What are the key benefits of adding foreign stocks to a portfolio? When a U.S. investor purchases foreign stocks, what two things is he or she hoping will happen?

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INVESTING IN INTERNATIONAL STOCKS

As noted in Chapter 8, the U.S. stock market amounts to only 40 percent of the world stock market, and as a result many U.S. investors hold at least some foreign stock. Analysts have long touted the benefits of investing overseas, arguing that foreign stocks both improve diversification and provide good growth opportunities. For example, after the U.S. stock market rose an average of 17.5
percent a year during the 1980s, many analysts thought that the U.S. market in the 1990s was due for a correction, and they suggested that investors should increase their holdings of foreign stocks.

To the surprise of many, however, U.S. stocks outperformed foreign stocks in the 1990s—they gained about 15 percent a year versus only 3 percent for foreign stocks. However, the Dow Jones STOXX Index (which tracks 600 European companies) outperformed the S&P 500 from 2002 through 2004. Table 9-2 shows how stocks in different countries performed in 2004. Column 2 indicates how stocks in each country performed in terms of the U.S. dollar, while Column 3 shows how the country’s stocks performed in terms of its local currency. For example, in 2004 Brazilian stocks rose by 25.12 percent, but the Brazilian real increased over 11 percent versus the U.S. dollar. Therefore, if U.S. investors had bought Brazilian stocks, they would have made 25.12 percent in Brazilian real terms, but those Brazilian reals would have bought 11.1 percent more U.S. dollars, so the effective return would have been 36.22 percent. Thus, the results of foreign investments depend in part on what happens to the exchange rate. Indeed, when you invest overseas, you are making two bets: (1) that foreign stocks will increase in their local markets, and (2) that the currencies in which you will be paid will rise relative to the dollar. For Brazil and most of the other countries shown in Table 9-2, both of these situations occurred during 2004.

Although U.S. stocks have generally outperformed foreign stocks in recent years, this by no means suggests that investors should avoid foreign stocks. Holding some foreign investments still improves diversification, and it is inevitable that there will be years when foreign stocks outperform domestic stocks, such as the period from 2002–2004. When this occurs, U.S. investors will be glad they put some of their money into overseas markets.

  • What are the key benefits of adding foreign stocks to a portfolio?
  • When a U.S. investor purchases foreign stocks, what two things is he or she hoping will happen?

What is the estimated beta on this page? What is the source of the estimated beta? Why might different sources produce different estimates of beta?

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Thomson ONE problems

Using Past Information to Estimate Required Returns

Chapter 8 discussed the basic trade-off between risk and return. In the Capital Asset Pricing Model (CAPM) discussion, beta is identified as the correct measure of risk for diversified shareholders. Recall that beta measures the extent to which the returns of a given  stock move with the stock market. When using the CAPM to estimate required returns, we would ideally like to know how the stock will move with the market in the future, but since we don’t have a crystal ball we generally use historical data to estimate this relationship with beta. As mentioned in the Web Appendix for this chapter, beta can be estimated by regressing the individual stock’s returns against the returns of the overall market. As an alternative to running our own regressions, we can instead rely on reported betas from a variety of sources. These published sources make it easy for us to readily obtain beta estimates for most large publicly traded corporations. However, a word of caution is in order. Beta estimates can often be quite sensitive to the time period in which the data are estimated, the market index used, and the frequency of the data used. Therefore, it is not uncommon to find a wide range of beta estimates among the various published sources. Indeed, Thomson One reports multiple beta estimates. These multiple estimates reflect the fact that Thomson One puts together data from a variety of different sources.

Discussion Questions
1. Begin by taking a look at the historical performance of the overall stock market. If you want to see, for example, the performance of the S&P 500, select INDICES and enter S&PCOMP. Click on PERFORMANCE and you will immediately see a quick summary of the market’s performance in recent months and years. How has the market per- formed over the past year? The past 3 years? The past 5 years? The past 10 years?

2. Now let’s take a closer look at the stocks of four companies: Colgate Palmolive (Ticker CL), Gillette (G), Merrill Lynch (MER), and Microsoft (MSFT). Before looking at the data, which of these companies would you expect to have a relatively high beta (greater than 1.0), and which of these companies would you expect to have a relatively low beta (less than 1.0)?

3. Select one of the four stocks listed in question 2 by selecting COMPANIES, entering the company’s ticker symbol, and clicking on GO. On the overview page, you should see a chart that summarizes how the stock has done relative to the S&P 500 over the past 6 months. Has the stock outperformed or underperformed the overall market during this time period?

4. Return to the overview page for the stock you selected. If you scroll down the page you should see an estimate of the company’s beta. What is the company’s beta? What was the source of the estimated beta?

5. Click on the tab labeled PRICES. What is the company’s current dividend yield? What has been its total return to investors over the past 6 months? Over the past year? Over the past 3 years? (Remember that total return includes the dividend yield plus any capital gains or losses.)

6. What is the estimated beta on this page? What is the source of the estimated beta? Why might different sources produce different estimates of beta? [Note if you want to see even more beta estimates, click OVERVIEWS (on second line of tabs) and then select the SEC DATABASE MARKET DATA. Scroll through the STOCK OVERVIEW SECTION and you will see a range of different beta estimates.]

7. Select a beta estimate that you believe is best. (If you are not sure, you may want to consider an average of the given estimates.) Assume that the risk-free rate is 5 per- cent and the market risk premium is 6 percent. What is the required return on the company’s stock?

8. Repeat the same exercise for each of the 3 remaining companies. Do the reported betas confirm your earlier intuition? In general, do you find that the higher-beta stocks tend to do better in up markets and worse in down markets? Explain.

Why is the T-bill’s return independent of the state of the economy? Do T-bills promise a completely risk-free return? Why are High Tech’s returns expected to move with the economy whereas Collections’ are expected to move counter to the economy?

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Risk and return

Assume that you recently graduated with a major in finance, and you just landed a job as a financial planner with Merrill Finch Inc., a large financial services corporation. Your first assignment is to
invest $100,000 for a client. Because the funds are to be invested in a business at the end of 1 year, you have been instructed to plan for a 1-year holding period. Further, your boss has restricted you to the investment alternatives in the following table, shown with their probabilities and associated outcomes. (Disregard for now the items at the bottom of the data; you will fill in the blanks later.)

RETURNS ON ALTERNATIVE INVESTMENTS ESTIMATED RATE OF RETURN
State of High U.S. Market 2-Stock
the Economy Probability T-Bills Tech Collections Rubber Portfolio Portfolio
Recession 0.1 5.5% (27.0%) 27.0% 6.0% a (17.0%) 0.0%
Below average 0.2 5.5 (7.0) 13.0 (14.0) (3.0)
Average 0.4 5.5 15.0 0.0 3.0 10.0 7.5
Above average 0.2 5.5 30.0 (11.0) 41.0 25.0
Boom 0.1 5.5 45.0 (21.0) 26.0 38.0 12.0
ˆr 1.0% 9.8% 10.5%
s 0.0 13.2 18.8 15.2 3.4
CV 13.2 1.9 1.4 0.5
b 0.87 0.88

a Note that the estimated returns of U.S. Rubber do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer tires than they would if the economy was stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a new car may choose to wait and instead purchase new tires for the car they currently own. Under these circumstances, we would expect U.S. Rubber’s stock price to be higher if there is a recession than if the economy was just below average.
Merrill Finch’s economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program, which was used to estimate the rate of return on each alternative under each state of the economy. High Tech Inc. is an electronics firm; Collections Inc. collects past-due debts; and U.S. Rubber manufactures tires and various other rubber and plastics products. Merrill Finch also maintains a “market portfolio” that owns a market-weighted fraction of all publicly traded stocks; you can invest in that portfolio, and thus obtain average stock market results.

Given the situation as described, answer the following questions.
a. (1) Why is the T-bill’s return independent of the state of the economy? Do T-bills promise a completely risk-free return?
(2) Why are High Tech’s returns expected to move with the economy whereas Collections’ are expected to move counter to the economy?

b. Calculate the expected rate of return on each alternative and fill in the blanks on the row for rˆ in the table above.

c. You should recognize that basing a decision solely on expected returns is only appropriate for risk-neutral individuals. Because your client, like virtually everyone, is risk averse, the riskiness of each alternative is an important aspect of the decision. One possible measure of risk is the standard deviation of returns.
(1) Calculate this value for each alternative, and fill in the blank on the row for s in the table.
(2) What type of risk is measured by the standard deviation?
(3) Draw a graph that shows roughly the shape of the probability distributions for High Tech, U.S. Rubber, and T-bills.

d. Suppose you suddenly remembered that the coefficient of variation (CV) is generally regarded as being a better measure of stand-alone risk than the standard deviation when the alternatives being considered have widely differing expected returns. Calculate the missing CVs, and fill in the blanks on the row for CV in the table. Does the CV produce the same risk rankings as the standard deviation?

e. Suppose you created a 2-stock portfolio by investing $50,000 in High Tech and $50,000 in Collections.
(1) Calculate the expected return (rˆp), the standard deviation (sp), and the coefficient of variation (CVp) for this portfolio and fill in the appropriate blanks in the table.
(2) How does the riskiness of this 2-stock portfolio compare with the riskiness of the individual stocks if they were held in isolation?

Suppose the owner of a life insurance policy has no other financial assets—the person’s only other asset is “human capital,” or earnings capacity. What is the correlation coefficient between the return on the insurance policy and that on the human capital?

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DISCUSSION QUESTIONS

1 Suppose you owned a portfolio consisting of $250,000 of long-term U.S. government bonds.
a. Would your portfolio be riskless? Explain.
b. Now suppose the portfolio consists of $250,000 of 30-day Treasury bills. Every 30 days your bills mature, and you will reinvest the principal ($250,000) in a new batch of bills. You plan to live on the investment income from your portfolio, and you want to maintain a constant standard of living. Is the T-bill portfolio truly riskless? Explain.
c. What is the least risky security you can think of? Explain.

2 The probability distribution of a less risky expected return is more peaked than that of a riskier return. What shape would the probability distribution have for (a) completely certain returns and (b) completely uncertain returns?

3 A life insurance policy is a financial asset, with the premiums paid representing the investment’s cost.
a. How would you calculate the expected return on a 1-year life insurance policy?
b. Suppose the owner of a life insurance policy has no other financial assets—the person’s only other asset is “human capital,” or earnings capacity. What is the correlation coefficient between the return on the insurance policy and that on the human capital?
c. Life insurance companies must pay administrative costs and sales representatives’ commissions, hence the expected rate of return on insurance premiums is generally low or even negative. Use portfolio concepts to explain why people buy life insurance in spite of low expected returns.

4 Is it possible to construct a portfolio of real-world stocks that has an expected return equal to the risk-free rate?

5 Stock A has an expected return of 7 percent, a standard deviation of expected returns of 35 percent, a correlation coefficient with the market of 0.3, and a beta coefficient of 0.5. Stock B has an expected return of 12 percent, a standard deviation of returns of 10 percent, a 0.7 correlation with the market, and a beta coefficient of 1.0. Which security is riskier? Why?

6 A stock had a 12 percent return last year, a year when the overall stock market declined. Does this mean that the stock has a negative beta and thus very little risk if held in a portfolio? Explain.

7 If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stock? Explain.

8 If a company’s beta were to double, would its required return also double?

9 In Chapter 7 we saw that if the market interest rate, rd, for a given bond increased, then the price of the bond would decline. Applying this same logic to stocks, explain

  • (a) How a decrease in risk aversion would affect stocks’ prices and earned rates of return,
  • (b) How this would affect risk premiums as measured by the historical difference between returns on stocks and returns on bonds, and
  • (c) The implications of this for the use of historical risk premiums when applying the SML equation.

How does the correlation between returns on a project and returns on the firm’s other assets affect the project’s risk? What are some important concepts for individual investors to consider when evaluating the risk and returns of various investments?

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IMPLICATIONS FOR CORPORATE MANAGERS AND INVESTORS

The connection between risk and return is an important concept, and it has numerous implications for both corporate managers and investors. As we will see in later chapters, corporate managers spend a great deal of time assessing the risk and returns on individual projects. Indeed, given their concerns about the risk of individual projects, it might be fair to ask why we spend so much time discussing the riskiness of stocks. Why not begin by looking at the riskiness of such business assets as plant and equipment? The reason is that for a management whose primary goal is stock price maximization, the overriding consideration is the riskiness of the firm’s stock, and the relevant risk of any physical asset must be measured in terms of its effect on the stock’s risk as seen by investors. For example, suppose Goodyear, the tire company, is considering a major investment in a new product, recapped tires. Sales of recaps, hence earnings on the new operation, are highly
uncertain, so on a stand-alone basis the new venture appears to be quite risky. However, suppose returns in the recap business are negatively correlated with Goodyear’s other operations—when times are good and people have plenty of money, they buy new cars with new tires, but when times are bad, they tend to keep their old cars and buy recaps for them. Therefore, returns would be high on regular operations and low on the recap division during good times, but the opposite would be true during recessions. The result might be a pattern like that shown earlier in Figure 8-5 for Stocks W and M. Thus, what appears to be a risky investment when viewed on a stand-alone basis might not be very risky when viewed within the context of the company as a whole.

This analysis can be extended to the corporation’s stockholders. Because Goodyear’s stock is owned by diversified stockholders, the real issue each time management makes an investment decision is this: How will this investment affect the risk of our stockholders? Again, the stand-alone risk of an individual project may look quite high, but viewed in the context of the project’s effect on stockholder risk, it may not be very large. We will address this issue again in Chapter 12, where we examine the effects of capital budgeting on companies’ beta coefficients and thus on stockholders’ risks. While these concepts are obviously important for individual investors, they are also important for corporate managers. We summarize below some key ideas that all investors should consider.

1. There is a trade-off between risk and return. The average investor likes higher returns but dislikes risk. It follows that higher-risk investments need to offer investors higher expected returns. Put another way—if you are seeking higher returns, you must be willing to assume higher risks.

2. Diversification is crucial. By diversifying wisely, investors can dramatically reduce risk without reducing their expected returns. Don’t put all of your money in one or two stocks, or one or two industries. A huge mistake many people make is to invest a high percentage of their funds in their employer’s stock. If the company goes bankrupt, they not only lose their job but also their invested capital. While no stock is completely riskless, you can smooth out the bumps by holding a well-diversified portfolio.

3. Real returns are what matters. All investors should understand the difference between nominal and real returns. When assessing performance, the real return (what you have left over after inflation) is what really matters. It follows that as expected inflation increases, investors need to receive higher nominal returns.

4. The risk of an investment often depends on how long you plan to hold the investment. Common stocks, for example, can be extremely risky for short- term investors. However, over the long haul the bumps tend to even out, and thus, stocks are less risky when held as part of a long-term portfolio. Indeed, in his best-selling book Stocks for the Long Run, Jeremy Siegel of the University of Pennsylvania concludes that “The safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds.”

5. While the past gives us insights into the risk and returns on various investments, there is no guarantee that the future will repeat the past. Stocks that have performed well in recent years might tumble, while stocks that have struggled may rebound. The same thing can hold true for the stock market as a whole. Even Jeremy Siegel, who has preached that stocks have historically been good long-term investments, has also argued that there is no assurance that returns in the future will be as strong as they have been in the past. More importantly, when purchasing a stock you always need to ask, “Is this stock fairly valued, or is it currently priced too high?” We discuss this issue more completely in the next chapter.

  • Explain the following statement: “The stand-alone risk of an individual corporate project may be quite high, but viewed in the context of its effect on stockholders’ risk, the project’s true risk may not be very large.”
  • How does the correlation between returns on a project and returns on the firm’s other assets affect the project’s risk?
  • What are some important concepts for individual investors to consider when evaluating the risk and returns of various investments?

What would happen to the SML graph in Figure 8-10 if inflation increased or decreased? What happens to the SML graph when risk aversion increases or decreases? What would the SML look like if investors were indifferent to risk, that is, if they had zero risk aversion? How can a firm influence the size of its beta?

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Changes in a Stock’s Beta Coefficient

As we shall see later in the book, a firm can influence its market risk, hence its beta, through (1) changes in the composition of its assets and (2) changes in the amount of debt it uses. A company’s beta can also change as a result of external factors such as increased competition in its industry, the expiration of basic patents, and the like. When such changes occur, the firm’s required rate of return also changes, and, as we shall see in Chapter 9, this will affect the firm’s stock price. For example, consider Allied Food Products, with a beta of 1.48. Now suppose some action occurred that caused Allied’s beta to increase from 1.48 to 2.0. If the conditions depicted in Figure 8-10 held, Allied’s required rate of return would increase from 13.4 to 16 percent:

r1 rRF (r M rRF )bi
6% (11% 6%)1.48
13.4%
to
r2 6% (11% 6%)2.0
16%

As we shall see in Chapter 9, this change would have a negative effect on Allied’s stock price.

 

Differentiate among a stock’s expected rate of return (rˆ), required rate of return (r), and realized, after-the-fact, historical return (r-).

Which would have to be larger to induce you to buy the stock, rˆ or r? At a given point in time, would rˆ, r, and r– typically be the same or different? Explain.
What are the differences between the relative volatility graph (Figure 8-9), where “betas are made,” and the SML graph (Figure 8-10), where “betas are used”? Explain how both graphs are constructed and the information they convey.
What would happen to the SML graph in Figure 8-10 if inflation increased or decreased?
What happens to the SML graph when risk aversion increases or decreases?
What would the SML look like if investors were indifferent to risk, that is, if they had zero risk aversion?
How can a firm influence the size of its beta?
A stock has a beta of 1.2. Assume that the risk-free rate is 4.5 percent and the market risk premium is 5 percent. What is the stock’s required rate of return? (10.5%)

What are a bond’s key features? What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky? How is the value of any asset whose value is based on expected future cash flows determined?

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Bonds and Their Valuation

7-22 Bond valuation

Robert Black and Carol Alvarez are vice presidents of Western Money Management and co-directors of the company’s pension fund management division. A major new client, the California League of Cities, has requested that Western present an investment seminar to the mayors of the represented cities, and Black and Alvarez, who will make the actual presentation, have asked you to help them by answering the following questions.

a. What are a bond’s key features?

b. What are call provisions and sinking fund provisions? Do these provisions make bonds more or less risky?

c. How is the value of any asset whose value is based on expected future cash flows determined?

d. How is a bond’s value determined? What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required return is 10 percent?

e. (1) What is the value of a 13 percent coupon bond that is otherwise identical to the bond described in part d? Would we now have a discount or a premium bond?
(2) What is the value of a 7 percent coupon bond with these characteristics? Would we now have a discount or a premium bond?
(3) What would happen to the values of the 7 percent, 10 percent, and 13 percent coupon bonds over time if the required return remained at 10 percent?

[Hint: With a financial calculator, enter PMT, I/YR, FV, and N, and then change (override) N to see what happens to the PV as it approaches maturity.]

f. (1) What is the yield to maturity on a 10-year, 9 percent, annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that it sells at a discount or at a premium tell you about the relationship between r d and the coupon rate?
(2) What are the total return, the current yield, and the capital gains yield for the discount bond? (Assume it is held to maturity and the company does not default on it.)

g. What is interest rate (or price) risk? Which has more interest rate risk, an annual payment 1-year bond or a10-year bond? Why?

h. What is reinvestment rate risk? Which has more reinvestment rate risk, a 1-year bond or a 10-year bond?

i. How does the equation for valuing a bond change if semiannual payments are made? Find the value of a 10-year, semiannual payment, 10 percent coupon bond if nominal rd 13 percent.

j. Suppose you could buy, for $1,000, either a 10 percent, 10-year, annual payment bond or a 10 percent, 10-year, semiannual payment bond. They are equally risky. Which would you prefer? If $1,000 is the proper price for the semiannual bond, what is the equilibrium price for the annual payment bond?

k. Suppose a 10-year, 10 percent, semiannual coupon bond with a par value of $1,000 is currently selling for $1,135.90, producing a nominal yield to maturity of 8 percent. However, it can be called after 4 years for $1,050.
(1) What is the bond’s nominal yield to call (YTC)?
(2) If you bought this bond, do you think you would be more likely to earn the YTM or the YTC? Why?

l. Does the yield to maturity represent the promised or expected return on the bond? Explain.

m. These bonds were rated AA by S&P. Would you consider them investment-grade or junk bonds?

n. What factors determine a company’s bond rating?

o. If this firm were to default on the bonds, would the company be immediately liquidated? Would the bondholders be assured of receiving all of their promised payments? Explain.

Would the yield spread on a corporate bond over a Treasury bond with the same maturity tend to become wider or narrower if the economy appeared to be heading into a recession? Would the change in the spread for a given company be affected by the firm’s credit strength?

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DISCUSSION QUESTIONS

1. A sinking fund can be set up in one of two ways:

  • a. The corporation makes annual payments to the trustee, who invests the proceeds in securities (frequently government bonds) and uses the accumulated total to retire the bond issue at maturity.
  • b. The trustee uses the annual payments to retire a portion of the issue each year, either calling a given percentage of the issue by a lottery and paying a specified price per bond or buying bonds on the open market, whichever is cheaper.
    What are the advantages and disadvantages of each procedure from the viewpoint of (a) the firm and (b) the bondholders?

2 Is it true that the following equation can be used to find the value of a bond with N years to maturity that pays interest once a year? Assume that the bond was issued several years ago.

3 “The values of outstanding bonds change whenever the going rate of interest changes. In general, short-term interest rates are more volatile than long-term interest rates. Therefore, short-term bond prices are more sensitive to interest rate changes than are long-term bond prices.” Is this statement true or false? Explain. (Hint: Make up a “reasonable” example based on a 1-year and a 20-year bond to help answer the question.)

4 If interest rates rise after a bond issue, what will happen to the bond’s price and YTM? Does the time to maturity affect the extent to which interest rate changes affect the bond’s price? (Again, an example might help you answer this question.)

5 If you buy a callable bond and interest rates decline, will the value of your bond rise by as much as it would have risen if the bond had not been callable? Explain.

6 Assume that you have a short investment horizon (less than 1 year). You are considering two investments: a 1-year Treasury security and a 20-year Treasury security. Which of the two investments would you view as being more risky? Explain.

7 Indicate whether each of the following actions will increase or decrease a bond’s yield to maturity:

  • a. The bond’s price increases.
  • b. The bond is downgraded by the rating agencies.
  • c. A change in the bankruptcy code makes it more difficult for bondholders to receive payments in the event the firm declares bankruptcy.
  • d. The economy seems to be shifting from a boom to a recession. Discuss the effects of the firm’s credit strength in your answer.
  • e. Investors learn that these bonds are subordinated to another debt issue.

8 Why is a call provision advantageous to a bond issuer? When would the issuer be likely to initiate a refunding call?

9 Are securities that provide for a sinking fund more or less risky from the bondholder’s perspective than those without this type of provision? Explain.

10 What’s the difference between a call for sinking fund purposes and a refunding call?

11 Why are convertibles and bonds with warrants typically offered with lower coupons than similarly rated straight bonds?

12 Explain whether the following statement is true or false: “Only weak companies issue debentures.”

13 Would the yield spread on a corporate bond over a Treasury bond with the same maturity tend to become wider or narrower if the economy appeared to be heading into a recession? Would the change in the spread for a given company be affected by the firm’s credit strength?

14 A bond’s expected return is sometimes estimated by its YTM and sometimes by its YTC. Under what conditions would the YTM provide a better estimate, and when would the YTC be better?

What is a bond? What are the four main types of bonds? Why are U.S. Treasury bonds not completely riskless? In addition to default risk, what key risk do investors in foreign bonds face?

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WHO ISSUES BONDS?

A bond is a long-term contract under which a borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. For example, on January 3, 2006, Allied Food Products borrowed $50 million by issuing $50 million of bonds. For convenience, we assume that Allied sold 50,000 individual bonds for $1,000 each. Actually, it could have sold one $50 million bond, 10 bonds each with a $5 million face value, or any other combination that totals to $50 million. In any event, Allied received the $50 million, and in exchange it promised to make annual interest payments and to repay the $50 million on a specified maturity date.

Until the 1970s, most bonds were beautifully engraved pieces of paper, and their key terms, including their face values, were spelled out on the bonds them- selves. Today, though, virtually all bonds are represented by electronic data stored in secure computers, much like the “money” in a bank checking account.1

Investors have many choices when investing in bonds, but bonds are classified into four main types:  Treasury, corporate, municipal, and foreign. Each differs with respect to risk and consequently to its expected return.
Treasury bonds, generally called Treasuries and sometimes referred to as government bonds, are issued by the federal government.2 It is reasonable to assume that the federal government will make good on its promised payments, so Treasuries have no default risk. However, these bonds’ prices decline when interest rates rise, so they are not completely risk free. Corporate bonds, as the name implies, are issued by corporations. Unlike Treasuries, corporate bonds are exposed to default risk—if the issuing company gets into trouble, it may be unable to make the promised interest and principal payments. Different corporate bonds have different levels of default risk, depending on the issuing company’s characteristics and on the terms of the specific bond. Default risk is often referred to as “credit risk,” and, as we saw in Chapter 6, the larger the default risk, the higher the interest rate investors demand.

Municipal bonds, or “munis,” are issued by state and local governments. Like corporates, munis are exposed to some default risk. However, munis offer one major advantage over all other bonds: As we discussed in Chapter 3, the interest earned on most munis is exempt from federal taxes, and also from state taxes if the holder is a resident of the issuing state. Consequently, the interest rates on munis are considerably lower than on corporates of equivalent risk.

Foreign bonds are issued by foreign governments or foreign corporations. Foreign corporate bonds are, of course, exposed to default risk, and so are the bonds of some foreign governments. An additional risk exists if the bonds are denominated in a currency other than that of the investor’s home currency. For example, if you purchase a corporate bond denominated in Japanese yen, even if the company does not default you still could lose money if the Japanese yen falls relative to the dollar.

  • What is a bond?
  • What are the four main types of bonds?
  • Why are U.S. Treasury bonds not completely riskless?
  • In addition to default risk, what key risk do investors in foreign bonds face?

If short-term interest rates are lower than long-term rates, why might a borrower still choose to finance with long-term debt? Explain the following statement: “The optimal financial policy depends in an important way on the nature of the firm’s assets.”

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INTEREST RATES AND BUSINESS DECISIONS

The yield curve for February 2005, shown earlier in Figure 6-4 in Section 6.4, indicates how much the U.S. government had to pay in February 2005 to borrow money for 1 year, 5 years, 10 years, and so on. A business borrower would have had to pay somewhat more, but assume for the moment that it is February 2005 and that the yield curve shown for that year applies to your company. Now suppose your company has decided to build a new plant with a 30-year life that will cost $1 million, and to raise the $1 million by borrowing rather than by issuing new stock. If you borrowed in February 2005 on a short-term basis—say, for one year—your interest cost would be only 3.1 percent, or $31,000. On the other hand, if you used long-term financing, your cost would be 4.6 percent, or $46,000. Therefore, at first glance, it would seem that you should use short-term debt.

However, this could prove to be a horrible mistake. If you use short-term debt, you will have to renew your loan every year, and the rate charged on each new loan will reflect the then-current short-term rate. Interest rates could return to their previous highs, in which case you would be paying 14 percent, or $140,000, per year. Those high interest payments would cut into and perhaps eliminate your profits. Your reduced profitability could increase your firm’s risk to the point where your bond rating was lowered, causing lenders to increase the risk premium built into your interest rate. That would further increase your inter- est payments, which would further reduce your profitability, worry lenders still more, and make them reluctant to even renew your loan. If your lenders refused to renew the loan and demanded its repayment, as they would have every right to do, you might have to sell assets at a loss, which could result in bankruptcy.

On the other hand, if you used long-term financing in 2005, your interest costs would remain constant at $46,000 per year, so an increase in interest rates in the economy would not hurt you. You might even be able to acquire some of your bankrupt competitors at bargain prices—bankruptcies increase dramatically when interest rates rise, primarily because many firms do use so much short-term debt.

Does all this suggest that firms should always avoid short-term debt? Not at all. If inflation falls over the next few years, so will interest rates. If you had borrowed on a long-term basis for 4.6 percent in February 2005, your company would be at a disadvantage if it were locked into 4.6 percent debt while its competitors (who used short-term debt in 2005) had a borrowing cost of only 3 percent or so.

Financing decisions would be easy if we could make accurate forecasts of future interest rates. Unfortunately, predicting interest rates with consistent accuracy is nearly impossible. However, even if it is difficult to predict future interest rate levels, it is easy to predict that interest rates will fluctuate—they always have, and they always will. This being the case, sound financial policy calls for using a mix of long- and short-term debt, as well as equity, to position the firm so that it can survive in any interest rate environment. Further, the optimal financial policy depends in an important way on the nature of the firm’s assets—the easier it is to sell off assets to generate cash, the more feasible it is to use more short-term debt. This makes it more feasible for a firm to finance cur-
rent assets like inventories and receivables with short-term debt than fixed assets like buildings. We will return to this issue later in the book, when we discuss working capital policy.

Changes in interest rates also have implications for savers. For example, if you had a 401(k) plan—and someday most of you will—you would probably want to invest some of your money in a bond mutual fund. You could choose a fund that had an average maturity of 25 years, 20 years, on down to only a few months (a money market fund). How would your choice affect your investment results, hence your retirement income? First, your annual interest income would be affected. For example, if the yield curve were upward sloping, as it normally is, you would earn more interest if you chose a fund that held long-term bonds. Note, though, that if you chose a long-term fund and interest rates then rose, the market value of the bonds in the fund would decline. For example, as we will see in Chapter 7, if you had $100,000 in a fund whose average bond had a maturity of 25 years and a coupon rate of 6 percent, and if interest rates then rose from 6 to 10 percent, the market value of your fund would decline from $100,000 to about $64,000. On the other hand, if rates declined, your fund would increase in value. In any event, your choice of maturity would have a major effect on your investment performance, hence on your future income.

  • If short-term interest rates are lower than long-term rates, why might a borrower still choose to finance with long-term debt?
  • Explain the following statement: “The optimal financial policy depends in an important way on the nature of the firm’s assets.”