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Students Corner - Portfolio Investment
& Management

Annexure-3   

The investment media includes, inter alia, bonds and debentures. This form of investment represents the most usual way of borrowing by a company. It is intended to suit the investment needs of a risk avert or who is primarily interested in steady returns coupled with safety of the principal sum. It would be worthwhile to comprehend the salient features, kinds, risk-return relationship, etc of debentures and bonds.

A debenture is a legal document containing an acknowledgement of indebtedness by a company. It contains a promise to pay a stated rate of interest for a defined period and then to repay the principal at a given date of maturity. In short, a debenture is a formal legal evidence of debt and is termed as the senior securities of a company. The position of a bond-holder contrasts sharply with that of a equity-holder. Whereas the former are creditors, the latter are the ultimate owners of the company. Bond-holders assume risk but comparatively lower than the equity holders in the same organization.

There are a number of risks in bond investment. One is the business risk, that a decline in earning power may impair the corporation's ability to service debt. The second is the purchasing power risk, the prospect that a severe inflation may impair the purchasing power of interest on debt as well as of the principal itself. The third is the so-called interest rate risk. If interest rate rises the market price of the security will decline until its yield becomes competitive with the new higher interest rate. Borrowing corporations and governmental bodies have to pay much higher interest on new issues and older outstanding bonds with lower fall in price, even in a recession period. To understand the nature of the inverse relationship between price and yield, it is necessary to know something about the methods of yield calculations.

Current Yield: The current yield on a bond is the annual interest due on it dividend by the bond's market price. The current yield is reliable measure of returns earned by perpetual bonds and /or almost any bond with a long time remaining to maturity.

Current Yield = Annual interest/ Market Price

Investors use the current yield determine the rate of return earned on each invested rupee, but they know this yield has some handicaps. It means bond returns over an indefinite time period. In theory the current yield assumes bonds are without a maturity date when interest payments cease or that a bond will be sold at the same price as the purchase price.

Yield to Maturity: The yield measure most commonly used for bonds is not current but yield to maturity (YTM) - the percentage yield that will be earned on the bonds from purchase date to maturity date. The YTM puts bonds income into a common denominator that permits investors to make yield comparisons. The YTM need not consider capital gains; bonds are redeemed at their face value at maturity. It considers time value of money, market discounts and premium, and is the return earned over the remaining life of a bond issue. The YTM is a complex computation based upon a rather simple idea. It is the discount rate that equals the present value of all cash flows from a bond to the cost.

figure-5

The problem with YTM is that it assumes investor can reinvest bond's periodic coupon payments at the same rate over time. The assumption that interest rates will remain constant is a key weakness of YTM. The problem with YTM, in effect is that it fails to take into account the effects of reinvestment risk and price, or market risk.

Preference shares are a hybrid security that is not heavily utilized by corporations as a means of raising capital. It is hybrid because it combines some of the characteristics of debt and some of equity. Legally a preference share represents a position of the ownership of the company, and thus is shown in the balance sheet with the equity shares as making up the capital stock or equity interest. Preference share is basically weak corporate security as it has the limitation of bonds with few of the advantages. It does not enjoy strong legal position of a bond when the corporation is required to pay return to the investor and refund the principal amount at maturity. As the returns to the holders are discretionary, the corporation is under much less compulsion to pay preference dividends than to pay bond interest because preference share is merely given the right to receive its specific dividend before any dividends are paid on the equity.

To determine the rates of return earned, the preference share holders use following three yields:

When preference shares do not have a maturity date, the investors use the current yield to measure the return available from dividends. They merely divide the annual dividend payment by the current market price to calculate this yield as follows:

Current Yield = Annual dividend / Market price

For example, if the 9% preference shares of XYZ Company are sold for Rs.72, the current yield is 12.5 per cent.

Current Yield = Rs.9 =12.5% ; or 100% = Rs.72.

However, the planning or holding period return would be more useful if the investment horizons are known.

If the issues are callable, their dividend payments cannot be expected to continue indefinitely. In this case, the probable call date is used as an investment terminal date to evaluate.

Dt + Cp - (Pi/n)
Y =     ------------------------------
        (Pi +Cp)/2

Equity represents an ownership position in a corporation. It is a residual claim, in the sense that creditors and preference shareholders must be paid as scheduled before equity shareholders can receive any payment. In bankruptcy equity holders are in principle entitled only to assets remaining after all prior claimants have been satisfied. Thus, risk is highest with equity shares and so must be its expected return. When investors buy equity shares, they receive certificates of ownership as proof of their being part owners of the company. The certificate states the number of shares purchased and their par value.

Equity analysis is more complicated than bond appraisal, and greater skill is required in selecting equity shares than fixed income securities. The attitude towards equity shares has varied from extreme pessimism to optimism from time to time. It is equity shares that entice most investors, and some investors have been known to feel a greater sympathy for their equity than their spouses. Presence of market and business risks associated with such investments falls to keep the investing public and institution out of the market because of their confidence in the ultimate success of the equity shares, i.e. towards overshadow risks. In fact the advantages of equity shares ownership are enough to lure the investors and change their attitude towards securities.

The security analyst, when faced with the problem of making a buy, hold, or sell decision, must first evaluate the past performance of the security and then coupled with his personal experience, predict its future performance and relative market position. The analyst, therefore, will normally base his predictions on several basic attributes of the security and modify these results in the light of his intuitive beliefs.

The valuation task is relatively straightforward in case of bond and preference share, because benefits are generally constant and reasonably certain. Equity valuation is different, because the return on equity is uncertain and can change from time to time. It is the size of the return and the degree of fluctuation (i.e. risk), which together determine the value of a share to the investor. Therefore, forecasting abilities of the analyst are far more crucial in the equity analysis. In fact, active equity management is based on the notion, explicitly stated or implied, that the stock market is not totally efficient. Put another way, active equity management assumes that all historical and current information is not fully and correctly reflected in the current price of every stock. Hence, there exit stocks that are undervalued, fairly valued and overvalued. The task of the active equity manager is to decide which stocks are which and invest accordingly. By contrast, an investor/equity manager who believes the market is efficient tends to favour a passive strategy, with indexing being the most common form of passive strategy.

A useful way of thinking about active versus passive strategy is in terms of three activities performed by the manager:

1. portfolio construction (deciding on the equity to buy or sell,

2. trading of securities, and

3. portfolio monitoring.

Figure-1 summarises the difference in the three activities for active management and passive management. Generally activie managers devote the majority of their time to portfolio construction. In contrast, with passive strategies such as indexing, managers devote less time to this activity.