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Risk and Return Fixed income (bonds) Equities (stocks) Asset Mix (how you combine stocks and bonds) Diversification
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Risk And Return In financial markets you get paid a Return for taking a Risk, and every
investment contains some risk The two most common definitions or risk are
the potential of permanent loss risk of borrower not paying back interest or principal risk of company not paying dividends or the value of company’s
shares declining
the volatility of day to day changes in the market value of investments
how much and how often does the value of our investment change, for better or worse
Fixed income (bonds and short-term money market investments) are typically less risky than equities
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As An Investor, You Have 2 Options
Make a loan to someone Cash deposit, GICs,
bankers acceptances, commercial paper, money market, bonds
Buy ownership in a company
Purchase stocks
All investments have Risk, it is only a matter of how much
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Risk And Return
Always a Tradeoff!!
Risk
Return
Low Risk
Low Return
Higher Risk
High Potential Return
Cash
Money Market
Government Bonds
Corporate Bonds
EquitiesCanadian, U.S. & International
Alternative Investmentsi.e. Private Equity, Hedge Funds
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What Are Fixed Income Securities?
They pay a fixed amount of income to the owner produce a steady income stream that you can use to budget
Fixed income securities have a limited life at some point the security matures and the borrower pays back
your principal
Stocks do not ‘mature’
they exist as long as the company exists
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Short Term Fixed Income Securities
Examples of short-term (usually less than one year) fixed income include: GICs
short-term borrowing by banks Treasury Bills
short-term borrowing by Federal and Provincial Governments
Bankers Acceptances and Commercial Paper short-term borrowing by corporations
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Short Term Fixed Income Securities
Examples of short-term (usually less than one year) fixed income include: Money Market
a pool of treasury bills, bankers acceptances, commercial paper, short term bonds, all with a very short term to maturity
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Long-Term Fixed Income Securities
Examples of long-term fixed income include:
Bonds long-term borrowing by governments (federal, provincial and
municipal) and corporations Mortgage and Asset Backed Securities
pools of mortgages that are packaged together and sold just like bonds
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Bonds
When talking about fixed income securities, we are usually talking about bonds
Bonds are a contract that entitle the owner to regular interest payments and the return of their principal (original amount of the loan) when the bond matures
Bonds are bought and sold in the open market, like stocks
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Bond Example
You receive the following interest payment each year
1 2 3 4 5 6 7 8 9 10 $40k $40k $40k $40k $40k $40k $40k $40k $40k $40k
Total payments over 10 years is $400,000 ($40k per year for 10 years)
Receive your principal of $1,000,000 back from the Government of Canada after 10 years, when bond matures
Total money received over 10 years is $1,400,000
Suppose you buy a new 10 Year $1,000,000 Government of Canada bond with a 4% coupon:
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Bonds: Changing Interest Rates Interest rates affect the price of most fixed
income securities, especially bonds
Interest rates (yields) go up and down, depending on what is happening in the economy; generally the better the economy, the higher the interest rate
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Bonds: Changing Interest Rates
Interest rates and the price of bonds move in opposite directions, i.e. when interest rates go up, bond prices go down; when interest rates go down, bond prices go up Interest rates
Bonds prices
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Bonds: Time to Maturity Can Have A Large Impact on Bond Prices
The longer the time to maturity, the more volatile the bond price for a given change in interest rates
a change in interest rates of 1% will not affect the price of a bond that matures tomorrow.
however, a 1% change in interest rates will have a much larger effect on a bond that matures in 10 years
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Bonds: Time to Maturity Can Have A Large Impact on Bond Prices
$0
$1
$2
$3
2 years 5 years 10 years 25 years
$ Change for 1% Change in Interest Rates
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Credit Rating Agencies How do you know which bonds to buy and which to
avoid?
Your investment counsellor starts the process by reviewing what independent credit rating agencies say about the bond
Two examples of credit rating agencies are Dominion Bond Rating Service and Standard & Poors
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Credit Rating Agencies DBRS and S&P look at things like cash flows, earnings
growth, the firm’s competitive position and future capital expenditures.
The agencies come up with a grade representing the credit quality of the borrower.
The better the credit quality, the higher the credit rating; the higher the rating, the lower the interest rate the borrower must pay on the debt.
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Fixed Income – Credit Qualities
Quality Counts
Bond
Rating
Interest
Rate
Investment Grade AAA 3%Best Quality (lowest risk, pays lowest rate of
interest)
AA 4%
A 6%
BBB 8%
Non-Investment Grade (Junk Bonds)
BB 10%
B 15%
CCC ???Worst Quality (highest risk, pays higher rate
of interest)
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Stocks What They Are
Called equities or common shares Ownership of a piece of the company Create earnings (sales – expenses) Provide a return
Capital gains (stock price goes up) Dividends
Listed on a stock exchange Can be traded Can be risky
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Stocks
Why a Company Issues Shares Raise Money
Start up the company Provide extra cash to run the business Buy property, plants, equipment Acquire other companies Alternative to borrowing money
Spread the Risk of Ownership
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Stocks
What A Company Does With Earnings (profits) Reinvest in the Company (retained earnings) Buy back their own Shares Acquire another Company Pay Dividends to Shareholders
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Stocks
Why Investors Buy Them Investors – First Nations
Provide long term Growth to a Portfolio Typically buy to hold for longer periods than
traders/speculators For Total Return
Capital gains Dividend income
Traders/Speculators – NOT First Nations Make quick profits from an increase in price Capital Gains
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ABC Company
Stocks can provide two types of returns:
1. Dividends – Provides Income
2. Capital Gains – Provides Growth
Stock Price = $100
Dividend = $4 ($1.00 paid each quarter)
Dividend Yield = 4%
Every year ABC stock pays $4/per share. So if you own 1,000 shares, you receive $4,000 in dividends each year for as long as you hold the stock
Stock Returns
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If ABC stock price rises you enjoy a Capital Gain
Buy Price = $100 per share
Price rises = $125 per share
Capital Gain = $25 per share
So if you bought 1,000 shares of ABC stock at $100 and the price goes to $125, you have a capital gain of $25,000
($25 x 1000 shares)
Stock Returns
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Stocks What Makes Them Change In Price
Earnings or Expected Earnings Company
Business model Competitive position Revenues and Expenses
Industry Anything affecting the particular industry or business of the
company Economy
Affects people’s ability to by Company’s products Consumer and Business spending Employment / Unemployment Interest Rates
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Stocks What Makes Them Change In Price
Demand for a Company’s Stock Information
What is know or factual about the Company Company reports and results Past performance , Earnings, etc.
Speculation What is assumed about the Company and its prospects Anticipation of changes to business and potential
earnings Rumours about the Company
Takeovers New business opportunities
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Asset Mix
Asset mix is another way of saying how much do you have in stocks and how much do you have in bonds
Each Trust has its own unique return requirements and risk tolerance
Asset mix will determine the risk/return levels in your trust portfolio
generally, the more stocks you have the more risk you take
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Asset Mix
How do you decide on asset mix? Assessment of First Nation’s
financial needs & long term goals ability to tolerate short-term loss in value ability to tolerate permanent loss of capital
Professional help is recommended do it right the first time (very costly to fix later) avoid actual losses or lost opportunities
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Asset Mix
Example of asset mix choices: Under three years:
fixed income only Three to five years
balanced account with more fixed income than equities, i.e. 70% fixed income and 30% equities
More than five years balanced account with more equities than fixed income, i.e.
40% fixed income and 60% equities
EACH FIRST NATION/TRUST HAS IT’S OWN UNIQUE FINANCIAL OBJECTIVES AND CONSTRAINTS.