Chapter 2 Investment Alternatives

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					Chapter 2: Investment
Alternatives
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.
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)
Bonds cont’d…
   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.
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.
Bonds cont’d…
   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.
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
    government’s 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.
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.
Corporate Bonds cont’d…

   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 issuer’s overall
    financial soundness.
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.
ABS – Asset-Backed Securities cont’d…

   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.
MBS’s cont’d…
   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.
Marketable Securities cont’d…

   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!
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.
Risks cont’d…

   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.
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.
Preferred Share cont’d
   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 investor’s point of view.
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.
Income Trusts Cont’d
   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.
Income Trusts Cont’d

   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.
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.
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.
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.
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.
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.
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.
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
    company’s annual report), the book value per share
    was $12.88. (11.910 billion/923.989million)
   At the time the observation for BCE Inc’s book
    value was recorded, the market price was in the
    $29 range. This implies that BCE’s market to book
    ratio was $29/$12.88= 2.25
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.
BCE cont’d…

   At the time the observation for BCE
    Inc.’s book value was recorded, the
    market price was in the $29 range.
    This implies that BCE’s market-to-book
    ratio was $29.00/$12.88=2.25
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.
Dividend Yield

   The income component of a stock’s
    return stated on a percentage basis.
   It is commonly calculated as the most
    recent annual dividend amount divided
    by the current market price.
Payout Ratio

   The ratio of dividends to earnings.
   It indicated the percentage of a firm’s
    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 firm’s current earning
    retained by it for reinvestment purposes.
Payout Ratio for BCE Inc.

   BCE Inc’s 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 %)
Dividends cont’d…

   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.
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.
Important Dates cont’d…

   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.
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.
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.
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.
   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.

				
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