ifma FOUNDATION What Is a Bond? Suggested Grade & Mastery Level High Schoo! - all levels Suggested Time 50 minutes Teacher Background ‘A bond is lke an JOU for a loan you've made to an institution like the government or a corporation. Similar to when you take out a car loan or a mortgage, when the government or a corporation borraws money from you they do so for a certain period of time at a certain rate of interest When you purchase a bond you are lending money to the issuer, who can be a corporation, the government or a government agency. In return for the loan the issuer promises to pay you ( the bond investor) a specific rate of interest known as the “coupon rate”. You are paid the interest on a predetermined schedule (usually quarterly) for the life of the bond, The life of a bond refers to the period of time the issuer has to repay the investor. The issuer also promises to repay the face value when the bond matures (.2., comes due). The face value is also known as “the principal” or the “par value.” Most bonds are issued with a $1000 face value. For the purposes of this lesson, wo will be discussing only “investment grade bonds’ which are the highest rated by Moody's, Standard & Poor's, and Fitch. (the main investment rating services in the United States). A bond that is rated investment grade is considered to have the least chance of missing interest payments or failing to pay back the principal (face or par) value, Bonds are also known as fixed-income investments because the investor knows the rate of interest and the interest payment schedule in advance of purchase. Bonds are often included in a diverse investment portfolio, There are a variety of bonds available. Described below are the bonds most familar to individual investors: Corporate bonds - Bonds are major sources of corporate borrowing. Debentures, the most common ype af corporate bond, are backed bythe genera credit of the corporation, while asset backed bonds are backed by spectic corporate assets, such as propery or equipment Municipal bonds Milions of bonds have been issued by state and local governments. General abiigation bonds are backed by the ful faih and credit of the issuer, and revenue bonds by the income generated by the pariclar project being financed. Agency bonds - Some government sponsored but privately owned corporations (like Fannie Mae and Fredaie Mac), and certain federal government agencies (Ike Ginnie Mae and Tennessee Valley Authority) fssue bonds to raise funds either to make loan many avaliable orto pay off new rejects, U.S Treasury bonds - US Treasury bonds are backed by the fl faith and credit ofthe United Sate government. When the government spends more than it collects in taxes and other revenues tissues Treasury notes, blls, and bonds to borrow the money to pay the diference ‘Treasury bonds have the longest term or period of time before the loan must be repel (10 years of more). Treasury bills have the shortest (ess than two years), Wl fcue “invest Copyright © 2072 SIFMA Foundation, All Righis Reserved, 1 of What isifma FOUNDATION It is important to research bond investments. There are a number of key variables to consider when purchasing bonds for your portfolio. The bond's maturity, redemption features, credit duality, interest (or coupon) rate, price, yield and tax status help determine the value of the bond and how well it meets your investment needs. Investors want to know the risks in buying a bond. ‘They can get a bond's rating information directly from rating services, financial press, or from a broker or financial adviser. Standard & Poor's, Moody's Investors Service, Inc., and Fitch are a few of the more popular rating services. Vocabulary: Default: Failure to pay principal or interest when due. Defaults can also occur for failure to meet non-payment obligations, such as reporting requirements, or when a material problem occurs for the issuer, such as a bankruptey, Fixed-Income Investments: Pay interest on a set schedule. Fixed-Income Investments include corporate, municipal, agency, and U.S. Treasury bonds, High-Yield Bonds: To attract investors, the issuers of these bonds pay a higher rate of interest than investment grade bonds with the same maturity. They are rated below investment grade bonds and are also called “Junk Bonds.’ Issuer: An entity which issues and is obligated to pay principal and interest on a debt security, Interest rate: Compensation paid or to be paid for the use of money. Interest is generally expressed as a percentage rate. (Also referred to as coupon rate) Investment Grade Bonds: Bonds that are sold by a very reliable issuer, the government, a large corporation, or a government agency that is most likely to repay the loan and the interest as promised, IOU: Means exactly as it sounds, “! Owe You.” itis an acknowledgement of a debt. Maturity: The date when the principal amount of a security is payable Par value: The principal amount of a bond or note due at maturity.( also referred to as face value) Prepayment: The unscheduled partial or complete payment of the principal amount outstanding on a mortgage or other debt before itis due. Principal: The face amount of a bond, payable at maturity (also referred to as face or par value) Trade date: The date when the purchase or sale of a bond is transacted, Performance Objectives Students will be able to: * Define the terms: Bond and Investment Grade Bond. + Identify and define four types of bonds. + Understand bonds as an investment tool. Mlk fcue “invest Copyright © 2012 SIFMA Foundation, All Righis Reserved, 2 of What isifma FOUNDATION Subject Areas Family and Consumer Sciences, Mathematics, English Language Arts Materials Fact Sheet 1: Saul & Pepper Activity Sheet 1: About Bonds Activity Sheet 2: Choosing Bonds Activity Sheet 3: An Interest in Bonds Springboard Activity Share the story in Fact Sheet 1 with your class: ‘Saul and Pepper have been friends since kindergarten. Both Saul and Pepper have good part time jobs. Pepper deposits a portion of the money she ears in the bank each week. Saul, on the other hand, spends most of the money he eams on building his baseball card collection. Recently, a rare 1975 Topps Mini George Brett rookie card has recently gone on sale for $100, This card would greatly enhance the value of Saul's current collection. However, he does not have money to buy the card. He asks Pepper to loan him $100. He also agrees to sign an IOU to pay Pepper back her $100 plus 7% interest in one month; the time it wil take him to have enough to pay her back, ‘Saul and Pepper's friend, John, works at a supermarket. He has recently become good friends with Jackson, who works at the same supermarket. John likes Jackson because he is reliable and willing to cover work shifts for him. One day, Jackson asks John to loan him $100. He promises to pay John back in three months with 7% interest. He signs an IOU agreeing to this, Group your students into their SMG teams and ask them to discuss the following Which 1OU pays the most money? Saul's or Jackson's? Why? Which IOU seems less risky? Why? Do you think Pepper should lend Saul the money? Should John lend money to Jackson? Why? Each team should be prepared to explain their answer in a class discussion Explain that investors can lend corporations, governments and government agencies money by buying bonds that are repaid by a due date with a set interest payment. This is just like Pepper can decide to lend Saul money or John can decide to lend Jackson money and expect to get repaid with interest on a set date. State that a bond is an |OU from the corporation, government, or government agency you have loaned money to. In addition to the original amount (or principal) borrowed, the bond pays interest. Introduce the term: Investment Grade Bonds Explain that “Investment Grade Bonds" are bonds sold by a very reliable issuer, a large corporation, government, or government agency that is most likely to repay the loan and the interest on a specified date as promised Wl fcue “invest Copyright © 2072 SIFMA Foundation, All Righis Reserved, 3 of What isifma FOUNDATION Procedure ‘You may have your students complete Activity Sheet 1 individually or in their SMG teams. (Once completed review the answers to Part 1. Discuss responses to Part 2 Explain that bonds are fixed-income investments. This means bond investors collect interest at regular intervals during the life of the bond, Interest can be simple or compounded depending on the type and structure of the bond, Distribute Activity Sheet 2, where they are asked to match different bond types to different types of investors, and have your students complete it. Discuss your students’ responses once the sheet is completed. Application Explain: Now that you understand how bonds provide investors safe reliable retums on their investments, think about how bonds could increase the diversification of your portfolio. Ask Working your teams, create a list of reasons you would include bonds as part of a well-balanced Portfolio. Be sure to explain how different types of bonds would enhance your portfolio differently. Assessment Have students in SMG teams complete Activity Sheet 3. Once completed ask your students to write a paragraph explaining which bonds they would recommend their SMG team purchase and why. Enrichment Acti ies Have your students visit the Foundation for Investor Education's Path to Investing site (www_pathtoinvesting org) or Investing in Bonds (wivw.Investinginbonds.com) to look up the definition of the following terms: Laddering Barbell Bond Swap Have your students explain how each is used to create a fixed securities portfolio that meets the goals of the investors in Activity Sheet 2, Mlk fcue “invest Copyright © 2072 SIFMA Foundation, All Righis Reserved, 4 of What isom \sifma ‘ ‘lis STOCK MARKET GAME. FOUNDATION Activity Sheet 1: Answer Key Part t 1 Part 2: How is a bond like an |OU? Bonds are like an IOU because they are also a loan, a different type of loan, Why is an investment grade bond considered a “safe” investment? ‘An investment grade bond is considered a “safe” investment because they are loans issued by corporations and governments considered trustworthy, How can an investor make money by buying a bond? {An investor can make money buying a bond because of the interest that Is eamed on the bond. Would you recommend your Stock Market Game team include a bond in your portfolio? Why, why not? Answers may vary, The local governments want to build a new bridge to connect two parts of a growing city. Which type of bond would a local government issue? Why? ‘A municipal bond because they are issued by state and local governments. ‘A home mortgage company backed by the government wants to raise money for more first ime home mortgage loans. Which type of bond would the government sponsored agency issue? Why? ‘An agency Bbond because the mortgage company is privately owned but backed by the government. {An investor wants to make the safest possible bond investment and plan to collect the interest for ten years. Which type of bond should the investor purchase? Why? AUS. Treasury bond would be the safest possible bond investment because it pays interest semiannually. ‘A large corporation wants to expand into Asian markets. They want to issue a bond and plan to guarantee the bond with land holdings in Latin America so What type of bond would they issue? Why? ‘A corporate bond because they are backed by an asset, in this case land holdings in Latin America © 2012 SIFMA Foundation for Investor Education. All rights reserved. 50f9sift ma La] rae I letocx MARKET GAME. FOUNDATION 5, A major corporation wants to issue a bond: they have a reputation for being a trustworthy ‘company. They want to use their credit rating to guarantee the bond. What type of bond would they issue? Why? A corporate bond because they are backing the bond with credit and their reputation for being trustworthy, 6, Aninvestor wants to support the increase of water power in America and would like to purchase a bond from the Tennessee Valley Authority. What type of bond would he purchase? Why? ‘An agency bond because it raises money for a new project, in this case increasing water power in America. © 2012 SIFMA Foundation for Investor Education. All rights reserved. 6of9e» \sifma ‘ La] ee ti lec MARKET GAME. FOUNDATION Activity Sheet 2: Answer Key Use the chart below to recommend bonds to the investors: Tax Type of Bond || Terms Risk Interest || Implications Corporate || t 100 years|] Lowto high |[ Highest, Taxable linked to risk Municipal |[ 7t050 years |[ Variable Low, but |[ Tax-exempt linked to risk ‘Agency 110.20 years || Lowto very |[ Medium _ |[Some tax-exempt] safe Treasury notes || 2.5,&10 || Verysafe Low |[Federally taxable years only Treasury bills || 413,826 || Verysafe Low |[Federaly taxable weeks only 1, Mr. Davis is an investor who needs a very safe investment since he will retire in two years. Which bond! bonds should he consider? Why? ‘An Agency bond because the risk is low to very safe and the terms range from 1 to 20 years. 2. Ms. Jones is a young investor. She is willing to take the most risk that bonds have to offer, Which bonds should she consider? Why? Corporate bonds because they have the most risk involved and can be from 1 to 100 years. 3, Mr.and Mrs. Peters want a tax exempt investment, Which type of bonds should they consider? Why? Municipal bonds because they are tax exempt and some Agency bonds can be tax exempt. 4, Mr. Fredrick wants a short term bond. Which bond should he consider? Why? A Treasury bill because the terms are 4, 13, & 26 weeks long, © 2012 SIFMA Foundation for Investor Education, All rights reserved. 7of3i'l im gsifima fils Stock MARKET GAME. FOUNDATION Activity Sheet 3: Answer Key You are investing $1000.00: 4. Atreasury bond will pay 3% interest a year for 30 years. How much interest will the investor collect at the end of 30 years? $30 for one year, $900 at the end of 30 years. 2. Amunicipal bond will pay 4% interest a year for 10 years. How much interest will you collect? $40 for one year, $400 at the end of 10 years. 3. A corporate bond will pay 6% interest each year for 2 years. How much interest will you collect? {$60 for one year, $120 at the end of 2 years. 4, Which investment would you most recommend to your SMG team? Why? ‘Answers may vary. You are investing $3000.00: 5. The Ginnie Mae Corp issues a § year bond at 3% interest per year. How much money will you have after the bond matures? $90 for one year, $450 at the end of 5 years. 6. A treasury bill has a 9% interest rate for 27 weeks. How much will you have collected after the bill matures? $270. 7. Acorporate bond will be issued for one year at a 6% interest rate. How much interest will you make on your investment? $180. 8. Which investment would you most recommend to your SMG team? Why? Answers may vary. © 2012 SIFMA Foundation for Investor Education. All rights reserved. 8of9Ii |e ‘egg gifima fils Stock MARKET GAME. FOUNDATION ‘You are investing $5000.00: 9. Acity government is issuing a bond for 20 years at 3.5% interest per year. How much interest will you collect when the bond matures? $175 for one year, $3,500 at the end of 20 years, 10. A large corporation is issuing a 1-year bond at 6.3% collected after the bond matures? how much money will you have $318. 11. The treasury department is issuing a 20-year bond at 4.5% interest per year. How much money will you have collected after the bond matures? $228 for one year, $4,500 for 20 years. 12, Which investment would you most recommend to your SMG team? Why? Answers may vary, © 2012 SIFMA Foundation for Investor Education. All rights reserved. 9of9