Question

Explain the risks associated with investing in Corporate Bonds, are they the same risk as for Government Bonds?

Why does a bond’s face or par value differ from its market value?

Why is the Required Return such an important concept in finance?

Explain the efficient markets hypothesis and why it is important to share prices

Describe what is meant by systematic risk and unsystematic risk. How is this distinction related to an investment’s beta?

Estimate an investor’s required rate of return using the Capital Asset Pricing Model

Answer 1

Explain the risks associated with investing in Corporate Bonds, are they the same risk as for Government Bonds?

A government bond

A government bond is a debt security issued by a government to support government spending and obligations. Government bonds can pay periodic interest payments called coupon payments. Government bonds issued by national governments are often considered low-risk investments since the issuing government backs them.Government bonds may also be known as sovereign debt.

Government bonds are issued by governments to raise money to finance projects or day-to-day operations. The U.S. Treasury Department sells the issued bonds during auctions throughout the year. Some Treasury bonds trade in the secondary market. Individual investors, working with a financial institution or broker, can buy and sell previously issued bonds through this marketplace. Treasuries are widely available for purchase through the U.S. Treasury, brokers as well as exchange-traded funds, which contain a basket of securities.

Fixed-rate government bonds can have interest rate risk, which occurs when interest rates are rising, and investors are holding lower paying fixed-rate bonds as compared to the market. Also, only select bonds keep up with inflation, which is a measure of price increases throughout the economy. If a fixed-rate government bond pays 2% per year, for example, and prices in the economy rise by 1.5%, the investor is only earning .5% in real terms.

Local governments may also issue bonds to fund projects such as infrastructure, libraries, or parks. These are known as municipal bonds, and often carry certain tax advantages for investors,

The Uses of Government Bonds

Government bonds assist in funding deficits in the federal budget and are used to raise capital for various projects such as infrastructure spending. However, government bonds are also used by the Federal Reserve Bank to control the nation's money supply.

When the Federal Reserve repurchases U.S. government bonds, the money supply increases throughout the economy as sellers receive funds to spend or invest in the market. Any funds deposited into banks are, in turn, used by those financial institutions to loan to companies and individuals, further boosting economic activity.

Pros and Cons of Government Bonds

As with all investments, government bonds provide both benefits and disadvantages to the bondholder. On the upside, these debt securities tend to return a steady stream of interest income. However, this return is usually lower than other products on the market due to the reduced level of risk involved in their investments.

The market for U.S. government bonds is very liquid, allowing the holder to resell them on the secondary bond market easily. There are even ETFs and mutual funds that focus their investment on Treasury bonds.

Fixed rate bonds may fall behind during periods of increasing inflation or rising market interest rates. Also, foreign bonds are exposed to sovereign or governmental risk, changes in currency rates, and have a higher risk of default.

Some U.S. Treasury bonds are free of state and federal taxes. But, the investor of foreign bonds may face taxes on income from these foreign investments.

Corporate Bond

A corporate bond is a type of debt security that is issued by a firm and sold to investors. The company gets the capital it needs and in return the investor is paid a pre-established number of interest payments at either a fixed or variable interest rate. When the bond expires, or "reaches maturity," the payments cease and the original investment is returned.

The backing for the bond is generally the ability of the company to repay, which depends on its prospects for future revenues and profitability. In some cases, the company's physical assets may be used as collateral.

Understanding Corporate Bonds

In the investment hierarchy, high-quality corporate bonds are considered a relatively safe and conservative investment. Investors building balanced portfolios often add bonds in order to offset riskier investments such as growth stocks. Over a lifetime, these investors tend to add more bonds and fewer risky investments in order to safeguard their accumulated capital. Retirees often invest a larger portion of their assets in bonds in order to establish a reliable income supplement.

In general, corporate bonds are considered to have a higher risk than U.S. government bonds. As a result, interest rates are almost always higher on corporate bonds, even for companies with top-flight credit quality. The difference between the yields on highly-rated corporate bonds and U.S. Treasuries is called the credit spread.

Corporate Bond Ratings

Before being issued to investors, bonds are reviewed for the creditworthiness of the issuer by one or more of three U.S. rating agencies: Standard & Poor's Global Ratings, Moody's Investor Services, and Fitch Ratings. Each has its own ranking system, but the highest-rated bonds are commonly referred to as "Triple-A" rated bonds. The lowest rated corporate bonds are called high-yield bonds due to their greater interest rate applied to compensate for their higher risk. These are also known as "junk" bonds.

Bond ratings are vital to altering investors to the quality and stability of the bond in question. These ratings consequently greatly influence interest rates, investment appetite, and bond pricing.

Why does a bond’s face or par value differ from its market value?

Face value, also known as the par value, is equal to a bond's price when it is first issued. After that, the price of the bond fluctuates in the market in accordance with changes in interest rates while the face value remains fixed.

The various terms surrounding bond prices and yields can be confusing to the average investor. A bond represents a loan made by investors to the entity issuing the bond, with the face value being the amount of principal the bond issuer borrows. The principal amount of the loan is paid back at some specified future date. Interest payments are made to the investor at regular, specified intervals during the term of the loan, typically every six months.

A bond is a fixed-rate security or investment vehicle. The interest rate to a bond investor or purchaser is a fixed, stated amount. However, the bond's yield, which is the interest amount relative to the bond's current market price, fluctuates with the price. As the bond's price varies, the price is described relative to the original par value, or face value; the bond is referred to as trading above par value or below par value.

The need to change the yield to reflect current market conditions drives the changes in price. Unfavorable developments demand higher yields, so bond prices must fall. In the same way, improvements in the company's situation allow it to raise funds at lower rates. Hence, the prices of existing bonds rise.

Factors That Influence Bond Prices

Three factors that influence a bond's current price are the credit rating of the issuer, market interest rates, and the time to maturity. As the bond nears its maturity date, the bond price naturally tends to move closer to par value.

The credit rating for a bond is determined by bond rating companies, such as Moody's or Standard & Poor's.23 Lower ratings generally cause a bond's price to fall since it is not as attractive to buyers. When the price drops, that action tends to increase the bond's appeal because lower-priced bonds offer higher yields.

Prevailing market interest rates change after a bond is issued, and bond prices must adjust to compensate investors. If interest rates rise, then bond prices must fall. Suppose a three-year bond pays 3% when it is issued, and then market interest rates rise by half a percentage point a year later. In order to sell the bond in the secondary market, the price of the bond will have to fall about 1% (extra 0.5% per year x 2 years), so it will be trading at a discount to face value. New bonds from firms with similar credit quality are now paying 3.5%. The old 3% bond still pays 3% in interest, but investors can now look forward to an extra 1% when the bond matures. Similarly, the price of the bond must rise if interest rates fall.

Time to maturity also usually influences bond prices. However, the exact effect depends on the shape of the yield curve. A normal yield curve features lower interest rates for short-term bonds and higher interest rates for long-term bonds. This situation is considered normal because longer-term bonds have higher interest rate risk. Investors will usually demand higher interest rates as compensation for taking that risk. However, the yield curve may flatten if there is widespread anticipation that interest rates will remain unchanged. If enough investors believe interest rates are going to fall, an inverted yield curve can occur.

Why is the Required Return such an important concept in finance?

The required rate of return is the minimum return an investor will accept for owning a company's stock, as compensation for a given level of risk associated with holding the stock. The RRR is also used in corporate finance to analyze the profitability of potential investment projects.

The required rate of return is also known as the hurdle rate, which like RRR, denotes the appropriate compensation needed for the level of risk present. Riskier projects usually have higher hurdle rates or RRRs than those that are less risky.

The required rate of return RRR is a key concept in equity valuation and corporate finance. It's a difficult metric to pinpoint due to the different investment goals and risk tolerance of individual investors and companies. Risk-return preferences, inflation expectations, and a company’s capital structure all play a role in determining the company's own required rate. Each one of these and other factors can have major effects on a security's intrinsic value.

For investors using the CAPM formula, the required rate of return for a stock with a high beta relative to the market should have a higher RRR. The higher RRR relative to other investments with low betas is necessary to compensate investors for the added level of risk associated with investing in the higher beta stock.

In other words, RRR is in part calculated by adding the risk premium to the expected risk-free rate of return to account for the added volatility and subsequent risk.

For capital projects, RRR is useful in determining whether to pursue one project versus another. The RRR is what's needed to go ahead with the project although some projects might not meet the RRR but are in the long-term best interests of the company.

Inflation must also be factored into RRR analysis. The RRR on a stock is the minimum rate of return on a stock that an investor considers acceptable, taking into account their cost of capital, inflation and the return available on other investments.

For example, if inflation is 3% per year, and the equity risk premium over the risk-free return (using a U.S. Treasury bill which returns 3%), then an investor might require a return of 9% per year to make the stock investment worthwhile. This is because a 9% return is really a 6% return after inflation, which means the investor would not be rewarded for the risk they were taking. They would receive the same risk-adjusted return by investing in the 3% yielding Treasury bill, which would have a zero real rate of return after adjusting for inflation.

RRR Using CAPM Formula Example

• A company has a beta of 1.50 meaning it's riskier than the overall market's beta of one.
• The current risk-free rate is 2% on a short-term U.S. Treasury.
• The long-term average rate of return for the market is 10%.
• RRR = 12% or (0.02 + 1.50 x (0.10 - 0.02)).

Explain the efficient markets hypothesis and why it is important to share prices

The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can obtain higher returns is by purchasing riskier investments.

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the market through either fundamental or technical analysis.

Theoretically, neither technical nor fundamental analysis can produce risk-adjusted excess returns (alpha) consistently, and only inside information can result in outsized risk-adjusted returns.

Proponents of the Efficient Market Hypothesis conclude that, because of the randomness of the market, investors could do better by investing in a low-cost, passive portfolio.

Data compiled by Morningstar Inc., in its June 2019 Active/Passive Barometer study, supports the EMH. Morningstar compared active managers’ returns in all categories against a composite made of related index funds and exchange-traded funds (ETFs). The study found that over a 10 year period beginning June 2009, only 23% of active managers were able to outperform their passive peers. Better success rates were found in foreign equity funds and bond funds. Lower success rates were found in US large cap funds. In general, investors have fared better by investing in low-cost index funds or ETFs.

While a percentage of active managers do outperform passive funds at some point, the challenge for investors is being able to identify which ones will do so over the long-term. Less than 25 percent of the top-performing active managers can consistently outperform their passive manager counterparts over time.

Describe what is meant by systematic risk and unsystematic risk. How is this distinction related to an investment’s beta?

There is always a risk incorporated in every investment like shares or debentures. The two major components of risk systematic risk and unsystematic risk, which when combined results in total risk. The systematic risk is a result of external and uncontrollable variables, which are not industry or security specific and affects the entire market leading to the fluctuation in prices of all the securities.

On the other hand, unsystematic risk refers to the risk which emerges out of controlled and known variables, that are industry or security specific.

Systematic risk cannot be eliminated by diversification of portfolio, whereas the diversification proves helpful in avoiding unsystematic risk. Take a full read of this article to know about the differences between systematic and unsystematic risk.

BASIS FOR COMPARISON	SYSTEMATIC RISK	UNSYSTEMATIC RISK
Meaning	Systematic risk refers to the hazard which is associated with the market or market segment as a whole.	Unsystematic risk refers to the risk associated with a particular security, company or industry.
Nature	Uncontrollable	Controllable
Factors	External factors	Internal factors
Affects	Large number of securities in the market.	Only particular company.
Types	Interest risk, market risk and purchasing power risk.	Business risk and financial risk
Protection	Asset allocation	Portfolio diversificat

Definition of Systematic Risk

By the term ‘systematic risk’, we mean the variation in the returns on securities, arising due to macroeconomic factors of business such as social, political or economic factors. Such fluctuations are related to the changes in the return of the entire market. Systematic risk is caused by the changes in government policy, the act of nature such as natural disaster, changes in the nation’s economy, international economic components, etc. The risk may result in the fall of the value of investments over a period. It is divided into three categories, that are explained as under:

• Interest risk: Risk caused by the fluctuation in the rate or interest from time to time and affects interest-bearing securities like bonds and debentures.
• Inflation risk: Alternatively known as purchasing power risk as it adversely affects the purchasing power of an individual. Such risk arises due to a rise in the cost of production, the rise in wages, etc.
• Market risk: The risk influences the prices of a share, i.e. the prices will rise or fall consistently over a period along with other shares of the market.

Definition of Unsystematic Risk

The risk arising due to the fluctuations in returns of a company’s security due to the micro-economic factors, i.e. factors existing in the organization, is known as unsystematic risk. The factors that cause such risk relates to a particular security of a company or industry so influences a particular organization only. The risk can be avoided by the organization if necessary actions are taken in this regard. It has been divided into two category business risk and financial risk, explained as under:

• Business risk: Risk inherent to the securities, is the company may or may not perform well. The risk when a company performs below average is known as a business risk. There are some factors that cause business risks like changes in government policies, the rise in competition, change in consumer taste and preferences, development of substitute products, technological changes, etc.
• Financial risk: Alternatively known as leveraged risk. When there is a change in the capital structure of the company, it amounts to a financial risk. The debt – equity ratio is the expression of such risk.