Chapter 4: Capital Markets - Information Impact on Prices PDF

# Chapter 4: Capital Markets - Information Impact on Prices ## Information Impact on Prices This chapter discusses how information impacts the prices of shares and bonds and the role of credit rating agencies in providing additional information. ### Lessons * **Lesson 1: Information Impact on S...

# Chapter 4: Capital Markets - Information Impact on Prices ## Information Impact on Prices This chapter discusses how information impacts the prices of shares and bonds and the role of credit rating agencies in providing additional information. ### Lessons * **Lesson 1: Information Impact on Security Prices in the Capital Markets** * **Lesson 2: The Role of Credit Rating Agencies in the Market** ## The Impact of Information on Price The price of bonds and shares will fluctuate based on available information about the issuing entity, including company-specific announcements, industry-wide performance indications, and economic indicators. ### Market Efficiency Market efficiency refers to how efficiently market prices reflect all available, relevant information. It's based on three types of information: * **Past Information:** Trading prices reflect all past information. This is referred to as the **weak form of market efficiency**. * **Publicly Available Information:** Prices reflect all publicly available information, past and present. This is referred to as the **semi-strong form of market efficiency**. * **Information Known Only to Insiders:** Prices reflect all available information, whether or not it is available to all investors. This is referred to as the **strong form of market efficiency**. Most studies indicate that market information travels instantly, and prices reflect all available information immediately. ## The Role of Credit Rating Agencies A credit rating agency assesses the creditworthiness of an entity using a proprietary scoring model. The rating reflects the entity's perceived ability to pay back debt by making timely principle and interest payments, as well as the entity's perceived probability of default. A bond's credit rating helps investors assess its appropriate yield to maturity. Bonds judged as likely to be repaid on time are considered investment-grade bonds, and bonds with a high probability of default are considered speculative bonds. Investment-grade bonds will yield lower interest rates than speculative bonds, as investors want to be compensated for increased risk. Credit rating agencies often change their credit ratings on a bond based on new information, causing a downgrade or an upgrade. A downgrade means that the probability of default has increased, often resulting in lower required yields on bonds and increases in the issuer's share price. Conversely, an upgrade indicates that the probability of default has decreased, often resulting in lower required yields on bonds and increases in the issuer's share price. ## Information Impact on Current Prices Once shares and bonds trade on a stock exchange, their prices will fluctuate. Investors use new information to reassess the market value of the securities, and prices will change accordingly. Information that may impact prices related to shares or bonds includes: * **Company-specific information:** * Forecasts of future earnings * Dividends or divestitures * Introduction of new products or the discontinuance of old products * New customers or geographic expansion of the company's market * A change in management or in the board of directors * Plans for restructuring, employee layoffs, or closing of facilities * Product recalls, frauds, and accounting errors * **Industry-wide performance indicators:** * Announcements by competitors * **Economic indicators:** * Interest rates * Foreign currency exchange rates * Economic outlook * Inflation or deflation * Prices for oil, energy costs, minerals, and metals ## Market Efficiency Many types of information are available to be interpreted by investors and analysts, and will ultimately influence the current market price of a security. ### How Information Affects Prices The following example demonstrates how information affects security prices. Let's say Car Power (CRPWR), a car parts designer and manufacturer, announces the discovery of a new technology for car engines. The new engine is cheaper to make and more efficient than currently available engines. As soon as the news becomes public, investors buy the shares of CRPWR to obtain a profit from the incremental increase in share price caused by the discovery. This price appreciation is caused by the increase in the net present value of the future cash flows to the company expected from the discovery. Buying activity leads to higher demand for CRPWR shares, and potential investors are eager to own CRPWR's shares, while existing shareholders are also less eager to sell their CRPWR shares, resulting in a bid up price. The announcement may also affect the willingness of investors to buy shares of competitors involved in the production of traditional engines. The new technology will affect the future demand for competitors' products and reduce the future cash flows to these firms. This reduction in future cash flows causes intrinsic values and market prices for competitors' shares to decline. Similarly, the new technology may reduce the need for gasoline. Thus, oil prices around the world could drop, and share prices of oil companies could subsequently decline as investors sell their shares. On the other hand, industries that use oil as a raw material to make other products, such as the plastics industry, would benefit from a drop in oil prices because it means lower raw material costs. Following the news, alert investors may buy shares of firms in these industries, as share prices will increase due to higher intrinsic values. Investment analysts facilitate how information is reflected in security prices. They continuously collect information regarding securities, evaluate the information, and determine its impact on intrinsic (or fundamental) values. Once they arrive at what they believe to be the intrinsic value, they compare it to the market price. If there is a discrepancy between the two, they act to take advantage of this opportunity. ### Forms of Market Efficiency Market efficiency may be defined as **weak, semi-strong, or strong**. * **Weak-form efficient market:** The market reflects all publicly available information. It does not consider insider information. This form of market efficiency implies that analysts cannot increase profits by studying past data for securities. This information is already reflected in security prices. For example, buying CRPWR shares after the announcement of the discovery of the new technology will be too late to benefit from a price change related to that discovery and its impact on CRPWR's intrinsic value, because that information is reflected in the share price as soon as it is made public. * **Semi-strong-form market:** The market reflects all publicly available and private information. It does not consider insider information. This form of market efficiency implies that no one can consistently earn a higher profit than what could be earned with a naive buy-and-hold strategy. This information is already reflected in security prices. For example, buying CRPWR shares after the announcement of the discovery of the new technology will be too late to benefit from a price change related to that discovery and its impact on CRPWR's intrinsic value, because that information is reflected in the share price as soon as it is made public. * **Strong-form efficient market:** This type of market efficiency is a hypothetical concept. It implies that all information, including insider information, is already reflected in the price of securities, and no one can consistently achieve abnormal returns. ### Empirical Evidence on Market Efficiency Most studies conducted to test market efficiency have not rejected the semi-strong-form efficient market hypothesis. Many studies have found that important information releases such as dividend changes, merger announcements, and earnings reports are almost always correctly anticipated by market analysts so that, in the majority of instances, information releases have little or no effect on share prices. The results of these studies indicate that market information travels instantly and prices reflect all available information immediately. Although the general consensus is that Canadian and U.S. markets are semi-strong-form efficient, the weight of the evidence suggests that markets in these two countries are not strongly efficient. Many studies conclude that insiders can earn abnormal profits if they trade on the basis of their privileged information. Regulations classify such practices as illegal and attempt to constrain the use of insider information for personal profits. Regulations require corporate officers to disclose their trades in securities on which they possess important information by virtue of their jobs. ### Implications of Market Efficiency * **Efficient capital markets:** Investors quickly learn about the desirability and economic values of financial and real assets. Therefore, market participants allocate funds to the most desirable assets first. This conclusion with the theory of optimal investment suggests that firms choose projects to maximize net present values. Firms that are successful in locating projects that accomplish this objective attract capital and increase shareholder wealth, while unsuccessful firms fade away through bankruptcy or mergers. * **One price for each security:** A security should have one price, even if it is trading simultaneously on several physically separated markets. Arbitrage is the ability to make a profit without taking on any risk; for instance, by purchasing one security (in one market) and immediately selling the same security (in another market) for a different price, taking advantage of temporary pricing differences. Arbitrage among market participants ensures the law of one price. For example, if a security trades at C$10 on the Toronto Stock Exchange (TSX) and at C$9 on the New York Stock Exchange (NYSE), market arbitragers would notice the difference, and exploit it for immediate riskless profit. They would sell the same stock on the TSX for C$10 and simultaneously buy it on the NYSE for C$9 for an immediate profit of C$1. Selling on the TSX would put downward pressure on the TSX's price, while buying on the NYSE would put upward pressure on the NYSE's price. The trading activity would continue until the two prices become equal. * **Market price accurately reflects the security's intrinsic value:** The market price of a security continuously approximates its intrinsic value and reflects all publicly available information on that security. The intrinsic value is determined by a firm's ability to generate cash from operations. Given that the intrinsic value of a security and therefore its price - reflects current information publicly available on the security, and that new information arrives randomly, future market (or stock price) trends are not predictable from past trends. Therefore, investors who rely on trading strategies based on historical market patterns should not earn superior returns. * **Securities are purchased on the basis of their expected return and risk characteristics:** Fads will not affect market trends or security prices for any prolonged period if investors' expectations are not met. ## The Role of Credit Rating Agencies in the Market In assessing the creditworthiness of a company or government, a scoring model is used. These scoring models consider the following characteristics of the issuing company: * Historical financial results * Cash flows * Working capital balances * Market value of equity * Other business filings and lawsuits * Payment history with suppliers and other lenders (whether the issuer paid its obligations on time) * Amount of total debt * Terms and conditions of existing debt, including amount secured and unsecured From this information, a rating is determined and published. Each agency has its own rating system that takes various factors into account when determining the credit ratings of various companies. ### Implication of Bond Ratings on Issuers A bond’s credit rating assists investors in assessing its appropriate yield to maturity, or yield. The yield is the return required on a bond that is purchased today in the market, if the bond is held to maturity. The yield on bond is influenced by the current interest rates prevailing in the market, and the issuer's credit rating, and it can change over time as interest rates change in the market. For example, a bond with a face value of $1,000 pays interest at 6% (its stated or coupon rate) semi-annually. However, its yield to maturity is 5%. The bond will pay interest of $30 ($1,000 x 6% / 2) every six months based on its coupon rate and not based on its yield to maturity. But when the bond is priced, the yield to maturity of 5% will be used as the discount rate. The Cost of Capital chapter provides more discussion on this topic. A bond with a AAA credit rating will yield the lowest interest rate since its default risk is low. In contrast, the yield of a bond rated at BBB will be higher, and a bond rated at CCC will be even higher. There is a spread that occurs between each rating as the credit rating goes from highest to lowest. The spread is small between AAA, AA, and A, for example, and gets larger as the rating declines from BBB to C. The credit rating impacts bonds in two ways. For issued bonds, the yield to maturity will be affected by changes in the credit rating. As such, changes in the issuer's credit rating will impact the price at which the bonds trade. If the yield is less than the stated (coupon) rate, the price of the bond will be higher than its face value and the bond is said to be trading at a premium. If the yield increases above the stated rate, then the price of the bond will fall below its face value and the bond is said to be trading at a discount. Referring to the earlier bond example, if the yield is 5% but the stated rate is 6%, this bond will be priced at more than $1,000. For bonds that have not yet been issued, the corporation's credit rating impacts the interest rate that will be required to be paid on any bonds issued. The higher a company's credit rating is, the lower its interest cost will be. Many public corporations have a credit rating that they want to maintain so that their interest costs remain manageable. If a company currently has a credit rating of A, which requires a yield of 7%, and the company wants to issue bonds at their face value, then the corporation must set the coupon rate at 7%. If the credit rating is very low, the yield required on the bonds may be so high that the company cannot afford to complete the bond issue. For example, assume a company's credit rating is B, and a B rating currently requires an interest rate of 10%. If the company cannot afford to pay 10% annually on the bond, it will not be able to issue bonds at this time and must look for alternative sources of financing. Alternatively, if the company goes ahead and issues the bonds with an interest rate of less than 10%, it will have to sell them for less than their face value and will not raise the total amount of proceeds that it had planned. Furthermore, even if the company can afford to pay the higher interest rate, the higher interest rate will impact the returns available for equity investors and the overall cost of capital. Credit rating agencies often change their credit ratings on a bond, causing a downgrade or an upgrade in the bond's credit quality. If a credit rating is downgraded, this means that the probability of default has increased. A downgrade occurs because new information has caused a reduction in expected future cash flows, increasing the probability of default. A downgrade causes the yield on the bond to be higher to reflect this increased risk. However, the announcement of a downgrade can also have an impact on the issuer's share price. A downgrade implies that there will be more uncertainty for the issuer going forward, causing analysts to reduce their forecasts with a resulting decrease in the intrinsic value and market price of a share. In contrast, a credit rating upgrade can be seen as positive information resulting in lower yields required on bonds and increases in the issuer's share price. **4.3a Let's look at an example** Exercise Equipment Inc. (EEI) is considering a new issue of bonds and hopes to raise $1,000,000 for capital expansion. EEI would like to set the interest rate on the bonds at 4.5%, payable semi-annually. The company has a credit rating of AA, and the current yield for AA-rated bonds is 5.25%. **Required:** Explain why the 4.5% rate is not appropriate. **Solution** Because bonds with a credit rating of AA are yielding 5.25% in the current market, issuing the bonds at a lower stated coupon rate would mean that EEI's bonds would have to sell for a discount in the market, and that the company would need to sell more bonds to raise the $1,000,000 needed. The market forces will work to re-price the bond to a value that more closely reflects bonds with similar credit ratings. If EEI wants to raise $1,000,000 and sell the bonds at face value, it should set the coupon rate to equal the current yield for similar bonds with the same credit rating, 5.25%. ## End-of-Chapter Practice **Practice Problem 1 (20 minutes)** Forest Lumber Company Ltd. (FLC) is a publicly traded forestry company that manufactures wood products and manages forests in various regions in Canada. It sells softwood throughout Canada, and 40% of its sales are to the United States. FLC's share price currently trades at $32.00 per share. It also has $30 million of bonds outstanding that mature in 10 years and currently have a yield to maturity of 6%. The company's current bond rating is BBB, which it has been for the past five years. On March 13, the company released its financial statements, that showed a profit higher than anticipated by the analysts. On the same day, at the directors' meeting, the CFO indicated that a union had now been officially organized at one of the company's manufacturing plants. This process had started about five months earlier and had been in the news during that time. The CFO also announced that an unsolicited offer had been received from a competitor to purchase a tract of forest FLC owns in Quebec. The offer price was very reasonable, and the CFO recommended that it be seriously considered. This was not public knowledge, and the offer stipulated that this would not be announced until the negotiations were well underway. **Required:** a) Assuming a semi-strong efficient market, how would the share price react on March 13 and why? Would there be any change in the yield of the bonds? b) It is now one year later, and the United States has announced a 25% tariff on softwood lumber imports. FLC has just announced that it will issue $10 million in new bonds. Discuss the implications for FLC's share price and bond yield after these announcements (assume the yield on the bonds was 6% before the tariff announcements). **Solution to Practice Problem 1** a) In a semi-strong-form efficient market, all past and publicly available information is reflected in FLC's current share price. Consequently, the formation of the union has been in the news for the past few months; as such, it is likely that it has been anticipated that the union would be formed. Under this assumption, the formation of the union would have already been reflected in the current $32.00 share price. If the market was not anticipating a union to be formed, then it is likely that this would lead to a reduction in the $32.00 share price, all other factors held equal. The release of the financial statements indicating higher-than-expected profits would be new positive information, which should cause the share price to increase, especially if the higher income is expected to continue in the future. The possible sale of a tract of forest to a competitor at a fair price is insider information. This would not be publicly available and would therefore not have an impact yet on FLC's trading share price at this point in time. With respect to any change in the yield of the bonds, this would be impacted by a change in the company's credit rating or a change in interest rates. If the positive profitable results are high enough to improve the company's credit rating, then the yield to maturity would be expected to decline due to lower risk of default. b) FLC currently sells 40% of its product to the United States. Assuming that this is still the case one year later, the additional 25% tariff will cause FLC's lumber to be more expensive in the United States and sales will likely decline significantly or FLC will be forced to realize a lower price due to the impact of the tariff if it wishes to maintain its volumes. The tariffs will cause uncertainty in the lumber market and declining profits for FLC, increasing the risk for the investors. Therefore, the share price will likely fall as lower future profits are expected and the risk has increased. Since the risk has increased, the bond yield will likely increase due to higher probability of default, which may cause a deterioration in the company's credit rating, causing the bond price to fall. As such, when FLC issues its new bonds for $10 million, the coupon rate would be expected to be higher than 6% if it wants to raise the full amount of $10 million and not issue the bonds at a discount. The higher interest costs will cause the profits to further decline, which will make the share price fall even further.