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Starting Early & Compounding
The earlier you start saving for retirement, the easier it will be to afford, given the number of financial obligations that tend to be incurred later in life Understanding the effects of compounding will illustrate how, in the retirement game, the early bird really does get the worm The sooner you invest, the more time your money has to grow COMPOUNDING
± The ability of an asset to generate earnings which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings. Also known as compound interest
What is inflation?
± Sustained increase in the general level of prices for goods and services ± Measured as an annual percentage increase ± As inflation rises, every dollar you own buys a smaller percentage of a good or service
Causes of Inflation
± Demand Pull Inflation
too much money chasing too few goods If demand is growing faster than supply, then prices will increase
± Cost Push Inflation
When companies costs go up, they need to increase prices to maintain profit margins Increased costs can include things such as wages, taxes, or increased costs of imports
Variations on Inflation Deflation ± General decline in prices. often caused by a reduction in the supply of money or credit ± Deflation has the side effect of increased unemployment since there is a lower level of demand in the economy. which can lead to an economic depression Hyperinflation ± Extremely rapid or out of control inflation Stagflation ± A condition of slow economic growth and relatively high unemployment a time of stagnation accompanied by a rise in prices. or inflation .
it is not as impressive . but when you factor in inflation.Inflation What is money illusion? ± Difference between nominal changes and real changes in money Return on risk free cash investments may look good.
Risk Appetite What is risk appetite? Is it important to know one s risk taking capability? What happens typically when one of your well chosen investments decline for a year or two? What do you do? ± Do you exit? ± Do you buy more? .
of our original investment Technically.Risk return trade-off The ability to sleep at night test ± Deciding what amount of risk you can take on while still being able to feel comfortable about your investments is a very important decision What is risk? ± The chance that an investment s actual return will be different than expected ± Risk is the possibility of loosing some. this is measured in statistics by standard deviation ± Standard deviation is applied to the annual rate of return of an investment to measure the investment s risk (volatility) . or even all.
Risk return trade-off Low levels of uncertainty (low risk) are associated with low potential returns High levels or uncertainty (high risk) are associated with high potential returns The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return A higher standard deviation means a higher risk and a higher possible return .
Diversification Outline goals and risk-orientation Don t put all your eggs in one basket! Diversification would depend on what the investor s circumstances. and objectives are Ensure that the investor is not reliant or dependent on the performance of one asset class or particular investment vehicle Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio Diversification lowers the risk of your portfolio . needs.
mutual funds and perhaps even some real estate 2. this will ensure that large losses are offset by other areas 3. You are not restricted to choosing only blue chip stocks.Diversification Three practices to ensure best diversification 1. Vary your securities by industry. Vary the risk in your securities. Spread your portfolio among multiple investment vehicles cash. In fact. bonds. stocks. it would be wise to pick investments with varied risk levels. This will minimize the impact of industry-specific risks .
Time Horizon How long are you planning to invest for? Difference between short term and long term financial needs Are you a short term player (less than one year) Are you going to need the money invested in the stock market over the next 2-3 years Invest in the stock markets only if there is a long term plan .
the average investor in a stock mutual fund earned 6.7% a year Fact#2: From 1984 through 1995. the average stock mutual fund in the USA posted a yearly return of 12. while the average investor in a bond mutual fund earned 8% What s wrong with this picture? .3%.Market Timing MF s vs.3%. MF holders Activity act#1: From 1984 through 1995. while the average bond mutual fund returned 9.
not Timing the market that s important Types of Investment Strategies ± Buy and Hold Strategy: Invest in a few well researched funds and hold onto them for a long time through thick and thin ± Flit in and out of a variety of funds. in an effort to maximize results .Market Timing Time is the key to successful investing It s time in the market.
SIP s What is market volatility? ± How does it affect investments? ± Is volatility good or bad? ± How does one use volatility to one s advantage? Activity David invests $6000 as a lump sum investment Peter invests the same amount. who has a higher probability of having earned more return on investment David or Peter? . but in multiples of $1000 each month for 6 months. Given a simulated market volatility environment.
regardless of the share price. a fixed dollar amount of a particular investment on a regular schedule Benefits of DCA? ± ± ± ± You gain whether the share prices go up or down When they go up. the value of the investment you have already goes up When they go down.Dollar Cost Averaging Ask any professional investor What is the hardest investment task? ± Picking the bottoms and tops in the market ± Trying to time the market is a very tricky strategy ± Solution Dollar Cost Averaging (DCA) What is Dollar Cost Averaging? ± The process of buying. you get more units for the same price Your entire capital is not at risk because it is being drip-fed into the market .
The inherent volatility of equity prices is used to enhance returns while reducing the time your entire capital is exposed to the market .
so each will behave differently over time The underlying principle or asset allocation is that the older a person gets. you may have to depend on your savings as your only source of income. stocks.Asset Allocation Asset allocation is an investment portfolio technique that aims to balance risk and create diversification by dividing assets among major categories such as bonds. Hence you should invest more conservatively because asset preservation is crucial at this time in life . and cash Each asset has different levels of return and risk. real estate. the less risk he or she should take on After you retire.
but that over a period of time. prices maintain an upward trend In short random walk says that stocks take a random and unpredictable path .Random Walk Theory Random Walk Theory gained popularity in 1973 when Burton Malkiel wrote A Random Walk Down Wall Street a book that is now regarded as an investment classic Random walk is a stock market theory that states that the past movement or direction of the price of a stock or overall market cannot be used to predict its future movement Stock price fluctuations are independent of each other and have the same probability distribution.
probably because it condemns the concepts on which it is based such as analysis and stock picking . fundamental. Attempts based on technical.Random Walk Theory The chance of a stock s future price going up is the same as it going down A follower of random walk believes it is impossible to outperform the market without assuming additional risk Malkiel constantly states that a long term buy and hold strategy is the best and that individuals should not attempt to time the markets. or any other analysis are futile Random walk has never been a popular concept with those on Wall Street.
you are engaging in a game of chance. it means that prices always reflect all information. ± If markets are efficient and current. not skill. so there is no way you will ever be able to buy a stock at a bargain price .Efficient Market Hypothesis Efficient market hypothesis is an idea developed in the 1960s by Eugene Fama ± It is impossible to beat the market because prices already incorporate and reflect all relevant information Supporters of this model believe it is pointless to search for undervalued stocks or try to predict trends in the market through fundamental analysis or technical analysis ± Any time you buy and sell securities.
Because stock prices are largely based on investor expectations. track records and other indicators.Efficient Market Hypothesis Highly controversial and often disputed theory The theory has been met with a lot of opposition. especially from the technical analysts Their argument against the efficient market theory is that many investors base their expectations on past prices. many believe it only makes sense to believe that past prices influence future prices . past earnings.
The Optimal Portfolio This theory assumes that investors try as much as possible to avoid risk while obtaining the highest return possible Investors will act rationally in making decisions based on maximizing their return for the level of risk that is acceptable for them The Optimal Portfolio shows us that it is possible to have a different number of portfolios that have varying levels of risk and return ± Each investor must decide how much risk they can handle and allocate (or diversify) their portfolio accordingly to this decision .
The Optimal Portfolio .
and serves as a model for the pricing of risky securities ± CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium ± If this expected return does not meet or beat our required return then the investment should not be undertaken ± Formula to describe the CAPM relationship Required (or expected) Return = RF Rate + (Market Return RF Rate) * Beta .Capital Asset Pricing Model CAPM describes the relationship between risk and expected return.
9 means it is more risky than the overall market ± This extra risk means we should expect a higher potential return than the 12% for the S&P 500 Required (or expected) Return = 5% + (12% .3% .5%) * 1.Capital Asset Pricing Model Lets take an example Current risk rate = 5% S&P 500 is expected to return 12% next year You are interested in determining the return that Joe s Oyster Bar Inc (JOB) will have next year JAB has a beta value of 1.9 ± Overall stock market has a beta of 1 ± JOB s beta of 1.9 Required (or expected) Return = 18.
regardless of the share price . it is not as impressive The risk/return tradeoff is the balance between the desire for the lowest possible risk against the highest possible return More risk equals greater possible return Diversification lowers the risk of your portfolio Dollar cost averaging is a technique where a fixed dollar amount is invested on a regular schedule. but when you factor in inflation.Conclusion Your investments gain most from compounded interest when you have time on your side Investing late means you need to invest that much more to derive a similar return on investment Return on risk free cash investments may look good.
and serves as a model for he pricing or risky securities .Conclusion Asset allocation divides assets among major categories in order to create diversification and balance the risk Random Walk Theory says that stocks take a random and unpredictable path Efficient Market Hypothesis (EMH) says it is impossible to beat the market because prices already incorporate and reflect all relevant information Optimal portfolio is a model that attempts to show how rational investors will maximize their return for the level or risk that is acceptable to them CAPM describes the relationship between risk and expected return.
FINANCIAL MARKETS [AN
FINACIAL MARKETS AN INTRODUCTION Purpose
± An introduction to financial markets ± Covers the role of the financial markets and their key functions including borrowing & lending, price determination, information aggregation and coordination, risk sharing, liquidity and efficiency ± Covers the major players in the market like brokers, dealers, Investment banks, financial intermediaries etc as well as financial market structures like auction markets, OTC markets, organized exchanges, intermediation financial markets, security markets
± Anything of durable value ± Anything that acts as a means of storing value over a period of time
± Assets in physical form (house, land, equipment etc) ± Including human capital assets embodied in people (skills, natural abilities, knowledge etc)
± Claims against real assets either directly (stock share equity claims) or indirectly (money holdings or claims to future income streams that originate ultimately from real assets)
. i.Basic terms Securities ± Financial assets exchanged in auction and over-the-counter markets whose distribution is subject to legal requirements and restrictions (e.g. by selling the lenders newly issued financial assets . information disclosure requirements) Lenders ± People who have available funds in excess of their desired expenditures that they are attempting to loan out Borrowers ± People who have a shortage of funds relative to their desired expenditures who are seeking to obtain loans..e. Borrowers attempt to obtain funds from lenders by selling to lenders newly issued claims against the borrowers' real assets.
S..Basic terms Financial markets ± A market in which financial assets are traded Enable exchange of previously issued financial assets Facilitate borrowing and lending by facilitating the sale by newly issued financial assets Examples of financial markets include ± The New York Stock Exchange (resale of previously issued stock shares) ± The U.g. . Treasury bills auction (sales of newly issued T-bills) ± An institution whose primary source of profits is through financial asset transactions Examples of such financial institutions include ± ± ± ± Discount brokers (e.S. government bond market (resale of previously issued bonds) ± U. Charles Schwab and Associates) Banks Insurance companies Complex multi-function financial institutions such as Merrill Lynch.
Functions of Financial Markets Six basic functions ± Borrowing & Lending Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes ± Price determination Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets ± Information aggregation & coordination Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers .
Functions of Financial Markets Six basic functions ± Risk sharing Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments ± Liquidity Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets ± Efficiency Financial markets reduce transaction costs and information costs .
one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured .In attempting to characterize the way financial markets operate.
.Major players in financial markets By definition. i.e. in the creation and/or exchange of financial assets. financial institutions are institutions that participate in financial markets. financial institutions can be roughly classified into the following four categories ± ± ± ± Brokers Dealers Investment banks Financial intermediaries . At present in the United States.
that is. the broker does not maintain inventories in these assets Profits of brokers are determined by the commissions they charge to the users of their services (either the buyers. the sellers. or both) Brokers could mean the inclusion of real .Brokers A commissioned agent of a buyer (or seller) who facilitates trade by locating a seller (or buyer) to complete the desired transaction A broker does not take a position in the assets he or she trades -.
Illustration of a stock broker Payment Stock Buyer ---------------Payment ------------>| |-------------> | | Stock | Stock Broker | Seller <-------------|<----------------|<------------Stock | (Passed Thru) | Stock Shares ----------------Shares .
They make profits by buying assets at relatively low prices and reselling them at relatively high prices (buy low . government bonds.e..sell high) The price at which a dealer offers to sell an asset (the "asked price") minus the price at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread and represents the dealer's profit margin on the asset exchange Real-world examples of dealers include car dealers. maintain inventories) in the assets he or she trades that permit the dealer to sell out of inventory rather than always having to locate sellers to match every offer to buy ± Dealers do not receive sales commissions.Dealers Like brokers ± Dealers facilitate trade by matching buyers with sellers of assets ± They do not engage in asset transformation Unlike brokers ± A dealer can and does "take positions" (i.S. and Nasdaq stock dealers . dealers in U.
Illustration of a bond dealer Payment ----------------Payment Bond Buyer ------------>| |-------------> | Dealer | Bond | | Seller <-------------| Bond Inventory |<------------Bonds | | Bonds ----------------- .
± Sales Assistance: Assisting in the sale of these securities to the public. either individually or by having several different investment banks form a syndicate to underwrite the issue jointly. and.Investment banks An investment bank assists in the initial sale of newly issued securities (i. . in IPOs = Initial Public Offerings) by engaging in a number of different activities: ± Advice: Advising corporations on whether they should issue bonds or stock. for bond issues. ± Underwriting: Guaranteeing corporations a price on the securities they offer.e. on the particular types of payment schedules these securities should offer..
financial intermediaries make profits by charging relatively high interest rates to borrowers and paying relatively low interest rates to savers .e.Financial intermediaries These are financial institutions that engage in financial asset transformation ± i. a deposit account ± They also typically hold financial assets as part of an investment portfolio rather than as an inventory for resale.. they purchase one kind of financial asset from borrowers (generally some kind of long-term loan contract whose terms are adapted to the specific circumstances of the borrower .g.. In addition to making profits on their investment portfolios.e.e. a mortgage) and sell a different kind of financial asset to savers (generally some kind of relatively liquid claim against the financial intermediary .g.
mutual savings banks. government retirement funds ± Investment Intermediaries Finance companies.Financial intermediaries Types of financial intermediaries include ± Depository Institutions Commercial banks. savings and loan associations. stock and bond mutual funds. pension funds. credit unions ± Contractual Savings Institutions Life insurance companies. fire and casualty insurance companies. money market mutual funds .
... B=Commercial Bank...................> | B | ------loan ------contracts Loan contracts issued by F to B are liabilities of F and assets of B NOTE: F=Firms...... | | | F |........ and H=Households .. | | ......Illustration of a Financial Intermediary: A Commercial Bank Lending by B Borrowing by B deposited funds ------<...........> | H | deposit ------accounts Deposit accounts issued by B to H are liabilities of B and assets of H ------funds ------| |<.
a financial intermediary (e.g. a dealer (taking positions in certain stocks and bonds it sells). and many actual financial institutions in the fast-changing financial landscape today engage in activities that overlap two or more of these classifications. through its provision of mutual funds and CMA checkable deposit accounts)..Caution: These four types of financial institutions are simplified idealized classifications. A prime example is Merrill Lynch. or even to some extent fall outside these classifications. which simultaneously acts as a broker. and an investment banker .
like an auction. the NYSE.Types of financial market structures What determines the types of financial market structures that may emerge? ± The costs of collecting and aggregating information These financial market structures take four basic forms ± Auction markets conducted through brokers ± OTC (over the counter) markets conducted through dealers ± Organized exchanges E. securities are traded on the floor of the exchange with the help of specialist traders who combine broker and dealer functions. Specifically. which combines auction and OTC market features.g. The specialists broker trades but also stands ready to buy and sell stocks from personal inventories if buy and sell orders do not match up ± Intermediation financial markets conducted through financial intermediaries Note: Financial markets taking the first three forms are generally referred to as securities markets . organized exchanges permit buyers and sellers to trade with each other in a centralized location. However.
execute trades in an open and competitive bidding process The "centralized facility" is not necessarily a place where buyers and sellers physically meet.. it is any institution that provides buyers and sellers with a centralized access to the bidding process All of the needed information about offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which is readily accessible to all would-be buyers and sellers. Rather. e. through their commissioned agents (brokers). through a computer network No private exchanges between individual buyers and sellers are made outside of the centralized facility .Auction markets It is some form of centralized facility (or clearing house) by which buyers and sellers.g.
for which bid and asked prices can be posted at any time the market is open and exchanges take place on a continual basis . for which bid and asked prices are all posted at one time ± or continuous markets such as stock exchanges and real estate markets.Auction markets This is typically a public market in the sense that it open to all agents who wish to participate Auction markets can either be ± call markets such as art auctions.
Treasury bills. some auction markets (e. in second-hand jewelry. paintings etc.g. This inspection tour can take the form of a ± Warehouse tour ± A catalog issued with pictures and descriptions of items to be sold ± Or (in televised auctions) a time during which assets are simply displayed one by one to viewers prior to bidding. .) allow would-be buyers to inspect the goods to be sold prior to the opening of the actual bidding process.g. notes & bonds) to cut down on information costs Alternatively. furniture..Auction markets Many auction markets trade in relatively homogeneous assets (e.
auction markets depend on volume to spread these costs over a wide number of participants .Auction markets Auction markets depend on participation for any one type of asset not being too "thin" The costs of collecting information about any one type of asset are sunk costs independent of the volume of trading in that asset ± Consequently.
because dealers can offset imbalances in the demand and supply of assets by trading out of their own accounts. the dealers themselves post bid and asked prices for this asset and then stand ready to buy or sell units of this asset with anyone who chooses to trade at these posted prices. or indeed the world. a country. ± The dealers provide customers more flexibility in trading than brokers. ± That is. who make the market in some type of asset.OTC (Over the counter) markets This has no centralized mechanism or facility for trading Instead. the market is a public market consisting of a number of dealers spread across a region. Many well-known common stocks are traded over-the-counter in the United States through NASDAQ (National Association of Securities Dealers Automated Quotation System) .
Intermediation Financial Markets This is a financial market in which financial intermediaries help transfer funds from savers to borrowers by issuing certain types of financial assets to savers and receiving other types of financial assets from borrowers The financial assets issued to savers are claims against the financial intermediaries. whereas the financial assets received from borrowers are claims against the borrowers. hence assets of the financial intermediaries . hence liabilities of the financial intermediaries.
What are Equities?
± An equity is a security that confers on the holder an ownership interest in the issuer
So, what are the key types of securities? To understand this, let s examine two categories of securities markets
± Primary market & Secondary market ± Debt market & Equity market
Primary and Secondary markets
± These are securities markets in which newly issued securities are offered for sale to buyers
± These are securities markets in which existing securities that have previously been issued are resold.
The initial issuer raises funds only through the primary market
. regardless of the success or failure of any investment projects for which the borrowed funds are used ± A debt instrument holder only participates in the management of the debt instrument issuer if the issuer goes bankrupt ± An example of a debt instrument is a 30-year mortgage.Debt and Equity markets Debt ± Debt instruments are particular types of securities that require the issuer (the borrower) to pay the holder (the lender) certain fixed dollar amounts at regularly scheduled intervals until a specified time (the maturity date) is reached.
Debt and Equity markets Equity ± An equity is a security that confers on the holder an ownership interest in the issuer ± There are two general categories of equities Preferred stock and Common stock .
Common stock Common stock shares issued by a corporation are claims to a share of the assets of a corporation as well as to a share of the corporation's net income ± i.. including the payment of any debt obligations ± This implies that the return that holders of common stock receive depends on the economic performance of the issuing corporation.e. the corporation's income after subtraction of taxes and other expenses. .
and ± By enjoying an appreciation in the price of their stock shares However. a corporation might instead choose to keep its profits as retained earnings to be used for new capital investment (self-financing of investment rather than debt or equity financing). the payment of dividends is not a contractual or legal requirement ± Even if net earnings are positive. . a corporation is not obliged to distribute dividends to shareholders For example.Common stock Holders of a corporation's common stock typically participate in any upside performance of the corporation in two ways ± By receiving a share of net income in the form of dividends.
$100). and ± Pay a fixed dividend expressed as a percentage of par value Preferred stock is a claim against a corporation's cash flow that is prior to the claims of its common stock holders but is generally subordinate to the claims of its debt holders In addition. like debt holders but unlike common stock holders.Preferred stock Preferred stock shares are usually issued ± With a par value (e..g.g. preferred stock combines some of the basic attributes of both debt and common stock and is often referred to as a hybrid security .. preferred stock holders generally do not participate in the management of issuers through voting or other means unless the issuer is in extreme financial distress (e. insolvency) Consequently.
at some point. Equity . and ± Equity financing When the company issues stock of the company Issuing stock is advantageous for a company because ± It does not require them to pay back the money or ± To make interest payments along the way .Debt vs. all companies need to raise money A company has two avenues to raise money ± Debt financing When the company takes a loan from the bank or issues bonds.basics Why does a company issue stock when it can keep all the profits to themselves? ± Because.
Debt vs. if the company is successful. and ± Promised interest payments An equity investment does not guarantee either ± If the company goes bankrupt. as an equity investor you stand to earn more than the bond holders . it guarantees ± The principal payment.basics When you buy a debt investment like a bond. Equity . as an equity investor you get paid only after the banks (creditors) and the bond holders have been paid However.
sometimes known as market value Market cap is calculated by multiplying a company s current stock price by the number of its existing shares For eg ± A stock with a current market value of $30 a share and a hundred million shares of existing stock would have a market cap of $3 billion .Market Capitalization One of the main ways to categorize stocks is by their market capitalization.
or stocks with even smaller market capitalization In general large cap stocks are less volatile than small-cap stocks . and small-cap.Market Capitalization contd Stocks are usually designated large-cap. Some experts also add a special category of micro-caps. medium or mid-cap.
Market Capitalization .
Ways to purchase Stock Using a Brokerage DRIPs or DIPs .
Using a Brokerage Full Service Brokerage ± Offer expert advice ± Manage your account ± Expensive Discount Brokerage ± Less personal attention ± Much cheaper .
DRIPs or DIPs Dividend Reinvestment Plans (DRIPs) or Direct Investment Plans (DIPs) ± Plans with which individual companies. allow shareholders to purchase stock directly from the company ± DRIPs are great ways to invest small amounts of money at regular intervals . for a minimal cost.
Animals in the Farm Bulls Bears Chickens Pigs .
Animals in the Farm contd BULLS When everything in the economy is great people are finding jobs. believing that stocks will go up. GDP is growing. and stocks are rising Picking stocks during a bull market is easier because everything is going up If a person is optimistic. he or she is called a bull and is said to have a bullish outlook .
Animals in the Farm contd BEARS When the economy is bad. recession is looming. believing that stocks are going to drop. and stock prices are falling Bear markets make it tough for investors to pick profitable stocks One solution to make money when stocks are falling is using a technique called short selling If a person is pessimistic. he or she is called a bear and is said to have a bearish outlook .
Animals in the Farm contd CHICKENS Afraid to lose anything Their fear overrides their need to make profits and so they turn only to money market securities or get out of the markets altogether .
as its often from their losses that the bulls and bears reap their profits .Animals in the Farm contd PIGS High risk investors looking for that one big score in a short period of time Pigs buy on hot tips and invest in companies without doing their due diligence Professional traders love the pigs.
Common Investor Behavior There are various types of investment styles and strategies Even though the bulls and the bears are constantly at odds. though not a lot The only loser is the pig! . they can both make money with the changing cycles in the market Even the chickens see some returns.
Common Investor Behavior contd Make sure you don t get into the market before you are ready Be conservative and never invest in anything you do not understand Before you jump in without the right knowledge. but pigs just get slaughtered!! . bears make money. think about the old market saying Bulls make money.
BONDS Primary & Secondary Markets .
where bonds are available directly to investors without any intermediary or any commission Brokers and banks may buy large amount of bonds in the primary market. where bonds are bought and sold after they are issued It is common for a bond to change hands a number of times in the secondary market before it matures .Introduction Newly issued bonds are sold in the primary markets. and then sell them to investors in the secondary market.
500 in interest ($450 a year for ten years) and get $10. the rate and the yield are both 4. you typically pay par value.5%.5% at issue and hold your investment to maturity. or sold for the first time. You would earn $4. and the yield is the same as the coupon rate At maturity you get par value back Example ± If you buy $10. you earn the coupon rate for as long as you own the bond.000 worth of 10 year fixed-rate bonds paying 4.The Primary Market If you buy a bond when its issued.000 back at the end of the term . or the face value of the bond If you hold the bond until it matures.
at a premium.The Secondary Market When you buy or sell bonds after the date they are issued. they trade on what s known as the secondary market. This is where most bond trading occurs The corporation. or at a discount . you may buy at par value. or agency that issued the bond gets no income from these secondary trades as it does when it first issues the bonds in the primary market When the bond matures. the issuer repays the par value to the current owner If you buy in a secondary market. government.
The Secondary Market Buying at a premium contd ± You pay more than the par value ± Usually bonds sell at a premium when their coupon rate is higher than the prevailing rate on similar bonds ± Although you ll earn a higher rate. your yield will be lower than the bond s coupon rate since you paid more for the bond Buying at a discount ± You pay less than par ± Bond is likely to be paying an interest rate that is lower than the current rate ± Yield will be higher than the coupon rate since you paid less for the bond .
US BOND MARKET .
3 main groups ± ISSUERS Sell bonds or other debt instruments Governments.Introduction Bond Market Bond market . other investors & individuals . Banks & Corporations ± UNDERWRITERS helps the issuers to sell the bonds Investment Banks & Other Financial institutions ± PURCHASERS those who buy the debt All players mentioned above.
Various Types of Bonds US Government Bonds Municipal Bonds Corporate Bonds Zero Coupon Bonds Agency Bonds Inflation Index Bonds Junk Bonds Brady Bonds Savings Bonds .
They are widely regarded as the safest bond investments.US Government Bonds Fixed Income securities Classified according to the length of time before maturity. as they are backed by the US Government Income earned is exempt from state and local taxes . ± US Treasury Bills maturities from 90 days to one year ± US Treasury Notes maturities from two to 10 years ± US Treasury Bonds maturities from 10 to 30 years Marketable securities from the US Government and are collectively called Treasuries.
US Government Bonds contd How US Treasury Bonds work? US Government the most reliable borrower in the world. never defaulted on a loan Since they are the safest in the world lower yields than other bonds of the same maturity Only risk you can t predict what price you will get for your bond if you have to sell before maturity .
US Government Bonds contd How US Treasury Bonds work?.. you can t redeem the security prior to maturity..contd Interest payments are exempt from local and state taxes (not from Federal income tax) You can buy Treasuries through a broker. You have to use the services of a broker to sell your bonds in the secondary market . or you can buy them directly from the federal government.. which holds regular auctions that individual investors can participate in If you buy from the government.
US Government Bonds contd Treasury Bonds. Bills and Notes All issued in face values of $1000. and it allows you to set up an account to make purchases of Treasury securities at auctions . ± This program is called Treasury Direct. T-Notes and TBills No matter what you buy. Hence they are called T-Bonds. you can often get a better deal when you buy direct. though there are different purchase minimums for each type of security Investors shorten the word Treasury to the letter T .
low income housing. ports. highways. water and sewer projects. airports and other public works . bridges. streets. state and federal taxes Good investment on an after-tax basis Step up on the risk scale from Treasuries Munis are what help local or state government pay for public projects ± Construction or improvement of schools.Municipal Bonds Also knows as munis Major advantage to munis is that the returns are free from city. hospitals.
Municipal Bonds contd Munis are usually high quality issues. since the governments that stands behind the bonds are generally not in danger of going bankrupt Some municipal bond issuers purchase insurance to guarantee that their bonds will be repaid ± Who pays for this insurance? Bond holders in the form of a lower return .
you don t pay state income tax on the interest double tax free munis ± And if you buy a muni issued by the city or locality where you live. you don t have to pay local income taxes so triple tax free! .Municipal Bonds Tax savings with munis contd ± Minis are called tax-free as they are exempt from federal tax ± If you buy a munis issued by your state.
If interest rates rise.Municipal Bonds contd RISK FACTORS Credit risk If the issuer is unable to meet its financial obligations Interest Rate Risk If the interest rates in the market place rise. the bond you own will be paying a lower yield relative to the yield offered by a newly issued bond Call Risk Many bonds allow the issuer to repay all or a portion of the bond prior to the maturity date Market Risk Price of bonds change in response to market conditions. newly issued bonds will pay a higher yield than existing issues .
Corporate Bonds Companies have three choices when they want to raise cash ± Issue shares of stock ± Borrow from the bank ± Borrow from investors by issuing bonds Most corporate bonds are fixed-rate bonds ± Interest rate fixed until maturity Some corporates use floating rates to determine the exact interest rate paid to bond holders .
Corporate Bonds contd Characterized by higher yields because there is a higher risk of a company defaulting than a government They can also be the most rewarding fixed-income investment because of the risk the investor must take on Corporate bonds Several maturities ± Short term : One to five years ± Intermediate term five to 15 years ± Long term longer than 15 years Convertible Bonds holder can convert into stock Callable Bonds allows a company to redeem an issue prior to maturity .
Corporate Bonds contd The credit quality of companies and governments is closely monitored by debt-rating agencies.expressed as letters ± Aaa. Aa. Caa. These agencies evaluate corporations and other bond issuers and their fiscal strength. C . Ca. Baa. ± Standard & Poor's ± Moody's ± Fitch IBCA They assign credit ratings based on the entity's perceived ability to pay its debts over time Those ratings -. A. Ba. B.
Corporate Bonds RISKS OF INVESTING IN BONDS Interest Rate Risk contd ± Risk that the bond prices will fall as interest rates rise ± Should the market interest rate rise from the date of the bond s purchase. the bond price will fall accordingly ± The bond will then be trading at a discount to reflect the lower return than an investor will make on the bond .
.Corporate Bonds RISKS OF INVESTING IN BONDS. Each year the investor receives $120. Suddenly.contd Reinvestment Risk contd ± The risk that the proceeds from a bond will be reinvested at a lower rate than the bond originally provided ± Eg If an investor bought a $1000 bond that had an annual coupon of 12%. which can be reinvested back into another bond. instead of the 12% rate of the original bond .. that $120 received from the bond can only be reinvested at 1%. But if over time the market rate falls to 1%..
which allow the bond issuer to purchase the bond back from the bondholders and retire the issue ± This is usually done when interest rates have fallen substantially since the issue date .contd Call Risk contd ± The risk that the bond will be called by its issuer ± Callable bonds have call provisions.Corporate Bonds RISKS OF INVESTING IN BONDS....
or at all. which help to give investors an idea of how likely it is that a payment default will occur . Standard and Poor s and Fitch give credit ratings to bond issues.Corporate Bonds RISKS OF INVESTING IN BONDS Default Risk contd contd ± The risk that the bond s issuer will be unable to pay the contractual interest or principal on the bond in a timely manner. ± Credit ratings services such as Moody s.
± For eg. if an investor purchases a 5% bond and then inflation rises to 10% a year. the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. which have a set interest rate from inception.Corporate Bonds RISKS OF INVESTING IN BONDS Inflation Risk . ± Interest rates of floating rate bonds (floaters) are adjusted periodically to match inflation rates.contd contd ± The risk that the rate of price increase in the economy deteriorates the returns associated with the bond ± This has the greatest effect on fixed bonds. limiting investors exposure to inflation risk .
Zero Coupon Bonds Fixed-income securities that don't make interest payments each year like regular bonds The bond is sold at a deep discount to its face value and at maturity. however. unless you hold them in a tax-deferred retirement account or an education IRA (Individual Retirement Account) . plus the principal Zeros do have a tax drawback. the bondholder collects all of the compounded interest.
known as Treasury strips -.Zero Coupon Bonds contd Advantages Zeros are usually priced aggressively and are useful for investors who are looking for a set payout on a given date People saving for college tuition and retirement are the prime targets The SmartMoney college portfolios make use of zero-coupon Treasuries -.for two reasons ± you can buy them in a maturity that matches the date your child will enter college ± generally have a slightly higher yield than a regular bond .
Zero Coupon Bonds
Zero Coupon Bonds
Vanilla or Straight Bonds
Issued by other Government agencies (usually at the federal level) to finance their activities These bonds help support projects relevant to public policy
± Farming, small business, loans to first time home buyers
These bonds do not carry the full faith and credit guarantee of Government issued bonds, but investors are likely to hold them in high regard as they are issued by a government agency
Federal Agencies that issue Bonds Federal National Mortgage Association (Fannie Mae) Federal Home Loan Mortgage Corporation (Freddie Mac) Farm Credit System Financial Assistance Corporation Federal Agricultural Mortgage Corporation (Farmer Mac)
Agency Bonds contd Federal Agencies that issue Bonds .contd Federal Home Loan Banks Student Loan Marketing Association (Sallie Mae) College Construction Loan Insurance Association (Connie Lee) Small Business Administration (SBA) Tennessee Valley Authority (TVA) Most investors are institutional. however individuals can also invest in this segment of debt securities .
whichever is greater .Inflation Index Bonds Gives both individual and institutional investors a chance to buy a security that keeps pace with inflation US Treasury pays you interest on the inflation adjusted principal amount Competitive bidding before the security s issue determines the fixed interest or coupon rate At maturity. the Treasury redeems your securities at their inflation adjusted principal or par amount.
they are safe backed by the full faith and credit of the US Government Exempt from state and local taxes. and the principal you receive when they mature won t drop below the par amount at which they were originally issued. Like other Treasury securities.Inflation Index Bonds contd The securities values are periodically adjusted for inflation. although federal income taxes apply .
Junk Bonds All bonds are characterized according to their credit quality and therefore fall into two broad categories ± Investment Grade : bonds issued by low to medium risk lenders ± Junk Bonds : issued by high risk lenders JUNK BONDS High yields. high risk! Very low credit ratings They pay high yields to bondholders. as it is difficult for them to acquire capital at an inexpensive cost .
A rising star may still be a junk bond but on its way to being investment quality .Junk Bonds contd Can be broken into 2 categories ± Fallen Angels : Bond that was once investment grade but has since been reduced to junk bond status because of the issuing company s poor credit quality ± Rising Stars Bond whose rating has been increased because of the issuing company s improving credit quality.
led the debt reduction plan for LDCs (Less Developed Countries) Idea was to restructure the debts of an LDC. along with the IMF (International Monetary Fund) and the World Bank. by converting the defaulted loans into a bond to ensure payment of capital .Brady Bonds Named after the former US Treasury Secretary Nicholas Brady Nicholas Brady. allowing that country to achieve economic growth and make interest payments.
but there are also bonds denominated in the currencies of several other countries Coupon bearing bonds with fixed. step or floating rate (or a combination of each) Maturities between 10 to 30 years Bonds issued at either par or discount Most issuers are Latin American countries .Brady Bonds contd Most Brady Bonds are denominated in US dollars.
Savings Bonds Vehicle of choice for millions of Americans to reach their savings goals Knows by their series names eg Series EE or Series HH Can be bought at most banks. with as little as $25 Many companies offer a payroll savings plan to allow their employees to automatically withhold money from each paycheck that goes to purchase savings bonds .
$500. $200.Savings Bonds contd Purchase price is always half of the face value ± $50 bond costs $25. $5000 & $10000 Liquid investments easy to cash in on your savings bonds if you need money No penalty if you cash in your savings bonds anytime after the first six months that you ve owned them.. $10000 bond costs $5000 Bonds available in 8 different denominations ± $50. $100. and you can cash them in at any bank . $1000. $75.
Savings Bonds contd The principal and interest of savings bonds are guaranteed by the full faith and credit of the US Government If you ever lose a savings bond it can be replaced Interest on savings bonds is exempt from state and local income taxes Federal income taxes are postponed until you cash your bond. or until it stops earning interest .
and can be extended for additional periods following that. Interest continues to accrue on the bonds during these extensions If bonds are used for college expenses then interest can be exempt from tax .Savings Bonds contd When a savings bond reaches maturity. it doesn t stop accumulating interest like most other bonds After maturity it is automatically extended for 10 years.
as their yields are tied to the inflation rate Usually exempt from income tax hence provide a more attractive after tax return Available directly from the US Treasury. they have virtually zero default risk and inflationary risk . these debt securities are an exceptionally low risk investment suitable for the most risk averse investor.Savings Bonds contd INFLATION LINKED SAVINGS BONDS Offer investors inflationary protection.
it will provide money to live on . that income will balance out the periodic dips in a stock dominated asset mix For those in retirement. your portfolio needs some steady and reliable income For younger people.Bond Strategies Whether you are just starting your investing career or have already amassed some wealth.
126.96.36.199.7.Bond Laddering One popular way that investors can help to balance the risk and return in a bond portfolio is to use a technique called laddering Building a laddered portfolio means that you buy a collection of bonds with different maturities spread out over your investment time frame For eg in a 10 year laddered portfolio.9 & 10 years .4. you might purchase bonds that mature in 1.6.
you have a high degree of stability. you d reinvest in a bond that matures in ten years. but because these bonds are not very sensitive to changing interest rates. thereby preserving the ladder (and so on for each year) Rationale behind laddering is quite simple ± When you buy bonds with short term maturities.Bond Laddering contd When the first bond matures in a year. you have to accept lower yields .
Bond Laddering Rationale behind laddering .contd contd ± When you buy bonds with long term maturities. but you must also accept the risk that the prices of the bonds may change ± With a laddered portfolio you would realize greater returns than from holding only short term bonds ± By spreading out the maturities of your portfolio. you can receive a higher yield. you get protection from interest changes .
maturity and risk profile . Which is why a lot of people opt for bond funds Like an equity mutual fund. if you are a novice investor.Bond vs Bond Funds Bonds are complex. a bond fund is managed by a professional investor who buys a portfolio of securities and makes all the decisions Most funds buy bonds of a specific type.
rather than annually or semiannually like a regular bond If you lack time and interest to manage a bond portfolio on your own or you want a mixed portfolio or corporates or municipals buy a bond fund However if you want a tailored portfolio that matures at a certain age. and want to avoid fees etc go ahead with direct bonds .Bond vs Bond Funds contd Bond funds pay out a coupon to investors often monthly.
Bond vs Bond Funds contd Advantages of Bond Funds Convenient For corporate and municipal bonds a professional manager backed by a strong research organization can make better decisions than an average individual investor Disadvantages of Bond Funds It is not a bond Fees and expenses that can cut into returns They have neither a fixed yield nor a contractual obligation to give investors back their principal at some later maturity date .
INVESTMENT COMPANIES An Introduction .
and each investor shares in the profits and losses in proportion to the investor s interest in the investment company The performance of the investment company will be based on (but not identical to) the performance of the securities and other assets that the investment company owns .What are Investment Companies? An Investment Company is a company that issues securities. and is primarily engaged in the business of investing in securities An investment company invests the money it receives from investors on a collective basis.
Types of Investment Companies Mutual Funds ± Legally knows as open-end companies ± Redeemable when investors want to sell their shares. at a price determined by the market UITs ± Legally known as unit investment trusts ± Redeemable . they sell them to other investors on the secondary market. they sell them back to the fund. or to a broker acting for the fund. at their NAV Closed-end Funds ± Legally known as closed-end companies ± Not redeemable when closed-end fund investors want to sell their shares.
interval funds and exchange-traded funds (ETFs) Some companies that might initially appear to be investment companies may actually be excluded under the federal securities laws ± Eg. such as stock funds. index funds. there are variations within each type of investment company. bond funds.Types of Investment Companies In addition. money market funds. Private investment funds with less than 100 investors .
but does not include a voting trust 3. or similar instrument Does not have board or directors Issues only redeemable securities. contract or custodianship or agency. or which has engaged in such business and has any such certificate outstanding 2. Face-amount Certification Company Engaged or proposes to engage in the business of issuing faceamount certificates of the installment type. Unit Investment Trust Organized under a trust indenture.Classification 1. each of which represents an undivided interest in a unit or specified securities. Management Company Company other than a face-amount certificate company or a unit investment trust .
Advantages of Mutual Funds Professional Management ± The primary advantage of MF s at least in theory is the professional management of your money ± Investors purchase funds because they do not have the time or the expertise to manage their own portfolio ± A MF is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments .
your risk is spread out ± The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by the gains in others ± Large MF s typically own hundreds of different stocks in many different industries Economies of Scale ± Because a MF buys and sells large amounts of securities at a time. its transaction costs are lower than you as an individual would pay .Advantages of Mutual Funds contd Diversification ± By owning shares in a MF instead of owning individual stocks or bonds.
a MF allows you to request that your shares be converted into cash at any time Simplicity ± Buying a MF is easy! Most banks have their own line of MFs and the minimum investment is small ± Most companies have automatic purchase plans whereby as little as $100 can be invested on a monthly basis .Advantages of Mutual Funds contd Liquidity ± Just like an individual stock.
and.Disadvantages of Mutual Funds Professional Management ± Many investors debate over whether or not the so-called professionals are any better than you or I at picking stocks Management is by no means infallible. even if the fund loses money. the manager still takes his/her cut The MF industry is masterful at burying costs under layers of jargon ± Costs ± .
It might have been more advantageous for the individual to defer the capital gains liability . which affects how profitable the individual is from the sale. For eg when a fund manager sells a security.Disadvantages of Mutual Funds contd ± Dilution Because funds have small holdings in so many different companies. fund managers don t consider your personal tax situation. a capital-gain tax is triggered. Dilution is often the result of a successful fund getting too big ± ± ± Taxes When making decisions about your money. high returns from a few investments often don t make much difference on the overall return.
and investment strategies . the higher the potential return. all funds have some level of risk its never possible to diversify away all risk Each fund has a predetermined investment objective that tailors the fund s assets. the higher the risk of loss Although some funds are less risky than others.Different types of Mutual Funds According to the last count there are over 10. regions of investment.000 Mutual Funds in North America! That means there are more mutual funds than stocks!! It is important to understand that each mutual fund has different risks and rewards In general.
Different types of Mutual Funds contd At a fundamental level there are three types of Mutual Funds ± Equity Funds (Stocks) ± Fixed Income Funds (Bonds) ± Money Market Funds .
Equity Funds (Stocks) Fund that invest in stocks represent the largest category of Mutual funds. Investment objective long term capital growth with some income There are many different types of equity funds because there are many different types of equities A great way to understand the universe of equity funds is to use a style box A style box is a graphical representation of Mutual Fund s characteristics .
Understanding the Style Box .
Understanding the Style Box contd The idea is to classify funds based on both the size of the companies invested in and the investment style of the manager This categorization is useful in determining how an investment fits into a particular investment portfolio from an asset allocation perspective An aggressive investor might focus primarily on small capitalization funds or growth funds The term value refers to a style of investing that looks for high quality companies that are out of favor with the market. price to book ratios. These companies are characterized by low P/E ratios. and high dividend yields etc .
etc A compromise between value and growth is blend . and cash flow. which refers to companies that have had (and are expected to continue to have) strong growth in earnings.Understanding the Style Box contd The opposite of value is growth. which simply refers to companies that are neither value nor growth stocks and so are classified as being somewhere in middle For eg a MF that invests in large cap companies where in strong financial shape but have recently seen their share price fall would be places in the upper left quadrant of the style box (large and value) The opposite of this would be a fund that invests in startup technology companies with excellent growth prospects. sales. Such a MF would reside in the bottom right quadrant (small and growth) .
Fixed Income Funds (Bonds) Their purpose is to provide current income on a steady basis When referring to MF s the terms fixed-income . Because there are many different types of bonds. These terms denote funds that invest primarily in government and corporate debt. bond and income are synonymous. bond funds can vary dramatically depending on where they invest For eg a fund specializing in high yield junk bonds is much more risky than a fund that invests in government securities. The target for these funds are conservative investors and retirees. but bond funds are without risk. Bond funds are likely to pay higher returns than certificates of deposit and money market investments. which means if the rates go up the value of the fund goes down . Nearly all bond funds are subject to interest rate risk.
Money Market Funds Consist of short term debt instruments. mostly T-bills Safe place to park your money Low returns but you wont have to worry about losing your principle A typical return is twice the amount you would earn in a regular checking/savings account and a little less than the average CD (Certificate of Deposit) .
± The strategy of balanced funds is to invest in a combination of fixed-income and equities.Other types of Mutual Funds Balanced Funds ± the objective of these funds is to provide a balanced mixture of safety. and capital appreciation. income. ± A typical balanced fund might have a weighting of 60% equity and 40% fixed income .
Other types of Mutual Funds contd Asset Allocation Fund ± Objectives are similar to those of a balanced fund. but these kinds of funds typically do not have to hold a specified percentage of any asset class ± The portfolio manager is therefore given freedom to switch the ratio of asset classes as the economy moves through the business cycle .
Other types of Mutual Funds
± International funds (or foreign funds) invest only outside your home country ± Global funds invest anywhere around the world, including your home country ± It is tough to classify these funds as either more risky or safer. On the one hand they tend to be more volatile and have unique country and/or political risks. But, on the flip side, they can, as part of a wellbalanced portfolio, actually reduce risk by increasing diversification. ± Although the world s economies are becoming more inter-related, it is likely that another economy somewhere is outperforming the economy of our home country.
Other types of Mutual Funds
These are funds that have proven to be popular but don t necessarily belong to the categories described so far. This type of MF forgoes broad diversification to concentrate on a certain segment of the economy
± ± ± targeted at specific sectors of the economy such as financial, technology, health, etc. These are extremely volatile. There is a greater possibility of gains, but you have to accept that your sector may tank
Other types of Mutual Funds
± ± Focus on a specific area of the world. Eg region (Latin America) or an individual country (Brazil). Just like sector funs, you have to accept the high risk of loss, which occurs if the region goes into a bad recession.
SOCIALLY RESPONSIBLE FUNDS (or ETHICAL FUNDS)
± ± ± Invest only in companies that meet the criteria of certain guidelines or beliefs. Most socially responsible funds do not invest in industries such as tobacco, alcoholic beverages, weapons, or nuclear power. The idea is to get a competitive performance while still maintaining a healthy conscience.
but because they are in the index . This process is also referred to as indexing Attempts to replicate the index by holding the same stocks in the same proportion Investment decisions usually involve little research and intervention They hold stocks not necessarily because they are worth investing in.Passively Managed Funds Also called Index Funds Rage of the second half of the 1990s Investment objective of nothing more than strictly mirroring a specific benchmark The portfolio of investments that are weighted the same as a stock exchange index in order to mirror its performance.
due to the millions of dollars it would take Most actively managed funds fail to beat broad indexes such as the S&P 500 .Passively Managed Funds contd ADVANTAGES You know exactly what you will be getting Lower management expense ratios on index funds Exposure to a wide swath of the stock market Strongly diversified equity portfolio No need to worry how a portfolio manager is moving your money among stocks Nearly impossible for an individual investor to replicate an index on his own.
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