FIN521 Chap.3 Bonds, Equities and Market Indices
Bonds, Equities and Market Indices
Three questions that sort every long claim
The capital market holds everything the money market does not: longer maturities, larger price swings and the residual claims. Three questions separate the instruments in it. Who owes the money, which distinguishes a sovereign from a company from a municipality. What stands behind the promise, which distinguishes a secured bond from a debenture.
And where the holder stands in the queue when there is not enough to go round, which is the difference between debt and equity in one sentence. Every comparison table in this chapter is those three questions asked of a different instrument.
Reading a quote without being tricked by the conventions
Three conventions cost marks every year.
Quoted figures express a percentage of face value rather than dollars, so something reading around one hundred is trading near its face amount rather than at a hundred dollars, and 138.244 against a thousand-dollar face means $1,382.44. Coupons are published at an annual rate even where the money arrives in two instalments, so a figure of 4.500 means $22.50 reaching the holder every six months.
And the change column refers to the ask price against the previous trading day, so yesterday's ask is today's ask minus the change.
The yield in the final column is computed semi-annually and then doubled by convention, which is why a bond priced above par must show a yield below its coupon.
What a share entitles you to, and the asymmetry that follows
Company ownership is divided into ordinary shares, each conferring a single vote together with a proportionate entitlement to whatever dividend the directors declare.
Two features decide almost every equity answer. The shareholder holds the residual claim and stands last in line behind every other claimant. And the shareholder has limited liability, so in a failure everything invested can be lost and never more.
Put them together and the payoff is bounded below at the amount invested and unbounded above, which is why equity and debt attract different investors and why an option written on a share can be priced at all.
An index is a construction choice
An index is one number summarising a market or part of one, and how it is built decides what it can tell you.
Weighting by price makes an index equivalent to owning exactly one share of every constituent, so influence follows the quoted price rather than the size of the underlying business. Weight by capitalisation instead and the figure tracks the proportional change in the aggregate worth of the constituents, which lets the biggest businesses dominate.
The same three shares can therefore produce very different index returns, and a stock split moves a price-weighted index unless its divisor is adjusted while leaving a value-weighted index untouched. A claim that an index rose because investors favoured large companies is testable only against the second kind.
What this chapter covers
- 01
Treasury notes and bonds, and inflation-linked issues
- 02
Secured bonds against debentures, and what collateral changes
- 03
Foreign bonds and Eurobonds, where Euro means offshore
- 04
Municipal bonds and why a tax exemption is priced in
- 05
Reading a listing: percentage of par, annual coupon, change column
- 06
Coupon rate, current yield and yield to maturity distinguished
- 07
Residual claim, limited liability and the asymmetric payoff
- 08
Dividend yield, capital gain and the price to earnings ratio
- 09
Price weighting against value weighting, and the effect of a split
Convert a listing row into dollars and check the yield ordering
- 3Convert the ask quote and the coupon rate into dollars.
- 2Recover the previous day's ask from the change column.
- 4Order coupon, current yield and yield to maturity, and say why that ordering is forced.
Key terms
- Par Value
- The face amount a bond repays at maturity and the base on which its coupon is calculated, conventionally one thousand dollars for corporate issues.
- Debenture
- An unsecured corporate bond, backed only by the issuer's general credit, which therefore ranks behind secured debt if the issuer fails.
- Eurobond
- A bond denominated in some currency other than the one used by the country in which it is placed. That prefix signals offshore issuance rather than anything European.
- Current Yield
- Annual coupon measured against what the bond costs today, so it reports income alone and says nothing about the gain or loss waiting at redemption.
- Limited Liability
- The principle that liability stops at the sum subscribed, so a collapse may take the whole investment and can never reach past it, which puts a floor under the equity payoff.
- Dividend Yield
- The annual dividend expressed as a percentage of the share price, which measures what the holding pays in cash rather than what it has gained.
- Price To Earnings Ratio
- Price set against the profit attributable to each share, stating how many dollars are being handed over for a single dollar of present earnings.
- Price Weighted Index
- An index whose members are weighted by share price, equivalent to a portfolio holding one share of each, and adjusted by a divisor when a member splits.
- Value Weighted Index
- An index tracking the proportional movement in the aggregate worth of everything it contains, so influence follows capitalisation.
- Inflation Linked Bond
- A government bond whose principal is tied to a cost-of-living measure, offering a hedge against inflation in exchange for a lower coupon.
Bonds, Equities and Market Indices FAQ
Why does a bond trading above par have a yield below its coupon?
Because the holder will be repaid less than they paid. The coupon is fixed at issue and measured against face value, while the yield to maturity measures the return on the price actually paid and also counts the loss from redeeming at par. Paying a premium for an above-market coupon means giving some of that coupon back at maturity, and the yield is what remains.
The same logic in reverse forces a discount bond's yield above its coupon.
Are municipal bonds a better investment because the interest is tax exempt?
Only for investors facing a high enough tax rate, because the exemption is already in the price. Issuers pay a lower coupon precisely because buyers do not pay tax on it, so a taxpayer in a low bracket ends up worse off than they would be in a comparable taxable bond. They are also not risk-free, since local and state governments do default.
The general lesson is the one the first chapter set out: an apparent advantage that is visible to everyone has already been priced.
Which index should I quote in an answer about market performance?
Say what the index measures before quoting it. A value-weighted index answers questions about the aggregate market value of a set of companies, which is usually what a question about investor preference or about the market as a whole is asking.
A price-weighted index answers a narrower question about a portfolio holding one share of each member, and it can move sharply because one high-priced constituent did, which makes it weak evidence for a claim about large companies.
Exam move
Take any listing table you can find, cover the price column and reconstruct it from the quote, then reconstruct the previous day's ask from the change. Do it until the three conventions stop needing thought, because they are the fastest marks in the second half of the midterm.
Then build a three-share index by hand, compute both weightings, split one share and watch which index moves; that single exercise answers most of what this chapter can ask.
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