Chap. 2 Investment Alternatives Focus on Marketable Instruments Fixed Income Capital (Bond) markets Equity Derivatives Sept 2003 These are short-term debt obligations - no more than one year in maturity. Only the most credit-worthy borrowers have access to the money-markets. There is no junk money market. Most instruments, like T-bills, are sold to investors at a discount to face value and mature at par. Ex T-bills, commercial paper, banker s acceptances. The text describes the securities as highly liquid: this means that, if desired, the original buyer can easily sell the security, before it matures, to another investor through the secondary market without incurring large transactions costs. However, some of these money market instruments are not really very liquid: T-bills and large issues are the most marketable. Less liquid securities - some commercial paper - are usually held to maturity. Individuals rarely invest directly in money market securities as, say, commercial paper often comes in minimum units of $100,000, and even $1 million. are the exception: the minimum is $10,000, increasing in increments of $5,000. This are easily purchased thorough a program called Treasury Direct. Most individuals invest indirectly in the money market through a money market mutual fund. The risk -free asset because: (1) no default risk, (2) lowprice risk because of it s short maturity. (3) highly liquid (or marketable) Another benefit: not subject to State/Local income or Intangibles taxes. Sold weekly at auction: individuals can place noncompetitive bids. Three and six month bill sold weekly, one year bills sold monthly Sold as a discounted note. minimum is $10,000, increasing in increments of $5,000. Unfortunately, the yields are often quoted using the antiquated bank discount method. This BDM assumes, in order of increasing inaccuracy: (1) a 360 day year (a 182 day bill would be more than a year), (2) simple compounding, (3) you buy (and redeem) the T-Bill at par, with gains treated as interest at maturity. The last two understates the YTM. 1
Example BD method: A 182 day T-Bill is auctioned off at $9,700 (FV is $10,000). BD yield ($300/$10,000)x 360/182 =.0593 Better is the bond equivalent yield, which uses the correct number of days in the year, and assumes you purchased the Bill at a discount. BEY yield ($300/$9,700)x 365/182 =.060165 both methods use simple annualization. But that s OK, because the bond market also uses simple annualization. The BEY allows one to directly compare long- and short -term yields. The compound yield is also called the effective annual yield. Ex: a 10% coupon bond pays a 5% coupon every six months. (1+.05)-1=.1025 = 10.25% effective rate Other money market instruments we focus on: Commercial Paper: similar to a T-Bill, a discounted note issued by a major corporation, including banks. Some small default risk, fully taxable. (Jumbo) Certificates of deposit:minimum $100,000 - so some default risk (there have been defaults). Fully taxable, marketable. Eurodollar deposit: Dollar deposits in offshore foreign banks: some default risk, fully taxable. Do not confuse the eurodollar with the Euro, the new currency of the European Union Eurodollars are U.S. dollars. LIBOR and Federal Funds. London Interbank Rate is essentially the overseas Fed funds rates (used by eurodollar banks). Short-term Municipal Obligations: Issued by state or local government agencies. Not subject to Federal Income tax. Thus called tax free. However, usually subject to state income taxes if the securities are issued by some governmental unit outside the state. Ex: NYC obligations are triple tax-free for residents of New York City. Bonds and other capital market debt Four major types of U.S. bonds: Treasury Bonds Mortgage-backed Securities (GNMAs, FNMAs, Freddie Macs). Municipal Bonds Corporate Bonds. 2
Bonds and other capital market debt All the securities in these indexes tend to be investment grade and long -term. However there is a wide wide difference in yields. The differences are due more to tax status and to call/prepayment risk than to default or interest-rate risk. Bonds and Tax Status The muni yield is the lowest because the interest is tax-free (Federal at least). The Treasury is next lowest because the bonds are not subject to state or local taxes. The other two - mortgage and corporate - are fully taxable. Consider call/prepayment risk: Another reason that the Treasury yield is lower than the GNMA, etc., is that most Treasury bonds cannot be called by the issuer (refinanced). One minor exception: some Treasury bonds, only those with duel maturity dates, allow early payoff of the bonds,but only five years before the maturity date. These callable bonds were not popular and are no longer issued. Call/prepayment risk: In contrast, both municipal and corporate bonds can be called after five or ten years after issuance. Terminology: call protectionsets the period in which the borrower cannot refinance the debt. A call provisionsets the period, on or after which, the bond can be called. The two terms really tell us the same thing but the first from the investor's standpoint, the second from the borrower s standpoint. Call/prepayment risk: Mortgage-backed is a special case: these are pass throughs, homeowners pay their P&I, and the payments are passed through to the owner of the GNMA. If the homeowner sells the house or refinances the mortgage, the investor gets the investment back too early. (The timing is usually awful too - when interest rates are low). This called prepayment risk, and there is no period of protection for the investor. Otherwise GNMAs are very attractive as they have about the same credit risk as an insured bank account. Common Equity Usually when we discuss stock we are referring to common equity - which gives the investor ownership in an enterprise. Joint stock companies have been around for centuries - possibly as early as the Roman empire. Ownership gives the shareholder the right to a share of the company s profits and a say in how the company carries out its activities (voting rights) Note, in a few cases, shares are issued in two classes - with and without voting rights. 3
Common Equity The WSJ provides each stock quote with the price/earnings ratio (P/E) and the dividend yield (dividend over price - D/P). The text defines the payout ratio (dividends/earnings) as the percent of earnings directed toward payments of dividends to common stock shareholders. The percent not paid out is retained to give the retention ratio. The payout ratio equals the dividend yield times the P/E ratio: D/E = D/P x P/E. Hybrids Preferred stock is strange beast: it is often little more than an unsecured fixed income instrument, paying a dividend instead of interest and having no maturity date. May be redeemable (callable) Tends to be held by other corporations, as dividend income is partly tax free for corporations Riskier than a bond as dividends may be omitted without threat of bankruptcy. Omitted dividends are usually cumulative, however, and must be paid ahead of any common dividends. Hybrids A better example of a true hybrid include convertible bonds and convertible preferred (essentially long-term call options issued by the company). Convertible may be used to acquire newly-issued common stock at sometime in the future. Since this means more shares must be issued, these securities usually dilute the ownership share of the existing shareholders. Executive stock options are also dilutive. ADRs essentially allow foreign securities to trade in U.S. stock markets. Many foreign Blue Chips trade on the NYSE. Most trade over the counter. The ADR simply "represents" the actual foreign shares (which are deposited at a trust bank), and are not always issued "one-to-one. For the variety of ADR to stock ratios and other neat information see ADR.com Benefits over foreign shares: (1) Easier and cheaper buying and selling: All transactions are done in dollars, in the U.S. and during regular U.S. trading times. (2) Dividends automatically converted to dollars at a favorable transaction fee. (3) Financial and accounting information is required to conform (at least partially) with U.S. standards. ADRs and the underlying foreign stock are linked through the process of arbitrage: since the ADR and stock are substitutes, the arbitrageur will buy the cheapest one and sell or short -sell the more expensive one. ADRPrice$ = ForeignStockPrice * CR * E Where the FSP is in another currency, the CR is the conversion ratiobetween the ADR and the foreign stock, and E is the exchange rate in dollars per currency unit (American terms). 4
Note, the UK tends to low-priced shares because they issue extra shares through rights offerings. The Swiss rarely split shares so their stocks are high priced. The Japanese and German prices are more like Americans stocks. (Sony and Daimler-Chrysler shares are each equal to the ADRs.) Glaxo sells in London for 12 pounds, there are two foreign shares for one ADR and the pound is worth $1.60. What should the ADR sell for? L12/share * 2sh/adr * $1.60/ = $ 38.40/adr Derivatives These are securities whose values are derived from the value of another (underlying) security. Essentially two types: futures and options. Futures are simply binding obligations to buy or sell the underlying security or commodity at some specified time in the future. Like futures, but options give the owner the choice, when the time comes, to buy the security (if a call option) or sell the security (if a put option). Derivatives Derivatives are sometimes thought of as risky - especially futures, as the speculator only has to put up a small good-faith deposit to enter into a futures contract. Leverage is often 20 to 1 equivalent to a five percent down payment Derivatives are useful in hedging and portfolio insurance. If the buyer of future or option makes a gain (or loss), the seller suffers a similar loss (or gain). Some call derivatives a zero -sum game 5