12INVESTING IN STOCKS AND BONDSEquity and Debt Investing

Learning Objectives

Upon reading this chapter, students should:Be able to categorize stocks according to their characteristicsUnderstand how to buy and sell stocks and bonds, with the help of a brokerKnow how to categorize bonds according to their characteristicsRecognize and analyze investment alternatives and evaluate portfolio performanceBe able to analyze bond investment alternatives and evaluate performance

Chapter Summary

An individual who buys shares of common stock in a corporation are shareholders of a corporation. A corporation is a recognized legal entity that sells stock to members of the public to raise the necessary capital for their business. Common stock holders are said to have a residual claim on a company’s assets. Shareholders of a corporation have certain rights and obligations. Each common stockholder has the right to vote. If they are unable to vote in person they may give someone else, through a written agreement known as a proxy, permission to vote on their behalf. As a shareholder, you have a right to limited liability. In the event the corporation is found liable for an act, the shareholders cannot be held responsible. One of the benefits of stock ownership is the payment of a stock dividend. Instead of receiving cash for your shares, you receive additional shares in the company’s stock. Additionally, if the company decides to sell additional shares of stock, shareholders may have preemptive rights entitling them to purchase the shares before the public.

Stocks are bought and sold in the primary market. In the primary market stocks are issued for the first time through a process known as an initial public offering. New stock issues are advertised in a format called a tombstone. All of the important information about the offering can be obtained by reading the prospectus. After the stocks have already been sold they are traded between investors in the secondary market. Trading among investors is accomplished through an organized securities exchange, which is a physical location or electronic marketplace where the trades are implemented. Each exchange has its own rules for how a stock qualifies to be a listed security. The Over the Counter market is a network of securities dealers who trade electronically. Some of the top stocks in the OTC market are traded on the NASDAQ.

There are a variety of ways in which common stock is classified. An income stock is one that pays investors a regular dividend rather than concentrating on reinvestment of profits. On the other hand, a growth stock is one that compensates investors primarily through increases in market value. Some corporate stocks are also referred to as blue chip stocks. These are stocks issued by established

companies that are large and stable. Stocks are also referred to as cyclical and defensive. These terms refer to the sensitivity of the stock to business cycles. On the basis of capitalization, stocks are also classified as large cap, mid cap or small cap. If an individual wishes to purchase stock they can contact a licensed broker who acts as an intermediary. To determine how much you will pay for a stock you need to look up the closing price for the stock by its ticker symbol. The closing price represents the price the stock for in the last transaction of the previous day. There are three types of orders you can make, market order, limit order or stop order.

Investors sometimes talk about selling short. This happens when they issue a sell order to their broker but don’t actually have the stock to sell. In doing so, an investor hopes the price of the stock will go down so they can replace the stock later at a lower price and make a profit on the difference. A stock broker is a licensed professional who facilitates securities transactions for clients. Brokers generally work for firms and are categorized by the terms full service and discount brokers. When you open an account with a brokerage firm they request you maintain a minimum amount your account. If you do not have sufficient funds you can borrow them from the brokerage firm. This is referred to as buying on margin.

Some investors will look at the historical performance of a stock. However, some investors use the earnings per share or the price to earnings ratios to help them estimate future rates of return. The two components of a stock’s rate of return are dividend yield and capital gains yield. Your investment in a particular stock is not secure. However, one measure commonly used to estimate the risk of stock investments held in a diversified portfolio is the beta. A stock’s beta measures its degree of market risk. You can also track the performance of a group of stock’s using a stock market index which tracks the performance of a particular group of stocks. Examples of these types of indexes are the Dow Jones Industrial Average and the S&P 500 Index.

Bonds

A bond is a type of financial security that represents your long term loan of money to a company or government entity that gives the investor the right to receive interest payments and to have the loan repaid in the future. The advantages of owning bonds are that they provide portfolio diversification, predictable source of income, lower risk, time horizons to match investment goals and it is possible to make a profit on price changes. Investors interested in purchasing bonds should become familiar with the terminology of bonds. For example, a bond issuer must provide a prospective investor with a prospectus. In addition, the issuer of the bond and the bondholder execute a legal contract known as a bond indenture. It specifies all of the important details of the bond agreement. The maturity date refers to when the bond comes due, and par value refers to the face value of the bond. There are several other terms like coupon rate, call provisions and convertibility. Purchasing bonds should be carried out with the same attention to detail as purchasing stocks.

There are several different types of bonds available to purchase. Corporate bonds are long term, interest-bearing debt securities issued by a corporation to help finance its long term operations. The U.S. government also sells bonds with various terms to maturity. If a security has a term of ten years or less, it is called a treasury note. If the term is for ten years or longer it is called a treasury bond. The primary reason for the issuance of treasury securities is to finance the national debt. Often referred to as a “muni” bond, state and local governments also issue bonds. This is done to finance specific projects and meet general operating expenses. One of the most important features of this type of bond is that the interest payments are exempt from federal income tax.

Besides the classifications based on type of issuer, bonds are sometimes classified into categories based on differences that affect their return and risk, such as whether they are secured and coupon arrangements. Most corporate and government bonds are debenture bonds, which is a legal term for unsecured. In contrast, secured bonds are secured by some specific form of collateral that is promised by the issuer. Bonds can also be classified according to how interest is calculated and paid. A zero-coupon bond makes no coupon payments but is instead discounted at the time of sale. Bonds are also classified according to risk. Several rating agencies, like Moody’s and Standard & Poor’s provide ratings based on risk. Many of the investment strategies discussed in Chapter 11 can be related to the purchase and sale of bonds. In addition, two strategies that are unique to fixed income strategies are laddering and maturity matching. The process of buying a bond is similar to that for buying a stock. You can find the bond price for the previous day and execute your purchase through a licensed broker.

Preferred Stock

Besides investing in common stock and bonds, an investor may want to invest in preferred stock. Preferred stock is issued by companies, and pays a fixed cash flow to investor. Like common stock, though, preferred stock pays a fixed cash flow to investors. The primary attraction of preferred stock is its steady dividend stream. The most important risks preferred stock investors face are interest rate risk, call risk and default risk.

Key Terms

Ask price The stock price requested by a potential seller.

Beta A measure of the market, or nondiversifiable, risk of a stock.

Bid price The stock price offered by a potential buyer.

Blue chip stock A stock that is issued by a large, stable, mature company.

Buying on margin Using borrowed funds from a broker to make a trade.

Capital gains yield The component of a stock investor’s total return that is equal to the ratio of the annual change in price to the market price of a stock.

Churning Excessive trading in a discretionary account.

Close price The last price at which a stock sold at the close of the previous business day.

Corporation A form of business organization that exists as a legal entity separate from its owners, who have limited liability for corporate losses.

Coupon payment The annual dollar interest payment on a bond, equal to the coupon rate multiplied by the face value, usually paid to investors in two equal installments.

Cyclical stock A stock exhibiting above-average sensitivity to the business cycle.

Day trader An active investor who buys and sells many times during the day in an attempt to make quick profits.

Debentures Unsecured bonds.

Defensive stock Stock that is relatively insensitive to the business cycle.

Dividend yield The component of a stock investor’s total return that is equal to the ratio of annual dividends to the market price of a stock.

EPS A measure of company profitability equal to annual earnings divided by the number of shares outstanding. Stands for earnings per share.

Face value The dollar amount the bondholder will receive at the bond’s maturity date.

Growth stock Stock that compensates investors primarily through increases in value of the shares over time.

Income stock Stock that compensates investors primarily through the regular payment of dividends.

Indenture A legal document that details the rights and obligations of the bondholders and bond issuer.

Investment-grade bonds Medium- and high-grade bonds with low risk of default on interest or principal.

IPO A company’s first stock offering to the public. Stands for initial public offering.

Junk bonds Bonds with a high risk of default.

Limit order A request to buy stock at any price up to a specified maximum or to sell stock at any price above a specified minimum.

Limited liability A statutory right of corporate shareholders that limits their potential losses to the value of the shares they hold.

Listed security A security that is approved to be bought or sold on a particular exchange.

Margin call A request from a brokerage firm that the holder of a margin account add money to the account to maintain the required minimum.

Market capitalization The total outstanding value of a company’s stock at current market prices. It is calculated as the current stock price multiplied by the number of shares outstanding.

Market order An offer to buy stock at the market price.

Municipal bond A long-term debt security issued by a state or local government entity.

NASDAQ An electronic reporting system for frequently traded over-the-counter stocks. Stands for National Association of Securities Dealers Automated Quotation System.

OTC market An electronic network for trading securities through securities dealers. Stands for over-the-counter market.

P/E ratio The measure of a company’s future earnings potential, calculated as market price divided by earnings per share. Stands for price-to-earnings ratio.

Preemptive right The right of a stockholder to maintain his or her proportionate ownership when the company issues additional shares of stock.

Primary market The market in which securities are sold by corporations to the public for the first time.

Prospectus A document that gives potential investors financial information about a stock issue and the issuing company.

Proxy A written agreement in which a shareholder gives another person the right to vote in his or her place.

Residual claim A common shareholder’s right to the firm’s assets and income after all the other claimholders are paid.

Round lot A group of 100 shares of stock; stock is normally traded in round lots.

Secondary market The market in which previously issued securities are traded between investors.

Secured bond A bond for which interest and principal payments are backed by assets or future cash flows pledged as collateral.

Securities exchange A physical location at which securities are traded; the largest securities exchange is the New York Stock Exchange.

Selling short A strategy in which an investor borrows stock from a broker, sells the stock, and later buys stock on the market to replace the borrowed stock.

Sinking fund A fund accumulated to pay an amount due at a specific time in the future, such as when a bond issue comes due.

Specialist A person responsible for matching a particular stock’s buy and sell orders at a specific securities exchange.

Stock dividend A dividend given to shareholders in the form of shares of stock instead of cash.

Stock market index An indicator that shows the average price movements of a particular group of stocks representing the market or some market segment.

Stockbroker A licensed professional who buys and sells securities on behalf of clients.

Stop order An order to buy or sell stock holdings when the market price reaches a certain level.

Tombstone ad A formal advertisement of a stock issue in the financial press.

Yield The annual return on investment, including current yield and capital gains yield.

YTM Annualized return on a bond, if it is held to maturity and all interest payments are reinvested at the same rate. Stands for yield to maturity.

Zero-coupon bond A bond that doesn’t make interest payments but instead is discounted at the time of sale.

Lecture Notes

1. Students may have never read The Wall Street Journal or had the experience of looking up the closing price for a bond or stock. In order to assist students with researching the market price for various securities, bring in a section of the newspaper. Using various examples of common stock and bonds, look at the closing price with students. Ask them to calculate the

purchase price for 100 shares of a particular financial security. This will encourage students to begin researching various securities and help them understand pricing.

2. Students may not understand the rating system used by Moody’s and Standard and Poors. Ask students to conduct some research using the following link: http://www.nasdbondinfo.com/asp/dailyindices.asp. Ask students to look up various bonds. For example, this site lists the top ten traded bonds. Discuss in class with the students the various terms used to describe bonds. This exercise will assist students in understanding the concepts in the chapter.

3. Students learn in this chapter that the purchase of securities is conducted through the use of a broker. Talk to students about the types of brokerage firms available, full service and discount. Ask students to weigh both the positive and negatives of using both types of brokerage firms and which one may be suitable for their investment goals

Suggestions for Learning Activities

1. Give students the opportunity to accumulate their own investment portfolio. There are several online stock market games that can be used which allow students to buy on margin, buy stocks and bonds, and the game also charges a commission fee similar to that of a broker. The best web site for the stock market game is . The game allows the instructor to set the time parameters and the money amount. At the conclusion of the stock game ask the students to write a one page essay about their experience. 2. The early part of the chapter discusses the difference between the primary and secondary markets. Ask students to purchase The Wall Street Journal and bring it to class. In groups have the students identify various tombstones for upcoming initial public offerings. Ask the students to discuss the following questions in groups: a. What is the price per share for this stock? b. What type of stock is it? c. What type of shares are being offered through the IPO? d. Which investment bank is underwriting the IPO? e. Would the students consider purchasing this stock as a part of their portfolio? 3. Divide students into groups of three. Instruct the students that they must do research on the bond market. Ask students to identify three of the various types of bonds and find the following information about each of them: a. What is the maturity date? b. Does the bond have coupon payments? c. What type of bond is it? d. What is the estimated return on that bond? e. Is it a debenture bond? After identifying the answers to these questions, ask the students to discuss the importance of understanding and knowing these facts about a bond before making a purchase. 4. Invite a guest speaker to class to discuss the various services provided by brokers to investors.

Suggestions for Additional Resources

1. http://www.cnnmoney.com2. http://www.nasd.com/investorrelations

3. http://www.fdic.gov 4. Kiplingers Magazine 5. Money magazine 6. Wall Street Journal 7. http://www.moneyinstructor.com/investing.asp8. http://www.investinginbonds.com/learnmore.asp?catid=2&id=629. http://www.investinginbonds.com/learnmore.asp?catid=2&id=62

Answers to Self-check Questions

12.1

1. Define NASDAQ, bid price, proxy, and specialist.

NASDAQ: An electronic reporting system for frequently traded over-the-counter stocks.

Proxy: A written agreement in which a shareholder gives another person the right to vote in his or her place.

Bid price: The stock price offered by a potential buyer.

Specialist: A person responsible for matching a particular stock’s buy and sell orders at a specific securities exchange.

2. List the five steps in a typical stock transaction.

1. The buyer places an offer to purchase the stock with a broker whose employing firm is a member of the exchange; similarly, the seller indicates to his or her broker a desire to sell a number of shares.

2. To implement the buyer’s request, the brokerage firm contacts its representative at the securities exchange to relay the price offer, or bid price, and the seller’s broker relays the sale offer, or ask price, through their respective representatives at the exchange.

3. Both brokerage representatives then go to the specialist for that stock at a physical location on the floor of the exchange called the specialist’s post. The specialist is the person at the exchange who is responsible for matching up the buy and sell orders for a particular stock.

4. Based on the bid and ask information received from many buyers and sellers, the specialist is able to match up buyers and sellers fairly. If there are too many buyers relative to sellers, or vice versa, the specialist actually sells or buys the shares as necessary to meet the market’s demand. For this reason, specialists are sometimes referred to as market makers.

5. When a match is made, the brokerage firms relay the information back to the buyer and seller of the shares. Transfer of money and shares is then accomplished through accounts at the respective brokerage firms.

3. Name the rights of a stockholder. Voting rights, limited liability, claim on income, preemptive rights, stock splits,

4. What are the differences between primary and secondary stock? Stock sold in the primary market is sold to the public for the first time and is riskier. Stock is more often sold in the secondary market.

12.2

1.Which type of stock compensates investors through increases in the value of their shares? Growth stock

2. List the classifications of common stock. Income vs. growth, blue chip, cyclical vs. defensive, industry and sector, market capitalization.

3. Define income stock, blue chip stock, and market capitalization.

Income stock: Stock that compensates investors primarily through the regular payment of dividends.

Blue chip stock: A stock that is issued by a large, stable, mature company.

Market capitalization: The total outstanding value of a company’s stock at current market prices. It is calculated as the current stock price multiplied by the number of shares outstanding.

12.3

1. Define margin call, churning, selling short, round lot, and close price.

Margin call: A request from a brokerage firm that the holder of a margin account add money to the account to maintain the required minimum.

Churning: Excessive trading in a discretionary account.

Close price: The last price at which a stock sold at the close of the previous business day.

Round lot: A group of 100 shares of stock; stock is normally traded in round lots.

Selling short: A strategy in which an investor borrows stock from a broker, sells the stock, and later buys stock on the market to replace the borrowed stock.

2. What are three types of orders you can make? stop, market, limit

3. What are some criteria for choosing a broker?

Does the brokerage firm have a useful website, and, if trades are to be executed on the site, can it provide evidence of past reliability during high-traffic trading periods?

Is the account insured by the SIPC?

What is the commission structure?

Will the broker pay you interest on any uninvested cash in your account? If so, at what rate?

What services does the broker provide besides executing trades?

12.4

1. Define EPS, P/E ratio, stock market index, and beta.

EPS: A measure of company profitability equal to annual earnings divided by the number of shares outstanding. Stands for earnings per share.

P/E ratio: The measure of a company’s future earnings potential, calculated as market price divided by earnings per share.

Stock market index: An indicator that shows the average price movements of a particular group of stocks representing the market or some market segment.

Beta: A measure of the market, or nondiversifiable, risk of a stock.

2. If a stock has the same market risk as the entire market, what is its beta? 1.

12.51. List the advantages of buying bonds. Diversification, predictable income, profit on price changes, lower risk and matching time horizon.

2. Define face value, zero-coupon bond, municipal bond, junk bond, and debentures. Debentures: Unsecured bonds.

Face value: The dollar amount the bondholder will receive at the bond’s maturity date.

Junk bonds: Bonds with a high risk of default.

Municipal bond: A long-term debt security issued by a state or local government entity.

Zero-coupon bond: A bond that doesn’t make interest payments but instead is discounted at the time of sale.

3. Cite three bond classifications. Risk, coupon arrangements, secured vs. unsecured.

12.6

1. List some bond investing strategies that are available. Laddering and maturity matching. Also diversification, dollar cost averaging, etc.

2. Where can you find out the price of a bond? The Wall Street Journal and other newspapers, various online sources, your broker.

12.7

1.Who rates preferred stock? Ratings agencies.

2. Cite the main advantage of preferred stock as an investment. Having a steady dividend stream.

Answers to Summary Questions

1. The major reason companies issue stock is to spread the risk among a large number of investors. True or false?

2. A written agreement that gives your common stock voting rights to someone else is known as a:

a. preemptive right.

b. proxy.

c. forfeit agreement.

d. voting assignment.

3. A stock issued by a large, stable, mature company is known as a (an):

a. income stock.

b growth stock.

c. large cap stock.

d. blue chip stock.

4.Which of the following would be considered a defensive stock?

a. Home Depot

b. Coca-Cola

c. Ford Motor Company

d. Delta Airlines

5. If your stock has made a profit and you want to protect your gains, you would most likely do a:

a. market order.

b. limit order.

c. stop order.

d. fill or kill order.

6.What is a short seller trying to do?

a. Buy low and sell high.

b. Sell high and buy low.

c. Buy on margin and repay with borrowed funds

d. Sell on margin and repay with borrowed funds

7.A stock paying an annual dividend of $1.10 and selling at a price of $27.50 would have a dividend yield of 2.5%. True or false?

8. The ratio most often seen as a measure of future earnings potential is the:

a. EPS.

b. P/E ratio.

c. dividend yield.

d. capital gains yield.

9. When you buy bonds issued by a company, you are then an owner of the company. True or false?

10. Bonds that are rated BBB or better by Standard & Poor's are referred to as:

a. top-notch bonds.

b. risk-free bonds.

c. investment-grade bonds.

d. recession-proof bonds.

11. If you determine the maximum maturity for your bond portfolio will be 4 years and you allocate 25 percent of your portfolio to one-year bonds, 25 percent of your portfolio to two-year bonds, 25 percent of your portfolio to three-year bonds and 25 percent of your portfolio to four-year bonds, you are practicing:

a bond spreading.

b. maturity matching.

c. laddering.

d. timing.

12. The primary reason to invest in preferred stock is the potential for large capital gains. True or false?

Answers to “Applying this Chapter” Questions

1. For each of the following stocks, identify the appropriate classifications:

Company Market Capitalization

Classifications

a. Microsoft Corporation

$283.1 billion large-cap, technology, cyclical

b. JetBlue Airways

$2.95 billion mid-cap, airline, cyclical

c. Longs Drug Stores

$801 million small-cap, retail, defensive

d. Trump Hotel & Casino Resort

$59 million small- or micro-cap, hotel.

2. Use the excerpt from the Wall Street Journal given in Figure 12–1 to find the following information about Deb Shops, Inc., a clothing retailer:

a. Ticker symbol - DEBS

b. Annual dividend - .50 per share

c. Close price - $23.97

d. 52-week high - $27.01

3. You can attempt to make investment gains by either buying stocks you think will increase in value or selling short stocks you think will decrease in value. In either case, you take the risk that the price will go in an unfavorable direction. Explain why selling short is an inherently riskier investment strategy. First, you’re betting against the general long-run upward trend in stock prices. Second, if you’re wrong, you must still make good on the transaction. If you’re long and the price falls, you can simply hold on to your investment in the hope it’ll recover, whereas losses on a short position must be realized.

45. You have a margin account with a minimum maintenance margin of 30 percent. You buy 100 shares of stock at $20 per share using only $1,200 of your own money. If the stock price fell to $15, would you get a margin call? No.

5. Seesaw Incorporated has a P/E ratio of 45 and beta of 2.2, while SlowMo Corporation has a P/E ratio of 12 and beta of 0.75. Which stock is riskier? What can you tell from the P/E ratios?

Seesaw is risker. Its beta is significantly greater than 1; indicating high market risk, whereas Slowmo’s beta is less than 1.

6. The coupon rate on a corporate bond issue is 8.5 percent. If you own one bond with a face value of $1,000, how much interest will you receive every six months from this investment? 8.5% X $1,000 = $85, so you’ll receive $85/2 or $42.50 per six-month period.

7. Indicate appropriate classifications for each of the following bonds:

a. Bond issued by the state of Texas to finance construction of an interstate highway, with payments to be made from tolls. Municipal bond

b. Bond issued by a fairly young, high-growth technology company that pays interest at five percentage points over the 10-year Treasury bond yield. Secured bond.

Answers to “You Try It!” Questions

Play the Market Risk-Free

Give yourself some play money and try your hand at stock investing at finance.yahoo.com. Decide on how you will diversify your stock portfolio across different classifications as discussed in this chapter (e.g., by industry, capitalization, risk). Start your account by selecting at least 10 stocks. Then track your portfolio over several weeks. Compare your performance to that of a benchmark index over the same time period.

Answers will vary.

Blue Chip Dividends For You

You own 400 shares of a blue chip company’s stock, which currently is worth $65 per share. The company pays a quarterly dividend of $0.90 for a total of $3.60 per year. a. How much will your dividend check be this quarter? b. What tax rate will be applicable to this dividend if the stock is held in a taxable account and you’re in the 15 percent federal income tax bracket? c. What is the dividend yield on this stock (pretax)?

a. 400 x 0.90 = $360.00 this quarter.

b. If you are in the 15% bracket for federal income taxes, your dividends will be taxes at the capital gains tax rate of 5%.

c. $3.60/$65.00 = 5.5%

Bond Yields

You buy a semiannual fixed rate coupon bond that has a face value of $1,000 and 10 years to maturity. The current market price is $910, and the coupon rate is 8 percent. Use the formula given in the chapter to calculate the approximate yield to maturity. What would the approximate yield to maturity be if the current price is $1,080?

[80 + (90/10)]/(1910/2)=89/955 = 9/32%

[80 +(-80/10)]/(2080/2) = 72/1040 = 6.92%