Module 2: Inventorying the Major Asset Classes Flashcards
Identify the major asset classes held in Canadian registered retirement plan funds including an example of a type of security held in each major asset class.
An “asset class” is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.
The major asset classes used by Canadian registered retirement plan funds are fixed income, equity, derivatives and alternative investments. Money market and bond securities fall within the asset class of fixed income. A stock falls within the asset class of equity. A futures contract is considered a derivative, while an investment in real estate is an example of an alternative investment.
Differentiate between the “money market” and the “capital market” and describe examples of securities included in each market.
Financial markets are traditionally segmented into money markets and capital markets. Bonds with maturities of less than one year are referred to as short-term securities or money market investments. As such, the money market is a subsector of the fixed-income market. Money market instruments include short-term, marketable, liquid, low-risk debt securities. Money market instruments are sometimes called “cash equivalents” or “cash.” Examples of money market securities are Treasury bills (T-bills), certificates of deposit (CDs), commercial paper and bankers’ acceptance (BA).
Capital market securities are much more diverse than those found in the money market and include longer term and riskier securities. Examples include bonds with maturities of greater than one year (longer term bonds), equities, and options and futures.
Outline basic characteristics of T-bills
T-bills provide the government with a way to raise money from the public. Investors buy T-bills at a price that is a discount from the stated maturity value. At maturity, the investor receives a payment from the government equal to the maturity value.
The difference between the purchase price and ultimate maturity value constitutes the investor’s earnings.
T-bills are purchased primarily by chartered banks, investments dealers, the Bank of Canada and individuals who obtain them on the secondary market from a government securities dealer. They are highly liquid, as they are easily converted to cash and sold at a low transaction cost with little price risk. They are offered in denominations of $1,000, $5,000, $25,000, $100,000 and $1 million.
Identify the primary reason registered retirement plan funds invest in money market instruments.
The primary reason registered retirement plan funds invest in low-risk T-bills and other money market securities is to meet liquidity needs. Holding such securities is usually regarded as equivalent to holding cash.
Outline basic characteristics of a certificate of deposit (CD).
A CD is a time deposit with a chartered bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor at the end of the fixed term of the deposit. Although CDs are not transferrable in Canada, some bank time deposits issued in denominations greater than $100,000 are negotiable—i.e., they can be sold to another investor if the owner needs to cash in the deposit before its maturity date. In Canada, these marketable securities are known as bearer deposit notes (BDNs).
Outline basic characteristics of commercial paper, and identify why it is issued.
“Commercial paper” (called “paper” or “notes”) is an unsecured debt instrument issued by a corporation. It is typically used to finance accounts receivable, inventories and short-term liabilities. Many firms issue commercial paper with the intent of rolling it over at maturity—that is, issuing new paper to obtain the funds necessary to retire the old paper.
Commercial paper maturities typically range up to one year. Longer maturities must be registered with the relevant securities commission, so they are almost never issued. It is most often issued with maturities of less than one or two months and minimum denominations of $50,000, and therefore, small investors can invest in commercial paper only indirectly, via money market mutual funds.
The debt is usually issued at a discount, reflecting prevailing market interest rates. Commercial paper is often backed by a bank line of credit, which gives the borrower access to cash that can be used, if needed, to pay off the paper at maturity. Almost all commercial paper is rated for credit quality by major rating agencies. It is a fairly safe asset because a firm’s condition can presumably be monitored and predicted over a term as short as one month. Since commercial paper is not backed by collateral, only companies with excellent credit ratings from a recognized credit agency will be able to sell paper at a reasonable price.
Outline basic characteristics of bankers’ acceptances. Identify where bankers’ acceptances are most widely used.
“Bankers’ acceptances” are money market instruments that consist of an order to a bank by a customer to pay a fixed amount at a future date, typically within six months. In return for a “stamping fee” (the fee charged by the bank for providing this guarantee), the bank endorses the order for payment as “accepted,” assuming responsibility for ultimate payment to the holder of the acceptance. This guarantee makes an acceptance second only to T-bills in terms of default security. At this point, the acceptance may be traded in secondary markets like any other claim on the bank. Acceptances sell at a discount from the face value of the payment order, just as T-bills sell at a discount from face value, with a similar calculation for yield.
Bankers’ acceptances are used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner. Traders can substitute the bank’s credit standing for their own.
Bankers’ acceptance rates are the main benchmark for Canadian-dollar interest rates known as the Canadian Dealer Offered Rate (CDOR), which serves both money and derivative markets.
Outline basic characteristics of repurchase agreements.
“Repurchase agreements” represent short-term borrowing in which a dealer sells government securities to an investor on an overnight basis. They include an agreement to buy back those securities the next day at a slightly higher price; the increase in the price is the overnight interest.
Explain the difference between “bond equivalent yield” used to quote yields for T-bills and the “effective annual yield” on a T-bill.
Financial pages report bond equivalent yields for T-bills rather than reporting their prices or their effective annual rates of return. The main difference between these concepts is that the bond equivalent yield uses simple interest based on a 365-day year, and the effective annual yield uses compound interest technique.
Explain how the formula used to calculate the bank discount yield for U.S. T-bills differs from the formula used to calculate the bond equivalent yield for Canadian T-bills and what this means for investors.
The calculation of the bank discount yield for U.S. T-bills uses a 360-day year (versus 365 days for Canada) and the par value of 1,000 in the denominator instead of price (P). To properly compare the returns for Canadian and U.S. T-bills, the same formula needs to be used for both.
Define the terms “principal,” “term to maturity,” “coupon rate,” “coupon payment” and “duration” in the context of bonds.
“Principal” is the amount the bond issuer agrees to pay on the date of maturity. Other terms for principal are “denomination” and “face value.”
“Term to maturity” is the time between the date a bond is issued and the date the bond issuer must pay the face value of the bond (called “redeeming the bond”) to the bondholder. The date when that occurs is the “maturity date” of the bond.
“Coupon rate” is the percentage of the bond’s face value that will be paid as income to the bondholder over the lifetime of the bond.
“Coupon payment” is the regular and fixed interest the bond issuer pays the bondholder. Usually paid on a semiannual basis.
“Duration” is a measure expressed as a number of years that can be used to identify the sensitivity of a bond’s price to a change in interest rates. Duration is calculated based on the bond’s features and its present value at time of calculation, and a higher duration (normally described as “longer”) shows that the bond has a greater sensitivity to changes in interest rates.
Explain the significance of “face value, “par,” “discount” and “premium” in the context of bonds. Provide an example.
”Face value” is the amount the bond issuer agrees to pay on the date of the bond’s maturity.
“Par,” “discount” and “premium” are used to describe the relationship between the face value of the bond to the current market, or trading, price of the bond. When the market value of the bond equals its face value, the bond is trading at “par.” For example, if the current price and face value are both $100, then the bond is trading at par. If the current price is lower than face value, the bond is trading at a discount, i.e. if the current price is $95 and face value is $100, the bond is trading at a discount. The bond is trading at a premium when the opposite occurs and the bond’s current price is above par—i.e., if the current price is $105 and face value is $100, the bond is selling at a premium.
Explain the concept of the yield curve as it applies to fixed income investments. Outline information that is revealed by the shape of the following curve.
A “yield curve” is a line that plots the interest rates of bonds (yields) with different maturity dates but equal credit quality at a set point in time. The graph shows a normal yield curve—Bonds with a long-term maturity have higher yields than shorter term bonds.
(Shape is the top left shape of a circle, so an arc with progressively decreasing slope)
Describe key risks associated with bonds and how investors can use bond rating services to assess their creditworthiness.
Inflation risk: The risk that the rate of inflation exceeds the rate of return, thus eroding the purchasing power of the bond.
Default risk: The risk that the issuer of the bond will not make payments as promised, e.g., in the event the issuer is bankrupt and insufficient assets exist to pay the bondholders.
Interest rate risk: The risk that a bond’s price will be negatively affected by changes in market interest rates.
Call risk: Callable bonds come with the risk that bond issuers exercise their right to repurchase the bond in advance of its maturity date, which results in the cessation of coupon payments.
Reinvestment risk: The risk that the future proceeds from bonds purchased will be reinvested at a time when interest rates have dropped.
Default risk can be assessed by an investor by making use of services offered by independent bond rating services. These include Standard & Poors (S&P), DBRS Morningstar, Moody’s and Fitch. These companies issue bond ratings that are based on their research into the financial status of the bond issuer, the nature of the obligations associated with their bonds and subsequent assessment of the likelihood of default. Each rating service has its own methodology, and each issues ratings using terms like AAA (highest rating), AA, BBB, etc. These letters indicate the likelihood that the issuer is financially strong and able to make the interest payments and repay the debt in full.
Compare Government of Canada, provincial and corporate bonds.
Government of Canada bonds are longer term marketable debt securities issued by the federal government. These bonds have varying maturities at issue date, ranging up to 40 years. They are generally noncallable and make semiannual coupon payments that are set at a competitive level designed to ensure their issue is at or near par value. (They are considered part of the money market when their term becomes less than three years.)
Provincial bonds are similar to federal government issues, with a variety of maturities and coupon rates. These securities are considered extremely safe assets, although not as safe as comparable Government of Canada bonds. Because of this, the yield of provincial bonds tends to be slightly higher than on Government of Canada bonds. The yield of provincial bonds also varies from province to province.
Corporate bonds enable private firms to borrow money directly from the public. These bonds are similar in structure to government issues. They typically pay semiannual coupons over their term to maturity and return the face value to the bondholder at maturity. They differ most importantly from government bonds in degree of risk; default risk is a real consideration in the purchase of corporate bonds.
Corporate bonds usually come with options attached. Callable bonds give the issuing firm the option to repurchase the bond from the holder at a stipulated call price. Retractable and extendible bonds give the bondholder the option to redeem the bonds earlier and later, respectively, than the stated maturity date. Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock.
