103-2 Debt Investments Flashcards
Preferred stock
Features of common stock and debt
Dividends not contractual obligation
Typically makes fixed periodic payments to investors
No voting rights
3 ways a bond can be issued
- Registered form: payments made to the owner of record
- Bearer form: payments made to whoever holds or possesses the bond
- Book-entry form: has its record of ownership held electronically in a central depository
Bond indenture
Formal agreement or contract between the issuer and the bond holder
Sinking fund
Separate fund established and funded each year by the bond issuer designed to accumulate an amount required to pay off the debt at maturity
Par Value (face value)
The amount of principal that the bond owner of bolder will receive at the time of maturity
This par value is assumed to be $1k unless stated otherwise
Coupon rate / nominal yield
The stated annual interest rate that will be paid each period for the term of the bond and is stated as a % of the par value of the bond
For the CFP assume semiannual coupon payments unless stated otherwise
Basis point
A measurement of the bond’s yield and is equal to 1/100 of 1% of yield
Call Provision
Included in the bond indenture allows the issuer to pay off the bond principal after a specified period, usually at a stipulated price higher than par value
Secured bond, such as a mortgage bond or collateral trust bond
Pledges specific assets that may be sold by the bond purchaser in the event that the bond issuer defaults in paying either the interest or the principal on the bond
Debenture
A bond that promises payments of interest and principal but pledges no specific assets
Debenture is an unsecured bond
Investment grade bond
BBB- or higher by S&P
Baa or higher by Moody’s
Generally is a high quality bond w/ little risk of default by the issuer
High-yield bond
Aka junk bond
BB+ or lower by S&P
Ba or lower by Moody’s
Primary risks bonds are subject to:
- IR risk
- Purchasing power risk
- Reinvestment rate risk
- Default (credit) risk
Effect of rating changes of bond yields
Upward revision will cause the market yield on the bond to decline, reflecting the bond’s improved quality
Downward revision will cause the market yield on the bond to increase; reflecting the bond’s decline in quality
U.S. Treasury Notes
Issued w/ maturity dates of 2, 3, 5, 7, 10 years
Issued at stated par value
Provide semiannual coupon payments
Exempt from income taxation at state and local levels
U.S. Treasury Bonds
Maturity of 30 years
Issued at stated par value
Provide semiannual coupon payments
Exempt from income taxation at state and local levels
Original Issue Discount (OID)
If the U.S. bond or note was originally issued at a discount after July 1, 1982, any investor who did not pay more than the face value must include in income each year a calculated share of this OID
The investor pays tax on income that has not yet been received in cash (i.e. phantom income)
Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities)
Zero-coupon bond’s creates by separating the semiannual coupon payments and the principal portions of a U.S. Treasury note or bond
Issued at a deep discount
Extremely sensitive to IR changes because the investor receives all the proceeds from the investment at maturity
Interest is taxed as ordinary income as it accrues, even tho no actual interest is paid until the bond matures (or is sold). For this reason, best to put in tax advantaged account
Treasury inflation-protected securities (TIPS)
Marketable securities whose principal is adjusted by changes in the CPI
Issued in terms of 5, 10, 30 years
Semiannual interest payments received by the investor are determined by multiplying the inflation-adjusted principal value by 1/2 of the fixed IR (because the interest payments are payable semiannually)
Savings Bonds
A part of the federal government debt structure
May be purchased and used for funding education costs and gifting
Include Series E, EE, H, HH, and I bonds
Series EE bond
The electronic EE bond is sold at 100% face value in any denomination from $25 to $10,000 and is eligible to earn interest up to 30 yrs
Must be held a minimum of 12 months, and a 3-month interest penalty is assessed if the bond is redeemed within 5 years of issue
Series H/HH bonds
Pay semiannual interest for up to 20 years in cash
No penalty for early redemption
Series I Savings bond
An inflation-indexed, or inflation-protected, debt security that is purchased electronically in any denomination from $25 to $10,000
IR combination of 2 separate rates:
1) fixed rate of return that remains the same for the life of the bond
2) semiannual inflation rate based on changes in the CPI during the previous six-month period
May be redeemed any time 12 months after the issue date for the principal plus interest accrued to that date
If redeemed within the first 5 years, there is a 3-month interest penalty
How to exclude Series EE and Series I bond interest from income tax
Can be done if the bond proceeds are used to pay for qualified higher education costs
Farm Credit Adminstration
Provides American agriculture w/ a source of credit
Has direct backing and guarantee of the U.S. government
Government National Mortgage Association (GNMA, or Ginnie Mae)
Guarantees investors the timely payment of principal and interest on mortgage-backed securities backed by federally insured loans
Has direct backing and guarantee of the U.S. government
Buys Federal Housing Administration and Department of Veterans Affairs mortgages and auctions them to private lenders, which pool the mortgages to create pass-through certificates for sale to investors
Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac)
Purchases mortgage loans and mortgage related securities for investment and issues guaranteed mortgage-related securities
Indirect backing and guarantee of the U.S. government
Created to promote the development of a nationwide secondary market in mortgages by purchasing conventional mortgages from financial institutions and packaging them into mortgage-backed securities for sale to investors
Federal National Mortgage Association (FNMA, or Fannie Mae)
Keeps funds flowing to the mortgage market, helps distressed homeowners, and encourages sustainable lending
Indirect backing and guaranteed of the U.S. government
Competes w/ FHLMC for investor money in the secondary marketplace
Student Loan Marketing Association (SLMA, or Sallie Mae)
Offers solutions to help families save, plan, and finance college expenses
Indirect backing and guarantee of the U.S. government
Municipal bonds
General Obligation and Revenue Bonds
Excluded from the recipient’s taxable income for regular income tax purposes, usually both for federal and state income tax purposes, if the bondholder is also a resident of the state or muni issuing the bond
General Obligation Bonds (GOs)
Municipal bonds that are issued to finance capital improvements benefiting the community
Often referred to as full faith and credit bonds
Revenue Bonds
May be used to finance any municipal facility (e.g., community airport) that generates sufficient income to satisfy the ongoing debt obligation
These are more risky than GOs and offer higher yields for similar maturities
Private activity (private purpose) bond
Part of a state or local government bond issue for which more than 10% of the proceeds of the issue are to be used for a private business use (such as the financing of a sports stadium)
Qualified private activity bonds
Tax-exempt bonds issued by a local or state government, the proceeds of which are used for a defined qualified purpose by an entity other than the government issuing the bonds
Insured Municipal Bonds
Insured against default, have reduced credit risk associated with the bond
Muni may insure its debt issue in hopes of increasing the bond rating, which, in turn, will allow the muni to lower the coupon rate on the issue
Taxable equivalent yield (TEY)
Used to compare the advisability of investing in municipal, tax-exempt issues to taxable, corporate issues
TEY = tax-exempt yield / 1 - marginal rate
After-tax yield
Used to compare the advisability of investing in taxable issues with that of investing in municipal tax-exempt issues
After-tax yield = pretax return x (1 - marginal tax rate)
Corporate bonds
Debt securities issued by public and private companies to raise capital
Subordinated debentures
Feature higher coupon (interest) rates than corporate secured bonds, muni bonds, or other U.S. Treasury securities
Market Discount Bond
A bond acquired at a discount
Zero-coupon bonds
Sold at a deep discount to their face value
Referred to as original issue discount (OID) bonds
Their prices are more volatile than other bonds of similar quality and they are not subject to reinvestment rate risk
Phantom Income
Zero-coupon bonds are issued in taxable form by corporations, meaning that the investor must include the accrued interest in his taxable income annually, even though no cash is received until the bond matures, is sold, or is called
Usually most appropriate if they are positioned within a retirement plan or other tax-deferred account
Yankee Bonds
Foreign bonds payable in U.S. dollars
Eurodollar Bonds
A second type of U.S. pay bond, but unlike Yankee bonds, they do not have to be registered w/ the SEC because they are issued and traded outside the U.S.
Promissory Note
A promise to pay a certain sum of money or make a series of payments to others, usually individuals
All of the interest is taxable to the investor at ordinary income rates in the year earned
Convertible bonds
Corporate bonds that may be exchanged for a fixed #of shares of the issuing company’s common stock
Pay lower IR than do non-convertible bonds
Good diversifier in a portfolio
A convertible bond will always sell for no less than the greater of its straight value or its conversion value
Conversion price
The stock price at which a convertible bond can be exchanged for shares of the issuer’s common stock
Conversion ratio
aka the conversion rate, expresses the # of shares of stock into which a bond may be converted
Conversion ratio = par value of convertible security / conversion price
Conversion Value calculation
conversion value = conversion ratio x market price of common stock
Convertible preferred stock
Can be exchanged for common stock at a conversion ratio determined when the shares are originally issued
