FNCE 3020 Financial Markets and Institutions Fall Semester 2006

1
FNCE 3020Financial Markets and Institutions
Fall Semester 2006

• Lecture 9
• The Capital Markets
• Bonds and Stocks

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Capital Markets Overview

• Defined financial markets involving financial
  assets with maturities of greater than one year.
• Best known capital market securities include
• Stocks and bonds
• Mortgages
• Primary issuers of these securities
• Federal government and local governments
• Corporations
• Individuals
• Largest purchasers of capital market securities.
• Individuals.
• Directly and through financial entities (e.g.,
  mutual funds)..

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Size and Composition of Capital Markets, 2005

• Stock Bond
  Total Capital
• Markets Markets
  Markets
• World 37.2 (39) 59.0 (61) 96.2 (100)
• U.S. 17.0 (46) 23.8 (40) 40.8 (42)
• EU 9.6 (26) 18.7 (32) 28.3 (29)
• Japan 7.5 (20) 8.7 (15) 16.2 (17)
• Note Trillions of U.S. dollars, and () of
  total.
• Source IMF, Global Financial Stability Report,
  2006 http//www.imf.org/External/Pubs/FT/GFSR/2006
  /02/index.htm

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The Bond Markets Governments and Corporates, 2005

• Bonds Total
• Govt Corporate Bonds
• World 23.1 (40) 35.9 (60) 59.0 (100)
  
• U.S. 5.9 (26) 17.9 (50) 23.8 (40)
• EU 6.7 (29) 12.0 (33) 18.7 (32)
• Japan 6.6 (29) 2.0 ( 6) 8.6
  (15)
• Note Trillions of U.S. dollars, and () of
  total.
• Source IMF, Global Financial Stability Report,
  2006 http//www.imf.org/External/Pubs/FT/GFSR/2006
  /02/index.htm

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Summary of Capital Markets Data

• Globally, bond markets are larger than stock
  markets
• About 1.6 times the size.
• The corporate bond market represents 60 of the
  total bond market with government debt
  representing 40.
• In the US and EU, the Corporate Bond markets are
  larger than the Government Bond markets.
• In Japan, the Government Bond market exceeds the
  corporate bond market.
• The worlds largest stock market and bond market
  is in the United States.
• However, the EUs bond market is a close second.
• Most of the growth in the EU bond market has come
  since the formation of the single European
  currency (1/99).
• This has helped created a large euro bond market.

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Bond Market Growth in Europe
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Countries That Export Capital, 2005
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Countries That Import Capital, 2005
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Trends in the U.S. Stock and Bond Markets
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Primary and Secondary Capital Markets

• Primary capital markets involve the initial sale
  (i.e., IPOs) of capital market securities.
• Issuers are raising new capital and/or refunding
  debt coming due.
• Secondary capital markets are where investors
  trade seasoned (outstanding) capital market
  securities.
• Over-the-counter markets
• Organized exchanges (i.e., NYSE)
• These markets are important for the liquidity
  of newly issued financial assets (in primary
  markets).

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Corporate Bonds Characteristics and Risk

• Face (par) value of 1,000 (U.S. Market).
• Generally, they pay interest semi-annually.
• Degree of risk varies with each bond
• Risk of default depends on creditworthiness of
  issuer.
• Interest rate varies with the general level of
  economic activity.
• Business cycle, inflationary expectations,
  Federal Reserve policy will affect the level and
  changes in rates and thus,
• Changes in market interest rates affect the price
  risk, or interest rate risk, associated with a
  bond.

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U.S. Bearer Bonds and Registered Bonds

• Earliest corporate bonds issued in the United
  States were usually bearer bonds.
• Whoever held the companys bonds (i.e., the
  bearer) could collect interest and/or sell the
  bonds.
• Bearer bonds, however, had significant problems.
• Companies never knew who held their bonds, so
  communication was inefficiently limited to
  notices in newspapers.
• Thus, registered corporate bonds started
  increasing in popularity in the 1880s and
  dominated U.S. capital markets by the early
  1900s.
• Under this arrangement, companies keep records of
  owners names by corresponding bond serial
  numbers.
• Actually done by banks for companies.
• By 1982, registered bonds became a U.S.
  government requirement for bonds issued in the
  United States.

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Bond Covenants (Binding Agreements)

• Bond covenants are binding agreements as noted in
  the bonds indenture.
• The indenture is the legal contract between the
  issuing company and the bond holders.
• A typical indenture will include
• Basic terms of the bond (coupon rate, coupon
  payment dates, maturity date)
• Amount of bonds to be issued.
• Description of property to be used as collateral
  (if any).
• Sinking fund provisions.
• Call provisions (if any)
• And details of any restrictive covenants
• Such as limitation on dividends payments to
  common stockholders and limitations on raising
  additional debt.

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Call Provision on Bonds

• Callable provision gives the issuer the right to
  call (i.e., buy back) the bond before the
  maturity date.
• Thus it allows for early redemption.
• The indenture will specify (in the call schedule)
  the dates and corresponding prices prior to
  maturity at which the bond can be called.
• Most corporate bonds today include a call
  provision.
• 70 of municipal bonds are callable.
• The Treasury has not issued callable bonds since
  1985.
• This option may turn out to be particularly
  valuable to the issuer should interest rates
  fall.
• The issuer can then call in its bonds and
  refinance at lower market interest rates.
• Holders of these bonds face call risk, which is
  the risk that a bond may be called when the
  investor does not want it to be called.
• Since bond are often called when interest rates
  decline, these investors get their cash back but
  have to reinvest it at the lower rates.

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Convertible Bonds

• Convertible bonds permit the bond holder the
  right to exchange the bond for the common stock
  of the issuing corporation.
• Convertible issues carry a coupon rate below that
  of a nonconvertible bond of comparable (risk)
  quality.
• An investor in a convertible security receives
  the upside potential of the common stock of the
  issuer, combined with the safety of principal in
  terms of a prior claim to assets over equity
  security holders.
• The investor, however, pays for this conversion
  privilege by accepting a lower yield-to-maturity
  than that offered on comparable non-convertible
  bonds.
• Also, if anticipated corporate growth is not
  realized, the investor sacrifices current yield
  and risks of not converting.

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Conversion Ratio

• An essential part of convertible bonds is the
  conversion ratio.
• Example A conversion ratio of 501 means that
  each 1,000 bond can be converted into 50 shares
  of common stock.
• At this ratio the bondholder, who paid par for
  the bond, will be able to exchange the bonds into
  stock valued at 20.00 per share (1,000/50
  20.00).
• If the bond is selling for 1,000, and if the
  market price of the stock is 10 per share, the
  convertible bond is said to be out of the money.
• You would be paying 20 a share for a stock
  trading at 10 per share.
• If the market price of the stock is 25 per
  share, the convertible bond is said to be in the
  money.

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Conversion Period

• Convertible bonds will be initially priced
  (conversion ratio) so as to be out of the
  money.
• Thus, when they are initially issued their
  conversion ratio price will be at a premium of
  the actual stock price.
• Time periods for convertibility can be
• Limited by the indenture (occurring during a
  specified time period in the future), or
• Unlimited up to the maturity date of the bond
• This is the usual case
• Convertible bonds will generally carry a callable
  feature as well, so that the issuer can force
  conversion if so desired.
• If there is a callable feature, it will usually
  be delayed so as to give the convertible bond
  time to trade in the money.

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3 Types of Corporate Bonds

• Secured Bonds (backed by collateral)
• Mortgage bonds (real estate)
• Equipment trust certificates (airplanes)
• Unsecured Bonds (backed by the general
  creditworthiness of issuer)
• Debentures
• Subordinated debentures
• Lower priority claim than debentures
• Credit ratings become important in the case of
  unsecured bonds.
• Junk Bonds
• Speculative grade
• Moderate to low ability to repay thus a high
  chance of default.

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Sample Corporate Bond
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Yields on Corporate and T-Bonds, U.S., 1978 -2006
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Common Stock

• Common stock (equity) represents an ownership
  position in a corporation.
• Common stock can offer a return to the holder in
  two ways
• Dividends paid to the stockholder (this is income
  return) and/or,
• Change in market price of the stock (this is
  capital appreciation over time).
• Stockholders also have a residual claim on all
  assets of the corporation.
• Thus, stockholders are last in line (in terms of
  claims against corporate assets) in the case of
  company bankruptcy.

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Dividend Yield (Income Return) on Stock, 1926-2000
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Capital Appreciation, DJIA, 1900 - 2001

• For the period 1900 to 2001, the average return
  was 7.3.
• However, there have been sub-periods where the
  markets have out performed this and under
  preformed this long term average

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P/E (price/earnings) Ratio The Driver of Capital
Appreciation, 1871-2001
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Types of Equity Positions

• Common stock
• Right to vote on company issues
• Receive dividends as (if) declared
• This depends upon company earnings and company
  objectives.
• Preferred stock
• Receives a fixed dividend.
• Cumulative and non-cumulative preferred issues.
• Do not usually vote on company issues
• Preferred stock comes before common stock in
  terms of claims against company assets.

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Corporate Stock Certificate
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Public Issues of Stocks and Bonds

• There are two principal ways that companies can
  sell their securities to the investors (i.e.,
  IPOs to investors)
• Public placement through investment bankers
• Act as underwriters in placing the stock with
  the public.
• They buy the securities from the firm at an
  agreed price (or best efforts) and distribute to
  public.
• Less risk for firm (if agreed price).
• Important to have a good book runner (lead
  investment banker), especially if it is a best
  efforts IPO.
• Private placement through investment bankers
• Securities placed directly with investment firms
  (e.g., with insurance companies, pension funds,
  mutual funds)
• Again it is important that the underwriter
  (investment bank) have appropriate connections
  with investment firms.

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Dow Jones Industrial Average

• The Dow Jones Industrial Average was created in
  1884 by the journalist Charles Henry Dow.
• Charles Dow originally constructed a list of
  eleven important companies and added up their
  stock prices at the end of each trading day.
• Dow then divided that number by eleven to come up
  with an average for the trading day.
• The original Dow Jones average included 9
  railroad stocks, illustrating the importance of
  the railroad industry in the late 19th/early 20th
  century.
• Today, the DJIA is a price-weighted average of 30
  blue-chip stocks.
• Because it is price weighted, stocks with the
  highest prices will have the most influence and
  those with the lowest, the least influence.

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DJIA 30 Stocks, Nov 9, 2005
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The DJIA, The Last 5 Years
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Web sites for the Dow and Other Indexes

• For the Dow Index
• http//finance.yahoo.com/q/bc?sDJIt1dc
• For a lot of good historical stuff on the Dow and
  other indexes see
• http//averages.dowjones.com/jsp/index.jsp
• For stock indexes in other countries see
• http//quote.yahoo.com/m2?u

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Real (Inflation Adjusted) Equity and Bond Returns
for Selected Countries, 1900 - 2000
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Historical Equity and Bond Returns for the U.S.
Market 1802 - 2001