Investing 101 Lecture 2 Fixed Income Products

Stock Game Tickers  Please write your name and your five chosen ones on a piece of paper and pass it to the front.

Reality Check!  Did anyone bring their Andex charts?  If so pleas pull them out. We are going to have a harder look at the importance of time horizon.

Wealth Accumulation of Stocks and Bonds ( )

What About Investment Expenses?  The previous performance ignores investment expenses  How much would investors have accumulated with a 1 percent annual expense ratio?

Wealth Accumulation after Expenses

What About Taxes?  The government taxes interest, dividend income, and realized capital gains  How much do taxes affect our wealth accumulations?  I assumed that dividends and interest income is taxed at the marginal tax rate of the average stock and bond holder and that capital gains are not taxed

Wealth Accumulation after Expenses and Taxes

What About (The real killer) Inflation?  $1 in 1926 could buy much more than $1 in 2002  Consumer prices increased over this period about ten-fold  How much does inflation affect our wealth accumulations?

Real Wealth Accumulation after Expenses and Taxes

Review!  What is a stock?  What is a Dividend?  What is a Capital Gain?  What is a Mutual fund?  How long does a stock live?

Main Teaching Points  What is a bond?  Where do bonds come from?  What are the benefits/rights of ownership?  How do bonds Work?  What are the risks of ownership?  Why do interest rates matter?

Just What The Hell Is A Bond Anyway?  A debt investment with which the investor loans money to an entity (company or government) that borrows the funds for a defined period of time at a specified interest rate.  A bond is NOT ownership  A bond does NOT give you any say in how a company is run.  A bond is a LOAN

What is a Coupon?  A coupon is a payment of interest on the loan.  A coupon can be paid quarterly, semi annually, annually or not at all.

Where Do Bonds Come From?  Bonds are born in the same way as stocks.  A company will approach an Investment Bank needing a debt issue.  The investment bank will analyze the market and the company to determine the best duration, rate, etc of the bond.

Why Are They Needed?  Difficult to explain however…..  M&M proposition II with taxes, optimal capital structure. (Graph)  Stock price unfavorable for an equity issue.  Excess debt capacity (D/E ratio off balace)  Gov’t financing projects (ie bridge) or borrowing in a pinch (ie war victory bonds).

Break  BEFORE you run off, find someone in class and explain to them the most interesting thing you have learned thus far.  10 min Break

Differences Between Bonds and Stocks  Bonds  A loan  No ownership  No vote  Guaranteed by assets (usually)  Seniority in Liquidation  Finite life span  Regular coupons.  Stocks  A purchase  Of ownership  A vote  Not Guaranteed  Subordinate to Debt, Preferred shares and any higher classes  Infinite lifespan  No sure dividends

Bond Benefits  “Guaranteed” return (if held to maturity)  Secured By Assets (in most cases)  Capital gain possiblities  “Safer” invesment  Steady Income Stream  Negative Correlation to stocks.

Bond Risks?!  Inflation risk  Interest rate risk  Default risk  Liquidity risk

Types Of Fixed Income Instruments  Strip Bond  Zero Bond/T-Bill  Coupon Bond  Floating Rate Bond  C – Paper  Preferred Shares*

What Makes One Bond Different From Another?  Governments are much less likely to go bankrupt than are companies. They can also print money if need be.  Large, established companies can borrow at lower rates.  Different bonds have different features. Ie callable, retractable, extendable.

Bond Rating  Dominion Bond Rating Service of DBRS rates bonds as to the investability of the bond.  Rating is from AAA to D  Anything below BB is considered “Junk.”(GM)

How Bonds Work  Always helpful to use a picture.  PV=(C/r)(1-1/(1+r)^t)/r + FV/(1+r)^t.  Inverse relationship between PV and r in that PV= FV/(1+r)^t.

Questions?

Extra  Bond Features. (callable, extendable, retractable, convertable)  GM Bonds.  Bell Curve.  Volatility of returns.  Balance Sheet  Cash flow statement  Income Statement  Prospectus.  Business models (Sole, partner etc)  Shorting  Google IPO  Financial Leverage. Margin Accounts.