Basics of Equity
Equity investment refers to the buying and holding of shares by individuals and funds in anticipation of returns through dividends and capital gains. It also refers to equity (ownership) participation in a private (unlisted) company, or a start-up (a company being created or newly created).
Equity shareholders are the owners of the company, sharing its risks, profits, and losses. They have voting rights, and a residual claim on the earnings and assets of the company, depending on their holdings. Shareholders have liability only to the extent of their holding. Their fortunes depend on the growth of the company: if the company prospers, the equity shareholders will be the greatest gainers. They are entitled to dividends and other benefits that the company may announce from time to time. At the same time, there is no guarantee of a return on their investments.
The value of a company increases in tandem with the rise in its assets and cash accruals. This, in turn, will drive the value of its stock. Positive news about future growth/expansion of the company tend to impact stock price favourably.
There are two ways of buying stock:
· At an initial public offering (IPO), or issue of new shares by an existing company
· From the secondary market, the stock exchange
An IPO is the company’s first listing of its common stock on a stock exchange. In this case, an investor buys the stock directly from the issuer, the company from the primary market. An investor can also buy/sell a listed company’s shares from stock exchanges such as BSE or NSE. An exchange is also called the secondary market because in this case, one buys/sells stocks from other investors.
Bond Basics
What are bonds?
A bond is a loan for which the subscribers are the lenders. The organisation that sells a bond is known as the issuer.
The issuer of a bond must pay the investors interest at a predetermined rate and schedule for the privilege of using their money.
Debt versus equity
Bonds are debt, whereas stocks are equity. This is the important distinction between the two securities. By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership comes with voting rights and the right to share in any future profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or government). The primary advantage of being a creditor is that an investor has a higher claim on assets than the shareholders: that is, in the case of a bankruptcy, a bondholder will get paid before a share holder. On the other hand, a bondholder is not eligible for a share of profits if a company does well – he or she is entitled only to the principal plus interest.
To sum up, there is generally less risk in owning bonds than in owning stocks, but this comes at the cost of a lower fixed return.
Why invest in bonds?
It is an investing axiom that stocks generate more returns than bonds. However, this does not mean that you should not invest in bonds. Bonds are considered appropriate any time, especially if you cannot tolerate the short-term volatility of the stock market. Here are two situations where this is most true:
· Retirement — The easiest example to think is of an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income from it is required to pay the bills.
· Shorter time horizons – Let’s say a young executive is planning to go back to college for an MBA in three years. It is true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment.
Bond Basics: Characteristics
All of these factors play a role in determining the value of a bond and the extent to which it fits in with the portfolio.
· Face value/Par value — The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A bond’s price fluctuates throughout its period due to a number of variables (more on this later). When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
· Coupon (The interest rate) — The coupon is the amount the bondholder will receive as interest payments. As previously mentioned, most bonds pay interest every six months, but it is possible for them to pay the interest monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10 per cent and its par value is Rs.1000, then it will pay Rs.100 as interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case, the interest rate is tied to market rates through an index, such as the rate on Treasury Bills.
· Maturity — The maturity date is the date in the future on which the investor’s principal will be repaid. Maturities can range from as little as one day to as long as 30 years. A bond that matures in one year is much more predictable and thus less riskier than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond is more susceptible to fluctuations than a shorter term bond.
· Issuer — The issuer of a bond is a crucial factor to consider, as the issuer’s stability is the main assurance of getting paid back. For example, the government is far more secure than any corporation. Its default risk (the chance of the debt not being paid back) is extremely small – so small that the government securities are known as risk-free assets. The reason behind this is that a government will always be able to bring in future revenue through taxation. A company, on the other hand, must continue to make profits, which is far from guaranteed. This added risk means corporate bonds must offer a higher yield in order to entice investors — this is the risk/return trade-off in action. The bond rating system helps investors determine a company’s credit risk. Think of a bond rating as the report card for a company’s credit rating. Blue-chip firms, which are safer investments, have a high rating, while risky companies have a low rating.
· Bond Basics: Yield, Price
At any time, a bond can be sold in the open market, where the price can fluctuate- based on the prevailing yield in the markets.
Measuring Return with Yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When one buys a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let us demonstrate this with an example. If one buys a bond with a 10 per cent coupon at Rs.1,000 par value, the yield is 10 per cent (Rs.100/Rs.1,000). But if the price goes down to Rs.800, then the yield goes up to 12.5 per cent. This happens because investors are getting the same guaranteed Rs.100 on an asset that is worth Rs.800 (Rs.100/Rs.800). Conversely, if the bond goes up in price to Rs.1,200, the yield shrinks to 8.33 per cent (Rs.100/Rs.1,200).
Yield to Maturity
When bond investors refer to yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the total return one will receive if you hold the bond to maturity. It equals all the interest payments an investor will receive (and assumes that one will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if purchased at a discount) or loss (if purchased at a premium).
The relationship of yield to price can be summarised as follows: when price goes up, yield goes down and vice versa. Technically the bond’s price and its yield are inversely related.
Price in the Market
The factor that influences the bond price more than any other factor is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising their yield and bringing them in line with new higher-coupon bonds. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them in line with newer bonds with lower coupons.