Understanding Bonds and Stocks
Bonds: Debt Instruments for Raising Capital
Key Skills for Bond Investors
Understanding Bond Structure
Calculating Bond Rates of Return
Understanding Interest Rate Risk
Differentiating Between Real and Nominal Returns
Components of a Bond
Bond
A security obligating the issuer to make specified payments to the bondholder.
Face Value
Payment at maturity, also known as “principal” or “par value.”
Coupon
Interest payments paid to the bondholder.
Coupon Rate
Annual interest payment as a percentage of face value.
Asked Price
The price investors pay to buy the bond.
Bid Price
The price asked by an investor selling the bond.
Spread
The difference between the bid and asked price, representing the seller’s profit.
Note: Treasury bonds are quoted in 32nds, while corporate bonds use decimals.
Calculating Bond Yields
Bond Pricing
The present value of all cash flows (coupons and face value repayment) discounted at the required rate of return.
Current Yield
Yield to Maturity
Relationship Between Interest Rates and Bond Prices
Rising Interest Rates
Cause bond prices to fall as the present value of future payments decreases.
Decreasing Interest Rates
Lead to rising bond prices due to increased present value of future payments.
Interest Rate Risk
The risk associated with bond price fluctuations due to changing interest rates.
Risks of Bonds, Credit Rating, and Default Risk
Default Risk
The risk of a bond issuer failing to meet payment obligations.
Compensation for Default Risk
Companies offer higher interest rates to compensate investors for this risk.
Default Premium
The additional yield investors require for bearing default risk, often the difference between corporate and U.S. Treasury bond yields with similar characteristics.
Calculation
Typically the difference between the promised yield on a corporate bond and the yield on a U.S. Treasury bond with the same coupon and maturity.
Credit Agency
An agency that assesses and rates the safety of most bonds.
Investment-Grade Bonds
Bonds rated Baa or above by Moody’s or BBB or above by Standard & Poor’s.
Junk Bond
A bond with a rating below Baa or BBB.
Types of Bonds
Zero-Coupon Bonds
Bonds issued below face value with no coupon payments, maturing at $1,000 face value.
Are corporate bonds the only type offered as zero-coupon bonds?
Floating-Rate Bonds
Bonds with coupon payments tied to current market rates, such as the short-term Treasury rate plus a fixed percentage.
Convertible Bonds
Bonds allowing holders to exchange them for a specified number of company shares at a later date.
Stocks: Ownership in Corporations
Terminology
Primary Market
Market for the sale of new securities by corporations.
Secondary Market
Market where previously issued securities are traded among investors.
Initial Public Offering (IPO)
The first public offering of a company’s stock.
Primary Offering
Occurs when a corporation sells its shares.
Market Cap (Market Capitalization)
The total value of a company’s outstanding shares.
P/E Ratio
Ratio of stock price to earnings per share.
Dividend Yield
The ratio of dividends paid to share price, indicating the expected dividend income per dollar invested.
Dividend Discount Model (DDM)
DDM Definition
A discounted cash-flow model stating that today’s stock price equals the present value of all expected future dividends.
Dividend Yield
Sustainable Growth Rate
Payout Ratio
The fraction of earnings paid out as dividends.
Plowback Ratio
The fraction of earnings retained by the firm.
Note: Plowback Ratio = 1 – Payout Ratio
g (Sustainable Growth Rate)
The firm’s growth rate assuming constant plowback ratio, return on equity, and debt ratio.
Technical Analysis
Identifying undervalued stocks by analyzing past stock price patterns.
Fundamental Analysis
Finding mispriced securities by analyzing fundamental information like accounting performance and earnings prospects.
Note: Efficient markets quickly eliminate bargains due to competition among analysts.
Random Walk Theory
Security prices change randomly with no predictable trends or patterns, offering equal chances of high or low returns regardless of past performance.
Net Present Value (NPV)
NPV Calculation and Rule
Opportunity Cost of Capital
The expected rate of return forgone by investing in a project.
Net Present Value
Present value of cash flows minus initial investment.
NPV Rule
Accept projects with positive NPV to increase shareholder wealth.
Payback Period
Payback Period Definition
The time it takes for cash flows to recover the initial investment.
Payback Period Rule
Accept projects with a payback period below a specified cutoff.
Discounted Payback Rule
The number of periods before the present value of cash flows equals or exceeds the initial investment.
Internal Rate of Return (IRR)
IRR Definition and Rule
IRR Definition
The discount rate resulting in a zero NPV for the project.
IRR Rule
Accept projects with an IRR higher than the opportunity cost of capital to increase shareholder wealth.