FNCE 5610, Personal Finance H Guy Williams, 2009

Transcription

1 Ch 12: Supplement A Fixed-Income Securities Basic Concepts of Lending Securities Fixed-income securities (bonds): are securities where an investor lends funds to the issuer in exchange for a promise of a stream of periodic interest payments (coupons) and a repayment of the loaned principal at the maturity of the bonds. Basic Concepts of Lending Securities (cont.) Coupon payments are interest payments paid to the bondholder on a semiannual basis and are based on a percentage of the face value, or par value, (generally $1000) of the bond. Maturity is the term of the bond (usually 1-30 years). Interest is paid until the maturity date when the maturity value (generally $1000) must be paid to the purchaser Some bonds can be called (redeemed) earlier if the issuer elects (usually when interest rates go down) Bonds Fixed periodic interest payments Fixed payment at maturity Value moves inversely to interest rates Default = bankruptcy Current price = PV of interest payments+ maturity amount No voting rights Stocks Possible dividend payments No fixed maturity Value moves inversely to interest rates No required payments to default Current Price depends on market value Voting rights FNCE5610 Lecture 6 Page 1 of 26

2 Valuation of Fixed-Income Securities The value of a bond is equal to the present value of the expected future cash flows Cash flows: coupon payments + maturity value Discount rate: based yield to maturity (see next) Zero-coupon bonds: no coupons, purchased at a discount to par Measures of Return Yield to maturity (YTM)= Solve for I based on cash flows: Current Price (PV)=$1100, coupon =$40, n=20 (10 years) FV=1000, i = 3.31x2=6.62% (assumes cash flows will be reinvested at the same ROR) Yield to call(ytc)= solve for i based on FNCE5610 Lecture 6 Page 2 of 26

3 PV = $1100, coupon = $40, n = 10 (if call date is in 5 years), FV = 1040 (par + premium), I = 3.16x2 = 6.32% Corporate Returns Versus Municipal Returns Types of Fixed-Income Securities Money market: short term, low risk, liquid includes: Certificates of deposit Inflation indexed bonds: treasury issued, interest determined by auction, principal value is adjusted for changes in CPI, protects purchasing power and principal from devaluation from rising interest rates. Types of Fixed-Income Securities (cont.) Municipal bonds: Income tax free bonds issued by states and cities. Lower yields then treasuries, attractive to high tax bracket investors. Corporate bonds, can be secured by assets or unsecured (called debentures) Convertible bonds, hybrid securities that look like a bond and act more like a stock, holder has right to convert to stock, lower yield. Mortgage-backed securities(mbss) and collateralized mortgage obligations(cmos) ownership claims against a pool of mortgages issued by government agencies (Fannie Mae) or private investment firms valuation a current issue FNCE5610 Lecture 6 Page 3 of 26

4 Series I bonds US treasury securities Protects against inflation (deflation) Interest not subject to state and local taxes. NO taxes if used for QHEE. 30 year bonds can be redeemed after 12 months. Penalty of 3 months interest in 1st 5 years. Rating Agencies Standard & Poor s Moody s Standard Credit Rating System FNCE5610 Lecture 6 Page 4 of 26

5 Risks of Fixed-Income Securities Systematic risks Interest rate risk Reinvestment rate risk Purchasing power risk Exchange rate risk Unsystematic risks Default (credit) risk Call risk Liquidity risk Volatility of Fixed-Income Securities Two key factors that influence volatility: Coupon rate The volatility in price for a bond is inversely related to the bond s coupon payment when interest rates change Maturity Bonds with longer terms are subject to more volatility with changing interest rates than bonds with shorter terms Result: Higher coupon rates and shorter terms = lower sensitivity to interest rate changes Term Structure of Interest Rates Yield curves reflect current market interest rates for various bond maturities Normal curve slopes upward ie: longer maturities pay higher interest longer maturities = greater risk therefore higher interest rates must be paid to make them attractive (Default, purchasing power, interest rate risk) Strategies to reduce interest rate risk The ladder strategy: a portfolio with staggered maturities (10 bonds, 1 maturing each year between 5 and 15 years) The barbell strategy: 1/2 short term bonds (5years) 1/2 long term (15 years) The bullet strategy: a series of bonds with various maturities centered on the desired duration. FNCE5610 Lecture 6 Page 5 of 26

6 Ch 12: Supplement B, Equity Securities Basic Concepts of Ownership-Type Investments What ownership means Dividends: earnings paid to stockholders Vs reinvested back into company Capital appreciation: increase in value of stock, realized and taxed on sale of stock Voting for BOD, mergers + Maintaining ownership percentage (sometimes) preemptive right to buy more stock of a new issue Liability: corporations separate legal entity protects shareholders from personal liability Types of Equity Securities Common stock Preferred stock Foreign securities Categories of Common Stocks Defensive stocks, conservative, resist market change. Cyclical stocks Blue-chip stocks GROWTH STOCKS For all: is the current price too high or is it low??? Income stocks Interest-sensitive stocks, housing, banking New economy stocks, tech, internet VALUE STOCKS Preferred Stock Preferred stock has characteristics of both fixed-income investments and common stock Dividend payments must be paid each year before paying a dividend to the common stockholders Paid before common shareholders if a liquidation FNCE5610 Lecture 6 Page 6 of 26

7 Foreign Securities 50% of worlds capitalization Growth opportunities Diversification Less efficient market = opportunity for undervalued securities Returns not highly correlated with US market (may increase efficiency of portfolio) American depository receipts (ADRs). Investor purchases foreign securities. Certificates issued by a US bank representing ownership of foreign company shares that are held in a bank in that country. Foreign mutual funds, Easy method to invest in foreign market with diversified portfolio and various objectives. International ishares, international exchange traded funds (ETF) like foreign mutual funds but trade on exchanges like stocks Risks of Equity Securities Systematic risks Market risk, market as a whole, nothing to do with a particular stock. Interest rate risk Exchange rate risk Unsystematic risks Business risk Financial risk Country risk Equity Markets and Benchmarks Primary market where new issues of securities (IPOs) are first offered to the public Secondary market (NYSE, ASE) where investors can buy and sell securities, previously issued in the primary market, with other investors Third market (OTC) over-the-counter trading of equity shares listed on an exchange Fourth market institutional traders that trade directly with other traders without the help of brokers (large blocks of securities) Market indexes and averages Provide investors information about the overall performance of the markets Dow Jones Industrial Average (DJIA) Standard & Poor s 500 Index (S&P 500) NASDAQ Russell Indexes FNCE5610 Lecture 6 Page 7 of 26

8 Wilshire 5000 Index EAFE Index Indexes provide benchmarks for comparison to a comparable portfolio s performance Measures of Return Time-weighted returns measure the performance of the portfolio manager without regard to actual deposits or withdrawals (buy and hold), for comparison to other managers Dollar-weighted returns measure the return that the investor actually received in their portfolio and includes the effect of deposits and withdrawals. Dividend yield (used with income stocks) = annual dividend per share/share price: $4/$100= 4% div yld FNCE5610 Lecture 6 Page 8 of 26

9 Dollar vs Time Weighted Many studies show the investor in a portfolio does MUCH worse then the portfolio performance WHY? Purchasing Equity Securities Long positions: purchase of a stock hoping it will go UP Short positions: Selling stock you have borrowed from a broker in the hope it will go DOWN and you will later buy it at the reduced price to replace the borrowed stock Trading Equities Brokerage accounts are either cash (all securities are paid in full) or margin ( the investor borrows up to 50% of the security purchase price from the brokerage house) FNCE5610 Lecture 6 Page 9 of 26

10 Online Trading: no broker Types of orders Market: execute now at best possible price (most common) Limit: execute at specified price or better Stop loss: specified price when the stock must be sold (limits downside risk) Stop limit: investor specifies max. price he will BUY, OR min. price he will SELL Analyzing Equities Technical analysis: Predicting future stock movement by studying historical movements, trends, moving averages etc. without regard to earnings, management, debt etc. Fundamental analysis: PV of all future cash flows= intrinsic value. What is the company worth? Ratio analysis, competitiveness in industry, interest rates etc. Analysts research and select stocks Portfolio managers allocate investor funds into stocks or funds. Valuing Equities Common stock value = PV of all future cash flows Price-to-Earnings Ratio: = market share price/earnings per share if price=$10/share and earnings are $1.00 per share then PE= 10 Compare P/E ratios among companies in same industry Capital Asset Pricing Model: developed from the efficient frontier and adds a risk free asset base to calculate the expected return for the portfolio. FNCE5610 Lecture 6 Page 10 of 26

11 Ch 12: Supplement C, Mutual Funds Introduction to Mutual Funds Mutual funds are open-end investment companies that sell shares to the public and pool the proceeds to invest in a portfolio of securities on behalf of their shareholders Mutual funds are the predominant method for small investors to own equity and fixed-income investments. Advantages of Mutual Funds Low Initial investment, often $500 or less, $50 /Month with checking drafts Diversification, 100 to 2000 different securities in one portfolio The effort and cost to duplicate such a portfolio would be prohibitive Ease Of Purchase, directly or broker Professional Management, managers, using extensive research departments constantly evaluate portfolio holdings and alternatives making it difficult for individual investors to match long term performance. Tax Efficiency of management fees, fees are directly deducted from returns and are therefore before tax to the investor. FNCE5610 Lecture 6 Page 11 of 26

12 Advantages of Mutual Funds (cont) Liquidity, can be redeemed daily at Net Asset Value (NAV) the total value of the underlying funds Transaction cost efficiency due to huge economies of scale, sometimes trading at less then 1cent/share Variety, specific fund objectives to match almost any investor objective (large, growth, green, tech, international ) Advantages of Mutual Funds (cont) Services: Extensive monthly or quarterly reporting statements Automatic drafts into the fund and withdrawals out Dollar Cost Averaging Automatic reinvestment of dividends and capital gains, check writing, maintenance of cost basis, telephone and wire redemptions. Transaction free switches between funds Allocation and planning software on web site Disadvantages of Mutual Funds Fees, Loads, And Expenses, operating, management and sales charges reduce the net return to the investor Liquidity feature requires funds maintain cash on hand, this lowers both return and risk compared to being fully invested Execution, large volume transactions can adversely effect prices Classification System (misclassification) is not standardized and it can sometimes be difficult to ascertain the actual objectives of a fund Built-In Gains (Or Losses) may be in the underlying securities that have not recently turned over, upon sale the gain or loss will be a taxable event to the current shareholder Types of Investment Companies Unit Investment Trust (UIT) unmanaged fund of professionally selected securities, often muni bonds, intended to be held to maturity FNCE5610 Lecture 6 Page 12 of 26

13 Exchange-traded funds (ETFs) index based portfolio of stocks that can be traded like a stock throughout the day Closed-end investment company, After IPO traded on market at premium or discount (unlike mutual funds at NAV), must be bought through a broker, fixed # of shares Open-end investment company, # of shares unlimited, purchased and sold at Net Asset Value (NAV)- the sum of the underlying securities, direct from the fund family or through a broker or investment advisor, generally for a fee Mutual Fund Classification Load funds: front or back end loads or fund with 12b1 fee over.25%/yr. No-load funds: no front or back end load and.25% or lower 12b1 fee, generally bought direct from fund without a broker or through an advisor who charges a separate fee for his services Mutual Fund Fees Loads or sales charges Front-end load: sales charge deducted from investment Back-end load: declining fee (generally starting at 5%) charged at sale of shares only in 1st 5-7 years Other mutual fund fees 12b-1 fees: maintenance fee paid to servicing broker.25%-.75% depending on share class Management fees: charged by the fund for it s portfolio management services. Average 1% +/-.9% Expense ratio: % of total fees to total assets (does not include sales charge) Classes of Load Fund Shares Class A shares front load up to 5.75% (less for bond funds) for under $25000 investments reducing to 1% or less for larger purchases (about 3.5% at 100K cumulative) FNCE5610 Lecture 6 Page 13 of 26

14 Class B shares: no front load, 5%,4,4,3,2,1,0% back end load if redeemed in the 1st 6 years.75% higher annual expense charge compared to Class A shares (generally not available over $100,000 investment since A shares would be more advantageous to investor) Class C shares: no front load, 1% back load for redemptions in 1st year only. Usually 1%/year higher expense charge compared to class A shares. How Do Fund Expenses Affect Performance? High performance funds may have high or low expense ratios However, the higher the expenses of the mutual fund, the more the fund manager will have to overcome them to achieve strong return performance Note: mutual fund returns are reported NET of the fees FNCE5610 Lecture 6 Page 14 of 26

15 Types and Objectives of Mutual Funds Money market mutual funds Provide investors the opportunity to earn competitive money market returns with the added benefits of ease of access and liquidity. Underlying securities mature in a maximum of 90 days to reduce risks and help maintain a constant $1/share price. Interest credited daily, check writing privileges Fixed-income mutual funds Provide diversified bond holdings which reduces default risk Types and Objectives of Mutual Funds (cont.) Equity mutual funds Provide investors easy, efficient access to equity stock securities makes up over 57% of all mutual fund assets Hybrid or balanced funds A portion of the portfolio is invested in cash, fixed-income securities, and equity securities Asset allocation accounts for over 90% of a portfolios returns Most investors will be allocated among a mix of money markets, bonds, and stocks How Do Investment Advisers Select Mutual Funds? Goal of client Prospectus: Fund objective Investment policy/strategy Manager tenure Historical performance Portfolio turnover Fees and expenses How to buy and sell shares Minimum initial investment Investor services How Do Investment Advisers Select Mutual Funds? (cont.) Databases of information such as Morningstar or Wiesenberger provide statistical information and analysis tools: FNCE5610 Lecture 6 Page 15 of 26

16 comparative performance and risk sector weightings and largest holdings imbedded gains and losses Style drift holdings overlap with other funds (See mstar reports and style boxes+) Modern Portfolio Theory MPT statistics and performance measures Coefficient of determination (R 2 ) Beta Jensen s Alpha Sharpe ratio MPT Statistics R 2 = Percentage change in the portfolio explained by changes in a market index. Select funds (and benchmark indexes) with high correlation(r 2 ) to the asset class you are building. Beta = Indicates the volatility of portfolio as compared to the market for diversified portfolios. Use to gauge the risk in your portfolio Alpha: Jensen s Alpha: Alpha measures the actual fund performance compared to expected performance given its level of risk (Beta) A POSITIVE ALPHA (returns greater then expected for level of risk) indicates that the fund manager has added value above what could have been achieved by simply investing in the corresponding index benchmark. FNCE5610 Lecture 6 Page 16 of 26

17 Alpha = Actual return-expected return = Rp [Rf + ß (Rm Rf)] Sharpe Ratio An investments excess return per unit of risk Excess return is return above the risk free interest rate (Alpha was excess return above the risk adjusted benchmark return) This makes comparisons of funds possible even when the funds are in different markets or capitalizations The higher the ratio the better risk adjusted return. Managing Mutual Fund Portfolios Issues to look for Changing asset size especially growing small cap funds Style shift: value, core and growth styles can change over time and reduce portfolio diversification Management changes especially when one manager runs the fund as opposed to a team of managers as some funds use Capital gains exposure- check amount of built in taxable gaids FNCE5610 Lecture 6 Page 17 of 26

18 Investing Process Summary (cont.) Select an appropriate asset mix based on the your answers (aggressive, moderate, conservative) Select the funds (or other securities) that match the selected asset mix (diversify) Add more money on a systematic basis Monitor the portfolio Determine how much TIME you are willing to devote to investments? Portfolio Management TIME Managing a portfolio of investments is time consuming. If you have the time, desire, skills and sufficient capital to invest on you own, then individual stocks and bonds and a discount internet brokerage may be appropriate. If not, then paying a broker and/or investing through mutual funds may be more appropriate. How To Put It All Together Portfolio aggregation sites: Yodlee.com Fidelity.com: full view Morningstar.com: Asset allocation and fund selection: FNCE5610 Lecture 6 Page 18 of 26

19 Ch 13: Individual Income Tax & Tax Planning Federal Income Tax Law Objectives Revenue-Raising Objectives: defense, roads, education Economic Objectives, ex: lower taxes during recessions (5/08-tax rebates) Social Objectives: redistribution of income, home ownership, charitable deductions, retirement, life insurance Individual Income Tax Rates Ordinary Rates (0%-35%) are applied to salaries, interest, dividends, rents, business income, SHORT term (under one year hold) capital gains Capital Gain Rates: 0%-15% (Long term,(over 1 year) lower then Ordinary rates) are applied to property held for personal use or production of income i.e.: investment securities, residence, auto (also Qualified dividends) Tax is due only upon sale or exchange Alternative Minimum Tax (AMT) A separate tax calculation designed to increase taxes for those who have substantial tax preference items on their return. These items are added back into the return, an exempt amount of income is subtracted and the tax is recalculated. If the alternative tax is higher, that amount is due. Tax preference items include: State and local income taxes, real property taxes, accelerated depreciation, interest on certain private activity bonds (some munis) incentive stock options, gain on sale of small business stock FNCE5610 Lecture 6 Page 19 of 26

20 Determining Income Tax Liability Taxable Income Total income Less: Exclusions from gross income = Gross income Less: Deductions for adjusted gross income = Adjusted gross income (AGI) (bottom of Pg1 on 1040 form) Less the larger of: Standard deduction or itemized deductions Less: Personal and dependency exemptions = Taxable income Excluded Income Retirement plan salary deferrals (401K) Life and Accident insurance proceeds Inheritances and Gifts received (could be subject to other taxes) Child support payments received Certain Employee fringe benefits (health ins+) Muni bond interest Scholarships Workers compensation FNCE5610 Lecture 6 Page 20 of 26

21 Deductions From Gross Inc. Above the Line deductions Business expenses Net capital losses: maximum of $3,000/yr, (carry forward bal) 1/2 self employed FICA tax paid Alimony paid IRA+ contributions self employed health and qualified LTC premiums Education expenses (limited) All subtracted from Gross Income to arrive at Adjusted Gross Income. An important number used in calculating many other limited deductions. Itemized Deductions Subtractions from AGI Medical expenses (>7.5% AGI) State and local income taxes Property taxes Mortgage interest Investment expenses (<Investment income) Charitable contributions Casualty/theft losses (>10% AGI + $100) Miscellaneous (tax prep fees+) (>2% AGI) NOTE: personal interest payments (car loans and credit card debt+) are NOT deductible 18% = 25.71% guaranteed return in a 30% tax bracket!! FNCE5610 Lecture 6 Page 21 of 26

22 Standard Deduction If itemized deductions do not exceed the standard deduction then the standard deduction is subtracted from AGI INSTEAD of all the itemized deductions. Standard deduction = Single $5700 Joint $11,400 (2009) Example: in the later years of a mortgage the interest portion of the payment will be less and may not be enough to make it an itemized deduction and is therefore paid with after tax dollars Personal and Dependent Exemptions A deduction (called an exemption) is allowed for the tax payer, spouse and each dependent To qualify as a dependent the taxpayer must furnish at least 1/2 the support during the year as well as meet other tests The exemption amount is $3650 each in 2009 (phases out $250K+ AGI- Jt) Income Tax Summary Total Inc - exclusions = Gross Inc Gross Inc -deductions = AGI AGI - Itemized OR Standard deductions and - exemptions = Taxable Income Go to taxable income tables and find your tax amount FINALLY: subtract any TAX CREDITS and make your check payable to the Internal Revenue Service! FNCE5610 Lecture 6 Page 22 of 26

23 Tax Credits Tax Credits are dollar for dollar reductions in the tax amount owed and are therefore MUCH more valuable then a mere tax deduction Common Tax Credits: Child and dependent care credit, Hope scholarship credit, Lifetime learning credit, Savers credit (up to $1000 (up to single joint income)) MYTH Dave just got great news, he is going to receive a $5000 bonus. On his way home, he happens to hear a news report about taxes possibly going up and suddenly realizes that the additional $5K will put him in a higher tax bracket. Since this is obviously the last thing he wants and being nobody's fool he marches into his bosses office (possibly for the last time) and gruffly declines the bonus. Marginal vs. Average Tax Rates The marginal tax rate (bracket) is the rate at which the last dollar is taxed. This rate CANNOT be multiplied times taxable income to determine tax liability because the bracket rate is not retroactive to the first taxable dollar. Instead the lower tax brackets are applied to the dollars in their bracket and the top tax rate is applied only to the dollars over the next lower bracket. You can NEVER lose money by making more money (in the US)(subject to change). Notes Tax Avoidance is the term for LEGALLY interpreting the laws to minimize your taxes and is perfectly acceptable. You would be foolish (or generous) not to utilize the laws to reduce taxes. There are often different legal interpretations even on the same issues. Tax Evasion involves fraudulent methods to reduce tax liability and is definitely ILLEGAL (not declaring all your income) Tax-Avoidance Investments Investment in Tax-Exempt Securities (muni bonds) Riras: tax free gains Deferral of tax on gains: held in Iras, Annuities, Life Insurance, also sec 1031 like kind exchanges such as real estate. Employee Benefits: 401K, deferred compensation FNCE5610 Lecture 6 Page 23 of 26

24 Exemption Opportunities: personal residence gains on sale up to $250K single, $500K joint, vacation rental home income if rented under 14 days Tax Shelters: subject to passive activity limits and income phase outs FNCE5610 Lecture 6 Page 24 of 26

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