Chapter 12 Investing in Bonds 1 Chapter Objectives • Identify the different types of bonds • Explain what affects the return from investing in a bond • Describe why some bonds are risky • Identify common bond investment strategies 2 Background on Bonds • Bonds: long-term debt securities issued by government agencies or corporations that are collateralized by assets • Debentures: long-term debt securities issued by government or corporations that are secured only by their promise to pay e.g. all Government of Canada bonds • Par value: for a bond, its face value, or the amount returned to the investor at the maturity date when the bond is due • Term to maturity: the date at which a bond will expire and the par value of the bond, along with any remaining coupon payments, is to be paid back to the bondholder (1-30 years) 3 Background on Bonds • Investors lend the issuers of bonds with funds • Issuers are obligated to make interest payments and to pay the par value at maturity • Coupon payments are normally paid semi-annually • Some bonds are issued at a price below par value • Bonds are normally quoted in a base value of 100 • E.g. A bond quoted at 95 is trading at 95% of the par value. If the par value is $1000, then the bond is trading at $950. 4 Bond Characteristics • Call feature: a feature on a bond that allows the issuer to repurchase the bond from the investor before maturity • Offer a slightly higher return than bonds without a call feature • Sinking fund: a pool of money that is set aside by a corporation or government to repurchase a set amount of bonds in a set period of time • Acts like a mandatory call feature • Convertible bond: a bond that can be converted into a stated number of shares of the issuer’s stock at a specified price • Tend to offer a lower return than non-convertible bonds 5 Bond Characteristics • Extendable bond: a shorter-term bond that allows the investor to extend the maturity date of the bond • Tend to offer a lower return than non-extendible bonds • Put feature (retractable bond): a feature on a bond that allows the investor to redeem the bond at its face value before it matures • Slightly lower return than similar bonds without a put feature 6 Yield to Maturity • Yield to maturity: the annualized return on a bond if it is held until maturity • If a bond sells at par value, its yield to maturity equals the coupon rate • Discount: a bond that is trading at a price below its par value • Its yield to maturity would exceed the coupon rate • Premium: a bond that is trading at a price above its par value • Its yield to maturity would be less than the coupon rate 7 Quick Check Courtney Anderson purchased a $10,000 par value bond at a quoted price 90. The bond has a coupon rate of 4 percent payable semi-annually. The bond will mature in three years. What is the yield to maturity for this bond if interest is compounded semi-annually? Bond quote at 90: $10,000 x 0.9 = $9000 Semi-annual payments: $10,000 x 0.04 2 = $200 7.8% 8 Bonds Trading in the Secondary Market • Investors can sell their bonds to other investors before the bonds reach maturity in the secondary market • When interest rates , bond prices • When interest rates , bond prices 9 Term Structures of Interest Rates • Term structure of interest rates: a graph that shows the relationship between bond yield to maturity and time to maturity • Resulting curve is known as a yield curve • Shape of the yield curve reflects the market’s sentiment about the direction for interest rates over time • Yield curve shapes include normal, steep, inverted, and flat 10 Normal Yield Curve 11 Term Structure Theories • Theories that attempt to explain why the term structure of interest rates is shaped the way that it is: • Liquidity preference theory: suggests that investors require a premium for investing in longer-term bonds • Pure expectations theory: suggests that the shape of the yield curve is a reflection of the market’s expectation for future interest rate movements • Market segmentation theory: suggests that the shape of the yield curve is determined by the supply and demand of bonds for various market players in different segments of the yield curve 12 Money Market Securities • Short-Term Debt Securities Lowest • yield to maturity T-Bills: short-term debt securities issued by the Canadian and provincial governments and sold at a discount • Do not make coupon payments • Banker’s acceptances (BAs): short-term debt securities issued by large firms that are guaranteed by a bank Highest • yield to maturity Commercial paper: a short-term debt security issued by large firms that is guaranteed by the issuing firm • Although not paid, interest must be recognized every year 13 Types of Bonds • Government of Canada Bonds • Government of Canada Bonds: debt securities issued by the Canadian government • Not exposed to the risk of default by the issuer • Issued with a term to maturity of between 1 and 30 years • Interest is paid semi-annually • Can be easily sold in the secondary market • Marketable bonds: Government of Canada bonds that can be sold in a secondary market 14 Types of Bonds • Federal Crown Corporation Bonds • Federal crown corporation bonds: debt securities issued by corporations established by the federal government • Not exposed to the risk of default by the issuer • Issued with a term to maturity of between 2 and 10 years • Interest is paid semi-annually • Can be easily sold in the secondary market 15 Types of Bonds • Provincial Bonds • Provincial bonds: debt securities issued by the various provincial governments • Risk of default by the issuer will differ depending on the province from which you purchased the bond • Issued with a term to maturity of between 1 and 30 years • Interest is paid semi-annually • Can be easily sold in the secondary market 16 Types of Bonds • Municipal Bonds • Municipal bonds: long-term debt securities issued by local government agencies • Provide the funds necessary for municipal projects • Very low default risk • Uncommon investments in Canada • Terms and condition will vary with the needs of the municipality 17 Types of Bonds • Corporate Bonds • Corporate bonds: long-term debt securities issued by large corporations • Subject to default risk • High-yield bonds: bonds issue by less stable corporations that are subject to a higher degree of default risk • Terms and condition will vary with the needs of the corporation 18 Other Fixed Income Products • Mortgage-Backed Securities (MBSs) • Mortgage-backed securities (MBSs): represent a pool of CMHC-insured residential mortgages that are issued by banks and other financial institutions • A guaranteed flow-through investment • Attractive to investors seeking income • Can be sold in the secondary market • Issued with a term to maturity of between 1 and 10 years • Subject to prepayment risk 19 Other Fixed Income Products • Strip Bonds • Strip bonds: long-term debt securities issued by the Government of Canada (and some provinces) that do not offer coupon payments • Can be sold at a very deep discount • Although not paid, interest must be recognized every year • Very safe investment in terms of default risk and can be sold in the secondary market • Very high interest rate risk 20 Other Fixed Income Products • Real Return Bonds • Real return bonds: long-term debt securities issued by the Government of Canada that protect you from inflation risk • All other bonds are exposed to inflation risk • The par value of the bond is adjusted for changes in the inflation rate • Coupon payments will increase with each increase in the face value • Issued with a term to maturity of between 1 and 30 years 21 Return from Investing in Bonds • Your return from investing in a bond depends on the price at the time you sell it • Impact of Interest Rate Movements • If the bond coupon rate is less than the current coupon rate on similar bonds, you must sell the bond at a discount • If the bond coupon rate is more than the current coupon rate on similar bonds, you can sell the bond for a premium 22 Return from Investing in Bonds • Tax Implications of Investing in Bonds • Interest income is taxed as ordinary income • Tax on interest income must be paid in the year it is earned • Selling bonds at a price different than what you paid for them results in a capital gain (or loss) 23 24 Valuing a Bond • The present value of future cash flows to be received by the investor, which are the periodic coupon payments and the principal payment at maturity • Market price of any bond is based on investors’ required rate of return, which is influenced by the interest rates that are available on alternative investments at the time 25 894.37 26 Risks from Investing in Bonds • Use of Risk Ratings to Measure the Default Risk • Reflect the likelihood that the issuers will repay their debt • Relationship of Risk Rating to Risk Premium • Risk premium: the extra yield required by investors to compensate for default risk • The lower the risk rating, the higher the risk premium offered on a bond • Impact of Economic Conditions • Higher risk of default when economic conditions are weak 27 https://www.fe.training/free-resources/credit/credit-rating/ • A higher rating, such as AAA, will allow a corporation to issue debt with a lower interest rate • If the firm’s rating has been reduced because of questionable financial statements, the price reduction on its bonds can be quite severe BC’s Credit Rating Drops for the Third Time 28 https://www.worldgovernmentbonds.com/world-credit-ratings/ Risks from Investing in Bonds • Default risk: the risk that the borrower of funds will not repay the creditors, coupons and/or principal • Call (prepayment) risk: the risk that a callable bond will be called • Inflation risk: the risk that the purchasing power of a bond investment will diminish due to a relative increase in inflation • Reinvestment risk: the risk that the income earned from a bond cannot be reinvested at the same or a higher rate of interest as was being earned from the bond • Interest rate risk: the risk that a bond’s price will decline in response to an increase in interest rates 30 Bond Investment Strategies • Bonds with longer terms to maturity are more sensitive to interest rate movements • Choose maturities on bonds that reflect your expectations of future interest rates • Consider investing in bonds that have a maturity that matches the time when you will need the funds • Most strategies involve investing in a diversified portfolio of bonds rather than in one bond • Reduces your exposure to possible default, but may not reduce your interest rate and reinvestment risks 31 Bond Investment Strategies • Interest rate strategy: selecting bonds based on interest rate expectations • Expect interest rates to decline, invest heavily in longterm bonds • Expect interest rates to increase, shift most of your money to bonds with short terms to maturity • Frequent trading results in high transaction costs but may generate more short-term capital gains 32 Bond Investment Strategies • Passive strategy: investing in a diversified portfolio of bonds that are held for a long period of time • Valuable for investors who want to generate stable interest income over time and do not want to incur costs associated with frequent trading • May reflect a portfolio of bonds with diversified risk levels • A portfolio may attempt to diversify across a wide range of bond maturities (i.e., bond laddering) • Maturity matching strategy: selecting bonds that will generate payments to match future expenses 33 Chapter 13 Investing in Mutual Funds 34 Chapter Objectives • Describe the advantages and disadvantages of mutual funds • Identify the types of mutual funds • Explain how to choose among mutual funds • Describe quotations of mutual funds • Explain the difference between ETFs and mutual funds • Explain the difference between segregated funds and mutual funds 35 Background on Pooled Investment Funds • Pooled investment fund: an investment vehicle that pools together money from many investors and invests that money in a variety of securities • E.g. mutual funds, ETFs, segregated funds, hedge funds • Provide diversification, economies of scale, and marketability • Marketability: ease of converting an investment into cash 36 Background on Mutual Funds • Money market mutual funds: invest in cash and cash equivalent investments that can be converted to cash quickly • Bond mutual funds: invest in bonds • Balanced mutual funds: invest in a combination of stocks and bonds • Equity mutual funds: invest in stocks • Mutual funds employ portfolio managers • Minimum initial investment is usually between $500 and $5000 37 Background on Mutual Funds • Advantages of Investing in Mutual Funds • Provide professional money management • Simplify the process of record keeping • You only have to evaluate the performance of the mutual fund relative to your goals • Mutual funds are available everywhere • Diversified portfolios 38 Background on Mutual Funds • Disadvantages of Investing in Mutual Funds • Management fees and other costs vary substantially among funds • Investor has no control over the investments that are purchased and/or sold within the mutual fund • Liquidity can be very low • Liquidity: the ease with which the investor can convert the investment into cash without a loss of capital 39 Net Asset Value per Share • Net asset value (NAV): the market value of the securities that a mutual fund has purchased minus any liabilities and fees owed to mutual fund’s managers • Net asset value per share (NAVPS): calculated by dividing the NAV by the number of shares in the fund • Interest or dividends earned by the fund are added to the market value of the assets • Fund expenses and any dividends distributed to the fund’s shareholder’s are deducted 40 41 Open-End Vs. Closed-End Funds • Open-end mutual funds: funds that sell shares directly to investors and will redeem those shares whenever investors wish to “cash” in (unlimited shares) • Fund managers typically maintain a small portion of cash or liquid securities so that they have sufficient liquidity when redemptions exceed new share purchases • Closed-end mutual funds: funds that issue shares to investors but do not redeem those shares; instead, the fund’s shares are traded on a stock exchange like a stock with market price determined by supply and demand • Price per share can differ from the fund’s NAVPS (either at a premium or at a discount) 42 Load Vs. No-Load Funds • No-load mutual funds: funds that sell directly to investors and do not charge a fee • Front-end load mutual fund: mutual funds that charge a fee at the time of purchase, which is paid to stockbrokers or other financial service advisers who execute transactions for investors • Back-end load mutual funds: mutual funds that charge a fee if shares are redeemed within a set period of time (BANNED in June 2022!) • Declining redemption schedule: a fee schedule where the back-end load charge reduces with each year an investor holds the fund 43 Example of Back-End Load 44 45 Management Expense Ratio (MER) • Management expense ratio: the annual expenses (administrative, legal, advisor compensation, research and marketing costs) incurred by a fund on a percentage basis • The higher the expense ratio, the lower the return for a given level of portfolio performance • On average, mutual funds have an MER of about 2.68% • Lower MER funds historically had better performance 46 Types of Mutual Funds • Types of Equity Mutual Funds • Growth Funds: focus on stocks that have potential for above-average growth • Small Capitalization (Small-Cap) Funds: focus on smaller firms that tend to have more potential for growth relative to larger firms • Mid-Size Capitalization (Mid-Cap) Funds: focus on medium-sized firms that are more established than small-cap firms • Dividend Funds: focus on firms that pay a high level of dividends. Less potential for high capital gains and exhibit less risk 47 Types of Mutual Funds • Balanced Growth and Income Funds: Contain both growth stocks and stocks that pay high dividends • Sector Funds: focus on stocks in a specific industry or sector, such as technology stocks (less diversified) • Index Funds: mutual funds that attempt to mirror the movements of an existing equity index • Fewer expenses than a typical mutual fund (do not incur expenses for researching various stocks) • Very low transaction costs • Tracking error: refers to how closely an index fund mirrors the movements of the existing index it is benchmarked against • Offer tax advantages since index funds engage in less trading 48 Types of Mutual Funds • International Equity Funds • Focus on firms that are based outside Canada • Attractive to investors who want to invest in a specific country • Expenses associated with managing an international equity fund are higher • “Global mutual funds” invest in stocks of both foreign firms and Canadian firms • Ethical Funds • Screen out firms viewed as offensive by some • Avoid investing in gambling, tobacco, ammunition, or pollution companies 49 50 Types of Mutual Funds • Types of Bond Mutual Funds • Canadian Bond Funds: invest in Canadian bonds • High-Yield Bond Funds: focus on relatively risky bonds issued by firms that may have a higher default risk • Index Bond Funds: intended to mimic performance of a specified bond index • Global Bond Funds: mutual funds that focus on bonds issued by non-Canadian firms or governments • Have foreign exchange risk and higher expenses 51 Return and Risk of a Mutual Fund • 4 Returns from Investing in a Mutual Fund 1. Interest income distributions 2. Dividend distributions 3. Capital Gain from Redeeming Shares • Occurs when you redeem shares at a higher price than the purchase price But why do you still have to pay capital gains taxes even if you don’t redeem the shares? 52 Return and Risk of a Mutual Fund 4. Capital gains distributions • Interest income, dividends, and capital gains must be distributed in the year that they are earned • Investors are normally given the opportunity to choose whether to receive these distributions in the form of a cash payment or as additional shares • Risk from Investing in an Equity Mutual Fund • Market risk: the susceptibility of a mutual fund’s performance to general stock market conditions 53 Return and Risk of a Mutual Fund • Risk from Investing in a Bond Mutual Fund • Performance of a bond mutual fund depends on the general movements in interest rates • Interest rate risk: the risk that occurs because of changes in the interest rate. This affects funds that invest in debt securities and other income-orientated investments • Longer-term or lower coupon bonds are the most sensitive • Bond funds that invest in bonds with a high degree of default risk tend to offer a higher potential return • Bond funds can have high and/or low levels of either interest rate risk and default risk 54 Return and Risk of a Mutual Fund • Tradeoff between Expected Return and Risk of Bond Funds • A bond fund that holds Government of Canada bonds with a short term remaining until maturity • No exposure to default risk and limited interest rate risk • Relatively low expected return • High-yield bond funds with long terms to maturity • Subject to default risk and a high level of interest rate risk • Potential for a very high return 55 Risk From Investing In Hedge Funds • Hedge funds: limited partnerships that manage portfolios of funds for wealthy individuals and financial institutions • Investor must be classified as either an accredited investor or a sophisticated investor to invest in a hedge fund • Not regulated by a securities commission • May invest in a wide variety of investments • May engage in short selling and/or buying stocks on margin 56 Exchange-Traded Funds (ETFs) • Share the same benefits of a mutual fund: • Diversification, economies of scale, and marketability • Differences: • Do not have a net asset value per share • Trade on the stock exchange and have a share price • Purchased in real time, whereas mutual funds are purchased at the end of the day 57 Exchange-Traded Funds • Fee Structure • Do not have a load structure • Initial fee you pay is the brokerage commission for completing the transaction • MER is generally lower than a mutual fund’s MER • Tend to be more tax efficient since there is not as much active trading in an ETF • Watch out for leveraged ETFs! 58 Segregated Funds • Insurance products that are regulated through the insurance legislation of the province in which they are sold • Principal Protection • Offer a maturity guarantee on your deposits when the contract matures • Usually matures 10 years after the date of purchase • Maturity guarantee is either 75% or 100% of principal • At maturity, client will receive the greater of the market value or the maturity guarantee amount • If the market value is below the guarantee amount, the insurance company will pay a top-up to the guarantee percentage 59 Segregated Funds 60 Segregated Funds • Death Benefit Guarantee • Determination of the value of the guarantee is made at the time of death of the policy owner • Death benefit guarantee is either 75 or 100 percent of the amount invested • Death benefit can be paid directly to the beneficiary, thereby avoiding probate fees • Creditor Protection • Money invested in a segregated fund is an asset of the insurance company, not of the policy owner • Only if a family class beneficiary (spouse, grandparent, parent, child) is named 61 Segregated Funds • Creditor protection will not work if: – Segregated fund was purchased when investor was experiencing financial difficulties – Outstanding CRA income tax liabilities – Segregated funds may not provide protection from claims arising under family law to provide for a dependent – The named beneficiary is outside of family class 62 Segregated Funds • Some seg funds allow investors to “reset” or “lock in” the guaranteed value of their investment when the market value is > than the original investment value – Maturity guarantee and death benefit guarantee increase – Maturity date of the fund also resets Source: RBC Insurance 63 Quick Check Trent invested $70,000 in a ten-year segregated equity fund with a 75% maturity guarantee and a 100% death benefit guarantee. He ended up passing away nine years after purchasing the fund and the investments were worth $59,000 on the date of his death. What amount would the insurance company pay out in total to Trent’s designated beneficiary? A. $11,000 B. $52,500 C. $59,000 D. $70,000 64 Segregated Funds Vs. Mutual Funds Seg Fund Mutual Fund Professional portfolio management a a Diversified investments a a Marketability: easy access to your money a a Estate planning benefits: ability to bypass probate a Depends Potential creditor protection for registered accounts a a Potential creditor protection for non-registered accounts a r A guarantee amount of the principal at maturity or at death a r Locked-in gains on investments using resets Some r MER fees Higher Lower 65 Segregated Funds • Any segregated fund will underperform its mutual fund equivalent as a result of the higher MERs • Determine whether the benefits of owning a segregated fund outweigh the added costs 100% Maturity & Death Benefit Guarantee Option MER 75% Maturity & Death Benefit Guarantee Option MER Underlying Mutual Fund MER (no guarantee) International Equity Segregated Fund 5.46 4.18 2.75 U.S. Equity Segregated Fund 5.26 4.40 2.76 Canadian Equity Segregated Fund 5.09 3.60 2.48 Canadian Value Segregated Fund 5.13 4.11 2.51 Money Market Segregated Fund 1.92 1.39 1.06 Investment Fund 66
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