Investing 101Investing 101

Lecture 2Lecture 2

Fixed Income ProductsFixed Income Products

Stock Game TickersStock Game Tickers

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

Reality Check!Reality Check!

Did anyone bring their Andex charts?Did anyone bring their Andex charts? If so pleas pull them out. We are going to If so pleas pull them out. We are going to

have a harder look at the importance of have a harder look at the importance of time horizon.time horizon.

Wealth Accumulation of Wealth Accumulation of Stocks and Bonds (1926-Stocks and Bonds (1926-2002)2002)

$0.10

$1.00

$10.00

$100.00

$1,000.00

$10,000.00

Stocks

Bonds

$1774.47

$59.71

What About Investment What About Investment Expenses?Expenses?

The previous performance ignores The previous performance ignores investment expensesinvestment expenses

How much would investors have How much would investors have accumulated with a 1 percent annual accumulated with a 1 percent annual expense ratio?expense ratio?

Wealth Accumulation Wealth Accumulation after Expensesafter Expenses

$0.10

$1.00

$10.00

$100.00

$1,000.00

$10,000.00

Stocks

Bonds

$825.45

$27.26

What About Taxes?What About Taxes?

The government taxes interest, dividend The government taxes interest, dividend income, and realized capital gainsincome, and realized capital gains

How much do taxes affect our wealth How much do taxes affect our wealth accumulations?accumulations? I assumed that dividends and interest I assumed that dividends and interest

income is taxed at the marginal tax rate of income is taxed at the marginal tax rate of the average stock and bond holder and that the average stock and bond holder and that capital gains are not taxedcapital gains are not taxed

Wealth Accumulation Wealth Accumulation after Expenses and Taxesafter Expenses and Taxes

$0.10

$1.00

$10.00

$100.00

$1,000.00

$10,000.00

1926

1930

1934

1938

1942

1946

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

Stocks

Bonds

$359.47

$9.11

What About (The real What About (The real killer) Inflation?killer) Inflation?

$1 in 1926 could buy much more than $1 $1 in 1926 could buy much more than $1 in 2002in 2002 Consumer prices increased over this period Consumer prices increased over this period

about ten-foldabout ten-fold

How much does inflation affect our How much does inflation affect our wealth accumulations?wealth accumulations?

Real Wealth Real Wealth Accumulation after Accumulation after Expenses and TaxesExpenses and Taxes

$0.10

$1.00

$10.00

$100.00

$1,000.00

$10,000.00

1926

1930

1934

1938

1942

1946

1950

1954

1958

1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

Stocks

Bonds

$35.60

$0.90

Review!Review!

What is a stock?What is a stock?

What is a Dividend?What is a Dividend?

What is a Capital Gain?What is a Capital Gain?

What is a Mutual fund?What is a Mutual fund?

How long does a stock live?How long does a stock live?

Main Teaching PointsMain Teaching Points

What is a bond?What is a bond? Where do bonds come from?Where do bonds come from? What are the benefits/rights of What are the benefits/rights of

ownership?ownership? How do bonds Work?How do bonds Work? What are the risks of ownership?What are the risks of ownership? Why do interest rates matter?Why do interest rates matter?

Just What The Hell Is A Just What The Hell Is A Bond Anyway?Bond Anyway?

A debt investment with which the A debt investment with which the investor loans money to an entity investor loans money to an entity (company or government) that (company or government) that borrows the funds for a defined borrows the funds for a defined period of time at a specified period of time at a specified interest rate.interest rate.

A bond is NOT ownershipA bond is NOT ownership A bond does NOT give you any A bond does NOT give you any

say in how a company is run. say in how a company is run. A bond is a LOANA bond is a LOAN

What is a Coupon?What is a Coupon?

A coupon is a payment of interest on the A coupon is a payment of interest on the loan.loan.

A coupon can be paid quarterly, semi A coupon can be paid quarterly, semi annually, annually or not at all.annually, annually or not at all.

Where Do Bonds Come Where Do Bonds Come From?From?

Bonds are born in the same way Bonds are born in the same way as stocks.as stocks.

A company will approach an A company will approach an Investment Bank needing a debt Investment Bank needing a debt issue. issue.

The investment bank will analyze The investment bank will analyze the market and the company to the market and the company to determine the best duration, rate, determine the best duration, rate, etc of the bond. etc of the bond.

Why Are They Needed?Why Are They Needed? Difficult to explain however…..Difficult to explain however….. M&M proposition II with taxes, optimal capital M&M proposition II with taxes, optimal capital

structure. (Graph)structure. (Graph) Stock price unfavorable for an equity issue.Stock price unfavorable for an equity issue. Excess debt capacity (D/E ratio off balace)Excess debt capacity (D/E ratio off balace) Gov’t financing projects (ie bridge) or Gov’t financing projects (ie bridge) or

borrowing in a pinch (ie war victory bonds).borrowing in a pinch (ie war victory bonds).

BreakBreak

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

10 min Break10 min Break

Differences Between Bonds Differences Between Bonds and Stocksand Stocks

BondsBonds A loanA loan No ownershipNo ownership No voteNo vote Guaranteed by assets Guaranteed by assets

(usually)(usually) Seniority in LiquidationSeniority in Liquidation Finite life spanFinite life span Regular coupons.Regular coupons.

StocksStocks A purchase A purchase Of ownershipOf ownership A vote A vote Not GuaranteedNot Guaranteed Subordinate to Debt, Subordinate to Debt,

Preferred shares and Preferred shares and any higher classesany higher classes

Infinite lifespanInfinite lifespan No sure dividendsNo sure dividends

Bond BenefitsBond Benefits

““Guaranteed” return (if held to maturity)Guaranteed” return (if held to maturity)

Secured By Assets (in most cases)Secured By Assets (in most cases)

Capital gain possiblitiesCapital gain possiblities

““Safer” invesmentSafer” invesment

Steady Income Stream Steady Income Stream

Negative Correlation to stocks.Negative Correlation to stocks.

Bond Risks?!Bond Risks?!

Inflation riskInflation risk

Interest rate riskInterest rate risk

Default riskDefault risk

Liquidity riskLiquidity risk

Types Of Fixed Income Types Of Fixed Income InstrumentsInstruments

Strip BondStrip Bond Zero Bond/T-BillZero Bond/T-Bill Coupon BondCoupon Bond Floating Rate BondFloating Rate Bond C – PaperC – Paper Preferred Shares*Preferred Shares*

What Makes One Bond What Makes One Bond Different From Another?Different From Another? Governments are much less likely to go Governments are much less likely to go

bankrupt than are companies. They can bankrupt than are companies. They can also print money if need be. also print money if need be.

Large, established companies can Large, established companies can borrow at lower rates.borrow at lower rates.

Different bonds have different features. Ie Different bonds have different features. Ie callable, retractable, extendable. callable, retractable, extendable.

Bond Rating Bond Rating

Dominion Bond Rating Service of DBRS Dominion Bond Rating Service of DBRS rates bonds as to the investability of the rates bonds as to the investability of the bond. bond.

Rating is from AAA to DRating is from AAA to D

Anything below BB is considered Anything below BB is considered “Junk.”(GM)“Junk.”(GM)

How Bonds WorkHow Bonds Work

Always helpful to use a picture.Always helpful to use a picture.

PV=(C/r)(1-1/(1+r)^t)/r + FV/(1+r)^t.PV=(C/r)(1-1/(1+r)^t)/r + FV/(1+r)^t.

Inverse relationship between PV and r in Inverse relationship between PV and r in that PV= FV/(1+r)^t.that PV= FV/(1+r)^t.

Questions?Questions?

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