Study Notes: Fixed Income and Equity Markets

Fixed Income and Equity Markets Study Notes

Institutional Structure of Issuance

  • Outline:

    • Institutional structure of issuance

    • Fixed income markets

    • Equity markets

    • Valuation

    • Fixed income securities

    • Equity securities

  • Reference:

    • Kidwell Chapters 8 - 10, CFA level 1 curriculum 2020 Readings 39, 43, and 44

Fixed Income Markets

Legal Identity of Issuer

  • The legal identity of the issuer can classify global debt into different sectors.

  • Global Debt by Sector at End of Q1 2018 in USD:

    • Total Global Debt: USD 247.2 trillion

    • Households: USD 46.5 trillion (18.8%)

    • Non-Financial Corporates: USD 73.5 trillion (29.7%)

    • Government: USD 66.5 trillion (26.9%)

    • Financial Sector: USD 60.6 trillion (24.5%)

  • Geographic and Sector Distribution

    • Mature Markets:

    • Total Debt: USD 178.3 trillion

    • Breakdown:

      • Households: USD 34.7 trillion (19.5%)

      • Non-Financial Corporates: USD 42.0 trillion (23.6%)

      • Government: USD 51.3 trillion (28.8%)

      • Financial Sector: USD 50.3 trillion (28.2%)

    • Emerging Markets:

    • Total Debt: USD 68.9 trillion

    • Breakdown:

      • Households: USD 11.9 trillion (17.3%)

      • Non-Financial Corporates: USD 31.5 trillion (45.7%)

      • Government: USD 15.2 trillion (22.1%)

      • Financial Sector: USD 10.4 trillion (15.1%)

Classification by Legal Identity of Issuer

  • Issuers are categorized into:

    • Sovereign: National government bonds

    • Local: Municipal bonds

    • Quasi-government: Agencies that are owned or sponsored by the government

Classification by Geography and Currency

  • Domestic Product:

    • Issued in a specific country

    • Denominated in the currency of that country

    • Issuer is domiciled in that country

  • Foreign Product:

    • Issued in a specific country

    • Denominated in the currency of that country

    • Issued by an entity domiciled in a different country

  • Eurobond:

    • Issued internationally

    • Trades outside the jurisdiction of the currency in which it is denominated

Examples of Geography and Currency

  • Domestic:

    • Issuer: U.S.; Target: U.S.; Currency: USD

  • Foreign:

    • Issuer: China; Target: U.S.; Currency: USD

  • Eurobond:

    • Issuer: China; Target: U.S.; Currency: CAD

Classification by Credit Quality

  • Fixed income investors face credit risk, defined as the risk of loss stemming from the issuer's failure to make full and timely payments of interest and/or principal.

  • Credit Rating Agencies:

    • Examples include Standard and Poor’s (S&P), Moody's, and Fitch

  • Credit Quality Tiers:

    • Investment Grade: Higher credit quality

    • High-Yield (or Speculative or Junk) Grade: Lower credit quality

  • Dynamic Credit Ratings: Ratings can change over time based on various factors

Factors Affecting Credit Quality

  • Factors include:

    • Source of repayments

    • Collateral backing

    • Specific contract terms

    • Credit enhancement through insurance

  • Examples:

    • A sovereign bond issued in domestic currency has higher credit quality due to the government's ability to print money and raise taxes.

    • A corporate loan that is secured by collateral is less risky than an unsecured loan, as the collateral can be sold for repayments.

    • A mortgage with insurance has higher credit quality since the insurance mitigates the risk of default.

Institutional Structure of Equity Issuance

Public Versus Private Equity

  • Public Equity Securities:

    • Issued through public offerings

    • Active secondary equity markets exist

  • Private Equity Securities:

    • Issued through private placements

    • Exited through OTC deals or public offerings

    • No active secondary market or quoted prices

    • Not accessible to retail investors

Cross-Listing Overseas

  • Cross-listing allows companies to access international investors:

    • Direct Invest:

    • Must adhere to foreign market regulations

    • Subject to foreign currency risks

    • Depository Receipts (DR):

    • A security that trades like a regular share

    • Represents an interest in a foreign company's equity

    • Equity shares of the foreign company are held by a local bank (the depository), which issues receipts to local investors.

    • Sponsored DR:

      • Holders have the same rights as owners of common shares.

    • Unsponsored DR:

      • The depository retains voting rights; cashflow rights go to local investors

Security Valuation

Expressions and Examples of Valuation

  • Price:

    • Example: Woolworth’s closing price was AUD 33.67 on ASX on January 16, 2024 and increased to AUD 35.53 two days later.

    • Analysts believe Woolworth’s target price should be AUD 36.

  • Return:

    • The daily return from January 16 to January 18, 2024, was approximately 6%.

    • Woolworth's dividend yield is 4.17%.

    • Required return on a 10-year bond priced at AUD 140 should be about 5%.

    • Effective interest rate for a bond priced at $921.01, with a coupon rate of 10.95% and 10 years to maturity is 11.89%.

  • Spread:

    • Woolworth's average bid price was AUD 35.65 and the ask was AUD 35.70, giving a bid-ask spread of AUD 0.05.

    • Credit spread on a 10-year, 10% Australian corporate bond rated AAA is 2% over a government bond.

Methods to Estimate the Price of a Security

  • Discounted Cash Flow Method:

    • The price of any financial asset equals the present value of future cash flows.

  • Relative Valuation:

    • The price is determined relative to similar securities.

  • Other Pricing Models:

    • Expected return is compensation for taking on risk.

Example: Discounted Cash Flow of a Bond

  • Formula:
    PB=PV(extEachcouponpayment)+PV(extPrincipalpayment)P_B = PV( ext{Each coupon payment}) + PV( ext{Principal payment})

  • Specific Scenario:

    • Par Value: USD 1000

    • Coupon Rate: 8% (annual payments)

    • Maturity: 3 years

    • Current Required Rate of Return: 10%

Current Yield vs. Yield to Maturity

  • Example Variables:

    • Face Value: USD 1,000

    • Current Price: USD 921.01

    • Annual Coupon Rate: 10.95%

    • Years to Maturity: 10

  • Current Yield Calculation:

    • i_c = rac{C}{P} = rac{109.5}{921.01} = 11.89 ext{%}

  • Yield to Maturity Calculation:

    • 921.01=109.5(1+i)+109.5(1+i)2+extrm…+109.5(1+i)10+1109.5(1+i)10921.01 = 109.5(1+i) + 109.5(1+i)^2 + extrm{…} + 109.5(1+i)^{10} + 1109.5(1+i)^{10}

    • i=YTM=12.4 ext{%}

Relationship Between Market Price and YTM

  • Findings on Market Prices:

    • When the bond is at par, the yield equals the coupon rate.

    • Price and yield are inversely related, meaning as the bond price decreases, the yield increases.

  • Example Data for a 10-Year Bond with 10% Coupon Rate (Face Value = $1,000):

    • Market Price: USD 1200; Yield to Maturity: 7.13%

    • Market Price: USD 1100; Yield to Maturity: 8.48%

    • Market Price: USD 1000; Yield to Maturity: 10.00%

    • Market Price: USD 900; Yield to Maturity: 11.75%

    • Market Price: USD 800; Yield to Maturity: 13.81%

Determinants of Fixed Income Product Value

  • Factors Affecting Value:

    • Yield-to-maturity

    • Time-to-maturity

    • Coupon payment frequency

    • Coupon rate

    • Tax status

    • Other risks: credit, liquidity, currency

    • The relationship between yield-to-maturity and time-to-maturity is represented by the term structure of interest rates and yield curves.

Relative Valuation of a Bond (Not on Exam)

  • Matrix Pricing Method:

    • For each maturity, compute the average yield of different coupon bonds and estimate market price via discounting cash flows.

The Value of Equity

Book Value, Market Value, Intrinsic Value

  • Definitions:

    • Book Value of Equity (BVE): The difference between total assets and total liabilities on a balance sheet; reflects historical shareholder wealth accumulation.

    • Market Value of Equity (MV): Product of market price per share and total number of outstanding shares; varied with investor expectations regarding future cash flows.

    • Market-to-Book Ratio: Reflects investor expectations for future growth opportunities.

Management Goals Regarding Equity Value

  • Management aims to increase both the BVE and MV of equity.

  • Management directly affects the BVE through actions, but indirectly influences the MV.

  • Intrinsic Value:

    • Defined as the present value of future cash flows; can only be estimated, neither book value nor market value always reflects intrinsic value accurately.

Return on Equity (ROE) Formulas

  • Basic Formula (for wealth at beginning of year t):

    • ROE=racNetIncomeBVEt−1ROE = rac{Net Income}{BVE_{t-1}}

  • Enhanced Formula (including reinvested wealth during year t):

    • ROE=racNetIncome(BVEt+BVEt−1)imes0.5ROE = rac{Net Income}{(BVE_{t} + BVE_{t-1}) imes 0.5}

  • Measures efficiency and effectiveness of profit generation from capital.

Investment Decision Example

  • Companies to Compare (in Thousands of USD):

    • Pfizer:

    • Net Income (2016): 7,215

    • Net Income (2017): 21,308

    • BVE (2016): 59,840

    • BVE (2017): 71,287

    • MV (2017): 212,757

    • Total Shares Outstanding (2017): 5,953

    • Novartis:

    • Net Income (2016): 6,712

    • Net Income (2017): 7,703

    • BVE (2016): 74,891

    • BVE (2017): 74,227

    • MV (2017): 210,869

    • Total Shares Outstanding (2017): 2,318

    • GlaxoSmithKline:

    • Net Income (2016): 1,126

    • Net Income (2017): 2,071

    • BVE (2016): 6,128

    • BVE (2017): 4,716

    • MV (2017): 89,968

    • Total Shares Outstanding (2017): 4,892

Accounting Method Evaluation

  • Return on Equity (ROE) for 2017:

    • Pfizer: 32.5%

    • Novartis: 10.3%

    • GlaxoSmithKline: 38.2%

  • Market-to-Book Ratio (2017):

    • Pfizer: 2.98

    • Novartis: 2.84

    • GlaxoSmithKline: 19.08

Limitations of Return on Equity and Market-to-Book Ratio

Discounted Cash Flow Method for Equity

  • Commonly utilizes the Dividend Discount Model (DDM) to estimate a stock’s target price.

  • Analysts compare the target price against the current market price to make recommendations (buy, hold, sell).

Relative Valuation of a Common Share

Price Multiples (PE Ratio)

  • Definition:

    • Measures how much investors are willing to pay per dollar of earnings.

  • Formula:

    • Price=P/EimesextForecastedEarningsPrice = P/E imes ext{Forecasted Earnings}

Practical Example of PE Ratio

  • If industry PE ratio is 16 and expected earnings per share is $1.13, the stock price should be:

    • Price=16imes1.13=18.08Price = 16 imes 1.13 = 18.08

  • If the market price is currently $20, the investor may reassess their position.

  • Assumption: The PE ratio reflects anticipated earnings without accounting for variants in growth rates across sectors or companies.