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Security Analysis With Portfolio Management

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  • Level: High school
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Question :

This assessment will cover the following questions:

  • What sort of characteristics are suitable for bond chosen for client for high tolerance risk?
  • What sort of characteristics are suitable for bond chosen for client for low tolerance risk?
  • What sort of characteristics are suitable for bond chosen for client for moderate tolerance risk?
  • If interest rates are decline in a sharp rate, what bond characteristics are suitable for that?
Answer :

INTRODUCTION

Security analysis is the evaluation of various tradable instruments in a market with the aim of ascertaining risk and profitability of those instruments so that sound decisions can be made (Pandya, 2013). The concept of security analysis is related with portfolio management in which distinctive securities are combined together in a portfolio that it will result in balanced profit and risk (Kevin, 2015). The main aim behind developing this report is to be familiar with the techniques of analysing the bonds as a fixed income security. This report is categorised into two sections. In Section A, topics such as effect of BREXIT upon financial market and investment management is analysed. In Section B, Macaulay and modified durations are computed along analysing the concept of zero coupon bonds and loanable funds. Later, in the section B, a case study of two individual’s portfolios are managed.

SECTION A

Question 1 (i)

BREXIT is the historic of United Kingdom in which they withdraw their membership from the European Union. In this event, the economy and markets of UK were highly impacted which had few positive as well negative impacts on the financial market of the UK. In the region of United Kingdom, financial markets operate by allowing individuals and firms to exchange securities such as bonds, future contracts, stocks and many more. In such market, sellers seek to sell their stock at highest price possible and buyers seek buy stocks at lowest price available. The event of BREXIT has influenced financial market as a whole and has also influenced various asset classes and investors. These asset classes are bond and stock market which are influenced by the act of British exit from European Union (Armour, 2017).

Financial markets including asset classes and investors are positively impacted by BREXIT as most of the financial market legislations were derived from European Union but after the case of BREXIT, UK will be now deemed to follow their own laws and regulations which will benefit the bond market and investors as now the coupon and interest rates laws can be fluctuated according to the economic growth of UK and not the growth of entire EU (Ramiah, Pham and Moosa, 2017).

Apart from the above positive impacts, there are various negative impacts as well which affects the functioning of financial markets by negatively influencing its asset classes and investors. Fiscal hawk is the most influencing factor which effects financial market of UK. Before the commencement of BREXIT, budget of entire European Union was the matter of EU referendum. But after the implementation of BREXIT, United Kingdom is in the serious need of emergency budget so that public spending can be tackled and financial market can be saved from the situation of fiscal hawk (Dhingra and et.al., 2016). The economy and financial market has been comparatively slow due to which investors are not getting reliable retunes which they expected. Few other negative impacts of BREXIT on UK financial markets are high interest rates and high taxation rates which ultimately leading towards the slow economic growth and development.

Question 1 (ii)

Warren Buffett and his mentor, Benjamin Graham, argued that market risk was less important than company risk when shares are being valued and investment are managed. This statement was evidently argued by both the economist above as it is important to balance the value of shares in order to effectively manage the investments. The major reason due to which shares and other stocks are undervalued are the market crashes and cyclicality of the businesses in which they experience ups and downs due to their industry life cycle. These reasons rise from the company individual risk and not from the market risk which lowers the value of shares and ultimately lead to mis management of investment which provides evidence to the argument to Warren Buffett (Bolton, Chen and Wang, 2011). This argument has various implications as well which includes raising price of products, increasing sales figures etc.

The argument provided by Warren Buffett can be challenged in order to critically analyse it and determine its negative impacts of considering company risk important than the market risk. The risk which arises out of the market is the reason of irrational market move, economy legislations and litigations. These factors can crash the market which will not only effect few investors but will impact the economy as a whole. The implications of this situation is even worse which includes fiscal hawk, depression in economy and intense inflation (Graham, Johnston and Kingsley, 2015).

The above critical discussion proves that the argument given by Warren Buffett is considerably effective when investment management of individuals and organisations are concerned. But the case in which economy of a nation is concerned, the market risk holds much importance than a company’s risk.

SECTION B

Question 2 (a) Calculating both Macaulay and modified durations

Macaulay Duration refers to a financial measure which helps an investor to ascertain weighted average period of cash flows from a bond (Hawawini, 2017). This duration is ascertained by combining the time period by the coupon payment and dividing the resulting value by 1 addition to yield percentage. On the other hand, modified duration is the measurable change in the value of the interest rates which are gained against the bonds. Both the modified and Macaulay durations are calculated using the information as follows:

(Source: Macaulay Duration Formula, 2020)

Bond description

Coupon bond “c”

8.50%

Flat yield curve “y”

10%

Settlement date

01-01-27

Maturity date “M”

01-01-28

Assumed payment frequency “n”

1 (annually)

Assumed par bond value “current bond price”

£100

Cash flows

Period 1

8.5

Period 2

8.5

Period 3

8.5

Period 4

8.5

Period 5

8.5

Period 6

8.5

Period 7

8.5

Period 8

108.5

Discount factors

Period 1 Discount factor

1 / ( 1 + 0.085 ) ^ 1

0.92166

Period 2 Discount factor

1 / ( 1 + 0.085 ) ^ 2

0.84946

Period 3 Discount factor

1 / ( 1 + 0.085 ) ^ 3

0.78291

Period 4 Discount factor

1 / ( 1 + 0.085 ) ^ 4

0.72157

Period 5 Discount factor

1 / ( 1 + 0.085 ) ^ 5

0.66505

Period 6 Discount factor

1 / ( 1 + 0.085 ) ^ 6

0.61295

Period 7 Discount factor

1 / ( 1 + 0.085 ) ^ 7

0.56493

Period 8 Discount factor

1 / ( 1 + 0.085 ) ^ 8

0.52067

Present value of the cash flow

Period 1

1 * 8.5 * 0.92166

7.8341

Period 2

1 * 8.5 * 0.84946

7.22037

Period 3

1 * 8.5 * 0.78291

6.65472

Period 4

1 * 8.5 * 0.72157

6.13338

Period 5

1 * 8.5 * 0.66505

5.65289

Period 6

1 * 8.5 * 0.61295

5.21003

Period 7

1 * 8.5 * 0.56493

4.80187

Period 8

1 * 8.5 * 0.52067

56.4926

Numerator

56.49264

Denominator

100

Macaulay Duration calculation

56.49264/100

Macaulay Duration

0.5649264

Modified Duration

Macaulay Duration / (1 + yield to maturity / number of coupon periods per year)

Modified Duration calculation

0.5649 / (1 + 10%)

Modified Duration

0.513545455

Question 2 (b) Analysing Why Zero Coupon Bond Have Higher Macaulay Duration Than Coupon Paying Bonds

A zero coupon bond is a kind of security which is issued at a heavy discount instead of issuing at par but it has no interest which can be earned by the bond holder (Hopewell and Kaufman, 2017). The Macaulay duration is weighted average time period of a bond. In case of a coupon paying bond, the Macaulay duration is less than the maturity period of that bond. As it can be seen in part “a” that the computed Macaulay duration is 0.5649 which is approximately six months. This time period is less than the maturity period which is 8 years. On the other hand, Macaulay duration and maturity period in the vase of zero coupon bonds is similar which evidently presents that Macaulay duration of zero coupon bonds is always higher than the coupon paying bonds.

Question 2 (c) Explaining The Statement “The Financial Markets Are Markets For Loanable Funds”

Financial markets are the marketplace in which securities such as shares, bonds, commodities and even currencies are exchanged between investors and market players. The financial markets are considered as the markets of loanable funds as in this market, interaction between borrowers and savers is done in which they exchange securities which with an adjusted interest rate (Kelton, 2011). The securities which are exchanged also includes bonds; these bonds are the loanable funds which organisations issue to public in order to procure finance. This relationship of bonds being a loanable fund, makes the financial market, a market of loanable funds.

Question 3 (a)

Mike and Belinda are two prospect investors who are planning to invest in fixed income securities. Characteristics and other elements which are related with these investors are:

Basis

Mike

Belinda

Age

35

65

Marginal income tax bracket

28%

15%

Primary goal

Capital appreciation

Income earning for retirement

Available amount for investment

£40000

£150000

Despite of various differences mentioned above, an element which is similar in both the cases is that Mike and Belinda wants to invest in fixed income generating securities. A fixed income security is a debt instrument issued by relevant authority such as government. It is a universal fact that investments are subject to market risk but the government securities such as bonds have low risk rating which makes it suitable for both the cases.

For the case of Mike who is a 35 years old aggressive investor having 28% tax bracket will be benefitted if he invests in Municipal bonds. This type of security is issued by government to fund the local region’ basic enmities such as schools, highways, bridges and hospitals. These type of bonds provide fixed income and the only risk which is included in this case is the bankruptcy of local government (Jenkins and Pickard, 2015). Municipal bonds are income tax free by which Mike will be benefitted as he already registered in the tax bracket of 28% and these bonds will not levy any more pressure on his tax liability. Also due to the aim of earning fixed income, Mike’s primary objective is to gain capital appreciation and not income enhancement for which this security of municipal bond is perfect.

The second security for the portfolio of Mike is Treasury Bonds. This security is advised for Mike as this will balance out the risk involved in municipal bonds as treasury bonds are issued are issued by central government which reduces the chance of bankruptcy. These type of bonds will also contribute in Mike’s agenda of gaining capital appreciation (Types of Bonds, 2020).

For the case of Belinda, who is a 65 years old women planning for her retirement having 15% tax bracket. The most suitable security for the portfolio of Belinda is Corporate bonds. These bonds are issued by large scale companies for their business expansion which carry a slightly higher risk than government bonds but results in high income generation. This type of bond can satisfy the primary agenda of Belinda of income generation. Due to high risk of corporate bond, the another security in which Belinda can invest is Treasury bond in order to balance out the risk and taxation involved in corporate bonds (Pflueger and Viceira, 2011). By this way, Belinda will able to gain high income, with reasonable risk and taxation which will not put a burden on her 15% marginal tax bracket.

Question 3 (b)

(i)

There are various characteristics of bond which are required to be considered for a client which has high risk tolerance. The concept of high risk tolerance is the ability to handle and understand the level of risk which a security holds as it also provides same level of returns. The client who has high risk tolerance prefers to gain high income like Belinda. The primary aim of this investor for her portfolio to gain high but fixed income. For such client, the characteristics which are considered are:

  • Usual par value of £1000 as high par value can result in high fluctuations of the bond value.
  • Frequent interest payments; bonds are the kind of a loan which are provided to local public against which they can gain interest. If the interest payment of a bond is more than twice in a year then it will result in high return and high profit and such feature must be considered for a client who is willing to tolerate high risk.
  • Long maturity period; such period is the time which a bond takes to mature and payback its initial amount or face value. If the maturity period of a bond is long, then there are high chances of fluctuation in the value of bond which implies that the risk in this type of bond is higher.

(ii)

There are various features which are specific to the type of bond which holds moderate risk. For a client who is aiming to invest in medium risk bond and has moderate risk tolerance like Belinda must consider following features in the bonds:

  • Floating coupon rate; this rate is the interest value which is gained by the investor over a set period of time (Akdal, 2011). The bonds which are suitable for moderate risk tolerant investors have floating coupon rate as the time period in which they can gain the interest is not fixed and keeps fluctuating.
  • Corporate Issuers; these are the organisation which issues the bond to fulfil their capital requirements. The bonds which hold high risk are corporate bond as there are high chances of bankruptcy.

(iii)

Investors which has low risk tolerance like Mike has main aim to appreciate their capital and not to earn the high income. For such investors, there are specific type of bonds which has few distinctive features mentioned below:

  • Short maturity period; If a bond has short maturity period then it is much more predictable and holds lower risk which is appropriate for investors which has low risk tolerance.
  • Government issuers; Bonds which are issued by government are more reliable and less risky as there are less chances of government to be held as bankrupt or insolvent.
  • “Aaa” rating from credit rating agencies; Bonds which high quality rating indicates a type of bond which has low risk and high reliability such as treasury bonds issued by central government.

(iv)

There are a specific set of features which bonds having low interest rates carries. In a situation, where investor believes that the interest rates will decline in the future sharply then they must look for few specific characteristics so that they can make reliable investment decisions:

  • High credit rating; If an investor expects sharp decline in interest rates then they must consider the characteristic of high credit rating. This rating is given by credit rating agencies which are considered as reliable (Pandya, 2013). Only the bonds having high credit rating will provide low interest as they will already be in profitable stage with high demand among investors.
  • Short maturity period; If a bond has short maturity period such as one year then the time in which the actual value will be realised by investors is low. This low realisable period will allow issuer to provide low interest rates.
  • Bonds at premium face value; Bonds which are issued at a premium value are tend to provide lower interest rates as they are already demanded more by the investors.

(v)

If investor believe that interest rates of a bond will rise sharply in the future, then there are two principle determinants which must be considered:

  • Poor credit rating; If a bond has a poor credit rating by the credit rating agencies such as Fitch Ratings, Standard and Poor’s, Moody’s etc. then the bond issuer will increase the interest value of their bond so that investor can be attracted. In the case of bonds with poor credit rating are of greater default risk due to which its interest is usually more.
  • Long maturity date; The bonds whether governmental or corporate, if have long maturity period such as 30 to 100 years then there are high chances of getting high interest. The reason behind this is the factor of inflation risk. In a case, where an organisation is issuing bonds for long maturity period then the bond holder will face the risk of inflation and in order to compensate that risk, organisation will provide more exposure of high interest rates.

Also Read:- Understanding Fundamentals of Project Management

CONCLUSION

From the above report, it has been concluded that the procedure of security analysis is the evaluation of certain set of securities so that they can be combined together to develop an effective portfolio. After developing the report, the concepts of BREXIT and financial markets are studied which summarises a relationship in which every external factors impacts the functioning of financial markets and even its instruments and investors. In the second section, it has been found that the durations which are concerned with flow of cash in a bond period are Macaulay and modified duration which can be computed using systematic formula. It has also been concluded that there are different features which needs to be considered when advising about portfolio management to clients which varies in risk tolerance.

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