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.