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Tutorial 12 (Chapter 14 and 15 Keown)

1. What are the three reasons why investors should consider adding bonds to
their portfolios?
Investors should consider adding bonds to their portfolios for the following three
reasons:
Bonds reduce risk through diversification because bonds do not move
together with other investments over time.
Bonds produce steady income, which is an advantage for those needing some
income from a portfolio to achieve their financial goals.
Bonds can be a safe investment if held to maturity. Interest on bonds must be
paid, or lenders (creditors) can force a firm into bankruptcy. If a bond is held
until maturity, the effects of interest rate changes will have no impact on the
bond's final par value.
2. What potential risks do investors face when they purchase junk bonds?
A junk bond is a low-rated bond (BB or below are considered to be junk bonds),
also called a high-yield bond.
Only firms that have yet to establish a record of solid performance or firms that
are experiencing credit difficult issue junk bonds. Because of either the lack of
track record or credit difficulty, there could be a higher probability of default
associated with these bonds. If the company default the investor could lose there
investment. In order to be adequately compensated for the risks investors should
demand a premium of between 3 percent and 5 percent in interest over the AAA
rate.
3. An investors required rate of return is important when valuing a bond.
What two factors can cause an investors required rate of return to change?
If a firm that issues a bond loses its credit worthiness because of poor sales or
decreased levels of earnings, an investor should demand a higher required rate of
return from the firms securities. In this case, the value of a bond will decrease. A
change in general interest rates will also change investors required rate of
return. If there is an expected increase in inflation, the interest rate will increase,
causing investors to demand a higher return for delaying consumption.

4. Describe the relationship between interest rates and bond values. If


investors required rate of return decreases, what should happen to the value
of the bonds? Would this bond be purchased at a premium or discount?
How did you make this determination?
There is an inverse relationship between interest rates and bond values. When
interest rates rise, bond values drop, and when interest rates decline, bond values
rise. Thus, if investors required rate of return decreases, the value of bonds in
the secondary market should increase. If the investors required rate of return is
lower than the coupon rate of the bond then the bond would sell at a premium to
par value.
This relationship is made most apparent with the relationship between current
yield and coupon rate. Given that the current yield is simply the return on
investment, then if investors require a lower return than the coupon rate offers
then they sell the bond thus increasing the market price of the bond.
5. What is a mutual fund? What makes mutual funds different from owning a
stock or a bond directly?
Mutual funds work by pooling investors money, and then investing the funds in
stocks, bonds, and various short-term securities.
Professional managers oversee these investments. Basically, when you purchase
shares in a mutual fund, you are buying a fraction of a very large portfolio, and
this helps diversify your holdings, thus reducing unsystematic risk.
6. Mutual fund investors make money in three ways. Name and briefly
describe each. How are these reflected in the formula for calculating total
returns?
Three ways mutual fund investors make money include:
As the values of all the securities held by the mutual fund increase, the
value of each mutual fund share also goes up.
Dividends.
If the fund sells a security for more than it originally paid for it, the
shareholders will receive this appreciation as a periodic capital gain
distribution.
All three are included in the total return calculation. Adding the dividends and
capital gains to the period price difference solves this formula. This sum is then
divided by the original price.

7. What is an REIT and how is one similar to and different from a mutual
fund?
REITs (real estate investment trusts) are similar to mutual funds in almost every
respect except that REITs specialize in real estate rather than securities.
A REIT must collect at least 75 percent of its income from real estate and must
distribute at least 95 percent of that income in the form of dividends.
There are three different types of REITs: equity, mortgage, and a hybrid of the
two. REITs are useful as a diversification tool, because they do not move closely
with the general stock market.
8. Why are money market mutual funds considered practically risk free?
Money market mutual funds invest primarily in Treasury bills and other very
short-term notes, unless they are tax-exempt funds or government securities
funds, in which case they invest in municipal debt or government securities
respectively, in any case the investments typically have maturities of less than 30
days. Because these investments are of such short maturity, they are considered
practically risk free, especially the government securities money market mutual
funds.

Attempt Discussion Case 1 (Chapter 14 pg 495) and


Discussion Case 1 (Chapter 15, pg 528).
BONDS - DISCUSSION CASE 1 ANSWERS
1.

Advantages associated with bonds include:

Making money if interest rates decrease.


Reducing risk through diversification.
Providing current and steady income.
Offering relative safety if held until maturity.
Disadvantages associated with bond investing include:

Losing money if interest rates increase. Interest rate risk


Losing money if an issuer experiences financial problems. Business risk
Having a bond called if interest rates fall. Call risk
Lacking liquidity. Liquidity risk
Not being able to reinvest interest at as high a rate as your initial return.
Reinvestment risk

2.

If interest rates were to increase, Miguel should purchase short-term high quality
bonds. Short-term bonds are less affected by changes in interest rates than longermaturity bonds. Miguel should avoid long-term bonds, especially zero-coupon
bonds, because the value of these bonds fluctuates wildly with changes in interest
rates.

3.

Miguel should consider the following guidelines when investing in bonds:


If Miguel is in a high marginal tax bracket he should consider a municipal bond.
He should always keep an eye on interest rates.
He should avoid bonds issued by firms that might experience financial problems.
Miguel should consider only high quality bonds.
He should avoid callable bonds.
He should take steps to match bond maturities to his investment time horizon.
Miguel should purchase large U.S. companies or the federal government bonds.
When in doubt, Miguel should simply buy a Treasury security.

4.

Miguel should choose a maturity that matches his investment horizon. By doing
this Miguel negates interest rate risk because he knows that he will be paid par value
at maturity, so changes in prices due to fluctuations in interest rates are meaningless
from a financial perspective. The reason why Miguel would not want to purchase
bonds shorter than the investment period is that he could suffer reinvestment risk,
or the risk associated when a bond matures and available rates are less than what was
previously earned.

5.

Preferred stock is a hybrid between common stock and corporate bonds. Unlike a
bond, preferred stock does not have a fixed maturity date and the termination of
dividends will not bring on bankruptcy. Preferred stock is similar to bonds in that
dividends are fixed and paid before common stock dividends. Preferred
stockholders do not have voting rights. Also, because dividends are fixed, preferred
shareholders typically dont share in corporate profits.

6.

Using the formula on page 458 gives a preferred stock value of $56.25:
Value of preferred stock

7.

= annual dividend / required rate of return


$56.25
= $4.50 / 0.08

Direct real estate investments require much time, effort, and expertise in order to
make above-average long-term rates of return. If Miguel is, in fact, serious about
making a real estate investment, he should consider an indirect one.
Indirect real estate investments are appropriate for investors with little expertise in
real estate management and those with little time to develop the necessary
expertise to be successful. An attractive indirect investment worth exploring is a real
estate investment trust.

Most direct real estate investments lack liquidity. In other words, if Miguel needed
to sell a direct real estate investment in order to generate cash immediately, there is
no guarantee that he could find a willing and able buyer and actually get a fair price
for his holdings.

While public real estate investment trusts (REITs) as part of a well-diversified and
risk-conscious portfolio. REITs are investment trusts that own and manage income
producing real estate such as shopping centers, self-storage units, apartments and
medical offices from which the REITs collects rent and management fees.
Public REITs can own several hundred or even into the thousands of assets. By law,
REITs are required to distribute 90 percent of their profits to their shareholders,
which makes them attractive investments to those who seek regular dividendsa
literal check in the mail. Because public REITs are traded on stock exchanges, it
is easy to buy and sell shares of REITs. (liquid and safe)

Attempt Discussion Case 1 (Chapter 15, pg 528).


DISCUSSION CASE 1 ANSWERS
1.

Telecommunication stocks tend to be quite volatile and, with $15,000 to invest, it


would be very difficult for Rick to achieve adequate diversification. A mutual fund
will provide Rick with diversification, professional management, minimal
transaction costs, liquidity, flexibility, and a number of useful services.

2.

Rick should consider investing in a telecom or aggressive growth fund, although he


should not invest entirely in one fund or in one sector. He might also look into an
index fund or other diversified growth fund.
These types of mutual funds attempt to maximize capital appreciation. While these
funds offer almost unlimited future growth, they also are more risky than bond
funds or growth and income funds.
Ricks best move would be to thoroughly research several mutual funds of various
styles and sectors and to choose two or three funds that best meet his investment
objective and time horizon.

3.

There are many factors to be considered when investing in the securities markets.

i)
ii)
iii)
iv)

consider his risk and volatility tolerance. Will he be able to sleep after a gain
of 10 percent one day and a loss of 12 percent the next?
define his investment objective and time horizon; a high-tech mutual fund
would not be appropriate if Rick needs the money in two years.
thoroughly evaluate the fund, including everything from managers tenure to
turnover ratio and from fund fees to investment services.
periodically monitor his investment choices.

4.

Mutual funds provide diversification, but they do not eliminate all risk. By
purchasing only one fund, Rick will be subject to business risk: the risk of poor
decisions made by the company. Also, no matter how many funds he purchases, he
will always be subject to systematic risk: risk that affects the entire market as a
whole.

5.

Closed-end funds don't sell directly to investors, nor will they buy back shares
upon demand. The price of the shares in a closed-end fund is determined by supply
and demand for those shares, not by their net asset value. Therefore, shares in some
closed-end funds sell above, while others sell below, their net asset value. Thus, if
Rick is worried about liquidity and marketability, he should invest in open-end
mutual funds.

6.

The bottom line is that Rick should keep his expenses as low as possible; expenses
erode returns. Expenses only benefit the company, not the investor. Rick should
avoid funds with sales commissions and instead seek out no-load funds with
minimal expenses.

7.

Growth fund
Most growth funds offer higher potential capital appreciation but usually at aboveaverage risk. Growth funds are more volatile than funds in the value and blend
categories. The companies in a growth fund portfolio are in an expansion phase and
they are not expected to pay dividends. Investing in growth funds requires a
tolerance for risk and a holding period with a time horizon of five to 10 years.
Index fund
When an investor purchases a share of an index fund, he or she is purchasing a share
of a portfolio that contains the securities in an underlying index. The index fund
holds the securities in the same proportion as they occur in the actual index, and
when the index decreases in value, the fund's shares decrease as well, and vice versa
Each index fund represents an interest in an underlying basket of securities. This
allows investors to gain broad exposure to a large group of companies easily.
This diversification also makes index funds much less volatile than individual
securities
Bond fund

A fund invested primarily in bonds and other debt instruments. The exact type of
debt the fund invests in will depend on its focus, but investments may include
government, corporate, municipal and convertible bonds, along with other debt
securities like mortgage-backed securities.