporations or governments need to
borrow funds for long periods, they
often
issue bonds. There are several different
types of bonds.
Savings Bonds
You may already be familiar with savings
bonds,
which are sometimes given to young
people as gifts. Savings bonds are low denomination ($50
to $10,000) bonds
issued by the United States government.
The government uses funds from the
sale
of savings bonds to help pay for public
works projects like buildings, roads, and
dams.
Like other government bonds,
savings bonds have virtually no risk of
default, or failure to
repay the loan.
The federal government pays interest
on savings bonds. However, unlike
most
other bond issuers, it does not send interest
payments to bondholders on a
regular
schedule. Instead, the purchaser buys a
savings bond for less than par value.
For
example, you can purchase a $50 savings
bond for only $25. When the bond
matures, you
receive the $25 you paid for
the bond plus $25 in interest.
| Treasury Bonds, Bills, and Notes
The United
States Treasury Department
issues Treasury bonds, as well as Treasury
bills and notes (T-bills
and T-notes). These
investments offer different lengths of
maturity, as shown in Figure 11.6.
Backed
by the “full faith and credit” of the United
States government, these
securities are
among the safest investments in terms of
default risk. The federal
government
temporarily stopped selling 30-year bonds
in 2001, upsetting many investors who
like
safe, long-term investments. | | |
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16.
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What is one advantage to purchasing government bonds?
a. | The interest rate changes in response to changes in the inflation rate | c. | There is almost no
chance that the bond purchaser will loose their investment because the seller goes
broke | b. | Government bonds usually pay a higher rate of interest than other types of
bonds. | d. | Government bonds are
protected by the Second Amendment to the U.S. Constitution |
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17.
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Which statement is true about Savings Bonds?
a. | Savings bonds are sold for less than par value and pay interest only after the bond
matures | c. | Savings bonds are sold for par value and pay interest to the bond holder on a regular
monthly basis. | b. | Savings bonds are sold for par value | d. | Savings bonds have no par value but they do pay
an interest rate |
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18.
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Which entity backs TBills and TNotes with its full faith and credit
a. | State Banks | c. | the United Nations | b. | Federal Credit Unions | d. | the U.S.
Government |
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Types of Bonds
Municipal Bonds
State and local governments and
municipalities (government units with corporate
status) issue bonds to finance
such
improvements as highways, state buildings,
libraries, parks, and schools. These
bonds
are called municipal bonds, or “munis.”
Because state and local
governments have
the power to tax, investors can assume that
these governments will be able to
keep up
with interest payments and repay the principal
at maturity. Standard & Poor’s
and
Moody’s therefore consider most municipal
bonds to be safe investments,
depending
upon the financial health of a particular
state or town. In addition, the interest
paid
on municipal bonds is not subject to income
taxes at the federal level or in the
issuing
state. Because they are relatively safe and
are tax-exempt, “munis” are
very attractive
to investors.
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Corporate Bonds
As you read in Chapter 8,
corporations
issue bonds to help raise money to expand
their businesses. These corporate
bonds are issued in fairly large denominations, such
as $1,000, $5,000, and $10,000.
The
interest on corporate bonds is taxed as
ordinary income.
Unlike city and other
governments, corporations have no tax base to help guarantee their ability to repay their loans, so
these bonds have moderate levels of risk. Investors in corporate bonds must depend on the success of
the corporation’s sales of goods and services to generate enough income to pay interest and
principal.
Corporations that issue bonds are
watched closely not only by Standard
&
Poor’s and Moody’s, but also by the
Securities and Exchange Commission
(SEC). The SEC is an independent government agency that regulates financial markets and
investment companies. It enforces laws prohibiting fraud and other dishonest investment
practices. | | |
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19.
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The City of Chula Vista wants to develop the bay front. What types of bonds are
they likely to sell to raise the needed money?
a. | Corporate Bonds | c. | Municipal Bonds | b. | Water Bonds | d. | Savings Bonds |
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20.
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What is true about Muni’s?
a. | They are safer than most other types of bonds | c. | They pay a higher rate of interest
than most other types of bonds | b. | They are less safe than most other types of
bonds | d. | Buying Muni’s
gives the buyer part ownership in the corporation |
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21.
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The purchaser of Municipal Bonds does not have to pay federal taxes on
the interest earned
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22.
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Why are corporate bonds more risky than municipal bonds?
a. | corporate bonds depend on taxes to secure their bonds | c. | municipal bonds must depend on the
sale of goods and services | b. | corporate bonds must depend on the success of
the corporation to sell goods and services | d. | municipal bonds and corporate bonds share the same risk to bond
holders |
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23.
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What does the Securities and Exchange Commission (SEC) do?
a. | sets the corporate bond rates | c. | sets the municipal bond
rates | b. | holds the investments of bond purchasers | d. | regulates financial markets and investment
companies |
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Types of Bonds
Junk Bonds
Junk bonds, or high-yield securities,
are
lower-rated, and potentially higher-paying,
bonds. They became especially
popular
investments during the 1980s and 1990s, when large numbers of aggressive
investors
made—but also sometimes lost—large
sums of money buying and selling
these
securities.
Junk bonds have been known to pay
over 12 percent interest at a time
when
government bonds are yielding only about
8 percent interest. On the other hand,
junk
bonds also carry bond ratings of“lower
medium grade” or
“speculative” (BB, Ba,
or lower). Investors in junk bonds therefore
face a strong
possibility that some of the
issuing firms will default on their debt. |
Nevertheless, in many cases junk bonds
have enabled companies to undertake
activities that would otherwise have been impossible to complete. (For more information on how to
follow the progress of a stock by
reading stock market reports, see page 284.) | | |
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24.
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What is true about “junk bonds?”
a. | they pay higher interest rates but are more risky as investments | c. | they are safer than
municipal bonds
| b. | they pay higher interest rates and are more
safe than other investments | d. | they have a higher bond rating than corporate bonds |
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25.
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Standard & Poor’s and Moody’s rate bonds according to their
assessments of the issuer’s ability to make interest payments and to repay the principal when
the bond matures.
What bond rating carries the least risk?
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26.
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Treasury bonds, notes, and bills represent debt that the government must repay
the investor. Which has the longest maturity time?
a. | Treasury Bills | c. | Treasury Notes | b. | Treasury Bonds |
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27.
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Which type allows you to get your money out the easiest?
a. | Treasury Bills | c. | Treasury Note | b. | Treasury Bonds |
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Other Types
of Financial Assets
In addition
to bonds, investors may choose
other financial assets. These include certificates of deposit and
money market mutual funds, as well as stock. You will read more about stock in Section 3.
Certificates of Deposit
Certificates of deposit (CDs) are one
of the
most common forms of investment. As you
read in Chapter 10, CDs are available
through
banks, which lend out the funds
deposited in CDs for a fixed amount of
time, such as 6 months
or a year. CDs are attractive to small investors because they cost as little as $100. Investors can
also choose among many terms of maturity. This means that if an investor foresees a future
expenditure, such as college tuition or a major home improvement, he or she can buy a CD that matures
just before the expenditure is due.
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Money Market Mutual
Funds
Money market mutual funds are special
types of mutual funds. As you read
in
Section 1, businesses collect money from
individual investors and then buy stocks,
bonds,
or other financial assets to form a
mutual fund.
In the case of money market
mutual
funds, intermediaries buy short-term financial
assets. Investors receive higher
interest
on a money market mutual fund than they
would receive from a savings account.
On
the other hand, money market mutual
funds are not covered by FDIC insurance.
(As you read
in Chapter 10, FDIC insurance
protects bank deposits up to $100,000
per account). This makes
them slightly
riskier than savings accounts. | | |
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28.
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Why are Certificates of Deposits (CD’s) popular among small
investors?
a. | They are inexpensive and it is easy to get your money out when you need
it | c. | They are expensive but it is easy to get your money out when you need
it | b. | They are inexpensive and they are long term forcing the investor to
save | d. | It is hard to get your
money out but they are inexpensive |
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29.
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Which statement is true about Money Market Mutual Funds?
a. | Mutual Funds are not popular with investors | c. | Mutual Funds are prohibited by the
U.S. Government and are classified as Junk Bonds | b. | Mutual Funds pay a lower rate of interest than
savings accounts but are covered by FDIC and are therefore less risky | d. | Mutual Funds pay a higher rate of interest than
savings accounts but are not covered by FDIC and are therefore more
risky |
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Financial Asset Markets
Financial assets,
including bonds, certificates
of deposit, and money market mutual
funds, are traded on
financial asset markets.
The various types of financial asset markets
are classified in
different ways.
Capital and Money Markets
One way
to classify financial asset markets
is according to the length of time for which
funds are
lent. This type of classification
includes capital markets and money
markets.
• Capital Markets in which
money is lent for periods longer than a
year are called
capital markets. Financial
assets that are traded in capital markets
include long-term
CDs and corporate
and government bonds that require more
than a year to mature.
• Money Markets in which
money is lent for periods of less than a
year are called
money markets. Financial
assets that are traded in money markets
include short-term CDs,
Treasury bills,
and money market mutual funds.
| Primary and Secondary Markets
Markets may also
be classified according to
whether assets can be resold to other
buyers. This type of
classification includes
primary and secondary markets.
• Primary markets
Financial assets that
can be redeemed only by the original
holder are sold on primary
markets.
Examples include savings bonds, which
are non-transferable (that is, the
original
buyer cannot sell them to another
buyer). Small certificates of deposit are
also in
the primary market because
investors would most likely cash them in
early rather than try to
sell them to
someone else.
• Secondary markets Financial assets that
can
be resold are sold on secondary
markets. This option for resale provides
liquidity to
investors. If there is a strong
secondary market for an asset, the
investor knows that the
asset can be
resold fairly quickly without a penalty,
thus providing the investor with
ready
cash. The secondary market also makes
possible the lively trade in stock that is
the
subject of the next section. | | |
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30.
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Which financial asset market has the shortest maturity time?
a. | capital markets | c. | primary markets | b. | money markets | d. | secondary
markets |
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31.
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Which financial asset markets include long-term CDs and corporate and government
bonds
a. | capital markets | c. | primary markets | b. | money markets | d. | secondary
markets |
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32.
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What is the difference between primary and secondary markets?
a. | who controls at least 51% of the corporations issuing the bonds | c. | the amount of taxes
paid on interest earned | b. | who can redeem the financial
assets | d. | whether or not they
are covered by FDIC |
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a. | municipal bond | h. | savings bond | b. | par value | i. | coupon rate | c. | junk
bond | j. | primary
market | d. | maturity | k. | capital market | e. | secondary market | l. | corporate bond | f. | Securities and
Exchange Commission | m. | money
market | g. | yield |
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33.
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a bond that a corporation issues to raise money to expand its
business
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34.
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an independent agency of the government that regulates financial markets and
investment companies
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35.
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the interest rate that a bond issuer will pay to a bondholder
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36.
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a lower rated, potentially higher-paying bond
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37.
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the amount that an investor pays to purchase a bond and that will be
repaid to the investor at maturity
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38.
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market for reselling financial assets
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39.
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the time at which payment to a bondholder is due
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40.
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market for selling financial assets that can only be redeemed by the
original holder
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41.
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the annual rate of return on a bond if the bond were held to
maturity
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42.
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market in which money is lent for periods of less than a year
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43.
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a bond issued by a state or local government or municipality to finance
such improvements as highways, state buildings, libraries, parks, and schools
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44.
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market in which money is lent for periods longer than a year
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45.
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low-denomination bond issued by the United States government
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