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- Chapter 16
Stocks, Bonds, and
Mutual Funds
1
- Chapter Goals
Illustrate the characteristics of bonds, stocks, and
mutual funds more fully.
Calculate the value of a bond and bond yields.
Compute the value of a stock.
Differentiate between fundamental and technical
stock analysis.
Develop a logical approach to selecting individual
mutual funds.
2
- Bonds
Bonds can be broadly classified by maturity and
quality.
Maturity: The number of years until the amount
borrowed is to be repaid.
The longer the period until maturity, the greater the
risk of the bond, as:
– The greater the potential for a change in the ability of a
company to repay its debt.
– A broad-based change in interest rates will have a greater
effect on long-term bonds.
Both factors are included in the term maturity risk.
3
- Bonds, cont.
Bonds are generally given the following classification
and risk profile by maturity date:
4
- Bonds, cont.
Quality: The likelihood that the bond will fulfill its
obligation to pay interest and repay the amount owed
at maturity.
There are bond rating agencies such as Standard &
Poor’s and Moody’s that assign ratings indicating the
relative quality of a bond.
– Ratings range from AAA, the highest, to C, the lowest.
– BBB represents the lowest possible rating for which the
rating agency believes the bond will fulfill all its obligations.
Anything below BBB is regarded as a high-yield
bond or a junk bond with a chance of default
(nonpayment) which typically results in bankruptcy.
The lower the rating the greater the default risk and,
5 correspondingly, higher anticipated returns.
- Bonds, cont.
Bonds can be classified into the following categories:
6
- Bonds, cont.
Liquidity: The ability to convert an asset into cash
quickly and at a relatively low transaction cost.
Liquidity risk: The possibility that you will not be able
to find a buyer at the current market price for an
asset.
Assets vary in terms of liquidity.
– For example, a U.S. Treasury bond is more liquid than one
from a small city.
– If you were to purchase the small city bond you would have
to spend costly time investigating it.
– You would worry that in selling it you might have to accept a
lower price than you would if you bought a comparable U.S.
government issue.
– The small city bond will, therefore, have to offer a higher
7 yield to attract investors.
- Bonds, cont.
We can express the expected return for bonds as:
Expected Risk-Free
Risk Premium
Bond Return Rate
Where:
Default
Risk Premium Liquidity Risk Maturity Risk
Risk
8
- Bond Characteristics
Coupon payments: Interest payments on bonds.
– The amount provided is stated in the bond instrument.
– Bond coupons are fixed contractual payments that are not
affected by changes in market rates over time.
Principal: The payment due at maturity.
– The amount due at maturity is called the par value, face
value, or maturity value.
– The market price of a bond is quoted one decimal point
lower than the price.
– Premium bond: A bond that sells for more than its par
value.
– Discount bond: A bond that sells for less than its par value.
– Due to changes in interest rates a discount bond has a
greater fluctuation in price than a premium bond.
9
- Bond Characteristics, cont.
Returns on bonds are called yields.
Annual Coupon
Coupon Yield
Face Value of Bond
Annual Coupon
Current Yield
Market Value of Bond
By knowing the coupon yield you can calculate how
much you will receive in cash payments per year.
The current yield provides you with the current
return on a bond should you purchase it at that time.
10
- Bond Characteristics, cont.
Yield to maturity: The return you would receive if you
purchased the bond today and held it until it was
repaid.
The return can be separated into two parts: the
coupon yield and the appreciation or depreciation in
the price of the bond.
The yield to maturity is the appropriate benchmark to
use in calculating financial return on investment.
11
- Bond Characteristics, cont.
Yield to maturity can be approximated as follows:
To accurately solve for the yield to maturity, we solve
the following equation for y, where PV = current
bond price CF = cash flow, and n = maturity.
CF1 CF2 CFn
PV ...
1 y (1 y ) 2 (1 y ) n
12
- Calculating the Value of a Bond
The value of a bond can be separated into its two
components:
Present Value Present Value of
Value of Bond
of Interest Payments Principal Payment
The mathematical formula for bond price is:
n
PMTt FV
PV
t 1 (1 i ) t (1 i ) n
Where PMT = annual coupon payment, i = market
interest rate, FV = face value of the bond, and n =
numbers of years to maturity.
13
- Types of Bonds
Cash Equivalents: Include money market accounts,
bank savings accounts, and U.S. Treasury bills.
– Can be liquidated at little or no charge, because they are
considered low risk securities.
Certificates of Deposit (CD): A form of bank debt with
maturity dates often clustered from three months to
five years.
– The repayment of interest and principal are guaranteed by a
federal agency for amounts totaling under $100,000 per
account.
14
- Types of Bonds, cont.
U.S. Treasury Securities: Highest quality securities.
– All rated AAA.
– Separated by maturity date:
Treasury bills (0-1 year)
Treasury notes (2-10 years)
Treasury bonds (10 years or more).
– Many Treasury securities are not callable.
– Subject to federal but not state taxes.
Corporate Bonds: Issued by businesses.
– Returns vary with the quantity of the bonds as reflected by
the issuer’s bond rating.
– Standard & Poor’s ratings of AAA to BBB are considered to
be of investment quality.
15 – Most corporate bonds are callable.
- Types of Bonds, cont.
High Yield (Junk) Bonds: Rated below BBB, usually
BB to C.
– Speculative.
– Yields usually incorporate an assumed potential for
bankruptcy.
Inflation-Indexed Bonds: The interest rate paid for
these bonds varies with the inflation rate.
Series EE Bonds: U.S. Government bonds that pay
both interest and principal when the bonds are
redeemed.
Zero Coupon Bonds: Bonds whose interest is paid at
maturity.
– Subject to income taxes on a current basis, hence most
16 suitable for tax-deferred accounts.
- Types of Bonds, cont.
Collateralized Mortgage Obligations: Fixed income
securities that are backed by pooled mortgages on
real estate.
– Investors receive on a current basis both interest and
principal repayments as well. A portion is repaid as people
move or refinance their mortgage.
Municipal Bonds: Issued by state and local
municipalities and others with non profit or other
public benefit in mind.
– Generally not subject to federal taxes and are free of state
taxes if you purchase them in the state you reside in.
International Bonds: Bonds of government and
private organizations.
– Additional volatility due to currency fluctuations.
17 Diversification benefits.
- Preferred Stocks
Preferred stocks have a lower priority on assets than
bonds in the event of bankruptcy and lack the
assurance of a bond’s contracted for return of
principal.
Consequently, preferred shares are generally
considered more risky and typically have higher
yields than bonds, and their prices can be more
sensitive to a change in market interest rates.
Preferred stocks can be valued as follows:
Do Where P = Price of the preferred
P shares, D0= Current dividend, and ke =
ke
18 The required rate of return.
- Stocks
Under efficient markets theory, the price of a stock at
any time fairly presents its true value.
Therefore, it is impossible to find undervalued stocks
and to outperform the market.
Efficient market theory suggests that you should
confine yourself to reducing risk by diversifying
rather than fruitless attempts to receive above
average results.
However, proponents of fundamental analysis and
technical analysis believe it is possible to outperform
the market. We next consider each.
19
- Fundamental Analysis
Fundamental analysis involves looking at economic
industry and company data to help determine the fair
value for a company. For example, a fundamental
analyst would ask:
– What is the outlook for the economy, and how does it affect
the company being looked at?
– What stage of development is the industry in, and will it
grow at a faster or slower rate than the overall economy?
– Is the company growing faster or slower than the industry
and how does its return on investment compare with that of
other companies in the industry?
May involve looking at annual reports, testing the
20
products offered, calculating ratios, and using overall
valuation models.
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