Chapter 10: Basics of Investing Flashcards
What often determines liquidity?
The presence of a secondary market.
What is another term for growth?
Capital appreciation.
What type of yield curve is particularly problematic for a fixed income investor trying to outpace inflation?
Flat yield curve.
What is volatility?
The extent to which the market value should be expected to fluctuate.
Which institutions sell GICs?
Banks, deposit brokers, credit unions, trusts, etc.
What are the 2 guarantees that GICs offer?
Guarantee of principal
Guaranteed rate of return
If a GIC has a term for longer than 5 years, what is it often called?
Term deposit
How does a market value adjustment for early withdrawals from a GIC work?
The FI will retroactively recalculate the interest payable. If interest rates have fallen, the client will have their GIC recalculated from the beginning using the lower interest rate. If rates have risen, the FI will penalize the client by reducing their return because the FI will now have to provide the new higher rate to a new client.
What is a GIC ladder?
A series of GICs, usually including maturity dates between 1 and 5 years.
What is a variation on GICs that allows for potential higher returns?
Market-Linked or Index-Linked GIC
Indexed GIC is also an option
Which type of GICs offer tax deferral? How?
Market-linked GICs, because the final return is not certain until the end of the term (therefore the return is not taxed until the end of the term).
How does taxation work on a GIC?
No tax is assessed in the year of purchase (unless the maturity is within that year) . Interest income (and tax) is assessed every year on the anniversary date.
How can you easily determine the amount of interest income you’ll have on a GIC in any given year?
Solve for the FV of the investment in the year in question as well as the year prior. The difference between the two values is the interest for the year.
Example: if the FV in year 5 is $1216.65 and the FV in year 4 is $1169.89, the interest assessed in year 5 is $46.79 (the amount of income that will need to be reported).
Which tax slip is received for interest income from a GIC?
T5
How does a corporation owning a GIC report interest income?
Taxation is calculated using the accrual method. The corp will be taxed at the corp’s year-end, on interest earned to that point.
For example, if a corp purchases a $1,000 GIC paying 4% and there are 122 days until the corp’s year end…
($1,000 x 4% x 122/365) = $13.37 of interest.
What does the term “security” mean?
Claim against something.
What are the 3 promises securities can offer?
- Debt - if the business fails, the debt holders will be assured of some seniority when the assets of the business are being liquidated
- Assets - lesser form of security as far as seniority
- Cash flow - many securities attach an additional promise of a certain amount of cash flow
What is the role of the investment dealer?
Deal with both publicly-traded companies and closely-held companies as well as governments and crown corporations. Provide a mechanism for these institutions to raise capital.
Why does an investor face greater risk when investing in a closely-held (not public) company?
Less disclosure and regulatory requirements.
What is the difference between a “bought deal” and “best efforts” deal?
In a bought deal (which is easier and more common), the investment dealer buys the securities from the issuer and then attempts to place those securities with its own clients.
In a best efforts deal, the investment dealer acts as a middle-man and tries to sell securities still owned by the issuer.
What is the term for the process of an investment dealer issuing securities on behalf of a corporation?
An offering
What is a corporation required to produce when making a public offering?
A prospectus
Why is the primary market important (and what is it)?
When securities are first created and sold through a public offering, this is said to happen on the primary markets. Primary markets offer the potential for corporations to raise capital.
How does an investor divest of a security acquired on the primary market?
Selling it on a secondary market.
Which role do securities dealers have in secondary markets?
They connect buyers with sellers and often serve as market makers by buying and selling securities to fill orders submitted by investors.
What is a market maker?
Investment dealer that buys and sells securities to fill orders submitted by investors, allowing investors instant liquidity or instant access to securities.
What are OTC markets?
Over-the-counter markets. Most bonds and derivatives are traded on OTC markets.
What is a reserve price in a securities auction?
Some auctions of securities involve a reserve price. If the highest bidder doesn’t hit that price, the security will not be sold at all.
What is a Dutch auction?
Bidders identify both the price and volume of shares they wish to purchase, which can be useful in setting the initial price of a security before an IPO.
How is the price of an IPO typically determined?
Usually based on an underwriting process by the securities dealer, then confirmed through the issuance of a red herring prospectus.
What is a red herring prospectus?
First/preliminary prospectus for an IPO. Allows prospective buyers to express interest in a security being offered, confirming the securities dealer’s underwriting process.
How do investment dealers make money when creating an IPO?
Charge firms to create the IPO, then charge investors a commission when securities are bought and sold. Often make a profit on the spread between the price at which they acquire a security and the price at which they dispose of a security.
What is a bond?
Debt security with a claim against an asset that normally provides cash flow to the investor.
Typically issued at par value, pay a stream of semi-annual payments (coupons) and pay a maturity value at their maturity.
How do you determine the value of a bond?
Based on the combination of the FV of the coupon payments and PV of the par value. Price is based on the PV of those amounts.
How should you set your financial calculator when calculating the PV of a normal bond?
P/Y and C/Y to 2 as normal bonds always provide a semi-annual return. PMT should be /2 of the annual coupon.
If interest rates rise/fall, what will a bond sell at?
Rise - discount to its par value
Fall - premium to its par value
What are the 3 factors that would normally cause bonds to have differing yields?
Term to maturity (long-term bonds present greater risk)
Credit rating of issuer
Characteristics of the bond
Which ratings (Moody’s) are considered “investment grade” issuers?
AAA, AA, A, BAA
Which ratings (Moody’s) are considered “speculative” issuers? (Junk bonds)
BAA, B, CAA, CA, C
When might a borrower have to repay a bond prematurely?
If the lender puts a condition in place that requires the loan to be repaid if the borrower’s rating falls.
What is the yield curve?
Graphical expression of yield to maturity of fixed income investments, especially bonds. Developed as a tool for bond investors to understand what types of yields were being offered at differing maturities.
What type of indicator is the yield curve?
Leading indicator
What are the 3 basic types of yield curves? Describe each.
- Normal (positive) yield curve - sign of a healthy and predictable investing environment where short-term investments provide a lower yield and yield increases as term to maturity increases
- Inverted yield curve - sign of unusual events, usually precursor to a recession. Generated when investors believe the stability of bonds is worth acquiring, even at a premium. This willingness to purchase bonds at a premium drives bond prices up, creating a corresponding decline in bond yields.
- Flat yield curve - created when investors are uncertain about the economy.
What is a steep yield curve?
Indicates a sharp rise in bond yields, generally indicative of investor enthusiasm.
What causes an inverted yield curve?
If investors are willing to pay a premium to acquire bonds (as bonds are considered more stable), this drives bond prices up which creates a corresponding decline in bond yields. In this case, the long-term bond yields may fall below the yields of short-term bond. Investors are willing to sacrifice yield in exchange for stability.
What may cause a flat yield curve?
Uncertainty about the economy, a flight to quality (such as in the case of an inverted yield curve), or relatively high short-term interest rates stemming from monetary policy.
What often precedes an inverted yield curve and is usually a leading indicator of a recession?
A flat yield curve
How is duration different from maturity?
Maturity indicates the amount of time that will pass until the bond matures. Duration is the extent to which a bond’s price will fluctuate in response to a change in interest rates. (Percentage change in a bond’s price for a 1% change in interest rates)
How can you solve for the price of a bond after a 1% increase in interest rates if the duration is 5.095 and its current price is $101.586?
$101.586 (current price) - duration (5.095%) = $96.410
What does an immunized bond portfolio contain?
A combination of high and low durations, with an average duration that matches the fund manager’s objectives.
What is the term for diversification of bond durations?
Immunization
What are zero-coupon bonds? What’s another name for them?
Zero-coupon bonds (strip bonds). Not actually issued by the issuer - ordinary bonds are purchased and then the coupons are sold, each for their respective PVs (leaving a bond with no coupon).
What does STRIPS stand for with respect to strip bonds?
Separate Trading of Registered Interest and Principal Securities
Which type of bond is typically sold as a strip bond?
A high-quality bond, such as a government bond.
How are strip bonds taxed?
Does not generate a capital gain, even though it doesn’t pay interest. Instead, it’s taxed as a prescribed debt instrument (in the same way as a GIC).
What is the duration of a strip bond?
Always equal to its term-to-maturity.
Are strip bonds risky?
Since their duration is equal to their term-to-maturity, they are extremely volatile as far as their day-to-day price is concerned. However, since the actual par value is fixed, they can provide a bit of stability in a portfolio (if the investor is willing to only consider the maturity value).
What are the 2 ways to calculate the yield of a strip bond?
Can use 2 as the P/YR since it’s a bond, but can also use 1 as the P/YR since it lacks coupons.
What is a callable/redeemable bond?
A bond that may be callable at some point in the future. These types of bonds offer a higher return since it’s riskier for the investor. The issuer has more flexibility, just at a higher price. Typically also a “call premium” attached to a callable bond (an extra premium if they call the bond).
How do you calculate the price of a callable bond?
- Assume that the bond will be called when doing calculation.
- Sell based on yield-to-call rather than yield-to-maturity.
- Call premium should be added to the par value of the bond.
Why are callable bonds attractive to investors?
Normally provide slightly higher returns than non-callable bonds.
What is a retractable bond?
One that allows the investor to retract the bond prior to maturity after a certain period.
What is a convertible bond?
Bond that can be converted into common shares at some point after they are issued. Issued with a conversion ratio. Bond prices are tied to the price of the underlying equity. More volatile than ordinary bonds, but not as risky as equity.
What is an extendible bond?
Bond with the option to extend the maturity, normally with a slightly higher coupon during the extended period.
What is a mortgage bond?
Safest corporate-issued bond as it provides the most senior form of debt. Normally, a specific asset is attached to the mortgage bond, but any other company assets can be claimed as well. Typically offer lower coupon rates due to the security.
What is a debenture?
Often used by junior issuers who may lack assets against which financing can be secured (can also be issued by senior companies though). Issuer promises a higher return to make up for the lack of assets to secure financing against.
Who can issue government bonds?
Federal, provincial, and municipal governments, as well as crown agencies such as utilities providers.
How do you calculate the taxation of a bond?
If you buy a bond at a premium, you’ll have a considerable amount of interest income and a capital loss at maturity.
If you buy a bond at a discount, you’ll have less interest income and a capital gain at maturity.
Working from left to right, what do each of these figures represent in the listing for a publicly traded bond?
7.220 739,000 4.57706 124.788 127.060 4.36923
Coupon rate # of bonds issued in this series Yield to the buyer at bid price Bid price Ask price Yield to the buyer at ask price
If a bond has a rating of BBBh,what does that mean?
This rating is from Dominion’s Bond Rating Service. BBB is adequate quality (from DBRS) and the h is a letter grade standing for high quality relative to other issuers at the same level of credit. BBBh means the company is in the upper third of quality of issuers of adequate quality bonds.
What does it mean if a bond has a bid price of $124.788?
It is selling at a premium to par value ($100). Seller would receive $12,478.80 for 100 units of the bond (100 x 124.788).
Why do bonds have a bid and ask price?
The investment dealer facilitating the transaction keeps the spread.
What is the difference between an individual investor and a professional manager buying and selling bonds?
Institutional investors have more bargaining power and can pay less for bonds they acquire (and demand a higher price for bonds they sell).
Why were Canada Savings Bonds so popular?
They could be purchased through payroll deduction.
How did CPBs differ from CSBs?
Canada Savings Bonds were redeemable at any point (with no interest paid in the first 3 months). CPBs were not redeemable at any point, only on their anniversary date. CPBs would offer a higher rate of return to compensate for the lower liquidity.
When did the Government of Canada announce they will no longer issue CSBs or CPBs?
In the 2017 Federal Budget
What are the 3 rights of common shareholders?
- Right to dividends
- Voting rights
- Equity rights
Why does the Board of Directors of a company have to weigh the value of keeping shareholders satisfied through paying dividends against the value of reinvesting in the corporation?
If a dividend is paid out to shareholders, it doesn’t necessarily improve the value of the business. If a company reinvests profits into the business, this increases the value of the company (and its shares by extension). However, corporations that don’t pay dividends will often see their share price drop, something that can make a company vulnerable for takeover.
