Investment Vehicles Flashcards
Negotiable Certificates of Deposit (CDs)
- you deposit funds into a bank and they sell you a CD
- Bank holds funds until CD maturity
- At maturity you get deposit back plus interest
- CDs can be sold before maturity
- carry interest rate risk
- insured up to $250k / individual
Money Market Deposit Accounts (MMDAs)
- Bank offered savings account
- FDIC insured up to $250k
Money Market Mutual Funds
- open ended investment companies offering safe investment choices
- not insured
- taxable interest: T-bills, neg. CDs, prime commercial paper
- tax-exempt CD: ST muni
Treasury Bills
- ST securities with maturity 1 yr or less
- issued at discount
Commercial paper
- ST unsecured promissory note
- issued by large companies
- denominations start at $100k
- maturity 270 days or less
- sold at discount and rated for quality
Banker’s Acceptance
- used to finance imports and exports
- foreign exporter wants payment guaranteed once good arrive
- bearer securities and can be held to maturity]- maturity is 9 mo or less
- trades at discount
Eurodollars
- deposit into any foreign bank that is denominated in dollars
- Eg. US dollar deposited into Hong Kong bank
Yankee Bonds
- dollar denominated bonds issues in the US by foreign banks
- issued in US when market conditions are more favorable that eurobond market or overseas markets
- registered with SEC
Bonds
debt security which obligated the issuer to pay interest and to repay principal when the debt matures at the end of its term
Par Value
- bonds are issued with stated par value (face value) which is usually $1,000
- issued with stated rate of interest (coupon or nominal
rate)
Discount Bond
- par value is higher than the bonds purchase price
- Eg. $1,000 par bond selling at $900
Premium Bond
- bonds purchase price is higher than par value
- Eg. $1,000 par value bond selling at $1,100
The Yield Ladder
Discount(YMCA) over coupon
YMCACMY
Premium (ACMY) under coupon
Nominal Yield
- stated rate of interest on the bond (coupon)
Accrued Interest
- interest on bonds is earned daily
- when bondholder sells a bond between the last interest payment received and the next one due, the buyer will compensate them for the interest lost
- at date of sale, accrued interest from last interest payment and the next due is calculated
- buyer of bond will pay this accrued amount in addition to the price of the bond
- at the next interest payment, the bond buyer will be reimbursed
- assume all bonds issued with accrual
Original Issue Discount (OID)
- discounted bond
- usually zero-coupon bond: paying no interest until maturity
- must report interest income even though nothing is yet received: phantom income
- OID muni - straight line basis, non taxable interest, held to maturity no cap gain
T-Bills vs T-Notes vs T-Bonds
T-Bills
- maturity: 3, 6, 12
- issued: 100 - 1M
- risk: safest
- default risk: none
- callable: N/A
- interest paid: no coupon
- taxation: federal only
- aution: weekly
T-Notes
- maturity: 1-10 yrs
- issued: 1k- 100k
- risk: RIP
- default risk: none
- callable: N/A
- interest paid: semiannual
- taxation: federal only
- aution: monthly
T-Bonds
- maturity: 10 -30 yrs
- issued: 1k- 1M
- risk: RIP
- default risk: none
- callable: 15 yrs prior to maturity
- interest paid: semiannual
- taxation: federal only
- aution: quarterly
Treasury STRIPS
- treasury issued zero-coupon bonds
- direct obligation of US government
- discount is treated as taxable income, earned annually
Treasury Inflation-Protection Securities (TIPS)
- marketable, offer protection against inflation
- face value is adjusted semiannually to keep pace with inflation according to CPI
- coupon lower than traditional but coupon rises as face value rises with inflation
- higher inflation rate = higher face value and fixed interest payments
- sold $1,000 denominations
TIPS Adjustment Process
Eg. $1,000 par, 10 yr maturity, 3.625% coupon
- if CPI rises annually by 6.5%, the principal is adjusted to $1,032.50 (1,0001.0325) and interest payment will be 18.13 (1,000.03625 /2)
- second payment uses new face value, (1,032.5 *.03625 / 2) = 18.71
- at end of first year principal is adjusted to 1,065 (1,000+32.50+32.50)
TIPS tax treatment
- taxed annually on interest plus appreciation in face value
- federal only
- interest and face value is taxed ordinary in year it occurred, not necessarily received
- decrease will cause ordinary deduction once interest is exhausted
Series EE bonds (issued after 2005)`
- non traded, non marketable, non transferable, non negotiable
- issued at face value
- earn fixed interest
- 20 year maturity with extra 10 years maturity
- denominations low as 50
- rates for new issues determined may and nov 1st
- interest accrues monthly and compounded semiannually
- held for minimum of 1 year
- 3 mo interest penalty for less than 5 years
- guarantees bond value will double after 20 years , if it doesn’t, treasury will make one time adjustment at maturity to make up difference
- interest based on 10 year treasury note yields
- interest not subject to federal tax until redeemed or matured
- option to have it taxed each year
- not state or local tax
HH Bonds
- exchanging at least $500 in EE bonds only
-interest semiannually by check - non-marketable
- after 2004 no longer option
- 20 year maturity so people may still have them
I Bonds
- inflation indexed
- non traded, non marketable, non transferable, non negotiable
- sold at face value
- accumulate interest monthly
- interest compounded every 6 weeks
- same denominations as EE but without guaranteed interest rate
I Bonds interest rate
2 parts
- fixed base rate: remains same for life of bond
- inflation adjustment rate: updated every 6 months to track CPI
- if used for education, tax exempt
Government National Mortgage Association (GNMA)
- GNMA buys FHA, VA, and farmers insured mortgages from banks and puts them into pools
- then issues pass through certificates representing individual interests in the pool
- guaranteed by gov but taxable at all levels
- minimum 25k certificate
- risks: Interest rate and reinvestment
- yield: interest and principal
Other agency securities- mortgage backed
gov. does not directly back these issues, backed through lines of credit
- FHLB
- FHMA
-FHLMC
Municipal bonds
- issued by states, cities, counties, other non federal units in order to raise capital
General Obligation Bonds (GO)
- backed by full faith and credit of municipality
- issuer will raise taxes if necessary to repay debt
- safest type of muni
Revenue bonds
- backed by specific source of revenue, not faith and credit
- backed by single source funds (toll roads, hospitals, power plants)
- greater risk than GO bonds, higher yields
Insured municipal bonds
- AAA rated
- insurer pays timely
- AMBAC, MBIA, BAM
Mortgage bonds (corporate)
- safest among long term corporate
- backed by property
- property can be sold if needed
Collateralized mortgage obligations (CMO)
- developed to eliminate risk of principal repayments varying for home owners and in turn affecting monthly interest
- cash flow basis, seperated based on expectation over time
- tranches used
- A-Z tranches paying fast pay, medium pay, and slow pay
- Z bears no coupon
Debenture
corporate debt backed only by integrity of issuer
Indenture
formal agreement between issuer and trustee
- trustee acts on behalf of bondholder
- covers following: form of bond (coupon or zero), amount, property pledged, etc
Investment Grade Bonds
- agencies rate bonds for credit risk
- corporate and muni have: DRIP
D: default risk
R: reinvestment risk
I: interest rate risk
P: purchasing power - government bonds have: RIP
Default risk
creditor may seize collateral and sell it to recoup the principal
Reinvestment risk
as payments are received from an investment, interest rates have fallen and when investor goes to reinvest funds, investor receives a lower yield
Interest rate risk
rising interest rates cause bond prices to fall
Purchasing power
inflation may lower the purchasing power of fixed bond interest
Rating agencies
S&P: Investment grade: AAA, AA, A, BBB
speculative grade: BB and below
Moody’s: Investment grade: Aaa, Aa, A, Baa
speculative grade: Ba and below
High Yield corporate bonds (junk bond)
- BB rating or below
- pays a higher yield to compensate for its greater risk
- rarely correct on exam
Convertible bond
- hybrid
- pay interest
- owner can convert bond into specific number of shares of common stock
- market price of convertible security depends on value of stock and interest that bond pays
Bond investment value calculation
- intrinsic value: PV of expected cash flows that must be discounted
- PMT is positive (interest received)
2//
FV: face value
PMT: (coupon * par)/2
N: yrs//
I/YR: yielding market rate
PV: ?? - current rate > coupon = discount
- coupon > current rate = premium
Bond conversion value calculation
CV = (PAR/CP) * Ps
CV = conversion value
Ps = current market price of stock
PAR = par value
CP = conversion price
Floor value
- every convertible security has a floor value
- a convertible bond will not sell for less than the larger of
- its value as a bond
- its conversion value
Callable bonds
issuer has the right to redeem the bond at a predetermined price at a date prior to maturity
- issuer likely to call bond if interest rates have dropped
- call premium to incentivize early redemption
- protected for stated period (10 yrs) before it can be called
Put bond
permits holder to sell the instrument back to issuer
- when rates rise and prices drop
- for this privilege, some yield is sacrificed
