Chapter 3 Flashcards
Bond
is a debt security issued by the corporation. The bond’s indenture contractually stipulates that the investor will be repaid his or her invested principal plus interest
Corporate Bond
is a contract between a corporation and the investor, whereby the investor lends the corporation money, in return for a legal promise that the corporation will pay the principal back to the investor on a specified date, with interest.
bond’s indenture
also called the “deed of trust”) on the bond certificate. It will specify how and when the principal will be repaid, the rate of interest (also called the coupon), a description of property secured as collateral against default, and steps that shall be taken in the event of default.
Secured Debt
secured debt, corporation goes bankrupt, the trustee will take possession of the assets and liquidate them on the bondholders’ behalf. If the company defaults on its bond payments, there is still the protection of income from the sale of the company’s assets, which secure the payments
types of secured corporate bonds
Mortgage bonds are secured by a first or second mortgage on real property.
Equipment trust certificates are secured by a specific piece of equipment.
Collateral trust bonds are secured by the securities of another corporation, which is usually affiliated with the issuer in some way.
Unsecured Debt
are secured only by the corporation’s good faith and credit, and not by a specific asset. If the company defaults, the bondholders will have the same claim on the company’s assets as any other general creditor. Though secured bondholders will be paid before debenture holders, owners of stock will be paid after unsecured bondholders.
High-Yield (Junk) Bonds
Unsecured corporate bonds that are not considered investment grade by credit rating companies - those rated BBB or below by Standard & Poor’s (S&P) or Baa or below by Moody’s, for example - are called high-yield bonds, or junk bonds
Convertible Bonds
A corporation may issue convertible bonds, which allow investors to convert a bond into shares of the company’s common stock at a predetermined ratio. A corporation will issue these bonds to borrow money at a lower rate of interest than the company would pay on an equivalent non-convertible bond issue. The assumption is that investors will forgo a bit of interest on exchange for the conversion feature.
Conversion price
is the price per share at which the corporation will sell the bondholder the stock in exchange for the bond.
conversion ratio
is the par value of the bond divided by the conversion price, and it gives you the number of shares received for each bond.
Cconversion ratio = Par value
Conversion price
parity
market price of the stock equals the conversion price of the stock, the situation is called parity.
Zero Coupon Bonds
debt securities issued at a deep discount from par, with the difference between the discount and the face value paying out at maturity. These bonds do not make regular interest, or coupon, payments. Corporations, municipalities and the U.S. government all offer zero-coupon bonds.
CMOs
collateralized mortgage obligations, are mortgage-backed securities purchased in $1,000 denominations that pool together a large number of private mortgages (usually on single-family residences), mortgage pass-through securities like those issued by Fannie Mae and Ginnie Mae, and other CMOs.
tranches.
own estimated life, interest rate and payment priority, even though all tranches are backed by the same pool of mortgages.
capital market
is a source of intermediate-term to long-term financing in the form of equity or debt securities with maturities of more than one year.
Money Markets
provides very short-term funds to corporations, municipalities and the United States government. Money market securities are debt issues with maturities of one year or less
3 Characteristics of Money Markets
Liquidity - Since they are fixed-income securities with short-term maturities of a year or less, money market instruments are extremely liquid.
Safety - They also provide a relatively high degree of safety because their issuers have the highest credit ratings.
Discount Pricing- A third characteristic they have in common is that they are issued at adiscount to their face value.
Money market securities issued by the U.S. government and its agencies include the following vehicles:
Treasury bills (T-bills)
Treasury and agency securities with remaining maturities of less than a year
Federal National Mortgage Association (Fannie Mae) short-term discount notes
Federal Home Loan Bank short-term discount notes and interest-bearing notes
Federal Farm Credit Bank notes and bonds maturing in one year
Short-term discount notes issued by other smaller agencies
Construction loan notes (CLNs)
A short-term obligation in the form of a note, used for the funding of construction projects such as housing developments. In most cases, the note issuers will repay the note obligation by issuing a longer term bond and using the proceeds from the bond to pay back the note.
Revenue anticipation notes (RANs
A short-term debt security issued on the premise that future revenues will be sufficient to meet repayment obligations.
RANs are generally used to generate immediate investment capital to begin a large project. These securities are repaid with future expected revenues from the completed project, which may come from sources like turnpike tolls or stadium ticket sales.
Bond anticipation notes (BANs
A short-term interest-bearing security issued in the anticipation of larger future bond issues.
Bond anticipation notes are smaller short-term bonds issued by governments and corporations. Knowing that the proceeds of the larger future issue will cover the anticipation notes, the issuing bodies use the notes as short-term financing.
Tax anticipation notes (TANs
Short-term debt securities issued in anticipation of future tax collections.
TANs are generally issued by state and municipal governments to provide immediate funding for a capital expenditure, such as highway construction
three most commonly used money market instruments
bankers’ acceptances
commercial paper
negotiable certificates of deposit
Negotiable CDs
are time deposits with a minimum face value of $100,000. Most, however, are issued for $1 million or more. They are unsecured promissory notes guaranteed by the issuing bank. Most negotiable CDs mature in one year or less. However, since they are negotiable, these CDs can be traded in the secondary market.
Banker’s Acceptance Notes
banker’s acceptance is a short-term time draft drawn on a bank with a specified payment date, usually between one and 270 days. U.S. corporations typically use bankers’ acceptances to buy goods and services in foreign countries.
Commercial Paper
Corporations use short-term, unsecured commercial paper to raise cash to finance accounts receivable and seasonal inventory declines. Paper maturity usually ranges from 30 to 270 days, although most paper matures within 90 days. It is issued in bearer form at a discount to the face value.
Examples of Treasury issues
Treasury bills (T-bills), Treasury notes (T-notes)and Treasury bonds (T-bonds). GSE issues include securities issued by Fannie Mae, Freddie Mac, Federal Land Banks, Federal Home Loan Banksand other agencies. The most common federal agency-issued security is the Government National Mortgage Association (GNMA) security, better known as a Ginnie Mae.
Treasury Bills
Treasury bills are direct, short-term debt obligations of the U.S. government. They are issued every week using a competitive bidding process in maturities of one month, three months and six months. Once per quarter, the U.S. government issues Treasury bills with one-year maturities. T-bills have minimal interest-rate risk, since they have very short-term maturities. Treasury bills are issued at a discount from their par value. That is, they do not pay interest. They are sold with a minimum denomination of $1,000 and in multiples of $1,000 thereafter.
Treasury Notes
Treasury notes are direct debt obligations of the U.S. Treasury that pay semiannual interest as a percentage of the stated par value, have intermediate-term maturities (1-10 years) and mature at par value.
Treasury Bonds
Treasury bonds are the direct debt obligations of the U.S. Treasury that pay semiannual interest as a percentage of par value and mature at par, like Treasury notes. They differ from T-notes in the length of their maturities, which are generally 10 to 30 years. They are also usually callable at par beginning 25 years after issue.
government-sponsored enterprises, or GSEs
government-sponsored enterprise securities are not direct obligations of the U.S. government, their credit risk is still considered low, as the federal government created the entities and will not let them default on their obligations.
Both federal agency and GSE securities are subject to federal taxation.
U.S. Savings Bonds
The main types of non-marketable government bonds are Series EE, HH, and I savings bonds
Series EE Bonds
Series EE Bonds are 30-year investments issued in denominations ranging from $50 to $10,000. They are purchased for half (50%) of their face value at financial institutions that are qualified as savings bond agents. (For investors who have purchased Series EE bonds since May 1, 1997, and have held the bonds for at least five years, the interest rate is equivalent to 90% of the average yield on five-year Treasury bonds based on the previous six months.) The rate is reset twice a year - on May 1 and November 1 - and is therefore variable.
Series HH Bonds
Series HH Bonds are 20-year investments that pay semiannual interest and have face values ranging from $500 to $10,000. The only way to acquire HH bonds is to exchange at least $500 in EE bonds. The interest on both Series EE and HH bonds is federally taxable but free of state and local taxes. Taxes on the interest of Series EE bonds can be deferred until the bond matures or is cashed in.
Series I Bonds
they are sold at face value, and their interest rate is reset semiannually based on the rate of inflation. Interest on I-bonds is paid over 30 years and is reinvested back into the principal of the bond as long as the bond is held. Series I bonds are free from state and local taxation. Moreover, federal taxes are deferred until the bonds are redeemed or mature. I bonds are partially or wholly tax-exempt if used for higher education, making them good candidates for college savings.
munis
When state and local governments or U.S. territories need to raise money, they may issue municipal bonds. Municipal bonds, commonly referred to in investing circles
Municipal bonds 2 types
general obligation bonds and revenue bonds
General Obligation (GO) Bonds
Only entities that have the ability to levy and collect taxes can issue GO bonds. They are usually issued to fund properties or facilities used by the public, such as government buildings, schools, prisons and police and fire stations. Local governments depend upon property taxes (ad valorem taxes) to pay the obligations of their debt securities, while state-issued GO bonds are paid from income, sales, and other taxes, as determined by the state legislature.
municipality’s financial safety and stability is usually based on four factors
Tax burden on and source of tax payments for the issuer
Budgetary structure and financial condition of the issuer
Existing issuer debt, as measured by net debt per capita and overlapping debt
Overall economic health of the community, including changes in property values, average household income, size of the employer pool and other demographics
Revenue Bonds
backed by user fees and other charges generated by a particular public works project. They are commonly used to finance the following endeavors:
Airports
Colleges and universitiesToll roads and bridges
Public power systems
Sewer and water systems
Hospitals
Housing developments
Sports facilities and convention centers
Rapid transit
Industrial development
calculate the tax equivalent yield (TEY)
After-tax Yield = Muni Bond Yield
(100% - customer’s tax bracket rate)
For example, let’s say Stanley Lehman, MD, is a high-income client of yours. He tells you that he earns a lot of money and is in the 35% tax bracket. You confirm his annual salary at $300,000 a year. Right now, 20-year munis are paying 4.8%. If Dr. Lehman is in the 35% tax bracket, the tax-equivalent yield (TEY) would be calculated as follows:
.048 =.048=7.38%
100-35.65
corporation generally issues two types of stock:
common and preferred
summary of the rights and privileges enjoyed by the common stockholder:
Stock Certificate
transfer agent for the company keeps a list of all registered stockholders and cancels old stock certificates while issuing new ones when shares are transferred. The registrar verifies that the company has not issued more shares than authorized by its charter.
shareholder generally cannot be held responsible for the company’s debts: if the business fails, shareholders only lose their original investment. If the business thrives, however, the shareholders expect to share in the company’s profits in the form of dividends and in the increased value of company stock, as reflected in the stock price. This limitation of loss to the original amount invested is referred to as limited liability.
right to earnings, transfers, dividends,
Preemptive right, right of inspection.
calculating yields on common stocks:
Current yield = Annual dividend/share
Market price/share
For example, let’s calculate the current yield of a stock that is currently paying a quarterly dividend of $.40 and trading at $44 a share:
3.6% yield = $.40 x 4
$44
Cumulative preferred stock
all preferred dividends are considered to be in arrears and must be paid to holders of cumulative preferred stock before common stockholders receive their dividends.
For example, if the preferred stock pays a 6% yield, but the company has only paid $2 per share for the past two years, it will owe shareholders a total of $14 in the third year:
That is, Year1 ($6 owed - $2 paid) + Year2 ($6 owed - $2 paid) + Year3 ($6).
Convertible preferred stock
Convertible preferred stock can be exchanged for common stock at a specific price and at the discretion of the shareholder. When this occurs, the value of the common stock for which the preferred stock is exchanged is called the conversion price. If the par value of the preferred stock is $150 and the conversion price is $30, the conversion ratio is 5-to-1.
Order of Payment Upon Bankruptcy
Wages owed to employees IRS (taxes) Secured debt Unsecured debt and general creditors Subordinated debt Preferred stockholders Common stockholders
American Depository Receipts (ADRs
This allows American investors to purchase the companies’ shares without the companies having to register with the SEC. Typically, a large U.S. bank with offices in the foreign country will purchase a large quantity of the stock, hold it in trust and then issue the ADRs, which are backed by the shares held in trust. ADR purchases receive no voting rights. Dividends are declared in the foreign currency, but converted and paid in U.S. dollars.
calls and puts
The holder of a call option buys the right from the writer to buy an underlying security - or “call” the security away from the seller - at a fixed price. The writer of the call option in turn has an obligation to sell the security at that fixed price if the buyer exercises the call right. When an investor owns a put, he has the right to sell, or put, the underlying security to the writer at a fixed price. The writer in turn has an obligation to buy the security from the put owner.
Exchange Traded Funds (ETFs):
ETFs are a relatively new type of security which combine features of both stocks and mutual funds. Each ETF is designed to track an index and owns a number of stocks. The portfolio is not actively managed and the ETF is traded like a stock.
Hedge funds
Hedge funds are aggressive portfolios designed to both maximize returns while minimizing risks. They are available only to small numbers of accredited investors and are therefore unregulated.
