Why do Companies Issue Stocks and Bonds? • To obtain capital (money) to complete the necessary activities of a business and expand, a company uses either equity or debt financing • Equity Financing– issuing stock to investors • An investor pays a company the price for the stock and, in return, obtains partial ownership of the company • Debt Financing– obtaining loans or issuing bonds in order to fund investments
Equity Financing Types of Stocks
Common Stock Ownership of a share of publicly-traded company • Elect the board of directors • Vote in annual shareholder’s meeting • Generally exercise control of the company • Rights of Common Stockholders • Limitations of Common Stockholders Investments in common stock appreciates as the company’s earnings grow • If company goes bankrupt, common stockholders get paid last • Not guaranteed dividend payments
Preferred Stock Hybrid between a stock and a bond Represents equity/ownership in a corporation, but to a limited degree • If company pays dividends, preferred stockholders will be paid before common stockholders • Preferred stockholders have a greater claim on company’s assets if the company liquidates • Rights of Preferred Stockholders • Limitations of Preferred Stockholders • Have no voice in how the company is managed • No voting rights
Stock Categorization • Industry • Examples: • Consumer Goods • ConAgra, General Mills • Personal Computers • Apple, Dell
Stock Categorization • Market Capitalization • Total market value of all of a company’s outstanding shares • Large-cap: securities issued by companies that have a market capitalization value of more than $10 billion • Mid-cap: securities issued by companies that have a market capitalization value between $2 and $10 billion • Small-cap: securities issued by companies that have a market capitalization value between $300 million and $2 billion WMT MSFT GE Market Cap Shares Outstanding Share Price = x
Stock Categorization • Market Capitalization • Total market value of all of a company’s outstanding shares • Example: Company ABC has a share price of $15 per share and has 20,000 shares outstanding. The market capitalization is 20,000 x $15 = $300,000,000. Therefore, Company ABC is considered a small cap company. The “Key Statistics” section on YahooFinance will show you the company’s market cap of the stock you look up. Market Cap Shares Outstanding Share Price = x
Stock Categorization • Company’s Sensitivity to the Business Cycle • Describes different stages of growth and decline in an economy • Peak: Economic activity is growing rapidly and production facilities are operating at full capacity • Contraction: Economy begins to slow down, unemployment rises, consumer spending declines, and sales decline • Trough: Economy is at the lowest point on the business cycle • Recovery: Employment levels and sales start to increase again • Expansion: Aperiod when business activity surges and the GDP expands until it reaches a peak (also known as an economic recovery)
Stock Categorization • Company’s Sensitivity to the Business Cycle • Describes different stages of growth and decline in an economy 5% Recession Recovery Expansion GDP Growth Peak Previous Peak Broken 0% -5% Trough
Business Cycle What determines a Company’s Sensitivity to the Business Cycle? • Defensive vs. Cyclical Stocks • Operating Leverage • Financial Leverage
Business Cycle • Defensive vs. Cyclical Stocks • Defensive Stock: not greatly affected by the business cycle. This is because defensive stocks are in industries such as food, utilities, and other consumer goods that are not considered “necessities”. Defensive stocks do not increase in price when the market surges or declines. • Example: ConAgra Foods
Business Cycle • Defensive vs. Cyclical Stocks (cont) • Cyclical Stocks: largely affected by the business cycle. Cyclical stocks will decrease when the market is weak and increase when the market is favorable. • Examples: Auto Makers (Ford), Airline Companies (Jet Blue Airlines) What are some reasons airlines and auto-makers are cyclical companies?
Business Cycle • Operating Leverage • Measures the amount of operating risk associated with a company’s level of fixed costs compared to its variable costs. • The greater the percentage of fixed costs to total expenses, the higher a company’s degree of operating leverage. Fixed Costs • Costs that do not change with the level of production. Examples of fixed operating costs include salaries, insurance expenses, and rent because regardless of how much you produce, these costs will not change. Variable Costs • Costs that change with the level of production. Examples include the costs of goods sold or sales. Generally the larger the production, the less each individual product costs to make because of “economies of scale”.
An Option’s Intrinsic Value • Example: Sky High Airlines has a high level of operating leverage. Aircraft and gate costs at airports are very large fixed costs incurred by Sky High Airlines. Regardless of how sales do, these costs do not change. Therefore, when sales increase, the variable costs will increase but to a lesser degree. These costs are comprised of fuel and maintenance of the planes. Sky High Airlines’ operating leverage would decrease because its percentage of fixed costs to total cost is not as large during an increase in sales. Fixed Costs = $15 million Variable Costs (low sales) = $18 million Variable Costs (high sales) = $25 million Operating Leverage (low sales) = 15/(15+18) = 45.5% Operating Leverage (high sales) = 15/(15+25) = 37.5%
Business Cycle • Financial Leverage • A way for a company to gain large returns without investing a lot of capital. Firms with a high degree of financial leverage are more sensitive to the business cycle. • Leverage = Debt/Equity • As you will learn in the next section, debt financing uses capital from outside the company to finance an investment, whereas equity financing comes from selling shares of ownership of the company.
Debt Financing Parts of a Bond • Principal – the face value of the bond • Maturity – the established time for the issuer to repay the bond • Coupon – the interest payments of a bond (usually every 6 months) • Yield – the rate of return realized from investing in the bond The term coupon comes from the early days of bonds. The physical paper bond was a certificate with coupon tickets that, when brought to the issuer, could be redeemed for the interest payment. Owners of the bond would clip the coupons in order to obtain their interest payments.
Who Issues Bonds and Why? Governments • The U.S. Government issues Treasury bonds in order to pay for government activities and to pay off government debt. • Treasury bonds are backed by the “full faith and credit” of the U.S. Government. Thus, these bonds are essentially free from default risk.
Government Bonds U.S. Government Issued Bonds Treasury Bills • Maturities: 4 weeks, 13 weeks, 26 weeks, and 52 weeks • Face value: $1,000 • Purchased at a discount and the full amount is repaid at maturity Treasury Notes • Maturities: over 1 to 10 years • Issued in denominationsof $1,000 to $5,000 • Coupons paid semi-annually Treasury Bonds • Maturities: over 30 years • Denominations: $1,000 to $1 million • Coupons paid semi-annually
Agencies • Organizations that are wholly owned and supported by the government • Issue bonds that have a direct government guarantee • Housing agencies are the most active issuers of bonds, among all agencies • Example: Government National Mortgage Association (GNMA), known as Ginnie Mae, is a U.S. housing agency.
Government Sponsored Enterprise (GSE’s) • Organizations that have an implied government guarantee but are not directly owned by the government • Example: Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac and Federal National Mortgage Association (FNMA) commonly known as Fannie Mae • GSE implies that the enterprise’s bonds are less risky than other bonds because the government would not allow them to fail because of their “implied” guarantee
Municipalities State and local governments issue Municipal bonds to borrow money to build and expand: • Schools • Government buildings • Water, power, and sewage systems • Prisons and hospitals • Colleges • Roads • Bridges • Public transportation • Airports • Highways
Why Buy Muni Bonds? Tax Free Income • Interest payments obtained from Municipal Bonds are exempt from federal tax and from state income tax if you reside in the specific state issuing them Safe Investment • United States Treasuries are the safest and municipals are considered second
Types of Muni Bonds • General Obligation Bonds (GO) • Revenue Bonds • Issued to raise funds for projects that no not provide direct sources of revenue • Examples: Roads, bridges, parks • Issued in order to fund projects that will serve the entire community, not only those who pay for the services • Backed by the full faith and credit of the issuing municipality • Interest and principal are paid through tax receipts • Finance income-producing projects • Examples: Airports, Power and Water municipalities • Income generated by these projects pays the bondholders their interest and principal revenue • Projects that are backed by revenue bonds provide services to only those in the community who pay for their services Mu Municipalities – Two Types of Bonds
Who Issues Bonds and Why? Corporations • Issue long-term debt to expand and finance their activities • Pay semi-annual coupons and repay face value of the bond at maturity • Corporate bonds are traded “over the counter”
Bond Ratings • Different rating agencies exist for bonds • Standard & Poor’s and Moody’s are the two most recognizable rating agencies • Bonds are rated according to their risk • Different factors affect the riskiness of a bond, one of the largest being default risk • Default risk is the ability of a company to repay the bond at maturity • If there exists a large default risk (more uncertainty the company will be able to repay its debt), the investor should require a greater return to compensate for the risk it is taking on
Bond Structure Debenture vs. Collateralized • Debenture Bonds– An unsecured, meaning it is not backed by any collateral. It can be a real asset (ex. Building) or a financial asset (ex. Loan or Bond). • Collateralized Bonds – Are backed by either a financial asset or a real asset. In the case of bankruptcy, the assets are sold and the proceeds are used to pay back the holder of the collateralized bonds. Collateralized bonds are safer than debenture bonds and, therefore, offer lower yield.
Bond Structure Currency Denomination • Refers to the currency in which the bond is issued and its coupon and principal payments are paid • The most common currencies are: • U.S. Dollars • EU Euros • Japanese Yen
Redemption Characteristics Callable Bonds • When a bond issued with a call option, the issuer has the option to retire the bond before maturity at a set price, known as the call price • Issuers exercise call options when interest rates are low and they can refinance at lower interest rates
Redemption Characteristics Convertible Bonds • Gives the bondholder the option to exchange the bond for a set number of shares of common stock in the issuing company Bond Common Stock Bondholder
Redemption Characteristics Sinking Fund Bonds • A means of repaying funds that were borrowed through a bond issue • The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market
Coupon Structure The coupon structure is the interest rate stated on a bond when the bond is offered. It is the percentage of the bond that will be paid, usually semi-annually or annually, as the coupon payment to the owner of the bond. The bond will either pay a fixed rate coupon or a floating rate coupon. Fixed Rate Bond • Majority of bonds are fixed rate bonds • The coupon rate does not fluctuate Floating Rate Bond • Bonds that have a coupon rate that is adjusted periodically, or “floats”, in conjunction with a short term rate, such as LIBOR (London Inter-Bank Offer Rate).
Payment of Principal The bond’s principal can be repaid with a “balloon payment” or through amortization. Balloon Payment • Treasuries, Munis, and Corporate Bonds are based off of balloon payments • A balloon payment system occurs when small payments are made throughout the duration of the bond and a large, “balloon” payment is made at maturity Amortization • The process by which the principal balance gradually declines over time and is at zero at maturity • Interest and principal make up a mortgage payment • In the beginning of the mortgage, the majority of the payment is interest • As the payments continue, a large portion of the payment is made up of principal repayment and a smaller portion is comprised of interest payment
Payment of Principal Example:30 Year Fixed Rate Mortgage $300,000 mortgage with $1,000 yearly payments Year 1 Payment Year 2 Payment Year 30 Payment Interest Portion Interest Portion Interest Portion $900 $875 $0 Mortgage $300,000 Mortgage $290,000 Mortgage $280,000 Mortgage $1,000 Mortgage $0 (repaid) $100 $125 $1,000 Principal Portion Principal Portion Principal Portion
Mortgage Backed Securities • A type of bond representing an investment in a pool of real estate loans. • This is a way for banks to free up capital to make additional loans and provide a way for market participants to invest in mortgages. • A pro rata share of the pool is sold to investors as bonds • The pooling together of illiquid assets, such as mortgage loans, and selling off shares in the pool as bonds is known as securitization
Mortgage Backed Securities Mortgage 1 Mortgage 3 Mortgage 5 Mortgage 7 Mortgage 2 Mortgage 4 Mortgage 6 Mortgage 8 Pool of Mortgages MBS MBS MBS MBS MBS
Mortgage Backed Securities Prepayment Risk • The largest risk when investing in a MBS • Prepayment occurs when the principal is repaid earlier than the scheduled maturity of the loan. Often, a borrower will prepay when they want to refinance their mortgage in a lower interest rate environment.
Mortgage Backed Securities • Example: I.N. Vestor wants to buy a house with a purchase price of $500,000. I.N. Vestor approaches his bank to secure a mortgage. He funds the purchase of the house with a 30-year mortgage at a 4% interest rate. Over the next 30 years, the bank will continue to receive principal and interest payments from I.N. Vestor. The bank wants to sell the stream of interest (4%) and principal payments from his loan to other investors. The bank is making money by devising and servicing the mortgages. In order to sell the interest stream to other investors, the bank bundles I.N. Vestor’s loan together with 5,000 other mortgages. Then the bundle, consisting of I.N. Vestor’s loan and the 5,000 other mortgages, are sold to investment banks as mortgage-backed securities. The investment bank then divides the pool of loans and sells these as separate bonds to investors.
Stocks vs. Bonds Companies that issue preferred stock are not obligated to pay dividends to their stockholders. • Issuers of bonds are required to pay coupons (interest payments) to their bondholders. Furthermore, if an issuer suspends payment on preferred stock dividends, common stock dividends cannot be paid • Most preferred stock are “cumulative,” that is, if dividends are suspended, the dividends accumulate and must be paid before any common stock dividends are paid
Stocks vs. Bonds • “Senior” means that the debt has priority over other types of debt in the case of bankruptcy. • “Unsecured” means that specific collateral does not exist and, therefore, has a lower priority in the case of bankruptcy.
Stocks vs. Bonds In case of liquidation, a company will pay back its debt in the following order: Less Risk, Less Return More Risk, More Return
Stocks vs. Bonds Collateral • An asset that backs the loan • If you fail to pay back the loan to the bank, then the lender can liquidate the collateral to repay the loan
Money Market Instruments Money Market Instruments are characterized as debt obligations with maturity up to one year. Treasury Bills(sometimes called T-bills) • Short-term debt, with a maturity of up to one year • Backed by the U.S. government • Sold in denominations of $1,000 • Maturities of one month, three months, six months, or twelve months Commercial Paper • An unsecured, short-term debt instrument • Issued by a corporation • Typically for financing of accounts receivable, inventories and meeting short-term liabilities • Maturities range from 1 to 270 days
Alternatives to Direct Stock Market Investment Exchange Traded Funds (ETFs) • Closed-ended fund that tracks and index • Can be traded like a stock • ETFs are stocks within specific sectors that mimic the market • Example: Spider (SPDR), which tracks the S&P 500 Index American Depository Receipts (ADRs) • A way to invest in foreign equity that is considered safer for U.S. investors • U.S. banks keep a certain amount of stock of a foreign company in its vaults (depository) • Investor can buy shares in that collection of stocks, priced in U.S. dollars.
American Depository Receipts (ADR) Alternatives to direct investment in the stock market • ADR • Way to invest in foreign equity that is considered safer for U.S. investors • U.S. banks place a certain amount of stock of a foreign company into its vault (depository) • Investors can buy shares in that collection of stocks, priced in U.S. dollars
Derivatives A financial instrument (security) that derives its value from an underlying asset. The price of the underlying asset determines the price of the derivative. Underlying assets include: • Stocks • Bonds • Commodities (gold, cattle, etc.) • Exchange rates • Indexes (NASDAQ 100)
Why Invest Using Dervatives? Hedging • Allow corporations and individuals to protect themselves against risk. For example, the risk that the stock will decline in value in the future. Speculation • The practice of partaking in risky financial transactions in order to profit from short- or medium-term fluctuations in the market value of tradable goods such as a financial instruments. In essence, it’s a guess.
Types of Derivatives Forwards • A forward is a private contract to buy or sell a security at a specific date in the future at a set price Futures • A future is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Future contracts specify the quality and quantity of the underlying asset. Future contracts are standardized to enable trading on a futures exchange. • Futures exchange – The central marketplace where futures contracts and options on futures contracts are traded
Difference between Forwards and Futures Standardization • Trades on an exchange and is subject to standards of the exchange • Futures are standardized. • Forward contracts are not standardized