Investments: Analysis and Management, Second Canadian Edition

1
Chapter 2
Investment Alternatives
2
Non-Marketable Financial Assets

• Examples Savings deposits, Canada Savings Bonds
  (CSBs), Guaranteed Investment Certificates (GICs)
• Commonly owned by individuals
• Represent direct exchange of claims between
  issuer and investor
• Usually safe investments which are easy to
  convert to cash without loss of value

3
Money Market Securities

• Examples Treasury bills, commercial paper,
  Eurodollars, repurchase agreements, bankers
  acceptances (B/As)
• Marketable claims are negotiable or saleable in
  the marketplace
• Short-term, liquid, relatively low-risk debt
  instruments
• Issued by governments and private firms

4
Treasury Bills (T-bills)

• Treasury Bills
• Short-term promissory notes issued by governments
  
• T-bills accounted for about one-half of all
  outstanding money market securities.
• Sold at a discount from face value in
  denominations of 5,000, 25,000, 100,000, and 1
  million
• Typical maturities are 91, 182, and 364 days
  although shorter maturities are also offered

5
Treasury Bills (T-bills)

• Treasury Bills
• Due to government backing, there is a very low
  risk of default
• Widely distributed and actively traded high
  liquidity
• In subsequent chapters we will use government
  T-bill rates as a measure of the riskless rate
  available to investors, commonly referred to as
  the risk-free rate

6
Fixed-Income Securities

• Marketable debt with maturity greater than one
  year
• More risky than money market securities
• Fixed-income securities have a specified payment
  schedule
• Dates and amount of interest and principal
  payments known in advance

7
Fixed-Income Securities

• Bonds long-term debt instruments
• Major bond types
• Government of Canada bonds
• U.S. Treasury bonds
• Provincial bonds
• Provincially-guaranteed bonds Ontario Hydro
• U.S. federal agency securities GNMAs (Ginnie
  Maes), FNMAs (Fannie Maes)

8
Fixed-Income Securities

• Major bond types (contd)
• Corporate bonds
• Usually pay semi-annual interest, are callable,
  carry a sinking fund provision, and have a par
  value of 1,000
• Convertible bonds may be exchanged for another
  asset
• Risk that issuer may default on payments

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Bond Characteristics

• Callable bonds give the issuer the option to
  call or repurchase outstanding bonds at
  predetermined call prices (generally at a
  premium over par) at specified times
• This feature is detrimental to the bondholders
  who are willing to pay less for them (i.e., they
  demand a higher return) than for similar
  non-callable bonds.
• Generally, the issuer agrees to give 30 or more
  days notice that the issue will be redeemed

10
Bond Characteristics

• Extendible Bonds gives the investor an option to
  extend the maturity date (buyer will extend in
  periods of low int. rates, will not in high
  interest rates)
• Retractable Bonds gives the investor an option
  to redeem the bond (sell back to the issuer) at
  par prior to maturity (high int. rates
  redeemed)
• Issuers are able to sell bonds with these
  features at higher prices than straight issues

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Bond Characteristics

• Convertible Bonds may be converted into common
  shares at predetermined prices.
• This feature makes the issue more saleable and
  lowers the interest rate that must be offered
• Permits the holding of a two-way security
• The safety of a bond
• The capital gains potential of a share
• Convertibles are normally callable

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Asset-Backed Securities

• Asset-backed securities are securitized assets
• E.g. mortgage-backed securities (Securities
  issued against an asset pool)
• Financial institution purchases an asset (usually
  a mortgage), and sells this to investors
• Investors assume little default risk as most
  mortgages are guaranteed by a federal government
  agency

13
Equity Securities

• Represent an ownership interest
• Preferred stock
• Preferred shareholders are paid after bondholders
  but before common shareholders
• Dividend known, fixed in advance
• May be cumulative if dividend omitted

14
Equity Securities

• Income trusts
• Pay out a portion of cash flows generated from
  underlying assets
• E.g. royalty trusts and real estate investment
  trusts (REITs)
• Common stock
• Common shareholders are residual claimants on
  income and assets
• Common shareholders can elect board of directors
  and vote on important issues

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Appendix 2-ATaxation of Investment Income in
Canada

• Interest income from debt securities is taxable
  at the full marginal rate
• Dividends and capital gains afford investors a
  tax break
• Dividend amount is grossed up (25), then
  taxpayer can claim a fed tax credit of 13.33 of
  taxable amount, and a prov. Tax credit (varying
  rate depending on province!)
• Capital gain only 50 is taxable