Chapter 3 SELECTING INVESTMENTS IN A GLOBAL MARKET Chapter 3 Questions Why should investors have a global perspective regarding their investments? What has happened to the relative size of U.S. and foreign stock and bond markets? How can changes in currency exchange rates affect the returns that U.S. investors experience on foreign securities? What advantage is there to diversifying in international markets? Chapter 3 Questions What alternative securities are available? What are their cash flow and risk properties? What are the historical return and risk characteristics of the major investment returns? What is the relationship among the returns for foreign and domestic investment instruments? What is the implication of these relationships for portfolio diversification? Why have a global perspective? The foreign market for stocks and bonds is huge! U.S. markets comprise less than half of the total available securities More opportunities broaden the range of risk- return choices Returns on non-U.S. securities have often exceeded U.S. securities Higher returns on equities are explained by higher growth rates in some countries Why have a global perspective? Diversification with foreign securities can help reduce portfolio risk. Since foreign investments are impacted by somewhat different forces than domestic investments, risks can be reduced. It’s easier than ever before! Barriers to global investing, both for companies and for individual investors, are getting smaller. Relative Size of U.S. and Foreign Markets The overall value of world financial markets has seen explosive growth ($2.3 trillion in 1969 to $63.8 trillion in 2000) The U.S. share of the overall world financial markets has gone from well over half (65% in 1969) to less than half (48% in 2000). For the equities market, the U.S. market was about 49% of the world market in 2000. See Exhibits 3.1 and 3.2 The Effect of Changing Exchange Rates For U.S. investors, a foreign security’s return in its domestic market is not the “bottom line.” Exchange rates have a major impact on the equivalent U.S. return on a foreign investment. The key factor is the changing strength of the U.S. dollar vis-à-vis the foreign currency. The Effect of Changing Exchange Rates Stronger dollar: Income from foreign investments get exchanged for fewer dollars over time, reducing net return for the U.S. investor. Weaker dollar: Income from foreign investments get exchanged for more dollars over time, increasing net return for the U.S. investor. Diversification in International Markets Can we reduce risk through international diversification? U.S. returns appear to give better performance on a risk per unit of return basis (lower Coefficient of Variation, see Exhibit 3.6) after considering exchange rate risk. While it may seem strange that combining apparently riskier investments with less risky investments can reduce risk, it works! The key reason: Correlation Diversification in International Markets Recall that diversification involves risk reduction. Correlations range from +1 (perfect positive correlation) to –1 (perfect negative correlation) By combining securities whose returns are not perfectly positively correlated with each other in a portfolio, the portfolio standard deviation characteristically falls. The lower the correlation coefficient between investments, the greater the benefit of diversification. Diversification in International Markets Correlations between U.S. markets and major foreign markets are relatively low. In bond markets, the correlations, while positive, are all below +.50 In equity markets, the correlations are a bit higher, but still relatively low with an average of about +.54 The bottom line: there is considerable benefit to international diversification. Portfolios that are diversified internationally tend to have substantially lower standard deviations. Diversification in International Markets Several words of caution: Correlations vary greatly between pairs of counties. As you might guess, there is a higher correlation between U.S. and Canadian returns than between U.S. and various European returns. Not all international diversification is created equal! Correlations are increasing over time. As global competition and various regulatory barriers have fallen, correlations have increased. Global Investment Choices Focus on capital market securities (at least one year to original maturity) Fixed-Income Investments Bonds, Preferred Stock Equities Derivatives Futures, Options Indirect, Managed Investments Mutual Funds, Hedge Funds Fixed Income Investments Except for preferred stock, fixed income securities are debts of the issuer. Promise specified cash flows at pre- determined times. Legal force behind the agreement varies by type of security and issuer, as does the corresponding risk borne by the investor. Fixed Income Investments Most fixed income instruments specify a number of features including the following: The maturity date – the date that the obligation is to be fully repaid, according to its provisions. The coupon – the income that the investor will receive each year. The par value – the principal value of the obligation; usually the original value and also the amount to be returned to the investor on the maturity date. Fixed Income Instruments U.S. Treasury Securities U.S. Government Agency Securities Municipal Bonds Corporate Bonds Other Fixed Income Instruments U.S. Treasury Securities Bills, notes, or bonds - depending on maturity Bills mature in less than 1 year Notes mature in 1 - 10 years Bonds mature in over 10 years Highly liquid Very low risk of default, so essentially no credit risk U.S. Government Agency Securities Sold by government agencies Federal National Mortgage Association (FNMA or Fannie Mae) Federal Home Loan Bank (FHLB) Government National Mortgage Association (GNMA or Ginnie Mae) Federal Housing Administration (FHA) Not direct obligations of the Treasury Still considered default-free and fairly liquid Municipal Bonds Issued by local governments General obligation bonds (GOs) Revenue bonds Exempt from federal income taxes and often state income taxes Popular instrument for high tax bracket investors. Corporate Bonds Debt securities issued by corporations. Vary by: Level of claim (security) Credit quality Term to maturity Special features Corporate Bonds: Secured or Unsecured? Secured bonds feature some sort of collateral to protect the investor. Mortgage bonds: backed by land and buildings Collateral trust bonds: backed by financial assets Equipment trust certificates: backed by specific pieces of equipment Unsecured bonds or debentures are backed only by the firm’s promise to pay. Subordinated debentures: lower priority claim Income bonds: pay only if profits are earned Corporate Bonds: Special Provisions The bond contract (the indenture) may include several important provisions that can influence the actual maturity of the bond. Call provision: allows the issuer to buy back or “call in” the bond prior to maturity at a specified call price Bonds range from freely callable (can be called any time) to non-callable Most have deferred calls, which are non-callable for a period of time, then freely callable Corporate Bonds: Special Provisions Sinking fund provision: requires the issuer to retire a portion of a bond issue prior to maturity. Like a call provision, the investor would typically receive a specified call price under a sinking fund provision. Both call provisions and sinking fund provisions can shorten the actual maturity of a bond. Other Fixed Income Instruments Convertible Bonds: Corporate bonds with the added option to exchange them for a fixed number of shares of common stock. Usually lower interest rates than if the same bond was not convertible Bonds with Warrants Allows bondholder to purchase the firm’s common stock at a fixed price for a given time period Usually lower interest rates on bonds with warrants attached Other Fixed Income Instruments Collateralized Mortgage Obligations (CMOs): securities that “pass through” the payments that borrowers make on mortgages, with specific distribution rules that apply to different classes of these instruments. Other asset-backed securities as well, such as certificates for automobile receivables (CARs) Zero coupon bonds: bonds that pay low or no coupon interest, and instead provide their return only in the form of price appreciation. Sell at a discount from par, mature to par value. International Bond Investing Eurobond: an international bond that pays cash flows in a currency not native to the country of issue Eurodollar bonds are denominated in U.S. dollars, but sold outside of the U.S. Yankee bond: a bond denominated in U.S. dollars, sold in the U.S., but issued by a foreign corporation or government International domestic bonds: U.S. investor in a foreign bond, subject to exchange rate risk. Bond Ratings Most bonds are rated for default, or credit risk by one or more rating agency. Duff and Phelps, Fitch Investors Service, Moody’s, Standard & Poors (S & P) Ratings from AAA to D, some agencies give slightly different modifiers or letters Top four ratings (AAA down to BBB): Investment Grade Securities Below the top four ratings: Speculative Grade Securities (High-yield or junk bonds) Preferred Stock Classified as a fixed income security since yearly dividends are stipulated. Preferred dividends are not legally binding, so preferred stock is technically not a debt. Since corporations are loathe to miss a dividend, they are binding in practical terms. Much of the outstanding preferred stock is held by other corporations. 80% of dividends received by one corporation from another are excluded from taxable income Equities Returns are not contractual. Instead, returns vary according to performance, and can be much better or much worse than fixed income investments. Equity represents an ownership interest. The owner gets as much or as little as is left over after all fixed and higher priority claims have been met. Most common equity investment: Common Stock Common Stock Represents the ownership of a corporation Relatively risky investment compared to fixed income securities Investment considerations include choice of business group or sector and at industries within those broad groups Business groups: Industrial firms, Utilities, Transportation firms, Financial Institutions Foreign Equity Investments Several means of obtaining an equity interest in foreign investments: Through American Depository Receipts (ADRs) Through direct investment in foreign shares listed on a U.S. or foreign stock exchange Through indirect investment in international or global mutual funds American Depository Receipts Easiest way to acquire foreign shares Certificates issued by a U.S. bank Represent indirect ownership of shares of a foreign firm on deposit in a bank in the firm’s home country Buy and sell in U.S. dollars Dividends in U.S. dollars May represent multiple shares Very popular, over 1500 ADR programs available in 2002 Direct Investment in Foreign Shares The most difficult approach, especially when purchasing stock in the foreign country (in the foreign currency) and transferring back to the investor’s home country. A growing number of foreign firms do list their stock directly on the NYSE. International and Global Mutual Funds Global funds: invest in both U.S. and foreign stocks International funds: invest mostly outside the U.S. Funds can specialize Diversification across many countries Concentrate in a segment of the world Concentrate in a specific country Concentrate in types of markets Derivative Securities There are many types of derivative investments, including financial derivative securities whose payoffs are tied to various financial assets. Options Warrants Puts and calls Futures contracts Option Contracts Warrants Give the owner the right to purchase a company’s common stock from the company at a specified price within a designated period of time. Puts and calls Give the owner the right to sell (put) or buy (call) a company’s stock within a specified period of time at a specified price (called the striking price). Futures Contracts Standardized contracts to make or take delivery of some financial (or other) asset in exchange a specified payment at a future date. Payment not due until the future date, but margin (a good faith deposit) is required. Futures contracts are often used to manage risk, especially the risk of changing interest rates. Managed Investments Investment companies sell shares in themselves and use the proceeds to invest in other investment instruments. Closed-end investment companies: offer a fixed number of shares. Open-end investment companies (Mutual funds): offer fluctuating number of shares based on purchases/sales of fund shares. Stock funds, Bond funds, Money market funds, Mixed funds Managed Investments Hedge Funds: typically act as a partnership where one partner manages funds for all other partners according to some investment strategy. Venture capital pools: Similar to hedge funds, these partnerships obtain an equity interest in promising start-up or privately held firms. Real Estate Investment Trusts (REITs): provides investors with an indirect means of investing in real estate. Historic Return and Risk Characteristics Historic investment results have been studied extensively. Ibbotson and Sinquefield (I&S) data chronicle rates of return for major classes of assets in the United States 1. Large-company common stocks 2. Small-capitalization common stocks 3. Long-term U.S. government bonds 4. Long-term corporate bonds 5. Intermediate-term U.S. Treasury bills 6. U.S. Treasury bills Summarizing the Historic Data History confirms the relationship between risk and return. The higher returning classes of investments (common stock, especially small-cap firms) have experienced greater volatility. Adjusting for inflation, thereby creating real returns, shows a small positive real interest rate for the lowest risk investment (T-bills: .72%) Summarizing the Historic Data The historical data also allows for the calculation of average premiums earned Equity risk premium = Common Stock return minus T-bill return = 6.97% Small-stock premium = Small stock return minus Large stock return = 1.22% Horizon premium = Long-term T-bond return minus T-bill return = 1.45% Default premium = Long-term Corporate bond return minus Long-term T-bond return = .36% World Portfolio Performance Examination of historical returns largely confirm expectations. Riskier assets also have had higher average returns. Coefficients of variation range widely, with the combined World Stock Index having a low CV, showing benefits of global diversification. Correlations between asset returns vary by global regions, also showing the potential, but variant advantages to global diversification.