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Chapter 16

Stocks, Bonds, and Mutual Funds

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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.

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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.

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Bonds, cont.

Bonds are generally given the following classification and risk profile by maturity date:

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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, correspondingly, higher anticipated returns.

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Bonds, cont.

Bonds can be classified into the following categories:

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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 yield to attract investors.

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Bonds, cont.

We can express the expected return for bonds as:

Where:

Expected Bond Return

Risk-Free Rate

Risk Premium

Risk Premium Liquidity RiskDefault

RiskMaturity Risk

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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.

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Bond Characteristics, cont.

Returns on bonds are called yields.

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.

BondofValueFace

CouponAnnual YieldCoupon

BondofValueMarket

CouponAnnualYieldCurrent

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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.

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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.

nn

y

CF

y

CF

y

CFPV

)1(...

)1(1 221

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Calculating the Value of a Bond

The value of a bond can be separated into its two components:

The mathematical formula for bond price is:

Where PMT = annual coupon payment, i = market interest rate, FV = face value of the bond, and n = numbers of years to maturity.

Value of BondPresent Value

of Interest PaymentsPresent Value of

Principal Payment

n

n

tt

t

i

FV

i

PMTPV

)1()1(1

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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.

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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. – Most corporate bonds are callable.

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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 suitable for tax-deferred accounts.

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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. Diversification benefits.

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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:

e

o

k

DP

Where P = Price of the preferred shares, D0= Current dividend, and ke = The required rate of return.

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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.

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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 products offered, calculating ratios, and using overall valuation models.

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Technical Analysis

Technical analysis focuses exclusively on price and volume.

One popular approach is relative strength, sometimes called momentum investing.

– With this approach, stocks that have had large price movements relative to the market are purchased.

– To the extent that it works, it may be due to people’s behavior patterns in purchasing stocks that have performed well.

Technical analysis contrasts with fundamental analysis, which says that the higher a stock rises without new positive developments, the less it is attractive.

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Dividend Discount Model

The dividend discount model assumes that a stock is equal to the sum of all its future dividends discounted to the present:

Where P0 = The current security price, D1= The annual dividend payable at the end of the year, g = Projected growth rate in dividends, ke = The company’s required rate of return on its equity.

gk

DP

e 1

0

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Dividend Discount Model, cont.

The company’s required rate of return is the return that an investor would require, given the company’s growth prospects and risk profile.

We can solve for it using a variety of methods. – One is to estimate the risk premium using another company in

the marketplace that is like it and add the risk-free rate to it. – Another method is to use the dividend discount model formula

but transposing its terms:

– Note that in this form the g represents the market’s expectation

of the growth rate as reflected in its current price. g

P

Dke

1

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Price-Earnings (P/E) Multiple

The P/E multiple method is based on earnings. It is literally the number of years of current earnings

it takes for you to “pay off” (reach) the cost of purchasing the shares at the current price.

Where P = Price and E = Earnings.

E

PMultiple P/E

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Price-Earnings (P/E) Multiple, cont.

Most commonly, the earnings per share (EPS) figure is either the latest 12-month actual EPS, projected EPS for the current year, or projected EPS for a future year.

This future-year figure, called the normalized P/E, is often used when the current EPS is not representative.

When earnings are not subject to unusual or cyclical factors, the higher the P/E ratio, the more highly regarded the company. Therefore, a fast-growing technology company would get a higher P/E than a slow-growing steel company.

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Price-Earnings (P/E) Multiple, cont.

The P/E multiple for the typical large company has fluctuated widely over the past 50 years:

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Mutual Funds

Mutual funds are often the choice of people with little time or inclination to manage individual monies themselves.

Given the public’s potential for inefficient selections and frequent unproductive changes in holdings, many financial planners would like to see even greater use of mutual funds.

The general mutual funds are typically extensions of the size and styles for stocks and maturities and qualities for bonds.

There are also special purpose stock funds.

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Mutual Funds, cont.

Examples of special purpose stock funds include:– Sector Funds: Utility, Technology, Energy– Industry Funds: Drug and REIT– Commodity: Gold, Precious Metals, Oil and Gas– Regional: Midwestern U.S.– International: Pacific Rim, European– Balanced: Blend of Stock and Bond– “Hedge”: Mergers and Acquisition, Market Neutral– Other: High Dividend Yield, Asset Allocation

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Bond Funds

Bond funds have their own categorizations. One criterion is maturity, the other is degree of risk. Maturity can be divided into short, intermediate, and

long term. Risk can be separated by gradations of quality –

high, medium, low.

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Bond Funds, cont.

Specialized bond funds include the following:– Government Securities..– Corporate.– High Yield.– Municipal.– International.– Emerging Market.– Floating Rate.– Inflation Indexed.– Other (zero-coupon bond funds, convertible securities

funds, multi-sector bond funds, etc.).

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Open End versus Closed End Funds

An open-end mutual fund is generally open to new deposits by existing or new investors, and redemptions by current holders. – The price established for the purchase or sale transaction is net asset

value (NAV), less commissions or redemption costs where applicable. – The NAV is obtained by adding up the market values of all of the

stocks in the portfolio and dividing by the total number of fund investor shares outstanding.

By a closed-end mutual fund, shares are typically traded through a stock exchange, often the New York Stock Exchange. – Purchases or sales prices are not necessarily made at NAV but are

established by supply and demand for the fund.

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Load versus No-Load Funds

Load fund: Provides a sales commission to the individual or brokerage firm that markets the fund with the new fund holder paying the charge.– A front-end load is one that is charged when the shares are

initially purchased. – A back-end loaded fund places the entire investor deposit

in a fund and then charges an annual sales commission. No-load fund: Does not offer sales commissions to

the marketers of the funds.

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Load versus No-Load Funds, cont.

Summary of load and no-load fund characteristics:

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Mutual Fund Performance

The majority of all actively managed mutual funds underperform the averages. Possible reasons:– Significant expenses to support analysts, portfolio

managers, and other overhead costs as well as trading costs to shift investment holdings.

– Mutual funds frequently keep 5 percent or more in cash for such reasons as meeting unusually larger redemptions.

– The relative performance between categories may differ substantially over extended periods of time.

– Fund overhead expenses including direct management fees can provide benefits other than performance.

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Taxation

Investment companies such as mutual funds are not taxed as an entity if they pay out all dividends and capital gains income to investors yearly. – Mutual fund dividends are taxed at ordinary income tax rates

whereas long-term capital gains distributions are subject to favorable tax rates.

– Capital gains taxes are paid by shareholders on net gains on fund sales of securities in their portfolio for the year based on fund costs to purchase those securities.

– Therefore, capital gains taxes may be paid yearly even though the shareholder has not sold any fund shares.

– Taxes are due on fund gains even if you personally had a loss in the shares you owned.

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Other Investment Management Structures

Separately managed accounts: Segregated assets that are managed personally for each individual.

Advantages: improved tax management and the ability to exclude certain assets.

Disadvantages: More difficulty in diversifying properly due to account minimums and problems in switching managers quickly and without objections.

Exchange-traded funds: Portfolios of stocks and bonds that are traded on the major exchanges.– Allows you to purchase and sell assets at a current market price

throughout the day. – In contrast, mutual funds your transactions can be only made only

once a day, and the purchase price is established after you have purchased the shares.

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Other Investment Management Structures, cont.

Unit investment trusts: Portfolios that are set up at a point in time as are mutual funds, but are generally unmanaged. – No ongoing overhead costs and are sometimes difficult to sell at

their NAV. Variable annuities: wrap mutual funds in a tax-sheltered

framework for an extra ongoing charge. Pension plans: Run by a corporation or provide a range

of investment vehicles for the employee to select from. – Where the employees select the investments, the alternatives

may be in the form of mutual funds or pooled pension account managers.

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Measuring Performance

Performance for an investment should be measured on a risk-adjusted basis. – Both the standard deviation and the beta coefficient measure risk,

the standard deviation total risk and the beta-market risk relative to a market index.

– The Sharpe Ratio, which is just the return less the risk-free rate divided by the standard deviation, measures return per unit of risk.

The alpha coefficient provides actual return minus expected return, given market performance and the individual security or mutual fund’s beta coefficient.– A positive alpha coefficient signifies market outperformance, the

larger the alpha the better the performance.

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Measuring Performance, cont.

Another method of measuring performance is comparing results for a fund with others like it.

Given the variation in performance by size and style, this approach is used instead of comparing results with one generally recognized benchmark of performance for the market such as the S&P500 or the Dow Jones Industrial Average.

Some advisors use this approach exclusively; they assume that risk is taken care of by grouping investments into the same size and style grid.

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Individual Asset Analysis

With passive management, the prime screen may be availability of a diversified mixture of funds benchmarked to the categories stated in the asset allocation.

The final choice for passive management might include exchange-traded funds as well as traditional funds, selected on the basis of their correlation with the benchmark, with those having the lowest expense ratios and the highest returns preferred.

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Individual Asset Analysis, cont.

Active fund selection is more involved. Some of the relevant steps and information needs are:– Try to obtain relevant descriptive information on the fund.– Identify the fund size and style.– Compare fund returns.– Look at the fund’s risk.– Look at consistency of performance.– Look at the tenure of the current portfolio manager.– Look at the fund’s correlation coefficient.– Observe the fund’s size.– Weigh the growth of assets in recent periods.– Look at tax efficiency.– Incorporate the fund’s expense ratio.

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Chapter Summary

The expected bond return is made up of the risk-free rate and the risk premium. The risk premium consists of liquidity risk, maturity risk, and default risk.

Technical analysis focuses on price and volume. Fundamental analysis looks at basic competitive factors among

others to arrive at a fair value for a company which may be at variance with its current price.

The dividend discount and P/E multiple are two of the principal methods of valuing a company. One approach uses dividends, the other earnings to arrive at decisions.

To attempt to select attractive mutual funds you should among other things look at their risk-adjusted performance relative to other funds in the same category.