FLVS Economics

ECONOMICS TOPIC 6 LESSON 6

Bonds and Other Financial Assets

ESSENTIAL QUESTION

How can you make your money work for you?

Objectives

Describe the characteristics of bonds as financial assets.

Explain how corporations raise money through bonds.

Describe the characteristics of other types of financial assets.

List four different types of financial asset markets.

Bonds as Financial Assets

Bonds are basically loans, or IOUs, that represent debt that the seller, or issuer, must repay to an investor. Bonds typically pay the investor a fixed amount of interest at regular intervals for a specific amount of time. Bonds are generally lower-risk investments.

The Three Components of Bonds

• Coupon rate The coupon rate is the interest rate that a bond issuer will pay to a bondholder.

• Maturity The time at which payment to a bondholder is due is called the bond’s maturity. The length of time to maturity varies with different bonds. Bonds usually mature in 10, 20, or 30 years.

• Par value A bond’s par value, assigned by the issuer, is the amount to be paid to the bondholder at maturity. Par value is also called face value or principal.

Buying Bonds at a Discount

In the free enterprise system, 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.

Why would someone sell a bond for less than its par value?

The answer lies in the fact that interest rates continually change. No one will pay $1,000 for a bond at 5 percent interest when they could go elsewhere and buy a $1,000 bond at 6 percent interest. To sell the bond at 5 percent, they will have to sell it at a discount. 

Bond Ratings

 Bonds are rated on a number of factors, focusing on the issuer’s financial strength—its ability to make future interest payments and its ability to repay the principal when the bond matures.

Costs and Benefits of Issuing Bonds

For 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.

2. Unlike stockholders, bondholders do not own a part of the company.

Bonds also pose two main disadvantages to the issuer:
1. The company must make fixed interest payments. 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.

Multiple Choice

Check Understanding Why do some people invest in bonds with a low interest rate?

• The investor may want a low-risk investment.

• The investor may want to make a high yield.

• The investor may want an investment with a low credit rating.

• The investor may want a bond that matures in 20 years.

Types of Bonds

•  Savings bonds are low-denomination ($50 to $10,000) bonds issued by the United States government. 

• 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,

Types of Bonds

Types of Bonds

•  Municipal Bonds

  State and local governments and municipalities (government units with corporate status) issue bonds to finance such projects as highways, state buildings, libraries, parks, and schools. 

• Corporate Bonds

  As you have already read, corporations issue bonds to help raise money to expand their businesses

Types of Bonds

•  Junk Bonds

  Bonds with a fairly high risk of default but a potentially high yield are known as junk bonds. 

Multiple Choice

Check Understanding Which type of bond might have been used to fund the construction of your school?

• Treasury bond

• municipal bond

• junk bond

• corporate bond

Other Types of Financial Assets

• Certificate of Deposit- CDs are attractive to small investors because they can deposit as little as $100. Investors can also choose among several terms of maturity

• Money Market Mutual Funds

  Money market mutual funds are special types of mutual funds. Financial intermediaries collect money from individual investors and then buy stocks, bonds, or other financial assets to form a mutual fund.

Multiple Choice

Contrast What is one advantage of a money market mutual fund as compared with a savings account?

• It has more risk.

• It has lower interest.

• It has higher interest.

• It’s insured by the FDIC.

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

Financial Asset Markets

• Capital markets Markets in which money is lent for periods longer than a year 

• Money markets Markets in which money is lent for periods of one year or less

• Primary markets Financial assets that can be redeemed only by the original holder 

• Secondary markets Financial assets that can be resold

Multiple Choice

Recall In what type of market is money lent for periods longer than a year?

• money market

• secondary market

• primary market

• capital market

Open Ended

How can you make your money work for you?