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FIN 2303 Lesson 11 - 14 - Lecture notes 11-14

Course

Introduction to Finance (FIN2303)

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Sylvia Johnston
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Lesson Eleven Twelve Bonds The Basics Bonds are simply a promise to repay an amount borrowed with interest. Bonds are issued governments, as well as corporations, and sometimes municipalities. Each bond issue has its own maturity date, coupon rate and features. A bond issue refers to all of the individual bonds issued using a specific bond indenture, meaning that the bond indenture may authorize million of bonds to be issued in total, with individual bonds, each being part of the bond issue, sold in denominations of or The term debenture refers to an unsecured bond, meaning that the issuer has not provided any security or collateral to protect the purchaser in the case of default (bankruptcy) of the issuer. Remember, the issuer is the company or government and the buyer is the investor Corporations can issue bonds and debentures, and normally, a debenture will pay a higher rate of interest (also called the coupon rate) since a debenture is not and therefore, is a riskier investment. Corporate bonds can be secured physical assets, such as property, buildings, equipment and train cars, or financial assets, such as stocks, bonds or other securities. Government bonds are different, in that they are not secured physical they are secured the power of taxation, meaning that the government in power can simply raise taxes to pay interest or principal payments to its bondholders. Bonds generally have a fixed interest rate, which is paid the borrower (company or government) to the lender (investor). The payment of interest compensates the lender for the missed opportunity cost of not having their principal, as well as the risk of not having their principal repaid. For example, a bond (i. a coupon rate) with a face value will pay of interest every six months. Most bonds in Canada make interest payments. confuse with The coupon rate paid on a bond does not change over time, whereas the yield will change daily, and even throughout the day. The coupon rate is set the issuer when the bond is first issued and reflects one thing, the interest payments made the issuer. The yield of a bond includes two things, the interest payments made the issuer, and the gain or loss on the face value of the bond. Consider this example: Campwealth Inc. issues a two year debenture today. Assume that the coupon rate of reflects the current interest rate required for similar bonds, meaning bonds with similar risk and a similar maturity date, etc. The price of the bonds will be for each of face value, which means that the bonds are trading at so the yield is coupon on face value for bonds trading at par). Over the next year, if Campwealth runs into financial difficulty and become a more risky investment, investors will want to earn more than on a bond so the price of Campwealth bonds will drop. assume the price drops to for every of face value. Recall that yield is calculated adding your coupon rate the on face value, so the yield is now calculated adding the coupon gain The gain on face value is calculated as Bonds Structure and Issues Bonds and debentures are issued pursuant to a deed of trust, or indenture agreement, which is a written agreement prepared the borrower (issuing company or government). The indenture includes all of the contractual agreements that pertain to a particular bond issue. If a company or government has multiple bond issues, each issue has its own indenture, and each indenture may contain different provisions. In addition to the basic terms of the bond such as face value (usually of each bond, the indenture will provide details of any security (collateral) that has been pledged to protect the investors, as well as any protective covenants. Protective covenants are rules or policies that a bond issuer (borrower) must follow, and can include dividend policies, limits on future bond issues, merger restrictions, or other restrictive provisions. Protective covenants are designed to provide protection to investors and reduce the risk of the borrower being unable to make interest payments when due or defaulting on the bond issue. Protective covenants are not absolute guarantees against default, but they do provide some comfort to investors. Some bonds include a call provision that allows the issuer redeem some or all the outstanding bonds of an issue. Some call provisions allow the bonds to be called at face value, whereas others provide the investor with a premium if the bonds are called. For example, if a bond issue has a call price of this means that there is a premium above face value (call prices are quoted per of face value). Most call provisions cannot be triggered for the first 5 or 10 years, during which the bonds are referred to as The price of a bond will be impacted the embedded features, such as a protective covenant, or call provisions. If the feature is a benefit to the purchaser, such as a protective covenant, the feature is considered a and it will increase the price of the bond slightly (since there is a benefit to the purchaser). If the feature is a benefit to the issuer, the price of the bond will be slightly lower as compared to a similar bond without the same feature. Bonds Pricing When you purchase a bond, you are buying two different income streams the repayment of your principal (or face value), and the regular interest payments (coupon payments). Although we normally quote one price for a bond, it is possible to calculate how this price is represented two different income streams. We can use Time Value of Money (TVM) for these two calculations. Consider the following example: Algonquin College issues in each bond having a par value of The coupon rate is and term to maturity is 25 years. All bonds are issued in Canada and pay interest payments. Using your calculator, first, CLEAR the TVM values CLR TVM (the FV Now, we will calculate the present value (PV, i. price) of the interest payments. This is simply the PV of an annuity, since a stream of interest payments is an annuity. SDT 01.01, ENTER all entered with 2 digits for You can select any starting year, as long as the ending year is 25 years later. Use the down arrow to toggle between inputs. CPN 4, ENTER, enter the annual coupon rate (do not enter in decimal format, i. 0) RDT 01.01, ENTER Redemption RV 100, ENTER Redemption ACT, ENTER your calculator shows 360, enter 2nd, ENTER to toggle between ACT and ACT Actual days interest calculation (Canadian format), 360 360 days used for interest calculation (US format) ENTER your calculator shows enter 2nd, ENTER to toggle between and 2 compounding periods per year annual compounding. YLD 4, ENTER, enter the annual yield. In this case, the bond is newly issued, so the yield and the coupon rate are assumed to be the same. PRI, we are solving for price, so enter CPT and your calculator will return 100. The bond worksheet calculates the price of a bond per of face value, so this bond is trading at par, meaning that you pay now for of maturing value (face value). Lesson Thirteen What a mutual fund is and how it is structured A mutual fund is a professionally managed large portfolio of assets, available for individual investors to purchase. Mutual funds are organized and managed an investment fund manager (sometimes called the or The fund manager charges a fee to manage the daily operations of the fund (called a and this fee is deducted from the fund assets. There are some expenses that are paid the fund, in addition to the management fee. The Management Expense Ratio includes the management fee, as well as most other costs associated with owning the fund. Ultimately, the investment returns of the fund are reduced MER, so it is important to understand the fee structure of a fund that you own, or are considering to buy. Most mutual funds in Canada are organized as open ended mutual fund trusts, meaning that the fund manager issues new units as new investors invest, and redeems units as investors sell their units. The number of units of the fund can change each day, and is not limited (i. the number of units is In comparison, a fund issues a set number of units when it is created, and no additional units are issued. There are very few funds available in Canada, about 100, as compared to over funds available. Since a mutual fund owns many securities, its price, called its net asset value per share, is determined dividing the market value of the fund portfolio, less its liabilities, the number of units outstanding. Consider the following example. The Brigata Diversified Portfolio owns stocks, bonds and cash worth It has net liabilities of and 3,839,625 units outstanding. The net asset value per unit is calculated as follows: 3,839,625 per unit (rounded). Most mutual fund unit prices are between and although some are outside of this range. Classification of funds investment objective With over funds to choose from, you can likely find a fund that has an investment objective and strategy to fit your investment program and risk profile. In fact, you are more likely to find funds that fit your so the process of eliminating funds can be the bigger challenge. Although there are many different fund classifications, the majority of funds can be broadly classified as follows: Money market or short term bond funds Lowest risk, suitable for very short term investment, where liquidity and income are most important. Fixed Income (bond) Low to medium risk, suitable for a short to medium term investment, where income is most important Balanced funds Medium risk, includes stocks and bonds, where a balance of both income and growth are important Equity (stock) funds Medium to risk, includes all equity, where growth is primary objective and income may be a secondary objective. Specialty funds High risk. Investment objective is very specific and limited, such one strategy (gold or precious metals stocks), one sector (health care stocks), one geographic region (emerging markets stocks), or an alternative strategy (commodities). Growth (usually aggressive growth) is the only objective. A investment objective and investment strategy, along with other important information, is detailed in the simplified prospectus, which is the legal offering document filed with the provincial regulators in the provinces and territories where the fund is available for sale. How to buy and sell mutual funds Mutual funds can be purchased through an advisor, or online through a discount broker, or web banking site. One important aspect of a mutual fund purchase to consider is the type of the fund. In general, there are two main options. A fund does not charge the investor a fee to purchase or sell the fund, whereas a load involves a fee to buy or sell the fund. Funds that have a fee to purchase or sell, normally are available through an advisor, who receives a portion of the load as compensation to assist the investor determine the correct fund(s) to purchase, as well as for ongoing investment advice and servicing. Load Type Fee to purchase fund Fee to sell fund No load No No load Yes. to No Deferred Sales Charge (DSC) No Yes. to Fee reduces each year. Usually after 6 or 7 years. Each deferred sales charge funds has its own schedule of fees. Below is a typical schedule of fees that could apply to a DSC equity fund. Consider the following mutual fund profile for the Brigata Diversified Portfolio, review some of the information it provides. 1. The Asset Class identifies the fund category, and the Fund Description provides a brief overview of the investment objective. These two factors allow you to quickly determine if the fund is suitable for further review, based on its type and risk profile. 2. The Total Returns are historical returns, and the Qrtl is the Quartile ranking between 1 and 4, amongst similar funds (1 is best, 4 is worst). Be sure not to focus too much on performance, it only indicates what happened in the past, and does not predict the future. It also does not tell you how much risk was taken to achieve the returns. 3. The Top Holdings section details the 10 largest investments in the fund. 4. Calendar Year returns should be reviewed along with the Total Returns to identify if a significant return (high or low) is skewing the Total Returns. i. A fund that has a return in year 1, and a return in year 2, 3 and 4 will have a average compound return (Total Return) for the 4 year period, even though it did not earn anything for 3 of 4 years. 5. The Portfolio Composition, or asset allocation, provides a basic summary of how the fund has allocated its investments. It is important to review the allocation since the fund type can include a fund with up to bonds, as well as a fund with up to in stocks, so clearly, not all balanced funds are similar. 6. Return Analysis provides some insight into the best and worst periods, as well as the number of years the fund generated a positive return vs. negative return. 7. Risk Analysis provides context for the Calendar Year and Total Returns. Standard deviation is a measure of risk, the lower the standard deviation, the lower the variability and the more consistent the annual returns are. A fund with high returns and low standard deviation is ideal. 8. The minimum initial investment is the amount required to open an account. Some funds require a large minimum investment of to 9. The Total Expense Ratio is the annual MER, which is the fee that is deducted from the fund before the returns are calculated. The Fee Schedule identifies if the fund is a No Load fund, or if it has an initial Sales Charge or Deferred Sales Charge.

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FIN 2303 Lesson 11 - 14 - Lecture notes 11-14

Course: Introduction to Finance (FIN2303)

71 Documents
Students shared 71 documents in this course

University: Algonquin College

Was this document helpful?
Lesson Eleven / Twelve
Bonds – The Basics
Bonds are simply a promise to repay an amount borrowed with interest. Bonds are issued by
governments, as well as corporations, and sometimes by municipalities. Each bond issue has its
own maturity date, coupon rate and features. A bond issue refers to all of the individual bonds
issued using a specific bond indenture, meaning that the bond indenture may authorize $100
million of bonds to be issued in total, with individual bonds, each being part of the bond issue,
sold in denominations of $50,000 or $100,000. The term debenture refers to an unsecured
bond, meaning that the issuer has not provided any security or collateral to protect the
purchaser in the case of default (bankruptcy) of the issuer. Remember, the issuer is the
company or government [the borrower] and the buyer is the investor [the lender].
Corporations can issue bonds and debentures, and normally, a debenture will pay a higher rate
of interest (also called the coupon rate) since a debenture is not secured; and therefore, is a
riskier investment. Corporate bonds can be secured by physical assets, such as property,
buildings, equipment and train cars, or by financial assets, such as stocks, bonds or other
securities. Government bonds are different, in that they are not secured by physical assets; they
are secured by the government’s power of taxation, meaning that the government in power can
simply raise taxes to pay interest or principal payments to its bondholders.
Bonds generally have a fixed interest rate, which is paid by the borrower (company or
government) to the lender (investor). The payment of interest compensates the lender for the
missed opportunity cost of not having their principal, as well as the risk of not having their
principal repaid. For example, a 6% bond (i.e. a 6% coupon rate) with a $1,000 face value will
pay $30 of interest every six months. Most bonds in Canada make semi-annual interest
payments. Don’t confuse “yield” with “coupon rate”. The coupon rate paid on a bond does not
change over time, whereas the bond’s yield will change daily, and even throughout the day. The
coupon rate is set by the issuer when the bond is first issued and reflects one thing, the interest
payments made by the issuer. The yield of a bond includes two things, the interest payments
made by the issuer, and the gain or loss on the face value of the bond.
Consider this example: Campwealth Inc. issues a 4%, two year debenture today. Assume that
the coupon rate of 4% reflects the current interest rate required for similar bonds, meaning
bonds with similar risk and a similar maturity date, etc. The price of the bonds will be $1,000 for
each $1,000 of face value, which means that the bonds are trading at “par”, so the yield is 4%
(4% coupon + 0% gain/loss on face value for bonds trading at par).
Over the next year, if Campwealth runs into financial difficulty and become a more risky
investment, investors will want to earn more than 4% on a bond investment; so the price of
Campwealth bonds will drop. Let’s assume the price drops to $909 for every $1,000 of face
value. Recall that yield is calculated by adding your coupon rate + the gain/loss on face value, so
the yield is now calculated by adding the 4% coupon + 10% gain = 14%. The gain on face value is
calculated as [($1,000 – $909) / $909 ] = 10%.

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