This article is part of The 45-Minute MBA series, where you’ll learn everything you need to know about business to become an effective leader of your organization (in less than 45 min of reading).
In my previous article in the series, I discussed the importance of having a financial calculator. I taught you how to compute the time value of money and walked you through a few examples. Today I’ll teach you about bonds and how to analyze them using your financial calculator.
3 Ways Organizations Raise Money
Before we get into the technical details about bonds, let’s discuss what they are.
When organizations (like companies and governments) need to raise money, they have few options. The first is to get traditional financing from a bank by taking out a loan like you or I would to buy a car or a house.
Organizations can also raise money in the public marketplace. They do this by issuing bonds and/or stock to public investors in return for cash. Stocks are an equity security (a piece of the company) and give the investors ownership and voting rights. Bonds are a debt security enabling investors to become a creditor to the organization (the company owes the investor that debt plus interest).
4 Types of Bonds
The 4 types of bonds are: Treasury, Corporate, Municipal, and Foreign. Although some of these bonds have common characteristics, the differences in the contractual features and underlying strength of the organizations backing them lead to major differences in risk.
Corporate Bond Ratings
Corporate bonds are independently rated to show the level of risk to the investor. A lower bond rating means a higher risk and a higher interest rate for the investor. The 3 major independent rating organizations are Moody’s, Standard & Poor’s (S&P), and Fitch. The table below shows the different bond ratings.
To better understand bonds, it’s important that you become familiar with the following terms:
Par Value – The amount of money the investor will get back when the bond matures. Corporate bonds typically have a par value of $1000.
Coupon Interest Rate – The bond’s interest rate when issued.
Maturity Date – The date the bond matures and the holder’s principal is repaid.
Yield to Maturity – The rate of return an investor will receive from the purchase date to the maturity date.
We can calculate these values with a financial calculator using the same variables we used to calculate the time value of money: N, I, PV, PMT, and FV. Here is a picture of the HP 10BII financial calculator app I have on my Iphone. The top row contains the functions you will need to calculate bond values.
N = Number of payment periods until the bond reaches its maturity date
I = The bond’s Interest rate
PV = The bond’s Current (Present) Value
PMT = The Payment issued to the bondholder based on the coupon interest rate (coupon rate * par value)
FV = Par (Future) value of the bond
Let’s do a calculation.
On January 1, 2012, Caterpillar, Inc. issued a series of bonds at par ($1000) that pay 10% interest and mature in 30 years. What will the price of the bonds be in 5 years assuming the interest rate falls to 8%?
Here’s the information you enter into your financial calculator to get the answer:
N= 25 (30-5) years
I = 8% (Current interest rate)
PV = ? (Present Value in 5 years)
PMT = $100 ($1000 Par Value * 10% interest)
FV = $1000 (Par Value)
After entering the information into your financial calculator, you find that the current price of the bonds (on January 1, 2017) is $1213.50.
Let’s try another one.
It’s 2020 and Caterpillar’s bonds have 12 years remaining until maturity. The bonds have a $1000 Par Value and a coupon interest rate of 10% paid annually. If the bonds sell at $850, what is their current yield to maturity?
N = 12 (years remaining)
I = ?
PV = -$850 (current price, expressed negative because the cash is an investor’s outflow)
PMT = $100 ($1000 Par Value * 10%)
FV = $1000 (Par Value)
After entering the numbers in our financial calculator, we find that the current yield to maturity is 12.48%.
Why would you buy a bond?
Compared to stocks, bonds offer less risk because they have a higher priority claim on a company’s assets. If a company has to liquidate its assets, the bondholders will get paid before the stock shareholders. Bonds also offer a steady payout (interest) to investors.
How do you buy a bond?
The best way to buy a bond is through a brokerage company. I have an online brokerage account with Scottrade where I can buy and sell bonds. Scottrade provides useful information that helps me make better investment decisions. Here is a Moody’s bond report for Caterpillar that I downloaded from the Scottrade website.
Treasury Direct is a good resource if you want to buy treasury bonds (bonds invested in US government debt). The website allows you to buy bonds directly from the government (no middle man!).
Treasury bonds are a good place to park your money if you want little-to-no risk. Your return will be lower than if you invest in corporate bonds or stocks, but your money will be guaranteed by the US government (which carries lower risk).
If you’re looking for a higher rate of return then you might invest in corporate bonds and stocks. These are good investments for people with a longer investing horizon that allows them to ride out the ups and downs of the market.
Please let me know if you have any questions.
What investing resource do you find most helpful? I’d love to hear from you in the comment section below.
In my next article, I’ll teach you how to analyze stocks.
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Here’s what I’ve covered so far:
How to Make Money Without a Job
Purpose of an Income Statement
Advantages of a Cash Flow Statement
The $40 Self Directed MBA Finance Course
Thanks for reading and have an excellent week.
-Scott
Scott Mackes is a leader and founder of the site “Margin of Excellence”. Connect with Scott on facebook and twitter.
