Marketable securities: prices and interest rates 11/10, 3/11

Introduction

In the cash investments discussed in the previous section, the investor's initial capital is secure. The investor cannot get back less than they put in. Another common feature is that such investments are not marketable.

8.1 Marketable securities

However, there are also marketable securities, such as gilts, bonds and certificates of deposit. Such securities are bought and sold, and they earn interest. What determines their price?

8.2 Prices of fixed interest stocks

The price of marketable securities is affected by the following.

(a) The interest rate (known as the coupon rate) on a stock is normally fixed at the outset, but it may become more or less attractive when compared with the interest rates in the money markets as a whole. Let us take an example. Suppose that investors in the market expect a return of 6.47%.

(i) 2¹/2% Consolidated Stock pays $2.50 interest for every $100 of the stock's nominal value.

However, the increased return means that:

al

therefore, the expected price is 0647

Where general interest rates rise, the price of stocks will fall.

(ii) Where general interest rates fall, the price of stocks will rise. For example, if the market required a return of 6%, the price of $100 nominal of a non-redeemable 2½% stock would be:

Both these examples ignore two other features affecting prices of stocks.

(b) The risk associated with the payment of interest and the eventual repayment of capital. Some Government securities are considered virtually risk-free but other fixed interest stocks may not be.

(c) The length of time to redemption or maturity. Suppose the following market values were quoted on 25 March 20X2.

9% Treasury Stock 20X5 $113.8029 9% Treasury Stock 20X9 $142.6311

The first stock is due to be redeemed in 20X5, whereas the second will not be redeemed until the year 20X9. In both cases, as with all government securities except those that are index-linked, the stocks will be redeemed at their nominal value of $100. The closer a stock gets to its redemption date the closer the price will approach $100. This is known as the pull to maturity.

8.3 Yields on fixed interest stocks

The paragraphs below concentrate on gilts (government securities) but the principles involved apply equally to any other fixed interest stocks including, for example company loan stock.

8.4 Interest yield

The yield for a particular gilt is an expression for the return on the stock if it was bought at the price ruling and held for one year.

INTEREST YIELD (also known as the flat yield or running yield) is the interest or coupon rate expressed as a percentage of the market price.

Interest yield = 100%

price Market

interest Gross

×

Learning outcome E2(b)

On 19 March 20X0 the market price of 9% Treasury Stock 20X9 is $134.1742. What is the interest yield?

The interest yield in practice is influenced by two other factors.

(a) Accrued interest

The interest on 10% Treasury Stock 20X3 is paid in two equal instalments on 8 March and 8 September each year. Thus, if an investor were to sell their stock on 1 June 20X0, in the absence of any other rules they would be forgoing a considerable amount of interest which will be received on 8 September 20X0 by the purchaser. The price paid by the purchaser must reflect this amount of accrued interest, and this type of calculation is tested in Question 3.4: Cost of purchase.

(b) Cum int and Ex int

For administrative reasons, issuers of securities (eg the government) must close their books some time before the due date for the payment of interest, so that they can prepare and send out the necessary documentation in time for it to reach the registered owners of securities before the due dates. Any person who buys stocks ex int will not receive the next interest payment. This will be sent to the former owner.

8.5 Redemption yields 5/13, 9/11, 5/11, 5/10

REDEMPTION YIELD is the rate of interest at which the total of the discounted values of any future

payments of interest and capital is equal to the current price of a security. (CIMA Official Terminology) The interest yield takes no account of the fact that most Government stocks are redeemable (ie that their face value will be repaid) nor of the proximity of the redemption date although we have seen how the pull to maturity can affect the price. A more realistic measure of the overall return available from a stock is the gross redemption yield. This takes account of both the interest payable until redemption and the

redemption value.

A bond with a coupon rate of 8% is redeemable in 9 years time for $100. Its current market price is $91.

What is the percentage yield to maturity?

Example: redemption yield (yield to maturity)

Question 3.3 Interest yield

KEY TERM KEY TERM

This is an internal rate of return calculation. (You should remember this from your CIMA C3 studies. We will look at it again in Chapter 16.) We will take two discount rates and see where the IRR is likely to fall.

Nine annual receipts of $8 and the final receipt in 9 years' time of $100, discounted at the IRR, will give us the current market price of $91.

We will begin by taking 10% as the discount rate.

t = 9, r = 10

($8 × 5.759) + ($100 × 0.424) = $46.07 + $42.40 = $88.47 This is very close to $91. Now we will try 9%.

t = 9, r = 9

($8 × 5.995) + ($100 × 0.46) = $47.96 + $46 = $93.96 We can see that the IRR must be midway between 10% and 9%.

(88.47 + 93.96)/2 = 91.22

So the percentage yield to maturity is 9.5%.

Note: If you are struggling to remember your CIMA C3 knowledge for this question you may want to leave it for now and return to it after you have studied Part D of this Study Text.

Yields are determined by market prices which in turn reflect the demand for particular stocks. Thus, if a yield is relatively low it can be concluded that the price is relatively high and that the demand for the stock is also relatively high. Conversely, a high yield means that a stock is relatively unpopular.

The major factors affecting choice are these.

(a) Whether the investor is looking for income or capital appreciation (b) The investor's tax position

(c) The investor's attitude to the risk inherent in gilts resulting from changes in interest rates. (It is important to remember that although the eventual repayment of a gilt is not in doubt, the market price may fluctuate widely between the date of purchase and the eventual redemption)

(d) Other aspects of the investor's business. (The banks and building societies tend traditionally to concentrate on holding short-dated stocks (redeemable soon) while the insurance companies and pension funds which have long-term liabilities often match these with long-dated gilts (redeemable further in the future)).

Section summary

The yield (profitability) of a money market instrument depends on:

• Its face value

• The interest rate offered

• The period of time before it is redeemed (ie converted into cash) by the issuer Solution