INVESTMENTS TEST 2 STUDY GUIDE 1 Contract between bondholder issuer A legal and binding contract between a bond issuer and the o The indenture specifies all the important features of a bond Indenture bondholders such as Maturity date timing of interest payments method of interest calculation callable convertible features if applicable etc o The indenture also contains all the terms and conditions applicable to the bond issue Other critical information included in the indenture are the financial covenants that govern the issuer and the formulas for calculating whether the issuer is within the covenants Sinking funds A bond indenture that calls for the issuer to periodically repurchase some proportion of the outstanding bonds prior to maturity o Bonds call for the payment of par value at the end of its life and to ensure that the commitment doesn t create a cash flow crisis the firms agree to purchase a sinking fund to spread the burden over several years 2 Calculate HPR Holding Period Return or Holding period rate of return HPR Ending Price Be ginning price C ash dividends Beginning Price EX The price of a share in a fund is currently 100 and your time horizon is one year You expect the cash dividend during the year to be 4 so your expected dividend yield is 4 Your HPR will depend on the price one year from now Suppose your best guess is that it will be 110 per share Then your capital gain will be 10 so your capital gains yield is 10 100 10 or 10 So HPR 110 100 4 14 14 100 3 Treasury Bond price from listed quoted price Treasury bonds issued with maturities ranging 10 to 30 years and may be purchased in denominations of only 100 but 1 000 denominations are much more common semiannual coupon The bond prices that you see quoted in the financial pages are not actually the prices that investors pay for the bond This is because the quoted price does not include the interest that accrues between coupon payment dates If a bond is purchased between coupon payments the buyer must pay the seller for accrued interest the prorated share of the upcoming semiannual coupon EX if 30 days have passed since the last coupon payment and there are 182 days in the semiannual coupon period the seller is entitled to a payment of accrued interest of 30 182 of the semiannual coupon The sale or invoice price of the bond whish is the amount the buyer actually pays would equal the stated price plus the accrued interest The practice of quoting bond prices net of accrued interest explains why the price of a maturing bond is listed at 1 000 rather than 1 000 plus one coupon payment A purchaser of an 8 coupon bond one day before the bonds maturity would receive 1 040 on the following day and so should be willing to pay a total price of 1 040 for the bond o 40 of that total payment constitutes the accrued interest for the preceding half year period o The bond price is quoted net of accrued interest in the financial pages and thus appears at 1 000 4 Taxable tax free yields Unlike interest payments on bonds dividends on preferred stock are not considered tax deductible expenses to the firm This reduces their attractiveness as a source of capital to issuing firms There is a offsetting tax advantage to preferred stock When one corporation buys the preferred stock of another corporation it pays only 30 of dividends received o EX If the firms tax bracket is 35 and it receives 10 000 in preferred dividend payments it will pay taxes on only 3 000 of that income State and local governments issue municipal bonds the outstanding feature of these is that interest payments are tax free Investors choosing between taxable and tax exempt bonds need to compare after tax returns on each bond One way of comparing bonds is to determine the interest rate in taxable bonds that would be necessary to provide an after tax return equal to that of municipals tax free Thus the equivalent taxable yield is simply the tax free rate divided by 1 t t federal plus local marginal tax rates The equivalent taxable interest rate increase with the investors tax bracket the higher the bracket the more valuable the tax exempt feature of municipals 5 Premium discount bonds Premium bond o A bond that is trading above its par value A bond will trade at a premium when it offers a coupon rate that is higher than prevailing interest rates This is because investors want a higher yield and will pay more for it o EX if a bond has a 7 coupon at a time when the prevailing interest rate is 5 investors will bid up the price of the bond until its yield to maturity is in line with the market interest rate of 5 As a result of this bidding up process the bond will trade at a premium to its par value A bond premium will reduce the yield to maturity of the bond while a bond discount will enhance its yield The size of the premium will decline as the bond approaches maturity The premium will dwindle to zero at maturity since bond issues are generally redeemed at par o A bond that is issued for less than its par or face value or a bond currently trading for less than its par value in the secondary market o The discount in a discount bond doesn t necessarily mean that investors get a better yield than the market is offering just a price below par Depending on the length of time until maturity zero coupon bonds can be issued at very large discounts to par sometimes 50 or more o Because a bond will always pay its full face value at maturity assuming no credit events occur discount bonds issued below par such as zero coupon bonds will steadily rise in price as the maturity date approaches These bonds will only make one payment to the holder par value at maturity as opposed to periodic interest payments Discount bond 6 Calculate reward to volatility ratio sharpe ratio Sharpe or reward to volatility ratio o Ratio of portfolio risk premium to standard deviation o A statistic commonly used to rank portfolios in terms of the risk return trade off S Porfolio Risk Premium Standard deviation of portfolio excess return E r p r f p E r p Expected Portfolio Return r f Ris k free rate p Portfolio Standard deviation Ex the sharpe ratio with an annual risk premium of 8 and standard deviation of 20 is 8 20 4 A higher sharpe ratio indicates a better reward per unit of volatility 7 Systematic Unsystematic risk Systematic Risk o The risk inherent to the entire market or an entire market segment Systematic risk also known as undiversifiable risk volatility or market risk affects the overall market