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Economic Factors- Investments.docx

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Wilfrid Laurier University
Leanne Hagarty

Chapter 4 – Economic Factors: Investment Instruments Type of Investments: BONDS Borrowing bonds from investors – investment for the creditor (person who is giving out the money) and debt for person taking the money Represents debt for issuing corporation or government Characteristics  Legal, binding agreement: there is recourse to investors if you don’t meet legal standards  Fixed rate of return (often paid semi-annually) AKA coupon rate o Does not change even if interest rates change o That coupon rate is locked in & quoted as annual rate  Fixed term – principal repaid: can figure out the value of it at the end of its life *different from stocks* o Know exactly what you get  Priority over stockholders: creditors get payments before stockholders o Relatively low-risk because guaranteed, lock-in but situations come where defaults occur (there is more possibility for recourse than stocks) Types  Secured (valuable assets held as collateral to back up promise) vs. Unsecured (AKA debentures) (based on word/good reputation of corporation or government)  Registered (keeps track of name & address of the bearer b/c value will be sent out to person who owns it) vs. Bearer (don’t keep track – bearer must redeem the principal if they bear the bond at the end of its term) Features  Callable: Allows issuer to pay back loan before the end of the term o Every issuer would want to have b/c flexible o Reduce future interest obligation o Can replace it with a lower interest rate bond o Details are on bond: pre-determined dates with pre-determined prices – may need to pay a little more  Serial: staggering a series of redemption rates o Bonds only pay principal at the end of maturity rate o Makes it easier on cashflow o Can change rate accordingly  Convertible (number 1 feature): only on corporate bond – can convert bond into common shares of the company o If you notice company is growing at a higher rate than the bond – change into stocks o Good for companies because they don’t need to pay interest anymore o Good for you because you get a higher return on your money if its growing Determinants of Bond Value 1. What impacts the coupon rate at bond issue?  Prevailing interest rates (needs to be competitive): has to be competitive & be on par with what other investments are offering.  Credit rating of issuer: ratings on how well they pay back bonds – affects how risky it is and should be reflected in coupon rates (  Features & time to maturity (not as much of a coupon rate if there are many features; may need to compensate for fewer features with high interest rate) o Time: longer that you have the pay for principal (idea that inflation will eat away at purchasing power) – longer you need to wait, more risk 2. What impacts bond price when traded?  Coupon rate & prevailing rates of interest (relationship – which determines what new bonds are issued at)  Changes in credit rating (ppl not as interested if their credit rating has dropped: affects the demand and in turn the price)  Economic/market risk (if company is able to repay): bond face value will vary with external changes  Inflation (eats away at purchasing power: if its going up, its eating away at future revenue streams – if inflation is increasing, bonds should decrease Concept of Yield • Percentage return on any investment “what you’re getting back from investment compared to what you paid” • Helps us to compare investments What you made Interest + Capital Gain Yield    x% What you paid What you paid For a bond: Interest (fixed)= coupon rate x face value (aka amount borrowed) Capital gain or loss = face value – purchase price  • In BU 111, always use a face value of $1,000 for bonds • If you buy bond in secondary markets, you could lose money or get money Approximate Yield to Maturity annual bond interest  annual capital gain  price paid for bond face value - price paid coupon rate x face value  time to maturity  price paid  - Need to calculate “what you made” on an annual basis Example: Approximate Yield to Maturity Example: You buy a 6% bond for $850 with 10 years to maturity. Calculate the Approximate Yield to Maturity on this bond. Step 1: Identify key information Coupon rate: 6% Purchase price/price paid: $850 Face Value: $1000 Time to maturity: 10 years Step 2: Calculate components Annual bond interest = face value * coupon = $1000 * 0.06 = $60 Annual Capital Gain = (1000 – 850)/10 = %15 Step 3: ((0.06 x $1000) + [($1000 - $850)/10 years])/$850 = 8.8% Yield is higher than coupon rate (8.8% v.s. 6%) because there is a capital gain – you paid $850 and got $1000 at the end Yield should reflect prevailing interest rates and any risk premium. face value - price paid coupon rate x face value + time to maturity Yield = price paid Can’t change coupon rate. Cant change face value. Cant change time to maturity. Can only change price paid to get appropriate yield. Bond Pricing Three scenarios to consider: 1) You pay less than face value ($1000) for the bond  Priced “At a Premium”  when the coupon rate is more than the expected yield  Example: You are buying a 2004 bond with a 7% coupon and today’s expected bond yields are 5%  Increase price paid because they would receive a higher  Willing to incur a capital loss because interest rate is greater than other products  You’re ok with higher price because you’re getting a higher rate than the ones you would buy today  Notice: With a Yield expectation that is less than the coupon rate, you would be willing to pay more than face value (a premium) for the bond; in other words you would take a capital loss. 3) You pay face value (=$1000) for the bond  Priced “At Par”  when the coupon rate is equal to the expected yield  Example: You are buying a 2006 bond with a 5% coupon and today’s expected bond yields are 5%  Notice: Since your Yield expectation is met by the coupon rate, you would have no capital gain, which means you pay face value for the bond. Bond Pricing Summary BOND PRICES VARY INVERSELY WITH INTEREST RATES: Inverse relationship If interest rates go down, older coupon rates are more attractive & thus you will need to pay more to buy it. Reading Bond Quotations Bonds issued at $1,000 face value and redeemed at $1,000 face value at maturity Issuer Coupon: % interest bond pays out Maturity: receive face value Price: % of face value (highest bid and ask quoted – but not used in class questions) Yield Change Type of Investments: STOCKS • Represents equity/capital for issuing company – Good for company because doesn’t have same binding fixed cost with raising capital as bonds • Characteristics – voting rights (who sits on BOD – help shape company a tiny bit) – no fixed term (sell stock at price determined by the market – can be higher or lower) • compared to bond, no maturity rate, no way to decide that when we want our capital back, that its there – variable return • don’t know if it will be positive or negative – discretionary payment (dividends) • bond: on-going return for the use of our money • stock might give you on-going return • not sure if they give you a dividend and they are not legally supposed to the way bond-issuers need to pay bond payments – higher level of risk than bond and can represent a better return [in rank, Bond is PREFERRED STOCK first, preferred “hybrid investment”: b/c they act like a stock is second COMMON STOCK bond in many respects and commons Gets preferential treatment (shareholders stock is last] are always ahead than common stock) No – unless number of dividends unpaid – when company has to do significant VOTING RIGHTS Yes reconstruction (not normal occurrence: exception when things are not going well) Yes but only after interest paid on debt (planne
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