Understanding Bonds - Question 89

How do bonds work?

When a bond is issued by a corporation or a municipality, it is sold at face value. The investor usually pays $1,000 per bond. The par value also includes the amount that will be redeemed or repaid at maturity.

To calculate the market price of a bond, use the following formula:

current yield = amount of coupon / market price

If a 6% bond is issued at par or $1,000, the amount of
coupon interest = $60

.06 = $60 / $100

When the Federal Reserve raises interest rates to 8% in order to reduce inflationary pressures, the market price is reduced as follows:

current yield = amount of coupon / market price

current yield = .08
coupon (remains constant)= $60
market price = X

.08 =$60/X ; 08 X = $60; X = $601.08; X = $750 market price

When interest rates are lowered, the market price of a bond increases. Let's assume the Federal Reserve lowers interest rates from 6% to 5% to stimulate the economy. The effect of the market price is as follows:

current yield = amount of coupon / market price

current yield = .05
coupon = $60

.05 = $60/X X = $1,200 market price

Understanding Bonds

Many investors view bonds and bond mutual funds as conservative investments that provide a steady income and represent a minimal risk to principal. That’s because if you hold your bond until maturity, you get the full amount of your investment plus interest. (A bond is an obligation of its issuer to pay the interest and principal as promised.)

Zero-coupon bonds are very popular among parents and grandparents who are funding a child's education. A zero-coupon bond is issued at a discount from its par value (or face value). It only pays interest with principal at maturity or at the time the bond is called. Unlike other types of bonds, interest on zero-coupon bonds is not paid to you every six months; it is automatically reinvested or compounded at the agreed-upon rate at time of purchase. The combination of compounding and the discounted price means that a relatively small investment can multiply significantly before the bond matures. The longer the maturity length of the bond, the deeper the discount usually is.

In addition to being used to fund a college education, zero coupon bonds appeal to many individual investors who are planning for retirement. If placed in SEPs, IRAs or Keoghs, they are not subject to immediate taxation since these accounts are tax-deferred. By making an investment in a zero-coupon bond today, investors know exactly how much they will receive at maturity.

Municipal bonds are debt securities issued by public authorities (such as states or municipalities) to raise funds for building or repairing schools, highways, prisons, bridges, tunnels and other public works. The interest payments you receive on municipal bonds is free from federal income taxes. The higher your tax bracket, the more you will benefit by investing in “munis” and earning tax-free income.

If you live in a high income tax state you may also derive additional benefits from owning in-state bonds that are also state income tax-exempt.

Interest on bonds issued by the U.S. Virgin Islands, Guam and the Commonwealth of Puerto Rico are exempt from federal, state and local taxes in all fifty states.

Corporate bonds complement many investment portfolios especially retirement accounts and accounts with low marginal tax rates.

Many reputable companies raise capital by issuing corporate bonds to purchase or update equipment, build plants, and replace outstanding debt with lower cost issues. Credit rating agencies such as Moody’s and Standard & Poor’s (S&P) study the creditworthiness of the issuer of the bond, and assign a rating to that bond as a general guideline for investors.

Investment grade ratings used by agencies are:
Moody's S&P
Aaa AAA
Aa AA
A A
Baa BBB

These agencies revise their ratings when they feel the creditworthiness of an issue changes.

United States government securities are among the most\ secure of all income-producing investments. They are available in two forms: direct obligations of the U. S. government and those issued by various agencies which are indirect obligations of the U.S. government.

All bonds (U.S. Treasuries, federal agencies, zero-coupons, corporate and municipals) are subject to market fluctuations if you sell them before they mature. Investing in bonds has become more complex in recent years as the choice of taxable and tax-exempt bonds has expanded and volatility in bond prices and interest rates has increased. (Question 89 to 102)

Understanding Equities - Question 88

Should I invest in retail company stocks?

Your question is very general and, while there are many dynamic retail corporations, there are also retailers who have either been unable to find their markets or have lost them.

An excellent way to judge retail sales is to make a “samestore sales comparison.” To do this, you need to compare sales at-stores that have been open for at least one year. By looking only at stores that have been open for a year or more, you eliminate the effects of increased sales caused by recent new store openings.

When analyzing a manufacturing company, use comparative unit sales rather than dollar sales to get a better indicator of demand for the company's products.

Understanding Equities - Question 87

What are defensive stocks?

Defensive stocks are stocks that are less vulnerable to the savings of the business cycle than most other stocks tend to be. Some defensive stocks include utilities, tobacco and food stocks. They are considered defensive because consumers need to buy these products or services regardless of changes in their personal incomes or job situation.

Understanding Equities - Question 86

What is the difference between “technical analysis” and “fundamental analysis” in evaluating stocks?

Fundamental analysis studies the basics of a company’s finances and its economic prospects before making a decision to buy, hold, or sell its stock. Fundamental analysis studies a company's prime earnings ratios, dividend history, rate of return, sales, and profitability history and trends.

Technical analysis uses past and current stock price movements to predict future prices of a company's stock. It relies heavily on charts to plot the price movement of stocks. No consideration is given to any of the components used in fundamental analysis.

Understanding Equities - Question 85

What is the difference between a limit order and market order?

A “limit order” specifies the highest price you are willing to pay for a stock, or the lowest price you will accept for the sale of a stock you own. If you make a “market order,” you are not specifying a price; your order will be executed for the best price available at the time you place the order. You'll learn the price after the order has been executed.

Understanding Equities - Question 84

How do analysts evaluate a stock? How accurate are they?

Analysts evaluate stocks by examining the earnings of a company and its prospects for the future. They also analyze the prospects for growth for the industry and economy, and look at the historical data of the company’s finances. They may meet with the company's management and discuss its growth and operations to get a feel for the effectiveness of its leadership. Some analysts meet with the company's competition, suppliers, customers and clients, and look for trends within the industry as well as the company. It is crucial that the analysts study the demand for the company's products or services (both domestically and overseas) so that they can accurately forecast growth prospects. In addition, they must have thorough understanding of the company's finances, profit margins, and areas for improvement.

Analysts who are not accurate in their predictions usually have to change jobs because they're replaced. Analysts stick out their necks by making forecasts and predictions, in black and white, in written reports. They are held accountable.