Both equity and fixed-income products are financial instruments that can help investors achieve their financial goals. Equity investments generally consist of stocks or stock funds, while fixed income securities generally consist of corporate or government bonds.
Equity and fixed-income products have their respective risk-and-return profiles; investors will often choose an optimal mix of both asset classes in order to achieve the desired risk-and-return combination for their portfolios.
Equity investments allow investors to hold partial ownership of issuing companies. As one of the principal asset classes, equity plays a vital role in financial analysis and portfolio management.
Equity investments come in various forms, such as stocks and stock mutual funds. Generally, stocks can be categorized into common stocks and preferred stocks. Common stocks, the securities that are traded most often, grant the owners the right to claim the issuing company’s assets, receive dividends, and vote at shareholders’ meetings. Preferred stocks, in comparison, also offer a claim on assets and rights to dividends, but do not grant the right to vote.
Dividends are the cash flows of stocks. They are discretionary, meaning that companies are not obligated to pay out dividends to investors. When paid, they are not tax-deductible and are often paid out quarterly. Preferred stock owners are entitled to dividends before common stock owners, although holders of both stocks can only receive dividends after all creditors of the company have been satisfied.
For investors, equity investments offer relatively higher returns than fixed income instruments. However, higher returns are accompanied by higher risks, which are made up of systematic risks and unsystematic risks.
Systematic risks are also known as market risk and refer to the market volatility in various economic conditions.
Unsystematic risks, also called idiosyncratic risks, refer to the risks that depend on the operations of individual companies. Systematic risks cannot be avoided through diversification (i.e., mixing a variety of stocks with distinctive characteristics), while unsystematic risks, on a portfolio level, can be minimized through diversification.
Important Variables in Analyzing Equity Instruments
We generally use two variables – expected return (E) and standard deviation (σ) – to describe the risk-and-return characteristics of an equity instrument. In constructing a portfolio, we consider these two variables of each asset class to determine their respective weights.
A fixed-income security promises fixed amounts of cash flows at fixed dates. We frequently refer to fixed-income securities as bonds.
We will discuss two types of bonds – zero-coupon bonds and coupon bonds. A zero-coupon bond (or zero) promises a single cash flow, equal to the face value (or par value) when the bond reaches maturity. Zero-coupon bonds are sold at a discount to their face value. The return on a zero-coupon bond is the difference between the purchase price and the bond’s face value.
A coupon bond, similarly, will also pay out its listed face value upon maturity. Additionally, it also promises a periodic cash flow, or coupon, to be received by the bondholder during their holding period. The coupon rate is the ratio of the coupon to the face value. Coupon payments are typically semi-annual for US bonds and annual for European bonds.
Fixed-income securities typically have lower risks, which means they provide lower returns. They generally involve default risk, i.e., the risk that the issuer will not meet the cash flow obligations. The only fixed-income securities that involve virtually no default risk are government treasury securities. Treasury securities include treasury bills (that mature in one year), notes (that mature in 1 to 10 years), and long-term bonds (that mature in more than 10 years).
Important Variables in Analyzing Fixed-Income Securities
Important variables in analyzing a bond include yield-to-maturity (YTM), as well as the Macaulay Duration (D) used in calculating the Modified Duration (D*).
The yield-to-maturity (YTM), is the single discount rate that matches the present value of the bond’s cash flows to the bond’s price. YTM is best used as an alternative way to quote a bond’s price.
For a bond with annual coupon rate c% and T years to maturity, the YTM (y) is given by:
Macaulay Duration (D), and subsequently Modified Duration (D*), are used to measure bond prices’ sensitivity to fluctuations of interest rates over the holding period. The Macaulay Duration is a weighted average number of the years in which the bond pays cash flows. Modified Duration, calculated as Macaulay Duration/(1+YTM), expresses the sensitivity of the bond’s price to interest rates in percentage units. Portfolio managers often pay great attention to a bond’s duration when selecting a bond, because a higher duration indicates potential higher volatility in the bond’s price.