Lesson 6: Save and Invest: Bonds—Lending Your Money

Transcript

1 Lesson 6 S nvest: Bonds—Lending Your Money ave and I Lesson Description This lesson introduces bonds as an investment option. Using a series of classroom visuals, students will identify the three main parts of a bond and describe why a bond might sell at a price different from its stated price. After learning the formulas for market price and bond yield, students will complete a case study about a fictional company. National Standards in K–12 Personal Finance Education ( www.jumpstart.org ) Saving and Investing Standard 2: Explain how investing builds wealth and helps meet financial goals. Standard 3: Evaluate investment alternatives. Instructional Objectives Students will: Explain the purpose of a public or private bond. • • Define face value, coupon rate and maturity date. Distinguish between bond yield (or rate of return) and the bond’s coupon rate. • Analyze factors that influence a bond’s yield and market price. • Time Required One to two 50-minute class periods Materials Required • Class set of Building Wealth • Copies of the following classroom visuals Visual 1: World War II Bonds • • Visual 2: Parts of a Bond • Visual 3: The Coupon Rate • Visual 4: Yield on a Bond • Visual 5: Relationship Between Price and Current Yield • Visual 6: Shopping For the Best Yield: Buying & Selling Bonds • Visual 7: The Big Picture • Visual 8: Buy, Sell or Hold • Visual 9: Market Price • Visual 10: Yields, Coupon Payment and Market Prices • Copies of the following handouts for each student H • andout 1: Case Study – Franklin Kite Company • Handout 2: What’s Your Bond Knowledge? 1 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

2 Procedure Bonds—Lending Your Money in the Building Wealth booklet on Ask students to read the section called 1. pages 12–14. Display Visual 1: World War II Bonds . Use the following questions to introduce bonds and explain their 2. function as debt instruments or IOUs for public and private entities. • Does the U.S. government ever spend more than it receives in tax revenue? Yes, since 2002, the U.S. has run a deficit (expenditures are greater than revenues). • How does the government spend more than it receives? It borrows money by selling bonds. Can other entities sell or issue bonds? • State or local governments as well as private businesses issue bonds. Note: Teacher may wish to point out to the students that the last time the U.S. issued war bonds was World War II. They were issued not only to help finance the war but also to help fight inflation. With full employment and rationing, war bonds were a means of removing money from circulation, thus helping fight inflationary pressures. 3. Display Visual 2: Parts of a Bond . Identify the parts of a bond using information from the visual. Discuss the features of bonds using the following information: Bonds are a written promise by the borrower to repay the amount borrowed plus interest (IOU). • • The three main parts of a bond are: • Face value (or par value) – the amount being borrowed • Maturity date – the date when the principal of the bond is repaid • Coupon rate – the rate of interest paid to the bond holder • A person who buys a bond becomes a lender and assumes the risk that the bond seller might not repay the debt. Nonpayment is called default. • The riskiness of bonds varies widely. U.S. Treasury bonds are traditionally considered to be the safest of all bonds. . Use the information on the visual to discuss the coupon rate. Tell stu 4. Display Visual 3: The Coupon Rate - dents that interest on this type of bond is computed by multiplying the coupon rate and the face value of the bond. This annual or semiannual interest payment is a significant benefit of bond ownership. Ask students about this specific bond. • What is the face value (par value) of this bond? $1,000 • What is the coupon rate of this bond? 5% • What will the coupon payment be on this bond? $50 (5% x $1,000) . Tell students that we all like a good deal, and bond investors are no 5. Display Visual 4: Yield on a Bond different. • Ask students what investors are looking for when they buy bonds. Emphasize that bond holders look for a good rate of return. 2 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

3 • Explain to the students that A bond’s rate of return is called its yield. • • There are two kinds of yields: coupon yield and current yield Read the definition of coupon yield and reference Visual 2 or 3 for the coupon yield. • Ask students what the coupon yield is. 5% • • Ask students if the coupon yield will ever change. No • Read the definition of current yield on Visual 4. Emphasize: To understand current yield, we must remember that bonds can be bought and sold. If you buy a • bond, you do not necessarily have to hold it to maturity. You can sell it. • Since people can buy and sell bonds like they buy and sell other goods, the price of the bond will fluctuate. Point out the formula that can be used to calculate the yield. • Coupon payment = yield bond price Ask students what will happen to the yield when the price of the bond changes? Remind students • - that the coupon yield and coupon payment are fixed. They do not change. Students should re spond that the current yield will change. Emphasize once again the difference between the coupon yield and the current yield. The current • yield changes as the market price changes. The coupon yield is fixed: It is the same as the coupon rate. 6. Display Visual 5: Relationship Between Price and Current Yield. • Point out to students that the relationship of yield to price can be summarized as follows: • When price goes up, yield goes down. When price goes down, yield goes up. • Technically, the bond’s price and its yield are inversely related. • • Point out the illustrations in the visual emphasizing that sellers drive down the price, thus increasing the yield; and buyers drive up the price, thus decreasing the yield. • Review the three components of the equation: current yield, coupon payment and bond’s price. • Check for student understanding by asking student to compute the coupon payment and the yield on a bond with a face value (par) of $1,000 and coupon rate of 3%. • What is the coupon payment? $30 • What is the current yield if the market price of the bond is $800? 3.75% ($30 ÷ $800 = 3.75%) • What is the current yield if the market price of the bond is $1,200? 2.5% ($30 ÷ $1,200 = 2.5%) Display Visual 6A: Shopping for the Best Yield: Buying and Selling Bonds . Review the bullet points. 7. Display Visual 6B . • Go over the first What If scenario in Visual 6B: Investor holds a bond with a 5% yield and new bonds are issued with an 8% yield. • Is the old bond as desirable as the new? No 3 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

4 • Sell the old and buy the new . What is the investor who owns the old bond inclined to do? • What happens to the price of the old bond? It goes down . What happens to the old bond’s yield? It goes up . • Go over the second What If scenario: Investor owns a bond that yields 8%. New bonds issued have a • 5% yield. • Is the old bond as desirable as the new? Yes, more desirable. • What is the investor who owns the old bond inclined to do? Hold the bond since it has a higher yield than the newly issued bond. What happens to the price of the old bond? • Since its yield is greater than the newly issued bond, investors will tend to buy it, thus driving up the price. • What happens to the old bond’s yield? It goes down. 8. Display Visual 7: The Big Picture . Review the concepts of coupon rate and payment, market price and current yield. 9. Display Visual 8: Market Price . Discuss the information and the formula with students. - 10. Display Visual 9: Yields, Coupon Payment and Market Prices . Ask the students to work in pairs to com pute the market prices in their notes. Review the correct answers using the information below. Current Yields for What should the Stated Coupon Rate Formula and Payment market price be? Similar Bonds 5% and $50 $625 8% $50 ÷ .08 5% and $50 $50 ÷ .05 5% $1,000 10% 5% and $50 $50 ÷ .10 $500 $50 ÷ .01 5% and $50 1% $5,000 Distribute Handout 1: Case Study – Franklin Kite Company . Have students work in pairs to complete the 11. information. Use the suggested answers to discuss student responses. Closure Review the major concepts of the lesson using the following questions: 12. • What is a bond and what are the three parts of the bond? A bond is a way for a business or the government to raise money. It is basically an IOU. The three parts of a bond are the face value (par value), the coupon rate and the maturity term. • What is the difference between the yield and the coupon rate? The yield is a rate of return based on the market value of the bond; the coupon rate is the rate of return based on the stated, par value of the bond. • What impact does a change in interest rates on similar investments have on the yield of a bond? An increase in interest rates on similar investments will lower the yield of the bond; a decrease in interest rates on similar investments will increase the yield of the bond. 4 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

5 What effect does a change in market rates have on the coupon rate of a bond? • The coupon rate is unaffected by market interest rates. What impact does a change in interest rates on similar investments have on the price of the bond? • Since the coupon rate can’t change, the market price of the bond must change to bring its yield in line with market rates. A fall in interest rates relative to a bond’s coupon rate will drive up the price of the bond. The increase in the price of the bond drives down the yield of the bond. An increase in interest rates relative to a bond’s coupon rate will drive down the price of the bond and thus increase the yield of the bond. The yield and price of the bond move in opposite directions. Assessment 13. - ? Have students complete the assessment indepen Distribute Handout 2: What’s Your Bond Knowledge dently. Optional Extension Have students research historic war bond posters using the Archival Research Catalog that is found on the National Archives website at http://www.archives.gov/research/arc/ . Numerous digital copies of historic war bond posters can be viewed online. Have students create a new poster advertising bonds in a similar style. The poster should include a picture and a slogan as well as reasons why buying bonds is a good investment. 5 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

6 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 1: World War II Bonds Source: www.archives.gov/research/arc/ 6 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

7 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 2: Parts of a Bond Issuer / borrower A CORPORATION General Obligation Description of project Profitable Projects Construction Bond Par Value (Face Value) $1,000 Coupon rate 5% Dated September 12, 1990 Date of issue and maturity date Due September 12, 2010 Interest payable Interest payment date September 12, 1991 And annually thereafter A Really Big Bank Trustee and paying agent Yourtown, U.S.A. 7 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

8 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 3: The Coupon Rate Coupon bonds have a stated coupon rate. The owner of the bond is entitled to a regular interest payment based on the coupon rate and the face (or par) value of the bond. For this bond, the coupon rate of return is 5%, and coupon payment is $50 per year. Coupon payment = Face (Par) value × Coupon rate $50 = $1,000 × 5% A CORPORATION General Obligation Profitable Projects Construction Bond 5% Dated September 12, 1990 Due September 12, 2010 Interest payable $1,000 September 12, 1991 And annually thereafter A Really Big Bank Yourtown, U.S.A. 8 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

9 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 4: Yield on a Bond What Is a Bond’s Yield? Its Rate of Return Two Kinds of Yields is the interest rate established when the bond is • Coupon Yield issued. It is the same as the coupon rate. It does not change. Current Yield is the interest rate of return that the bond provides • at the present price. The current yield is calculated by dividing the coupon payment by the current price of the bond. Let’s look at the formula Coupon Payment Current Yield = Bond’s Price • As bonds are bought and sold, their prices change. • The coupon payment is fixed. • Therefore, the current yield will change as the price changes. 9 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

10 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 5: Relationship Between Price and Current Yield Yield Goes Up • Price Goes Down  bond prices )  ( Sellers drive down ( Buyers • Price Goes Up  Yield Goes Down  bond prices) up drive - Sellers drive down bond prices. If bond sells for less than its face value, the cur rent yield goes up. Coupon YIELD Price of = payment bond ÷ If bond sells for more than its face value, the current yield goes down. YIELD Price of Coupon = payment bond ÷ 10 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

11 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 6A: Shopping for the Best Yield: Buying and Selling Bonds Do I buy or sell? • People often buy and sell bonds in search of the best yield. • Investors want a yield that is at least as good as other investments with similar risk characteristics. Buyers drive up the price and thus drive down the yield. • Sellers drive down the price and thus drive up the yield. • 11 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

12 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 6B: Shopping for the Best Yield: Buying and Selling Bonds What if? An investor owns a bond that has a 5% rate of return, but new bonds being issued that are otherwise similar offer a coupon rate of 8%? What is most likely to happen? • Is the old bond as desirable as the new? • What is the investor who owns the old bond with a 5% rate of return inclined to do? • What happens to the price of the old bond? • What happens to the old bond’s yield? What if? An investor owns a bond that has an 8% rate of return (current yield). New bonds issued have a 5% coupon rate. What is most likely to happen? • Is the old bond as desirable as the new? • What is the investor who owns a bond with an 8% rate of return inclined to do? What happens to the price of the old bond? • What happens to the old bond’s yield? • 12 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

13 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 7: The Big Picture I get it! Investors want to get the best rate of return possible. If a bond promises a yield lower than others in the market, investors will SELL that bond. The price will fall and the yield will rise. If a bond promises a yield higher than the others in the market, investors will BUY that bond. The price will rise and the yield will fall. Since the coupon payment is fixed, the market price changes to adjust the yield. 13 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

14 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 8: Market Price Think about the formula to calculate current yield: Coupon payment ÷ Price = Current Yield If we know the yield, how can we calculate the price? Coupon payment ÷ Current Yield = Price Think about the bond that had a coupon payment of $50. Other similar bonds have a yield of 7%. This bond should sell for $714.29. $50 ÷ 7% = $714.29 Remember that dividing by 7% is the same as dividing by .07. 14 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

15 Lesson 6 – Save and Invest: Bonds—Lending Your Money Visual 9: Yields, Coupon Payment and Market Prices What is the Current Yields for Stated Coupon Formula Bonds market price be? Rate and Payment .08 8% 5% and $50 $50 ÷ 5% 5% and $50 5% and $50 10% 5% and $50 1% 15 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

16 Date: Name: Lesson 6 – Save and Invest: Bonds—Lending Your Money Handout 1: Case Study: Franklin Kite Company - Franklin Kite Company, a kite manufacturer in Philadel Franklin Kite Company phia, Pa., needs $10,000 to retool its assembly line to produce the next generation of the “electric kite.” General Obligation Construction Bond As a finance officer with the company, you have decided 6% to raise the entire $10,000 by selling 10 bonds with a $1,000 Dated January 1, 2005 face value of $1,000 each. You decide to offer an annual Due January 1, 2010 coupon rate on the bonds of 6%. You have been asked to explain the bond program to the Interest Payable - board of directors in Philadelphia. Answer these ques January 1, 2006, and annually thereafter tions to prepare for your presentation. National Bank - Anytown, U.S.A. 1. Identify the following features of each of the 10 bonds: Length of maturity Face value (or par value) Coupon rate 2. What will be the amount of annual interest payment on each bond? 3. What is the total interest payment for Franklin Kite Company each year for ALL 10 bonds? 4. If the potential buyers for Franklin Kite Co. bonds are concerned about the future of the company, these bonds might be considered risky. How could the company make the bonds more attractive to buyers? 5. If similar bonds are issued with a coupon rate of 8%, will the price of Franklin Kite Company bonds rise or fall? 6. If similar bonds are issued with a coupon rate of 2%, will the price of Franklin Kite Company bonds rise or fall? 7. Calculate the market price of Franklin Kite Company bonds if similar bonds have the following yields: Other Bonds’ Yield Coupon Payment Market Price 8% $60 5% $60 2% $60 8. What is the relationship between the price of a bond and the rate of return on the bond? 16 Lesson 6 — Save and Invest: Bonds—Lending Your Money Federal Reserve Bank of Dallas

17 Lesson 6 – Save and Invest: Bonds—Lending Your Money Handout 1: Case Study: Franklin Kite Company Suggested Answers Identify the following features of each of the 10 bonds: 1. Length of maturity 5 years $1,000 Face value (or par value) Coupon rate 6% What will be the amount of annual interest payment on each bond? $60 2. What is the total interest payment for Franklin Kite Company each year for ALL 10 bonds? $600 3. 4. If the potential buyers for Franklin Kite Co. bonds are concerned about the future of the company, these bonds might be considered risky. How could the company make the bonds more attractive to buyers? Offer a higher coupon rate If similar bonds are issued with a coupon rate of 8%, will the value of Franklin Kite Company bonds rise or 5. fall? Fall 6. If similar bonds are issued with a coupon rate of 2%, will the value of Franklin Kite Company bonds rise or fall? Rise 7. Calculate the market price of Franklin Kite Company bonds if similar bonds have the following yields: Other Bonds’ Yield Coupon Payment Market Price 8% $60 $750 5% $60 $1,200 2% $60 $3,000 8. What is the relationship between the price of a bond and the rate of return on the bond? As one rises, the other falls. As one falls, the other rises. 17 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

18 Date: Name: Lesson 6 – Save and Invest: Bonds—Lending Your Money Handout 2: What’s Your Bond Knowledge? Matching Match the following terms using definitions from the lesson and Building Wealth . ___ Bond 1. Nominal, or face, value of a bond A. ___ Treasury note Debt obligation issued by private or public entity B. 2. 3. ___ Par value Treasury bond or note that is tied to inflation so that the C. 4. principal amount of the investment increases or decreases ___ Premium ___ Yield (Current) according to the annual inflation rate 5. ___ Treasury bond Calculated as coupon payment ÷ market price of the bond 6. D. 7. E. Interest rate stated on a bond expressed as a percentage of ___ Treasury bill the par (face) value 8. ___ Discount 9. F. Short-term investment issued by the U.S. government for one ___ U.S. savings bond ___ Treasury Inflation-Protected Security year or less 10. Bond is sold for a price higher than its face value ___ Coupon rate G. 11. H. Bond is sold for a price lower than its face value Nontransferable registered bond issued by the U.S. govern - I. ment in denominations of $50 to $10,000 - Government security with a term of more than 10 years; inter J. est is paid semiannually K. Government security with a maturity that can range from two to 10 years; interest is paid every six months 18 Lesson 6 — Save and Invest: Bonds—Lending Your Money Federal Reserve Bank of Dallas

19 Name: Date: Lesson 6 – Save and Invest: Bonds—Lending Your Money Handout 2: What’s Your Bond Knowledge? Page 2 You own a bond that has a coupon rate of 6%. Now, similar bonds are being sold with the following cou - pon rates. Has the value of your bond gone up, down or stayed the same? 2% 12. 4% 13. 6% 14. 8% 15. 10% 16. What is the coupon rate of a $1,000 bond that pays a $60 coupon payment? 17. 18. What is the coupon payment of a $1,000 bond with a 4% coupon rate? 19. What is the yield of a $900 bond with a $40 coupon payment? 20. What is the market price of a $1,000 bond with a 5% coupon when the yield on similar investments is 3%? 21. What is the market price of a $1,000 bond with a 5% coupon when the yield on similar investments is 8%? 19 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

20 Lesson 6 – Save and Invest: Bonds—Lending Your Money Handout 2: What’s Your Bond Knowledge? Answers 1. B 2. K 3. A 4. G 5. D 6. J 7. F 8. H 9. I 10. C 11. E 12. Increased 13. Increased 14. Stayed the same 15. Decreased 16. Decreased 17. 6% 18. $40 19. 4.4% $1,667 20. $625 21. 20 Federal Reserve Bank of Dallas Lesson 6 — Save and Invest: Bonds—Lending Your Money

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