Chapter 2: Investment Alternatives

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Chapter 2 Investment Alternatives
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Bonds

• The par value (face value) of most bonds is
  1000.
• The bond generally matures (terminates) on a
  specified date and it technically known as a term
  bond.
• Most bonds are coupon bonds, where coupon refers
  to the periodic interest that the issuer pays to
  the holder of bonds.

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Government of Canada Coupon Bond

• A five-year, 5.50 Government of Canada coupon
  bond was listed in the Globe and Mail on May 21,
  2004. Assuming the bond has a par value of
  1000, it has a dollar coupon of 55.00 (5.5 of
  1000) therefore, knowing the percentage coupon
  rate is the same as knowing the coupon payment in
  dollars. If the interest on the bond is paid
  semi-annually, this bond would pay interest (the
  coupons) of 27.50 on a specified date every six
  months. The 1000 principal would be repaid five
  years hence at the maturity date. (Therefore we
  say the term-to-maturity date is five years)

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Bonds contd

• By convention, bond prices are quoted as a
  proportion of par value using 100 as par rather
  than 1000.
• Therefore a price of 90 represents 900, as a
  price of 55 represents 550, using the normal
  assumption of a par value of 1000.
• The easiest way to convert quoted bond prices to
  actual prices is to remember that they are quote
  in percentages, with the common assumption of a
  1000 par value.

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Price of a Government of Canada Bond

• The ask price of the five year 5.5 Government
  of Canada bond was 105.86 on May 20, 2004. This
  quoted price represents 105.86 percent of 1000,
  or 1058.60
• This suggests that an investor could purchase the
  bond for 1058.60 on that day.

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Bonds contd

• Bonds trade on an accrued interest basis.
  Meaning, the bond buyer must pay the bond seller
  the price of the bond as well as the interest
  that has been earned (accrued) on the bond since
  the last interest payment.
• This allows an investor to sell a bond at any
  time without losing the interest that has
  accrued.
• Bond buyers should remember this additional cost
  when buying a bond because prices are quoted in
  the paper without the accrued interest.

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Government Bonds

• Government bonds are issued by the government and
  are the largest single issuer of bonds within any
  given country. These bonds are sold at
  competitive auctions and are sold at
  approximately face value with investors
  submitting bids on yields. Within these types of
  bonds, interest rates are paid semi-annually and
  that the face value of these bonds come in
  1,000, 5,000, 10,000, 100,000, 500,000 and 1
  million. Unlike other types of bonds, these are
  considerably safe in terms of risk and default
  because of the governments ability to print
  money and increase taxes to level the value. Many
  people purchase these types of bonds with the
  idea of earning a steady stream of income and
  with assurance of receiving par value when they
  mature.

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Corporate Bonds

• Corporate bonds are usually purchased by large
  corporations to help finance their operations.
  These types of bonds offer a wide variety of
  maturities, coupons and special features which
  intrigue buyers.
• Corporate bonds are also referred to as, senior
  securities in the sense that they offer priority
  payment on any common or preferred stocks.

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Corporate Bonds contd

• Within the bond category itself there are various
  degrees of security.
• Mortgage bonds are secured by real assets which
  means that holders have legal claim to specific
  assets of the issuer.
• Debentures are generally unsecured and are backed
  only by the issuers overall financial soundness.
  

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ABS Asset-Backed Securities

• Securitization refers to the transformation of
  illiquid, risky individual loans into more
  liquid, less risky securities referred to as
  asset-backed securities.
• The best example of this process is
  mortgage-backed securities (MBS).
• These are created when a financial institution
  purchases a number of mortgage loans that are
  then repackaged and sold to investors as mortgage
  pools.
• Investors in MBSs are in effect, purchasing a
  piece of a mortgage pool.

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ABS Asset-Backed Securities contd

• MBS investors assume little default risk because
  most mortgages are guaranteed by a federal
  government agency.
• The Canada Mortgage and Housing Corporation
  (CMHC) introduced MBSs in Canada in 1987. they
  issue fully guaranteed securities in support of
  the mortgage market.
• These securities have attracted considerable
  attention in recent years because the principal
  and interest payments on the underlying mortgages
  used as collateral are passed through to the
  bondholder monthly as the mortgages are repaid.

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MBSs contd

• These securities are not completely riskless
  because they can receive varying amounts of
  monthly payments depending on how quickly home
  owners pay off their mortgages. Although the
  stated maturity rate can be as long as 40 years,
  the average life of these securities of this life
  has actually been much shorter. ABSs are created
  when an underwriter, such as a bank bundles some
  types of assets linked debt, and sells investors
  the right to invest payments made on that debt.

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Marketable Securities contd

• Marketable securities have been backed by car
  loans, credit card receivables, small business
  loans, leases for photo copiers or aircraft etc.
  The assets that can be securitized seem to be
  limited only by the imagination of the packagers.
  As evidenced by the fact that new asset types
  include items such as student loans, mutual fund
  fees, tax liens, monthly hydro bills, and
  delinquent child support payments!

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Risks of MBS

• As we have seen in 2007 and 2008 investors
  underestimated the risks associated many of these
  investments. The market value of MBS had fallen
  to 6.5 trillion by February of 2008. As a result
  of the massive market write downs from the
  subprime crisis fallout
• This decline in value occurred despite the fact
  that the actual number of low grade (subprime)
  mortgages comprising MBSs was supposed to be
  relatively small.

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Risks contd

• Indeed, many investors (mainly institutional
  investors the so-called experts) holding
  various MBSs and ABSs experienced severe losses
  as the market values of these instruments
  declined substantially.

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Equity Securities

• Equity securities represent an ownership in a
  corporation.
• Preferred Stock a hybrid security that is part
  equity and part fixed-income security because it
  increases in value but also pays a dividend.
• P/S rank below creditors but above common
  shareholders in terms of priority of payment of
  income and in case of liquidation.
• While payment of preferred dividends is not
  obligatory like interest payments, payment to
  common s/h has to wait until preferred s/h
  receive full payment of the dividends to which
  they are entitled.

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Preferred Share contd

• Most preferred shares are non-voting however,
  once a stated number of dividend payments have
  been omitted, it is common practice to assign
  voting privileges to the preferred.
• P/S usually have a cumulative feature
  associated with their dividends. This requires
  the firm to pay all preferred dividends (both
  current and arrears) before paying any dividends
  to common s/h, and that make p/s less risky than
  c/s from the investors point of view.

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Income Trusts

• Income Trusts investment instruments that pay
  out a substantial portion of cash flows generated
  from the underlying revenue-generating assets.
• Two of the more recognizable forms being royalty
  trusts and real estate investments trusts
  (REITs).
• Technically, the trust owns the underlying assets
  and investors purchase units in the trust, which
  entitles them to a certain (substantial) portion
  of the cash flows generated by the underlying
  assets.

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Income Trusts Contd

• The income trust structure is attractive because
  it generates tax savings at the business level
  since it minimizes or eliminates taxes at the
  corporate level, thus reducing (or avoiding) the
  double taxation of income that would have been
  distributed by a similar tax paying corporation.
  
• This tax avoidance is possible because income
  trusts are permitted to treat part (or all) of
  the investment in the equity of the operating
  company as debt for tax purposes.
• As a result, they can classify the payments to
  trust unit holders as an interest expense, which
  reduces (or eliminates) taxable income.

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Income Trusts Contd

• This is different from dividend payments made by
  corporations, which are not tax deductible and
  are made from after tax income.
• As a result, income trusts are able to offer
  investors a higher cash flow yield that would
  otherwise be possible hence the attractiveness
  to investors.

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Common Stock

• Represents the ownership interest of corporations
  or the equity of the shareholders.
• If a firms shares are owned by only a few
  individuals, the firm is said to be closely held.
  
• Most companies choose to go public, or they sell
  common stock to the general public, primarily to
  let them raise additional capital more easily.

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Common Stock Continued

• As the residual claimants of the corporations,
  shareholders are entitled to income remaining
  after the fixed income claimants such as the
  preferred shareholders have been paid also, in
  case of liquidation of the corporation, they are
  entitled to the remaining assets after all other
  claims (including preferred stock) are satisfied.

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Common Stock

• As owners, the holders of common stock are
  entitled to elect the directors of the
  corporation and vote on major issues.
• Each shareholder is allowed to cast votes equal
  to the number of shares owned when such votes
  take place.

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Common Stock

• There often exists a clause in a corporations
  charter that grants existing shareholders the
  first or pre-emptive right to purchase any new
  common stock sold by the corporation.
• This right is a piece of paper giving each
  stockholder the option to buy a specified number
  of new shares, usually at a discount, during a
  specified short period of time.
• These rights are valuable and can be sold in the
  market.

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Common Stock

• Shareholders also have limited liability, meaning
  they cannot be held responsible for the debts of
  the company or lose more than their original
  investment.

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Characteristics of Common Stocks

• Book value of a corporation is the accounting
  value of the common equity as shown on the
  balance sheet.
• It is the total value of common equity for a
  corporation, represented by the sum of common
  stock outstanding, capital in excess of par value
  and/or contributed surplus, and retained
  earnings.
• Dividing this sum total book value by the
  number of common shares outstanding, produces the
  book value per share.

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Book Value for BCE Inc.

• BCE Inc. reported 11.910 billion in common
  shareholders equity for fiscal year-end 2003.
  This is the book value of common equity. Based
  on the year-end common shares outstanding of
  923.989 million for that year (a figure obtained
  from the companys annual report), the book value
  per share was 12.88. (11.910
  billion/923.989million)
• At the time the observation for BCE Incs book
  value was recorded, the market price was in the
  29 range. This implies that BCEs market to
  book ratio was 29/12.88 2.25

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Value of Shares

• The market value or price of the equity is the
  variable of concern to investors.
• The total market value for a corporation is
  calculated by multiplying the market price per
  share of the stock by the number of shares
  outstanding.
• This represents the total value of the firm as
  determined in the market place.
• The market value of one share of stock, of
  course, is simple the observed current market
  price.

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BCE contd

• At the time the observation for BCE Inc.s book
  value was recorded, the market price was in the
  29 range. This implies that BCEs
  market-to-book ratio was 29.00/12.882.25

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Dividends

• The only cash payments regularly made by
  corporations to their stockholders.
• They are decided upon and declared by the board
  of directors.
• The common stockholder has no specific promises
  to receive any cash from the corporation since
  the stock never matures and dividends do not have
  to be paid.

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Dividend Yield

• The income component of a stocks return stated
  on a percentage basis.
• It is commonly calculated as the most recent
  annual dividend amount divided by the current
  market price.

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Payout Ratio

• The ratio of dividends to earnings.
• It indicated the percentage of a firms earning
  paid out in cash to its stockholders.
• The complement of the payout ratio is the
  retention ratio, and it indicated the percentage
  of a firms current earning retained by it for
  reinvestment purposes.

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Payout Ratio for BCE Inc.

• BCE Incs 2003 earning were 1.90/share, and it
  paid an annual dividend on its common shares of
  1.20/share. Assuming a price for BCE of 29,
  the dividend yield would be 1.20/29.00, or
  4.14. The payout ratio was 1.2/1.9, or 63.16
  percent and the retention ratio was 36.84 (i.e.,
  100 - 63.15 )

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Dividends contd

• Dividends are declared and paid quarterly, but to
  receive a declared dividend, an investor must be
  a holder of record on the specified date that a
  company closes its stock transfer books and
  compiles the list of stockholders to be paid.

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Important Dates!

• The ex dividend date is set at the second
  business day before the record date, and shares
  trade without the right to the associated
  dividend on and after this date.
• Since stock trades settle on the third business
  day after a trade, a purchaser of the share two
  days before the record date would not settle
  until the day after the record date, and would
  not be entitled to receive the dividend.

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Important Dates contd

• Shares are said to trade ex dividend after the ex
  dividend date.
• This will be reflected in the share price, which
  typically falls by an amount close to the
  dividend amount on the ex rights date.

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Tax effects

• There may be tax impacts if you are holding a
  stock or fund on the ex-dividend date. The
  dividend is paid out regardless of how long you
  held the stock or fund, and that may be taxable
  income to you.

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Announcing Dividends for BCE Inc.

• Assume that the board of directors of BCE Inc.
  meets on April 24 and declares a quarterly
  dividend, payable on June 30. April 24 is called
  the declaration date. The board will declare a
  holder-of-record date, say, June 9. The books
  close on this date, but BCE goes ex-dividend on
  June 7 (assuming June 7 and June 8 are regular
  business days). To receive this dividend, an
  investor must purchase the stock by June 6. The
  dividend will be mailed to the stockholders of
  record on the payment date, June 30.

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Extra notes for Dividend Dates

• The key date to remember for dividend paying
  stocks is the ex-dividend date. The Record Date,
  or Date of Record determines the Ex-dividend
  date, when you must own the stock.
• In order to receive the upcoming dividend payment
  pay-out you must already own or you must purchase
  the stock prior to the ex-dividend date.
• It is important to know when you buy or sell
  stock, in some countries there is a three-day
  settlement period (three stock trading days) on
  all buy and sell orders.
• Here is an example The ex-dividend date is two
  stock business days prior to the record date. To
  be a stockholder on the Record Date you must
  purchase the stock before the ex-dividend date.
  The latest date you can buy the stock to be a
  stockholder on record and be entitled to the
  dividend would be one day prior to the
  ex-dividend date to allow for the three
  stock-trading-day settlement of the stock
  purchase. If you purchase the stock the day
  before the ex-dividend date you would be a
  stockholder on the record date and would be
  entitled to receive the dividend payment.

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• You must be a stockholder on the record date to
  receive the dividend payment.
• You do not have to sell the stock after the
  record date to be entitled to the dividend.
  However, you must hold without selling your stock
  until the ex-dividend date or after to be
  entitled to the dividend payment. In this
  example, assuming that you purchased the stock
  one day before the ex-dividend date, you would be
  a stockholder on record date. If you sell the
  stock on the ex-dividend date, the buyer of your
  stock would be a stockholder one day after the
  record date given the three stock business
  trading day settlement. The person that bought
  your stock would not be entitled to receive the
  dividend.
• You only have to own the stock one day to be
  entitled to receive the dividend payment.
• If you buy prior to the ex-dividend date, you are
  buying in time to receive and be entitled to the
  upcoming dividend payment. Selling your stock on
  the ex-dividend date or after, means selling it
  without the dividend. The buyer of your stock
  will not receive the latest dividend payment
  pay-out, but would receive the next dividend
  pay-out if held until the next ex-dividend date.
• Like any trading system, overall market sentiment
  and momentum are key. One advantage is that
  dividend paying stocks do have a tendency to be
  much more stable and predictable and have the
  tendency to appreciate in price due to the
  dividend payment.