Series 7 Chapter 3 Flashcards
KYC
The know your customer (KYC) rule places an obligation on the firm and associated person to seek information from customers. Customers are not required to provide all information asked; therefore, the KYC rule provides some flexibility when information is unavailable, despite the fact that the firm or the associated person asked for it.
In this case, when some customer information is unavailable despite a firm’s request for it, the firm may narrow the range of recommendations it makes. The rule does not prohibit a firm from making a recommendation in the absence of certain customer-specific information if the firm has enough information about the customer to have a reasonable basis to believe the recommendation is suitable based on what the firm knows. The significance of specific types of customer information will depend on the facts and circumstances of the particular case. Of course, the firm itself may require, in order for customers to receive recommendations, that customers provide certain types of information.
Both financial and nonfinancial information must be gathered before making investment recommendations.
Before making a recommendation for a new customer a representative must
must try to find out as much about that person’s financial and nonfinancial situation as possible. Financial investment considerations can be expressed as a sum of money. Financial questions have answers that show up on a customer’s personal balance sheet or income statement. Asking a customer, “when would you like to retire?” is not a financial question—it is nonfinancial. The answer does not show up on the customer’s personal balance sheet or income statement.
customer balance sheet
An individual, like a business, has a financial balance sheet—a snapshot of the individual’s financial condition at a point in time. A customer’s net worth is determined by subtracting liabilities from assets (assets – liabilities = net worth). Representatives determine the status of a customer’s personal balance sheet by asking questions similar to the following.
■ What are the values of tangible assets? Home? Car? Collectibles?
■ What are your liabilities? How much do you owe on your mortgage? Car? Outstanding
Loans?
■ What are the values of securities you currently own?
■ Have you established long-term investment accounts, and what are the values of those accounts? Do you have an IRA, corporate pension, or profit-sharing plan; and what are the values of those plans? What is the cash value of your life insurance?
■ What is your net worth? How much of it is liquid?
customer income statement
To make appropriate investment recommendations, representatives must know the customer’s income situation. They gather information about the customer’s marital status, financial responsibilities, projected inheritances, and pending job changes by asking the following questions.
■ What is your total gross income? Total family income?
■ How much do you pay in monthly expenses?
■ What is your net spendable income after expenses? How much of this is available for investment?
Before recommending any investment to a customer, a representative must,
at a minimum, make a reasonable effort to obtain information concerning the customers financial status and investment objectivies
customer profile:non financial investment considerations
Once representatives have an idea of the customer’s financial status, they gather information on the nonfinancial status. A nonfinancial investment consideration is one that cannot be expressed as a sum of money or a numerical cash flow (risk tolerance, or tax bracket, for example). Nonfinancial considerations often carry more weight than the financial considerations and include the following:
■ Age
■ Marital status
■ Number and ages of dependents
■ Employment
■ Employment of family members
■ Current and future family educational needs
■ Current and future family health care needs
■ Risk tolerance
■ Attitude toward investing
■ Tax status
No matter how much an analysis of a customer’s financial status tells the representative about the ability to invest, it is the customer’s emotional acceptance of investing and motivation to invest, which molds the portfolio.
To understand a customer’s attitude for investment, the representative should ask questions similar to the following.
■ What kind of risks can you afford to take?
■ How liquid must your investments be?
■ How important are tax considerations?
■ Are you seeking long-term or short-term investments?
■ What is your investment experience?
■ What types of investments do you currently hold?
■ How would you react to a loss of 5% of your principal? 10%? 50%?
■ What level of return do you consider good? Poor? Excellent?
■ What combination of risks and returns do you feel comfortable with?
■ What is your investment temperament?
■ Do you get bored with stable investments?
■ Can you tolerate market fluctuations?
■ How stable is your income?
■ Do you anticipate any financial changes in the future?
risk points
■■ Low risk—conservative
■■ Some risk—moderate
■■ More than average risk—moderately aggressive
■■ High risk—aggressive
If you key on the right word, you’ll get the correct answer.
preservation of capital
For many people, the most important investment objective is to preserve their capital. In general, when clients speak of safety, they usually mean preservation of capital. Recommendations may include the following:
■ Money market securities
■ Money market mutual funds
■ Certificates of deposit (CDs)
■ Government securities
■ Principal-protected funds may also be appropriate if they are looking to invest for a longer time horizon
current income
Many investors, particularly those on fixed incomes, want to generate additional current income.
■ Traditional debt securities such as corporate, government, municipal bonds, and agency securities may provide steady interest income.
■ Equity securities may be purchased for the dividends they produce; these include preferred stocks, utilities, and blue-chip stocks that have a solid dividend paying history. (A blue- chip stock is the stock of a large, well-established and financially sound company that has operated for many years and is usually a company people are familiar with.)
■ Many pooled investments can provide income as well, such as income-oriented mutual
capital growth
refers to an increase in an investment’s value over time. This can come from increases in the security’s value. Growth-oriented investments are equity oriented.
price to earnings ratio
Measures the relationship between a company’s
stock price, with the company’s earnings per share (EPS). The P/E ratio indicates how
much investors are willing to pay for a every dollar of earnings.
A high P/E ratio indicates investors expect higher earnings (growth momentum).
A low P/E ratio may indicate the stock is undervalued and may be more representative of a value investment.
higher the pe ratio
the better
tax advantage products
Investors often seek ways to reduce their taxes. Some products, like IRAs and annuities, allow interest to accumulate tax-deferred (an investor pays no taxes until money is withdrawn from the account). Other products, like municipal bonds, offer tax-free interest income.
are municipal bonds suitable for retirement accounts
no
liquid investments include
securities listed on an exchange or unlisted Nasdaq securities; ■ mutual funds;
■ exchange-traded funds; and
■ real estate investment trusts (REITs).
illiquid investments include
■ annuities, when initially purchased and/or when the annuitant is under age 591⁄2; ■ real estate;
■ direct participation programs;
■ hedge funds; and
■ funds of hedge funds.
annuities and liquidity
Annuities—particularly when issued—are not considered liquid. Most annuities have a surrender penalty that may last at least seven to 10 years. In addition, there are taxes and a 10% tax penalty for withdrawals before 591⁄2 years of age.
speculation
A customer may want to speculate—that is, try to earn much higher-than-average returns in exchange for higher-than-average risks. Investors who are interested in speculation may be interested in:
■ option contracts;
■ high-yield bonds;
■ unlisted or non-Nasdaq stocks or bonds;
■ sector funds;
■ precious metals; and
■ special situation funds.
As a registered representative, one must always determine the suitability of such recommendations.
recommendation for preservation of capital/safety
CDs, money market mutual funds, fixed annuities, government securities and funds, agency issues, investment-grade corporate bonds and corporate bond funds
Growth (balanced/moderate growth)
(aggressive growth)
recommendation
Common stock, common stock mutual funds Blue-chip stocks, defensive stocks Technology stocks, sector funds
income
(tax free income)
(high yield income)
(from stock portfolio)
recommendation
Bonds (but not zero coupons), REITs, CMOs
Municipal bonds, municipal bond funds, Roth IRAs
Below investment-grade corporate bonds, corporate bond funds Preferred stocks, utility stocks, blue-chip stocks
liquidity recommendation
Securities listed on an exchange, Nasdaq stocks or bonds, mutual funds, publicly traded REITS
portfolio diversification
recommendation
Mutual funds, in general; more specifically, asset allocation funds and balanced funds
For equity portfolios, add some debt and vice versa For domestic portfolios, add some foreign securities For bond portfolios, diversify by region/rating
speculation recommendation
Option contracts, DPPs, high-yield bonds, unlisted/non-Nasdaq stocks or bonds, sector funds, precious metals, commodities, futures
business risk
Business risk is a form of unsystematic risk; it affects companies and industries individually. Business risk can be reduced by diversifying investments.
inflation risk
Also known as purchasing power risk or constant dollar risk, inflation risk is the effect of continually rising prices on investments, resulting in less purchasing power as time goes on. A client who buys a fixed return security such as a bond, fixed annuity, or preferred stock
may not see the investment keep pace with inflation.
capital risk
Capital risk or principal risk is the potential for an investor to lose all his money (invested capital) under circumstances either related or unrelated to an issuer’s financial strength.
timing risk
Even an investment in the soundest company with the most profit potential might do poorly simply because the investment was timed wrongly. The risk to an investor of buying or selling at the wrong time and incurring losses or lower gains is known as timing risk.
interest rate risk
Interest rate risk refers to the sensitivity of an investment’s price or value to fluctuations in interest rates. The term is generally associated with debt (i.e., bonds, bond funds) and preferred stocks because their prices are interest-rate sensitive. An inverse relationship exists with these securities; as yields go up, prices go down, and vice versa.
Know that the longer a bond’s maturity (or duration), the more volatile it is in response to interest rate changes compared with similar short-term bonds. For bonds with short maturities, the opposite is true. Their prices remain fairly stable because investors generally will not sell them at deep discounts or buy them at high premiums.
short term interest rates are more or less volatile than long term
more
duration
is another useful tool in bond calculations; it is a measure of the amount of time a bond will take to pay for itself. Each interest payment is taken to be part of a discounted cash flow, so there is more to the calculation than simply adding up the interest payments. For the Series 7, remember that duration is often used to assess the sensitivity of a bond in response to interest rate changes—the longer the duration, the greater the sensitivity, and thus greater interest rate risk in an environment of changing interest rates. Remember also that the duration of an interest-paying bond is always shorter than the time to its maturity because the interest payments can be reinvested and earn additional interest. By way of comparison, the duration of a zero-coupon bond is always equal to the time to its maturity because there is only one payment—the one made when the bond matures.
Remember that there are two components to the computation: the interest rate and the maturity date. If the maturity dates are about the same (the difference between a 20-year maturity and a 22-year one is almost insignificant), then the bond paying the highest coupon rate will always have the shortest duration and that with the lowest coupon, the longest. However, if the coupon rates are approximately the same, then the bond that will mature first will have the shortest duration, and the one that will mature last will have the longest duration.
reinvestment risk
When interest rates decline, it is difficult for bond investors to reinvest the proceeds from investment distributions and maintain the same level of return at the same level of (default) risk. Reinvestment risk is mostly associated with bonds that mature or when a bond or preferred stock is called by the issuer.
market risk
Both stocks and bonds involve some degree of market risk—the risk that investors may lose some of their principal due to price volatility in the overall market (also known as systematic risk).
An investor cannot diversify away market risk. If the entire market is in a tailspin, all of the investor’s securities will likely decline.
This is systematic
credit risk
Credit risk, also called financial risk or default risk, involves the danger of losing all or part of one’s invested principal through an issuer’s failure. Credit risk is associated with debt securities, not equity securities, and varies with the investment product.
Bonds backed by the federal government or municipalities tend to be very secure and have low credit risk. Long-term bonds involve more credit risk than short-term bonds because of the increased uncertainty that results from holding bonds for many years.
Bond investors concerned about credit risks should pay attention to the ratings. Two of the best-known rating services that analyze the financial strength of thousands of corporate and municipal issuers are Moody’s Investors Service and Standard & Poor’s (S&P) Corporation.
To a great extent, a bond’s value depends on how much credit risk investors take. The higher the rating, the less likely the bond is to default and, therefore, the lower the coupon rate. Clients seeking the highest-possible yields from bonds might want to buy bonds with lower ratings; higher yields reward investors for taking more credit risk.
There is also a variable price difference between speculative and investment-grade debt, other things such as maturity date being equal. During times of confidence in the economy, the price of a AAA bond and that of a BB bond, for example, will be closer together than during periods of economic uncertainty. This reflects investors’ reduced willingness to take risks during periods of uncertainty: speculative debt is discounted more than during periods of confidence.
liquidity risk
The risk that a client might not be able to sell an investment and receive its current market value quickly is known as liquidity risk.
The marketability of the securities you recommend must be consistent with the client’s liquidity needs.
legislative risk
Legislative risk exists because federal and state legislatures have the power to change laws, and this can impact securities (companies) negatively and result in capital loss for investors.
social risk or political risk
Risk associated with the possibility of unfavorable government action or social changes resulting in a loss of value is also called social risk or political risk. Political risk is an important risk to discuss when recommending foreign or international investments because governments outside the United States may not be as stable as ours.
call risk
Related to reinvestment risk, call risk is the risk that a bond might be called by the issuer before maturity, and investors cannot reinvest their principal at the same or a higher rate of return. When interest rates are falling, bonds with higher coupon rates are most likely to be called.
call protection
Investors concerned about call risk should look for call protection, a period of time during which a bond may not be called. Corporate and municipal issuers generally provide some years of call protection.
bonds can’t be ____ but
bonds can’t be called but the bonds within a bond portfolio can be called
how can callable bonds benefit the issuer
If general interest rates decline, the issuer can redeem bonds with a high interest rate and replace them with bonds with a lower rate.
■ The issuer can call bonds to reduce its debt any time after the initial call date.
■ The issuer can replace short-term debt issues with long-term issues and vice versa.
■ The issuer can call bonds as a means of forcing the conversion of convertible corporate bonds.
currency risk
This is the risk that changes in the exchange rate between the investor’s home currency and that of the issuer’s one will have an adverse affect on an investment’s return. As a rule of thumb, an investor who purchases an international fund (e.g., a foreign bond fund) will lose if the U.S. dollar appreciates against the foreign currency. The investor will profit if the U.S. dollar weakens (depreciates) against the foreign currency.
in measuring investment performance
be sure to avoid comparing apples to oranges. Finding and applying the right evaluation standards for investments is important. Otherwise, the wrong conclusions may result.
asset allocation
Asset allocation (more accurately, but rarely stated, asset class allocation) refers to the spreading of portfolio funds among different asset classes. Proponents of asset allocation feel that the mix of assets within a portfolio, rather than individual stock selection or marketing timing, is the primary factor underlying the variability of returns in portfolio performance. There are three major types (each with subclasses) of asset classes: ■ Stock, with subclasses based on market capitalization, value versus growth, and foreign equity ■ Bonds, with subclasses based on maturity (intermediate versus long-term), and issuer (Treasury versus corporate versus non-U.S. issuers) ■ Cash, focusing mainly on the standard risk-free investment, the 90-day Treasury bill, but also including other short-term money market instruments
strategic asset allocation
Strategic asset allocation refers to the proportion of various types of investments composing a long-term investment portfolio
portfolio rebalancing
Over time, the portfolio is rebalanced to bring the asset mix back to the target allocations. If the stock market should perform better than expected, the client’s proportion of stocks to bonds would be out of balance. So, on some timely basis (perhaps quarterly), stocks would be sold and bonds would be purchased (or funds would be placed in cash) to bring the proportions back to the desired levels.
tactical asset allocation
refers to short-term portfolio adjustments that adjust the portfolio mix between asset classes in consideration of current market conditions.
Modern portfolio theory
MPT employs a scientific approach to measuring risk and, by extension, to choosing investments. It involves calculating projected returns of various portfolio combinations to identify those that are likely to provide the best returns at different levels of risk. It is the concept of minimizing risk by combining volatile and price-stable investments in a single portfolio.
Harry Markowitz, the founder of MPT, explained how to best assemble a diversified portfolio and proved that the portfolio with a lower amount of volatility would do better than a portfolio with a greater amount of volatility.
MPT focuses on the relationships among all the investments in a portfolio. This theory holds that specific risks can be diversified by building portfolios of securities whose returns are not correlated. MPT seeks to reduce the risk in a portfolio while simultaneously increasing expected returns.
Holding securities that tend to move in the same direction as one another does not lower an investor’s risk. Diversification reduces risk only when assets whose prices move inversely, or at different times, in relation to one another are combined.
Modern portfolio theory wants
wants securities in a portfolio to have negative correlation, not positive correlation. Perfect negative correlation is –1.0 and would indicate that if one security goes up, the other security would go down the same amount. Obviously, this is not an exact science, but it is an indication of the movement of the portfolio.
Some analysis tools that are used in MPT include the following terms.
Capital Asset pricing model
The CAPM is used to calculate the return that an investment should achieve based on the risk that is taken. The more risk taken, the higher the potential returns. Investors should be rewarded for the risk they take. CAPM calculates a required return based on a risk multiplier called the beta coefficient.
A portfolio’s total risk is made up of unsystematic risk and systematic risk. If an investor has a diversified portfolio, unsystematic risk is reduced to almost zero. Therefore, the only real risk is systematic risk and this is the risk that needs a required return.
Investors with a well-diversified portfolio will find that the risk affecting the portfolio is wholly systematic (markets moving together). Individual investments have both systematic and unsystematic risk; however, in a portfolio that is diversified, only the systematic risk of a new security would be relevant.
In other words, if an individual investment becomes part of a well-diversified portfolio, the unsystematic risk can be ignored.
Beta (beta coefficient)
Beta and beta coefficient mean the same thing. In the securities industry, coefficient is ordinarily dropped for purposes of convenience. A stock or portfolio’s beta is a measure of its volatility in relation to the overall market (systematic risk). The overall market is typically based on the S&P 500. A security that has a beta of one moves in line with the market. A security or portfolio with a beta of greater than one is generally going to be more volatile than the overall market. The reverse is true when the beta is less than one.
A security that does not move in relation to market movement would have a beta of zero. For example, a money market security or money market mutual fund would have a beta of close to zero.
alpha
Analysts advise when to buy, sell, or hold securities. The CAPM is a method that analysts may use to make these decisions. Based on its beta, an analyst would calculate the expected return for the security.
Alpha is the extent to which an asset’s or portfolio’s actual return exceeds or falls short of its expected return. A positive alpha would indicate a buy recommendation.
a positive or negative alpha is desirable
positive alpha
Fundamental analysis
Fundamental analysis is the study of the business prospects of an individual company within the context of its industry and the overall economy.
They do this by examining the company in detail, including the financial statements and company management.
business cycle
Expansion
Peak
Contraction
Trough
Defensive industries
are least affected by normal business cycles. Companies in defensive industries generally produce nondurable consumer goods, such as: ■ food; ■ pharmaceuticals; ■ tobacco; and ■ utilities.
sector rotation
will “rotate” into defensive issues when it appears the business cycle is headed into the contraction phase. They then rotate into cyclical issues when the economy is in the expansion phase. This is also called segment rotation.
cyclical industries
are highly sensitive to business cycles and inflation trends. Most cyclical industries produce:
■ steel;
■ heavy equipment (such as tractors, airplanes, cranes);
■ automobiles; and
■ capital goods (such as washers and dryers).
During recessions, the demand for durable goods declines as manufacturers postpone investments in new capital goods and consumers postpone purchases of automobiles.
Cyclical industries perform better in expanding economies.
countercyclical industries
Countercyclical industries, on the other hand, tend to turn down as the economy heats up and to rise when the economy turns down. Gold and gold mining stocks have historically been a countercyclical industry.
growth industries
Every industry passes through four phases during its existence: introduction, growth, maturity, and decline. An industry is considered in its growth phase if the industry is growing faster than the economy as a whole because of technological changes, new products, or changing consumer tastes.
Technology associated with computers and bioengineering are considered growth industries. Because many growth companies retain nearly all of their earnings to finance their business expansion, growth stocks usually pay little or no dividends.
special situation stocks
Special situation stocks are stocks of a company with unusual profit potential resulting from nonrecurring circumstances, such as new management, the discovery of a valuable natural resource on corporate property, or the introduction of a new product.
financial statements
A corporation’s financial statements provide a fundamental analyst with the information needed to assess that corporation’s profitability, liquidity, financial strength (ability of cash flow to meet debt payments), and operating efficiency. By examining how certain numbers from one statement relate to prior statements, and how the resulting ratios relate to the com- pany’s competitors, the analyst can determine how financially viable the company is.
Companies issue quarterly and annual financial reports to the SEC. A company’s balance sheet and income statement are included in these reports.
balance sheet
The balance sheet provides a snapshot of a company’s financial position at a specific point in time. It identifies the value of the company’s assets (what it owns) and its liabilities (what it owes). The difference between these two figures is the corporation’s owners’ equity, or net worth.
equation =assets=liabilities +owners equity
assets
Assets appear on the balance sheet in order of liquidity, which is the ease with which they can be turned into cash. Assets that are most readily convertible into cash are listed first, followed by less liquid assets. Balance sheets commonly identify three types of assets: current assets (cash and assets easily convertible into cash), fixed assets (physical assets that could eventually be sold), and other assets (usually intangible and only of value to the corporation that owns them).
current assets
Current assets include all cash and other items expected to be converted into cash within the next 12 months, including the following.
■ Cash and equivalents include cash and short-term safe investments, such as money market instruments that can be readily sold, as well as other marketable securities.Accounts receivable include amounts due from customers for goods delivered or services
rendered, reduced by the allowance for bad debts.
■ Inventory is the cost of raw materials, work in process, and finished goods ready for sale.
■ Prepaid expenses are items a company has already paid for but has not yet benefited from, such as prepaid advertising, rents, insurance, and operating supplies.
fixed assets
Fixed assets are property, plant, and equipment. Unlike current assets, they are not easily converted into cash. Fixed assets, such as factories, have limited useful lives because wear and tear eventually reduce their value. For this reason, their cost can be depreciated over time or deducted from taxable income in annual installments to compensate for loss in value.
other assets
Intangible assets are nonphysical properties, such as formulas, brand names, contract rights, and trademarks. Goodwill, also an intangible asset, reflects the corporation’s reputation and relationship with its clients.
liabilities
Total liabilities on a balance sheet represent all financial claims by creditors against the corporation’s assets. Balance sheets usually include two main types of liabilities: current liabili- ties and long-term liabilities.
current liabilities
Current liabilities are corporate debt obligations due for payment within the next 12 months. These include the following:
■ Accounts payable—amounts owed to suppliers of materials and other business costs
■ Accrued wages payable—unpaid wages, salaries, commissions, and interest
■ Current long-term debt—any portion of long-term debt due within 12 months
■ Notes payable—the balance due on equipment purchased on credit or cash borrowed
■ Accrued taxes—unpaid federal, state, and local taxes
long term liabilities
are financial obligations due for payment after 12 months. Examples would include bonds and mortgages.
under current accounting practice, deferred tax credits are treated as
liability
shareholder equity
shareholder equity, also called net worth or owners’ equity, is the stockholder claims on a company’s assets after all its creditors have been paid. Shareholder equity equals total assets less total liabilities. On a balance sheet, three types of shareholder equity are identified: capital stock at par, capital in excess of par, and retained earnings.
capital stock at part
Capital stock includes preferred and common stock, listed at par value. Par value is the total dollar value assigned to stock certificates when a corporation’s owners (the stockholders) first contributed capital. Par value of common stock is an arbitrary value with no relationship to market price.
capital in excess of par
Capital in excess of par, often called additional paid-in capital or paid-in surplus, is the amount of money over par value that a company received for selling stock.
retained earnings
sometimes called earned surplus or accumulated earnings, are profits that have not been paid out in dividends. Retained earnings represent the total of all earnings held since the corporation was formed, less dividends paid to stockholders. Operating losses in any year reduce the retained earnings from prior years.
capitalization
is the combined sum of its long-term debt and equity securi- ties.
capital structure
The capital structure is the relative amounts of debt and equity that compose a compa- ny’s capitalization. Some companies finance their business with a large proportion of borrowed funds; others finance growth with retained earnings from normal operations and little or no debt.
Looking at the balance sheet, a corporation builds its capital structure with equity and debt, including the following four elements:
■ Long-term debt
■ Capital stock (common and preferred)
■ Capital in excess of par
■ Retained earnings (earned surplus)
financial leverage
Financial leverage is a company’s ability to use long-term debt to increase its return on equity. A company with a high ratio of long-term debt-to-equity is said to be highly leveraged. Stockholders benefit from leverage if the return on borrowed money exceeds the debt service costs. But leverage is risky because excessive increases in debt raise the possibility of
default in a business downturn.
In general, industrial companies with debt-to-equity ratios of 50% or higher are considered
highly leveraged. However, utilities, with their relatively stable earnings and cash flows, can be more highly leveraged without subjecting stockholders to undue risk. If a company is highly leveraged, it is also affected more by changes in interest rates.
working capital
Working capital is the amount of capital or cash a company has available. Working capital is a measure of a firm’s liquidity, which is its ability to quickly turn assets into cash to meet its short-term obligations.
working capital =current assets - current liabilities
current ratio
Knowing the amount of working capital is useful, but it becomes an even better indicator when paired with the current ratio. This computation uses the same two items—current assets and current liabilities—but expresses them as a ratio of one to the other. Simply divide the current assets by the current liabilities, and the higher the ratio, the more liquid the company is.
quick asset ratio
Sometimes it is important for the analyst to use an even stricter test of a company’s ability to meet its short-term obligations (as such, “pass the acid test”)The quick asset ratio uses the company’s quick assets instead of all of the current assets. Quick assets are current assets minus the inventory. Then divide these quick assets by the current liabilities to arrive at the quick ratio.
debt-equity ratio
The best way to measure the amount of financial leverage being employed by the company is by calculating the debt-to-equity ratio. It is really a misnomer—it should be called the debt- to-total capitalization ratio because that is what it is. For example, using the numbers in the capitalization example, we see that the total capital employed in the business is $90 million. Of that, $50 million is long-term debt. So, we want to know how much of the $90 million total is represented by debt capital. The answer is simple: $50 million of the $90 million, or 55.55%. That is the debt-to-equity ratio, and it indicates that this is a highly leveraged company (over 50%).
book value per share
A fundamental analyst is described as one who focuses on the company’s books. Therefore, one of the key numbers computed is the book value per share. The calculation is almost identical to one we have already studied—net asset value (NAV) per share of an investment company.
In the case of a corporation, it is basically the liquidation value of the enterprise. That is, let’s assume we sold all of our assets, paid back everyone we owe, and then split what is left among the stockholders. But, remember, before we can hand over anything to the common shareholders, we must take care of any outstanding preferred stock. So, from the funds that are left after we pay off all the liabilities, we give the preferred shareholders back their par (or stated) value and the rest belongs to the common stockholders.
But, there is one more thing. In the case of liquidation, some of the assets on our books might not really be worth what we’re carrying them at—in particular, those that are known as intangible assets (goodwill, patents, trademarks, copyrights, etc.). That is why the analyst uses only the tangible assets, computed by subtracting those intangibles from the total assets.
balance sheets
Balance sheets, by definition, must balance. Every financial change in a business requires two offsetting changes on the company books, known as double-entry bookkeeping. For example, when a company pays a previously declared cash dividend, cash (a current asset) is reduced while dividends payable (a current liability of the same amount) is eradicated. This results in no change to working capital or net worth because each side of the balance sheet has been lowered by the same amount.
book value per share formula
tangible assets- liabilities-par value perfered
_________
shares of common outstanding stock
depreciating assets
Because fixed assets (e.g., buildings, equipment, and machinery) wear out as they are used, they decline in value over time. This decline in value is called depreciation. A company’s tax bills are reduced each year the company depreciates fixed assets used in the businesses.
Depreciation affects the company in two ways: accumulated depreciation reduces the value of fixed assets on the balance sheet, and the annual depreciation deduction reduces tax- able income on the income statement.
Companies may elect either straight-line or accelerated depreciation. By use of the straight-line method, a company depreciates fixed assets by an equal amount each year over the asset’s useful life. A piece of equipment costing $1 million with a 10-year useful life will generate a depreciation deduction of $100,000 per year.
Accelerated depreciation is a method that depreciates fixed assets more during the earlier years of their useful life and less during the later years.
footnotes
Footnotes to the financial statements identify significant financial and management issues that may affect the company’s overall performance, such as accounting methods used, extraor- dinary items, pending litigation, and management philosophy.
Typically, a company separately discloses details about its long-term debt in the footnotes. These disclosures are useful for determining the timing and amount of future cash outflows. The disclosures usually include a discussion of the nature of the liabilities, maturity dates, stated and effective interest rates, call provisions and conversion privileges, restrictions imposed by creditors, assets pledged as security, and the amount of debt maturing in each of the next five years.
Also disclosed in the footnotes would be off-the-books financing arrangements, such as debt guarantees.
footnotes are generally found
found on the bottom of the financial statements and can be several pages long
income statement
The income statement, sometimes called the profit and loss or P&L statement, summarizes a company’s revenues (sales) and expenses for a fiscal period, usually quarterly, year to date, or the full year. It compares revenue against costs and expenses during the period. Fundamental analysts use the income statement to judge the efficiency and profitability of a company’s oper- ation. Just as with the balance sheet, technical analysts generally ignore this information—it is not relevant to their charting schemes.
revenues
indicate the firm’s total sales during the period (the money that came in).
cost of goods sold
is the costs of labor, material, and production (includ- ing depreciation on assets employed in production) used to create finished goods. Subtracting COGS from revenues shows the gross operating profit.
The two major methods of accounting for material costs are the first in, first out method (FIFO) and last in, first out method (LIFO). Under LIFO accounting, COGS normally will reflect higher costs of more recently purchased inventory (last items in). As a result of higher reported production costs under LIFO, reported income is reduced. The opposite is true if the FIFO method is used.
Pretax margin is determined by subtracting COGS and other operating costs (rent and utilities) from sales to arrive at net operating profit. The resulting figure is earnings before interest and taxes (EBIT).
Interest payments on a corporation’s debt is not considered an operating expense. However, interest payments reduce the corporation’s taxable income. Pretax income, the amount of tax- able income, is operating income less interest payment expenses.
If dividends are paid to stockholders, they are paid out of net income after taxes have been paid. After dividends have been paid, the remaining income is added to retained earnings and is available to invest in the business.
pretax income
the amount of tax- able income, is operating income less interest payment expenses.
If dividends are paid to stockholders, they are paid out of net income after taxes have been paid. After dividends have been paid, the remaining income is added to retained earnings and is available to invest in the business.
income statement shows
whats comes in, what goes out and how much is left before taxes
balance sheet reports
The balance sheet reports what resources (assets) a company owns and how
it has funded them. How the firm has financed the assets is revealed by the capital structure—for example, long-term debt and owners’ equity (preferred stock, common stock, and retained earnings)
interest payments _____a corporations taxable income
dividend payments to stock holders are paid from ___
because dividends are taxable as income to stockholders, they are taxed
interest payments are taxed
reduce
after tax dollars
twice
once
Accounting for depreciation
As mentioned earlier, when reviewing the balance sheet, fixed assets are shown at their cost minus accumulated depreciation. For these assets, which wear out over a period of time, tax law requires that the loss of value be deducted over the asset’s useful life, longer for some assets, shorter for others (you won’t have to know depreciation schedules). On the income statement, the allowable portion for the year is shown as an expense and, for our purposes, will generally be part of COGS. Remember, if the company uses accelerated depreciation, the expenses will be higher in the early years, resulting in lower pretax income (and lower-income taxes) but higher income later on.
earnings per share
EPS= Earns available to common
__________
number of shares outstanding
SPS after dilution
assumes that all convertible securities, such as warrants and convertible bonds and preferred stock, have been converted into the common. Because of tax adjustments, the calculations for figuring EPS after dilution can be complicated and will not be tested.
current yield (dividend yield)
A common stock’s current yield (CY), like the current yield on bonds, expresses the annual income payout (dividends rather than interest) as a percentage of the current stock price:
CY= annual dividends per common share
_________
Market value per common share
dividend payout ratio
The dividend payout ratio measures the proportion of earnings paid to stockholders as dividends:
=Annual dividends per common share
___________
Earnings per share
In general, older companies pay out larger percentages of earnings as dividends. Utilities as a group have an especially high payout ratio. Growth companies normally have the lowest ratios because they reinvest their earnings in the businesses. Companies on the way up hope to reward stockholders with gains in the stock value rather than with high dividend income.
statement of cash flow
The statement of cash flow reports a business’s sources and uses of cash and the beginning and ending values for cash and cash equivalents each year. The three components generating cash flow are:
■ operating activities;
■ investing activities; and
■ financing activities.
Most financial professionals add revenues and expenses that do not involve cash inflows or outflows (e.g., cost allocations, such as depreciation and amortization) back to the company’s net income to determine the cash flow.
As described previously, the cash flow statement will also reflect money from operations, financing, and investing, but not accounting changes.
operating activities
Operating activities (all transactions and events that normally enter into the determina- tion of operating income) include cash receipts (money coming in) from selling goods or pro- viding services, as well as income from items such as interest and dividends. Operating activi- ties also include cash payments (money going out) such as cost of inventory, payroll, taxes, interest, utilities, and rent. The net amount of cash provided (or used) by operating activities is the key figure on a statement of cash flows. Even though it would seem that interest and dividends would belong in investing activities, the accounting gurus put them here.
investing activities
Investing activities include transactions and events involving the purchase and sale of securities, land, buildings, equipment, and other assets not generally held for resale as a prod- uct of the business. It also covers the making and collecting of loans. Investing activities are not classified as operating activities because they have an indirect relationship to the central, ongoing operation of the business (usually the sale of goods or services).
financing activities
All financing activities deal with the flow of cash to or from the business owners (equity financing) and creditors (debt financing). For example, cash proceeds from issuing stock or bonds would be classified under financing activities. Likewise, payments to repurchase stock (treasury stock) or to retire bonds and the payment of dividends are also financing activitie
cash flow from operations will only use
items from the income statement, while cash flow from financing activities will use balance sheet items.Make sure you know which one the question is asking about.
Earnings before interest and taxes
EBIT helps a fundamental analyst to evaluate a company’s performance without incorporating interest expenses or income tax rates. Without accounting for interest or taxes that are variables for every company, the fundamental analyst can focus on operating profitability as a single measure of success.
This is very important when comparing companies within an industry that have different debt obligations or tax obligations.
It is calculated from information found on the income statement.
earnings before taxes
With EBIT, the analyst has taken out the tax structure when evaluating a company in an industry—once again, making it easier to compare companies within an industry. Note that a highly-leveraged company will have a relatively higher interest expense, and a lower EBT to a company with less debt obligations.
price-to-earnings ratio
The widely used price-to-earnings (P/E) ratio provides investors with a rough idea of the relationship between the prices of different common stocks compared with the earnings that accrue to one share of stock.
Current market price of a common share
_______
earnings per share
if the stocks market price and P/E are known, the EPS can be calculated
Current market price of common stock
_________
P/E ratio
technical analysis
Technical analysis attempts to predict the direction of prices on the basis of historic price and trading volume patterns when laid out graphically on charts.
Both technical and fundamental analyses attempt
to predict the supply and demand of markets and individual stocks.
fundamental analysis
concentrate on broad-based economic trends; current business conditions within an industry; and the quality of a particular corporation’s business, finances, and management.
market averages and indexes
Stock prices tend to move, or trend, together, although some move in the opposite direction. The average stock, by definition, tends to rise in a bull market and decline in a bear market. Technical analysts chart the daily prices and volume movements of individual stocks and market indexes to discern patterns that allow them to predict the direction of market price movements.
trading volume
Market trading volume substantially above normal signifies or confirms a pattern in the direction of prices. If overall volume has been listless for months and suddenly jumps significantly, a technical analyst views that as the beginning of a trend.
support and resistance levels
Stock prices may move within a narrow range for months or even years.
The bottom of this trading range is known as the support level;
the top of the trading range is called the resistance level.
bearish breakout
A decline through the support level
bullish breakout
a rise through the resistance level
breakouts usually signal the
beginning of a new upward or downward trend.
market breadth
The number of issues closing up or down on a specific day reflects market breadth. The number of advances and declines can be a significant indication of the market’s relative strength. When declines outnumber advances by a large amount, the market is bearish even if it closed higher. In bull markets, advances substantially outnumber declines.
advance/decline line
Technical analysts plot daily advances and declines on a graph to produce an advance/decline line that gives them an indication of market breadth trends.
charting stocks
In addition to studying the overall market, technical analysts attempt to identify patterns in the prices of individual stocks.
trendlines
Although a stock’s price may spike up or down daily, over time its price tends to move in one direction. Technical analysts identify patterns in the trendlines of individual stocks from graphs as they do patterns in the overall market. They base their buy or sell recommendations on a stock’s price trendline. An upward trendline is bullish; a downward one is bearish.
consolidations
If a stock’s price stays within a narrow range, it is said to be consolidating. When viewed on a graph, the trendline is horizontal and moves sideways, neither up nor down.
reversal
A reversal indicates that an upward or a downward trendline has halted, and the stock’s price is moving in the opposite direction. Between the two trendlines, a period of consolida- tion occurs, and the stock price levels off. A genuine reversal pattern can be difficult to rec- ognize because trends are composed of many rises and declines, which may occur at different rates and for different lengths of time.
saucer
Because of its gently curving shape, an easily identifiable reversal pattern
(reversal of a downtrend)
inverted saucer
reversal of an uptrend
head and shoulders
named for its resemblance to the human body.
head and shoulders top indicates
the beginning of a bearish trend in the stock. First, the stock price rises, then it reaches a plateau at the neckline (left shoulder). A second advance pushes the price higher, but then the price falls back to the neckline (head). Finally, the stock price rises again, but falls back to the neckline (right shoulder) and contin- ues downward, indicating a reversal of the upward trend.
head and shoulders bottom
and indicates a bullish reversal.
If market indexes such as the S&P 500 and the Dow are declining, but the number of declining stocks relative to the number of advancing stocks is failing (fewer stocks declining),
the market is said to be oversold and is likely to reverse itself.
Conversely, if market indexes are rising, but the number of declining stocks relative to the number of advancing stocks is rising (fewer stocks rising),
the market is said to be overbought and is ready for a correction.
technical analysis
Technical analysts follow various theories regarding market trends. Some of them are outlined next.
Dow Theory
Analysts use the Dow theory to confirm the end of a major market trend.
According to the theory, the three types of changes in stock prices
Primary trend(1 year or more) Secondary trend(3-12 weeks) short term fluctuations(hours or days)
odd-lot theory
Typically, small investors engage in odd-lot trading. Followers of the odd-lot theory believe that these small investors invariably buy and sell at the wrong times. When odd-lot traders buy, odd-lot analysts are bearish. When odd-lot traders sell, odd-lot analysts are bullish.
This theory goes way back in time. Think of the 1930s when a house might have cost $4,000. People took out mortgages for that kind of money. If a stock is priced at $40, and a round lot of that stock cost $4,000, most people didn’t have that kind of money. So they bought one or two shares because that is what they could afford. They were not necessarily well-informed investors and often traded on emotion—buying when they should have sold, selling when they should have bought.
The standard trading unit for equity securities
odd lot is
a round lot (100 shares)
less than 100 shares
short interest
refers to the number of shares that have been sold short. Because short posi- tions must be repurchased eventually, most analysts believe that short interest reflects man- datory demand, which creates a support level for stock prices. High short interest is a bullish indicator, and low short interest is a bearish indicator.
equity securities
Corporations issue equity (and debt) securities as a means of raising capital in order to implement ideas such as expanding operations or funding a merger or acquisition.
Investing in equity securities is perhaps the most visible and accessible means of creating wealth. Individual investors become owners of a publicly traded company by buying stock in that company. In doing so, they can participate in the company’s success over time. They also share in the risk of operating a business; they can lose their investment.
Equity securities are more risky for investors compared with bonds, because once you pay for a security, the issuer is under no obligation to ever give you any of your money back.
two types of equity securities
The two primary types of equity securities most investors are familiar with are common and preferred stocks. These are considered ownership positions in a corporation. All corporations issue common stock. Each share of common stock entitles its owner to a portion of the company’s profits and dividends and an equal vote on directors and other important matters. Most corporations are organized in such a way that their stockholders regularly vote for and elect candidates to a board of directors (BOD) to oversee the company’s business. By electing a BOD, stockholders have some say in the company’s management but are not involved with the day-to-day details of its operations.
common stock
Corporations may issue two types of stock: common and preferred. When speaking of stocks, people generally refer to common stock. Preferred stock represents equity ownership in a corporation, but it usually does not have the same voting rights or appreciation potential as common stock. Preferred stock normally pays a fixed, semiannual dividend and has priority claims over common stock; that is, the preferred is paid first if a company declares bankruptcy. Common stock can be classified as: ■ authorized; ■ issued; ■ outstanding; and ■ treasury.
authorized stock
refers to a specific number of shares the company has authorization to issue or sell. This is laid out in the company’s original charter. Often, a company sells only a portion of the authorized shares to raise enough capital for its foreseeable needs. The company may sell the remaining authorized shares in the future or use them for other purposes. Should the company decide to sell more shares than are authorized, the charter must be amended through a stockholder vote.
issued stock
has been authorized and distributed to investors. When a corporation issues, or sells, fewer shares than the total number authorized, it normally reserves the unissued shares for future needs, including:
■ raising new capital for expansion;
■ paying stock dividends;
■ providing stock purchase plans for employees or stock options for corporate officers;
■ exchanging common stock for outstanding convertible bonds or preferred stock; or
■ satisfying the exercise of outstanding stock purchase warrants.
Authorized but unissued stock does not carry the rights and privileges of issued shares and is not considered in determining a company’s total capitalization.
outstanding stock
includes any shares that a company has issued but has not repurchased— that is, stock that is investor owned.
treasury stock
Treasury stock is stock a corporation has issued and subsequently repurchased from the public. The corporation can hold this stock indefinitely or can reissue or retire it. A corporation could reissue its treasury stock to fund employee bonus plans, distribute it to stockholders as a stock dividend, or under certain circumstances, redistribute it to the public in an additional offering. Treasury stock does not carry the rights of outstanding common shares, such as voting rights and the right to receive dividends.
By buying its own shares in the open market, the corporation reduces the number of shares outstanding. If fewer shares are outstanding and operating income remains the same, EPS increase. A corporation buys back its stock for a number of reasons, such as to:
■ increase EPS;
■ have an inventory of stock available to distribute as stock options, fund an employee
pension plan, and so on; or
■ use for future acquisitions.
common shareholders rights
Common stockholders use their voting rights to exercise control of a corporation by electing a BOD and by voting on important corporate policy matters at annual meetings, such as:
■ issuance of convertible securities (dilutive to current stockholders) or additional common stock;
■ substantial changes in the corporation’s business, such as mergers or acquisitions; and
■ declarations of stock splits (forward and reverse).
Stockholders have the right to vote on the issuance of convertible securities because they will dilute current stockholders’ proportionate ownership when converted (changed into shares of common).
calculating the number of votes
A stockholder can cast one vote for each share of stock owned. Depending on the com- pany’s bylaws and applicable state laws, a stockholder may have either a statutory or cumula- tive vote.
statutory voting
Statutory voting allows a stockholder to cast one vote per share owned for each item on a ballot, such as candidates for the BOD. A board candidate needs a simple majority to be elected.
cumulative voting
Cumulative voting allows stockholders to allocate their total votes in any manner they choose.
Shareholders do not vote on dividend-related matters,such as when they are declared and how much they will be.
they do
They do vote on stock splits, board members, and issuance of additional equity-related securities such as common stock, preferred stock, and convertible securities.
cumulative voting benefits the
statutory voting benefits
smaller investor
larger shareholders
t is not uncommon for one company to attempt to takeover another by acquir- ing a significant percentage of its voting shares.
known as
tender offer
A tender offer may also be made by an issuer of noncallable bonds when interest rates have fallen.
The SEC defines tender offer as “an active and widespread solicitation by a company or third party (often called the bidder or offeror) to purchase a substantial percentage of the company’s securities. Bidders may conduct tender offers to acquire equity (common stock) in a particular company or debt issued by the company. A tender offer where the company seeks to acquire its own securities is often referred to as an issuer tender offer. A tender offer where a third party seeks to acquire another company’s securities is referred to as a third party tender offer.”
In general, tender offers for equity securities need shareholder approval.
proxies
Stockholders often find it difficult to attend the annual stockholders’ meeting, so most vote on company matters by means of a proxy, a form of an absentee ballot. After it has been returned to the company, a proxy can be automatically canceled if the stockholder attends the meeting, authorizes a subsequent proxy, or dies. When a company sends proxies to shareholders, usually for a specific meeting, it is known as a proxy solicitation.
Companies that solicit proxies must supply detailed and accurate information to the shareholders about the proposals to be voted on. Before making a proxy solicitation, companies must submit the information to the SEC for review.
If a proxy vote could change control of a company (a proxy contest), all persons involved in the contest must register with the SEC as participants or face criminal penalties. This registration requirement includes anyone providing unsolicited advice to stockholders about how to vote. However, registered representatives who advise customers who request advice are not considered to be participants. A stockholder may revoke a proxy at any time before the company tabulates the final vote at its annual meeting.
The cost of forwarding proxy material, annual reports, information statements, and other material to shareholders is reimbursed by the issuer to the member firms that send the materials. Reimbursed expenses include postage (including return postage) at the lowest available rate, the cost of envelopes (if not provided by the issuer), and communication expenses (excluding overhead) incurred when receiving voting returns either electronically or over the phone.
nonvoting common stock
Companies may issue both voting and nonvoting (or limited voting) common stock, normally differentiating the issues as Class A and Class B, respectively. Issuing nonvoting stock allows a company to raise additional capital while maintaining management control and continuity without diluting voting power.
preemptive rights
When a corporation raises capital through the sale of additional common stock, it may be required by law or its corporate charter to offer the securities to its common stockholders
before the general public. This is known as an antidilution provision. Stockholders then have a preemptive right to purchase enough newly issued shares to maintain their proportionate ownership in the corporation.
limited liability
Stockholders cannot lose more than the amount they have paid for a corporation’s stock. Limited liability protects stockholders from having to pay a corporation’s debts in bankruptcy.
inspection of corporate
Stockholders have the right to receive annual financial statements and obtain lists of stockholders. Inspection rights do not include the right to examine detailed financial records or the minutes of BOD meetings.
residual claims to assets
If a corporation is liquidated, the common stockholder (as owner) has a residual right to claim corporate assets after all debts and other security holders have been satisfied. The com- mon stockholder is at the bottom of the liquidation priority list.
stock split
Although investors and executives are generally delighted to see a company’s stock price rise, a high market price may inhibit trading of the stock. To make the stock price attractive to a wider base of investors—that is, retail versus institutional investors—the company can declare a stock split.
foward split
A forward stock split increases the number of shares and reduces the price without affect- ing the total market value of shares outstanding; an investor will receive more shares, but the value of each share is reduced. The total market value of the ownership interest is the same before and after the split.
reverse split
A reverse split has the opposite effect on the number and price of shares. After a reverse split, investors own fewer shares worth more per share.
capital appreciation
An increase in the market price of shares is known as capital appreciation. Historically, owning common stock has provided investors with high real returns.
income
Many corporations pay regular quarterly cash dividends to stockholders, but dividends are not considered to be fixed like the dividend stated on preferred stock. A company’s dividends may increase over time as profitability increases. Dividends, which can be a significant source
of income for investors, are a major reason many people invest in stocks. Issuers may also pay stock dividends (additional shares in the issuing company) or property dividends (shares in a subsidiary company or a product sample).
Stock dividends, rather than cash dividends, are more likely to be paid by companies that wish to reinvest earnings for research and development. Technology companies, aggressive growth companies, and new companies are examples of companies likely to pay stock a stock dividend. When a stock dividend is paid, the shareholder receives more common stock of the issuer. There is no economic benefit, because the price of the security is reduced by the amount of the distribution on the morning of the ex-date.
just read it
preferred stock
Preferred stock is an equity security because it represents ownership in the corporation. However, it does not normally offer the appreciation potential associated with common stock. Not all corporations issue preferred stock.
Like a bond, a preferred stock is issued with a fixed (stated) rate of return. In the case of the preferred stock, it is a dividend rather than interest that is being paid. As such, these securities
are generally purchased for income. Although the dividend of most preferred stocks is fixed, some are issued with a variable dividend payout known as adjustable-rate preferred stock. Like other fixed-income assets such as bonds, preferred stock prices tend to move inversely with interest rates. Most preferred stock is nonvoting.
Preferred stock does not typically have the same growth potential as common stock and therefore is subject to inflation risk. However, preferred stockholders generally have two advantages over common stockholders.
■ When the BOD declares dividends, owners of preferred stock must receive their stated dividend in full before common stockholders may be paid a dividend.
■ If a corporation goes bankrupt, preferred stockholders have a priority claim over common stockholders on the assets remaining after creditors have been paid.
Because of these features, preferred stock appeals to investors seeking income and safety.
fixed dividend
Preferred stock’s fixed dividend is a key attraction for income-oriented investors. Normally, a preferred stock is identified by its annual dividend payment stated as a percentage of its par value, which is usually $100 on the Series 7 exam. (A preferred stock’s par value is meaningful to the investor, unlike that of common stock.) A preferred stock with a par value of $100 that pays $6 in annual dividends is known as a 6% preferred. The dividend of preferred stock with par value other than $100 is stated in a dollar amount, such as a $6 preferred.
The stated rate of dividend payment causes the price of preferred stock to act like the price of a bond: prices and interest rates have an inverse relationship.
preferred stock represents
ownership in a company like common stock but is sensitive to interest rates- just like the price of a bond
preferred stock unlike bonds has no preset date at which it matures and no scheduled redemption date or maturity levels
straight preferred
has no special features beyond the stated dividend payment. Missed dividends are not paid to the holder. The year’s stated dividend must be paid on straight pre- ferred if any dividend is to be paid to common shareholders.
cumulative preferred
Buyers of preferred stock expect fixed dividend payments. The directors of a company in financial difficulty can reduce or suspend dividend payments to both common and preferred stockholders. With cumulative preferred, any dividends in arrears must be paid before paying a common dividend.
convertible preferred
A preferred stock is convertible if the owner can exchange each preferred share for shares of common stock. The price at which the investor can convert is a preset amount and is noted on the stock certificate. Because the value of a convertible preferred stock is linked to the value of the issuer’s common stock, the convertible preferred’s price fluctuates in line with the common.
Convertible preferred is often issued with a lower stated dividend rate than nonconvertible preferred because the investor may have the opportunity to convert to common shares and enjoy capital gains. In addition, the conversion of preferred stock into shares of common increases the total number of common shares outstanding, which decreases earnings per common share and may decrease the common stock’s market value. When the underlying common stock has the same value as the convertible preferred, it is said to be at its parity price.
participating perferred
In addition to fixed dividends, participating preferred stock offers owners a share of cor- porate profits that remain after all dividends and interest due other securities are paid. The percentage to which participating preferred stock participates is noted on the stock certificate. Before the participating dividend can be paid, a common dividend must be declared.
callable preferred
Corporations often issue callable preferred or redeemable preferred, which a company can buy back from investors at a stated price on the call date or any date thereafter. The right to call the stock allows the company to replace a relatively high fixed dividend obligation with a lower one should interest rates decline.
adjustable rate preferred
Some preferred stocks are issued with adjustable/variable dividend rates. Such dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bill and money market rates, and can be adjusted as often as semiannually.
preemptive rights
Existing stockholders have preemptive rights or stock rights that entitle them to main- tain their proportionate ownership in a company by buying newly issued shares before the company offers them to the general public.
rights offering
A rights offering allows stockholders to purchase common stock below the current market price. The rights are valued separately from the stock and trade in the secondary market during the subscription period.
A stockholder who receives rights may:
■ exercise the rights to buy stock by sending the rights certificates and a check for the required amount to the rights agent;
■ sell the rights and profit from their market value (rights certificates are negotiable securities); or
■ let the rights expire and lose their value.
subscription right certificate
A subscription right is a certificate representing a short-term (typically 30 to 45 days) privilege to buy additional shares of a corporation. One right is issued for each common stock share outstanding.
terms of the offering
The terms of a rights offering are stipulated on the subscription right certificates mailed to stockholders. The terms describe how many new shares a stockholder may buy, the price, the date the new stock will be issued, and the final date for exercising the rights.
investor who buys cum rights
investor who buys ex rights
receives the right
does not receive the right
value of one right
market price -subscription price
_________
number of rights to purchase 1 share +1
warrant
A warrant is a certificate granting its owner the right to purchase securities from the issuer at a specified price (normally higher than the current market price) as of the date of issue of the warrant. Warrants represent the right to purchase shares but, in and of themselves, do not represent ownership. Therefore, warrant holders do not have voting rights until they exercise the warrants and become shareholders. Unlike a right, a warrant is usually a long-term instru- ment, giving the investor the choice of buying shares at a later date at the exercise price.
origination of warrents
Warrants are usually offered to the public as (sweeteners), or inducements, in connection with other securities, such as bonds or preferred stock, to make those securities more attrac- tive. The issuer is able to reduce the cost of debt or the fixed dividend of preferred stock because of the added benefit to investors that allows them to exercise the warrant. Such offer- ings are often bundled as (units.)
American depository recipes
American Depositary Receipts (ADRs) are negotiable security instruments that are issued by a domestic (U.S.) bank and trade on the U.S. securities markets. Each ADR represents a specific number of shares in a foreign company held by a custodian, typically a bank in that company’s country. The stock must remain on deposit as long as the ADRs are outstanding because the ADRs are the depositary bank’s guarantee that it holds the stock.
rights of ADR owners
ADR owners have most of the rights common stockholders normally hold. These include the right to receive dividends when declared. Generally, ADRs do not have voting rights, though some ADR issuers will pass on voting rights to the holders of ADRs. As for preemptive rights, the issuing bank sells off the rights and distributes the proceeds pro rata to holders.
delivery of foreign security
ADR owners have the right to exchange their ADR certificates for the foreign shares they represent. They can do this by returning the ADRs to the depositary banks, which cancel the ADRs and deliver the underlying stock.
Taxes on ADR’s
In most countries, a withholding tax on dividends is taken at the source. In the case of investors holding ADRs, this would be a foreign income tax. The foreign income tax may be taken as a credit against any U.S. income taxes owed by the investor.
currency risk
In addition to the normal risks associated with stock ownership, ADR investors are sub- ject to currency risk, the possibility that an investment denominated in one currency could decline if the value of that currency declines in its exchange rate with the U.S. dollar.
Currency exchange rates are an important consideration because ADRs represent shares of stock in companies located in foreign countries.
registered owner
ADRs are registered on the books of the U.S. banks responsible for them. The individual investors in the ADRs are not considered the stock’s registered owners. ADRs are registered on the books of U.S. banks, so dividends are sent to the custodian banks as registered owners. The banks collect the payments and convert them into U.S. dollars.
Sponsored adrs
All exchange-listed ADRs are sponsored—that is, the foreign company sponsors the issue to increase its ownership base. Issuers that sponsor ADRs provide holders with financial statements in English. Sponsored ADRs are sometimes referred to as American depositary shares (ADSs). Nonsponsored ADRs are issued by banks without the assistance and participation of the issuer.
penny stocks
The SEC adopted the penny stock cold-calling rules to prevent certain abusive sales practices involving high-risk securities sold to unsophisticated investors. These rules involve the solicitation of non-Nasdaq equity securities traded in the over-the-counter (OTC) market for less than $5 per share. These equity securities are frequently called penny stocks and are considered highly speculative.
These rules state that when a BD’s representative contacts a potential customer to purchase penny stocks, the representative must first determine suitability on the basis of information about the buyer’s financial situation and objectives. The customer must sign and date this suitability statement before the penny stock trades can be effected. In addition, the BD must disclose:
■ the name of the penny stock;
■ the number of shares to be purchased;
■ a current quotation; and
■ the aggregate amount of any compensation received by the firm in connection with such transaction.
Regardless of activity, if the account holds penny stocks, BDs must provide a monthly statement of account to the customer. This must indicate the market value and number of shares for each penny stock held in the account, as well as the issuer’s name.
established customer
Established customers are exempt from the suitability statement requirement but not from
the disclosure requirements. An established customer is someone who:
■ has held an account with the BD for at least one year (and has made a deposit of funds or securities); or
■ has made at least three penny stock purchases of different issuers on different days.
Creditor of the company
When investors purchase a company’s debt, they lend money to the company, and as a creditor of the company, the company is obligated to pay investors back. Therefore, when a corporation issues debt, it is considered risky for the issuer and conservative for investors.
Bonds have a fixed value—usually $1,000 per bond (par or face value). If a bond is held until maturity, the investor will get that amount back, plus the interest the bond earns, unless the issuer of the bond defaults, or fails to pay. In addition to the risk of default, investors also face potential market risk if bonds are sold before maturity.
For example, if the price of the bonds in the secondary market—or what other investors will pay to buy them—is less than par, and the bonds are sold at that point, the investor may realize a loss on the sale.
The market value of bonds may decrease if there’s a rise in interest rates between the time the bonds were issued and their maturity dates. In that case, demand for older bonds paying lower rates decreases. If sold at that time, investors potentially take that loss. Market prices can also fall below par if the bonds are downgraded by an independent rating agency because of problems with the company’s finances.
Bonds are riskier for issuers to issue than issuing stock because when an investor purchases a bond, the issuer is obligated to pay interest as scheduled, and the principal at maturity. Failure to do so can lead to a bankruptcy filing.
current yield=
annual income/ current market price
rating services such as standard and poors and moody investors service
evaluate the credit quality of bond issues and publish their ratings. S&P and Moody’s rate both corporate and municipal bonds. Both base their bond ratings primarily on an issuer’s creditworthiness—that is, the issuer’s ability to pay interest and principal as they come due.
A plus or minus sign in an S&P rating indicates that the bond falls within the top (+) or bottom (–) of that particular category. Moody’s uses A1 and Baa1 to indicate the highest- quality bonds within those two categories. Moody’s provides ratings for short-term municipal notes, designating MIG 1–4 (best–adequate) and SG (speculative grade).
The rating organizations rate those issues that either pay to be rated or have enough bonds outstanding to generate constant investor interest. The fact that a bond is not rated does not indicate its quality; many issues are too small to justify the expense of a bond rating.
secured bond
when the issuer has identified specific assets as collateral for interest and principal payments.
in a default for bonds
In a default, the bondholder can lay claim to the collateral.
mortgage bonds
have the highest priority among all claims on assets pledged as collateral. Although mortgage bonds, in general, are considered relatively safe, individual bonds are only as secure as the assets that secure them and are rated accordingly. When multiple classes of a mortgage bond exist, the first claim on the pledged property goes to first-mortgage bonds, second claim to second-mortgage bonds, and so on.
collateral trust bonds
are issued by corporations that own securities of other companies as investments. A corporation issues bonds secured by a pledge of those securities as collateral. The trust indenture usually contains a covenant requiring that a trustee hold the pledged securities. Collateral trust bonds may be backed by:
■ another company’s stocks and bonds;
■ stocks and bonds of partially or wholly owned subsidiaries;
■ pledging company’s prior lien long-term bonds that have been held in trust to secure short-term bonds; or
■ installment payments or other obligations of the corporation’s clients.
collateral trust bonds
are issued by corporations that own securities of other companies as investments. A corporation issues bonds secured by a pledge of those securities as collateral. The trust indenture usually contains a covenant requiring that a trustee hold the pledged securities. Collateral trust bonds may be backed by:
■ another company’s stocks and bonds;
■ stocks and bonds of partially or wholly owned subsidiaries;
■ pledging company’s prior lien long-term bonds that have been held in trust to secure short-term bonds; or
■ installment payments or other obligations of the corporation’s clients.
Equipment trust certificates
Railroads, airlines, trucking companies, and oil companies use equipment trust certificates (ETCs), or equipment notes and bonds, to finance the purchase of capital equipment. ETCs are issued serially so that the amount outstanding goes down year to year in line with the depreciating value of the collateral (e.g., aircraft or railroad cars).
Title to the newly-acquired equipment is held in trust, usually by a bank, until all certificates have been paid in full. Because the certificates normally mature before the equipment wears out, the amount borrowed is generally less than the full value of the property securing the certificates.
unsecured bonds
have no specific collateral backing and are classified as either debentures or subordinated debentures.
debentures
Debentures are backed by the general credit of the issuing corporation, and a debenture owner is considered a general creditor of the company. Debentures are below secured bonds and above subordinated debentures and preferred and common stock in the priority of claims on corporate assets.
subordinated debentures
The claims of subordinated debenture owners are paid last of all debt obligations, including general creditors, in the case of liquidation. Subordinated debentures generally offer higher yields than either straight debentures or secured bonds because of their subordinate (thus riskier) status, and they often have conversion features.
liquidation (who gets stuff first)
In the event a company goes bankrupt, the hierarchy of claims on the company’s assets is:
■ secured debt (bonds and mortgages);
■ unsecured liabilities (debentures) and general creditors;
■ subordinated debt;
■ preferred stockholders; and
■ common stockholders.
guaranteed bonds
Guaranteed bonds are backed by a company other than the issuer, such as a parent company. This backing effectively increases the issue’s safety.
income bonds
Income bonds, also known as adjustment bonds, are used when a company is reorganizing and coming out of bankruptcy. Income bonds pay interest only if the corporation has enough income to meet the interest payment and if the BOD declares a payment. Because missed interest payments do not accumulate for future payment, these bonds are not suitable investments for customers seeking income.
zero coupon bonds
Bonds are normally issued as interest-paying securities. Zero-coupon bonds (zeroes) are an issuer’s debt obligations that do not make regular interest payments. Instead, zeroes are issued, or sold, at a deep discount to their face value and mature at par. The difference between the discounted purchase price and the full face value at maturity is the return, or accreted interest, the investor receives.
The price of a zero-coupon bond reflects the general interest rate climate for similar maturities. Zero-coupon bonds are issued by corporations, municipalities, and the U.S. Treasury and may be created by BDs from other types of securities.
advantages and disadvantages of zero coupon bonds
A zero-coupon bond requires a relatively small investment, perhaps $300 to $400 per bond, and matures at $1,000. Zero-coupon bonds offer investors a way to speculate on interest rate moves. Because they sell at deep discounts and offer no cash interest payments to the holder, zeroes are substantially more volatile than traditional bonds; their prices fluctuate wildly with changes in market rates. Moreover, the longer the time to maturity, the greater the volatility. When interest rates change, a zero’s price changes much more as a percentage of its market value than an ordinary bond’s price.
taxation of zero coupon bonds
Although zeroes pay no regular interest income, investors in zeroes owe income tax each year on the amount by which the bonds have accreted, just as if the investor had received it in cash. The income tax is due regardless of the direction of the market price.
zero coupon bonds which are purchased at a discount and mature at face value are
are a suitable investment for future anticipated expenses, such as college tuition.
Taxation on zero coupon bonds
Although zeroes pay no regular interest income, investors in zeroes owe income tax each year on the amount by which the bonds have accreted, just as if the investor had received it in cash. The income tax is due regardless of the direction of the market price.
If the exam asks you to choose the security that has no reinvestment risk, the answer to
look for is a zero because, with no interest payments to reinvest, the investor has no reinvestment risk. Furthermore, because there is no reinvestment risk, buying a zero is the only way to lock in a rate of return.
convertible bonds
are corporate bonds that may be exchanged for a fixed number of shares of the issuing company’s common stock. They are convertible into common stock, so convertible bonds pay lower interest rates than nonconvertible bonds and generally trade in line with the common stock. Convertible bonds have fixed interest payments and maturity dates, so they are less volatile than common stock.
- 1 Advantages of Convertible Securities to the Issuer
A corporation adds a conversion feature to its bonds or preferred stock to make it more marketable. Other reasons corporations issue convertible securities include the following.
■ Convertibles can be sold with a lower coupon rate than nonconvertibles because of the conversion feature.
■ A company can eliminate a fixed interest charge as conversion takes place, thus reducing debt.
■ Because conversion normally occurs over time, it does not have an adverse effect on the stock price, which may occur after a subsequent primary offering.
■ By issuing convertibles rather than common stock, a corporation avoids immediate dilution of primary earnings per share (EPS).
■ At issuance, conversion price is higher than market price of the common stock.
Disadvantages of Convertible Securities to the Issuer
On the other hand, convertibles have potential disadvantages for a corporation and its stockholders.
■ When bonds are converted, shareholders’ equity is diluted; that is, more shares are outstanding, so each share now represents a smaller fraction of ownership in the company.
■ Common stockholders have a voice in the company’s management, so a substantial conversion could cause a shift in the control of the company.
■ Reducing corporate debt through conversion means a loss of leverage.
■ The resulting decrease in deductible interest costs raises the corporation’s taxable income.
Therefore, the corporation pays increased taxes as conversion takes place.
convertible debenture
pays interest at a fixed rate and is redeemable for its face value at maturity, provided the debenture is not converted. As a rule, interest income is higher and surer than dividend income on the underlying common stock. Similarly, convertible preferred stock usually pays a higher dividend than does common stock.
conversion price
The conversion price is the stock price at which a convertible bond can be exchanged for shares of common stock.
conversion ratio
The conversion ratio, also called the conversion rate, expresses the number of shares of stock a bond may be converted into.
PArity
means that two securities are of equal dollar value (in this case, a convertible bond and the common stock into which it can be converted).
When the equity market is strong and stock prices are rising
the convertible’s value rises with the underlying common stock’s value.
When equity prices are declining
the convert- ible’s market price declines as well but generally levels off when its yield becomes competitive with the yield on nonconvertible bonds. This tends to keep it from declining as much as the common stock. Convertible bonds normally sell at a premium above parity, which is why they are not constantly exchanged for common stock when the stock price is rising.
equity linked notes
are debt instruments where the final payment at maturity is based on the return of a single stock, a basket of stocks, or an equity index. In the case where the note is based on the return of an index, the security would be known as an index-linked note. In the instances where the securities are traded on an exchange (most still are not), they are generally referred to as exchange-traded notes (ETNs). ELNs, exchange-traded or not, are considered nonconventional structured products with unique risks, and therefore, not suitable for most investors.
Collaterzlied mortgage obligations
are a type of asset-backed security. Asset-backed securities are ones whose value and income payments are derived from or backed by a specific pool of underlying assets. These pools of assets can include expected payments from different types of loans such as mort- gages—as is the case with CMOs—auto loans, or other types of loans. In some instances, asset-backed securities can pool expected cash flow from credit cards, leases, or even royalty payments.
Pooling the assets into financial instruments allows them to be sold to general investors more easily than selling them individually. This process is called securitization, and it allows the risk of investing in the underlying assets to be diversified because each security will now represent only a fraction of the total value of the diverse pool of underlying assets. CMOs pool a large number of mortgages, usually on single-family residences. A pool of mortgages is structured into maturity classes called tranches (the French word for slice). CMOs are issued by private-sector financing corporations and are often backed by Ginnie Mae, Fannie Mae, and Freddie Mac pass-through securities. As a result, CMOs backed by government agency securities have historically been rated high.
A CMO pays principal and interest from the mortgage pool monthly; however, it repays principal to only one tranche at a time. In addition to interest payments, investors in a short- term tranche must receive all of their principal before the next tranche begins to receive principal repayments. Principal payments are made in $1,000 increments to randomly selected bonds within a tranche. Changes in interest rates affect the rate of mortgage prepayments, and this, in turn, affects the flow of interest payment and principal repayment to the CMO investor.
Principal only CMos
The flow of income from underlying mortgages is divided into principal and interest streams and directed to the owners of POs and interest-only CMOs (IOs), respectively. For a PO, the income stream comes from principal payments on the underlying mortgages—both scheduled mortgage principal payments and prepayments. Thus, the security ultimately repays its entire face value to the investor.
A PO sells at a discount from par; the difference between the discounted price and the principal value is the investor’s return. Its market value, like all deeply-discounted securities, tends to be volatile. POs, in particular, are affected by fluctuations in prepayment rates. The value of a PO rises as interest rates drop and prepayments accelerate, and its value falls when interest rates rise and prepayments decline.
Taxation on zero coupon bonds
Although zeroes pay no regular interest income, investors in zeroes owe income tax each year on the amount by which the bonds have accreted, just as if the investor had received it in cash. The income tax is due regardless of the direction of the market price.
If the exam asks you to choose the security that has no reinvestment risk, the answer to
look for is a zero because, with no interest payments to reinvest, the investor has no reinvestment risk. Furthermore, because there is no reinvestment risk, buying a zero is the only way to lock in a rate of return.
convertible bonds
are corporate bonds that may be exchanged for a fixed number of shares of the issuing company’s common stock. They are convertible into common stock, so convertible bonds pay lower interest rates than nonconvertible bonds and generally trade in line with the common stock. Convertible bonds have fixed interest payments and maturity dates, so they are less volatile than common stock.
- 1 Advantages of Convertible Securities to the Issuer
A corporation adds a conversion feature to its bonds or preferred stock to make it more marketable. Other reasons corporations issue convertible securities include the following.
■ Convertibles can be sold with a lower coupon rate than nonconvertibles because of the conversion feature.
■ A company can eliminate a fixed interest charge as conversion takes place, thus reducing debt.
■ Because conversion normally occurs over time, it does not have an adverse effect on the stock price, which may occur after a subsequent primary offering.
■ By issuing convertibles rather than common stock, a corporation avoids immediate dilution of primary earnings per share (EPS).
■ At issuance, conversion price is higher than market price of the common stock.
Disadvantages of Convertible Securities to the Issuer
On the other hand, convertibles have potential disadvantages for a corporation and its stockholders.
■ When bonds are converted, shareholders’ equity is diluted; that is, more shares are outstanding, so each share now represents a smaller fraction of ownership in the company.
■ Common stockholders have a voice in the company’s management, so a substantial conversion could cause a shift in the control of the company.
■ Reducing corporate debt through conversion means a loss of leverage.
■ The resulting decrease in deductible interest costs raises the corporation’s taxable income.
Therefore, the corporation pays increased taxes as conversion takes place.
convertible debenture
pays interest at a fixed rate and is redeemable for its face value at maturity, provided the debenture is not converted. As a rule, interest income is higher and surer than dividend income on the underlying common stock. Similarly, convertible preferred stock usually pays a higher dividend than does common stock.
conversion price
The conversion price is the stock price at which a convertible bond can be exchanged for shares of common stock.
conversion ratio
The conversion ratio, also called the conversion rate, expresses the number of shares of stock a bond may be converted into.
PArity
means that two securities are of equal dollar value (in this case, a convertible bond and the common stock into which it can be converted).
When the equity market is strong and stock prices are rising
the convertible’s value rises with the underlying common stock’s value.
When equity prices are declining
the convert- ible’s market price declines as well but generally levels off when its yield becomes competitive with the yield on nonconvertible bonds. This tends to keep it from declining as much as the common stock. Convertible bonds normally sell at a premium above parity, which is why they are not constantly exchanged for common stock when the stock price is rising.
equity linked notes
are debt instruments where the final payment at maturity is based on the return of a single stock, a basket of stocks, or an equity index. In the case where the note is based on the return of an index, the security would be known as an index-linked note. In the instances where the securities are traded on an exchange (most still are not), they are generally referred to as exchange-traded notes (ETNs). ELNs, exchange-traded or not, are considered nonconventional structured products with unique risks, and therefore, not suitable for most investors.
Collaterzlied mortgage obligations
are a type of asset-backed security. Asset-backed securities are ones whose value and income payments are derived from or backed by a specific pool of underlying assets. These pools of assets can include expected payments from different types of loans such as mort- gages—as is the case with CMOs—auto loans, or other types of loans. In some instances, asset-backed securities can pool expected cash flow from credit cards, leases, or even royalty payments.
Pooling the assets into financial instruments allows them to be sold to general investors more easily than selling them individually. This process is called securitization, and it allows the risk of investing in the underlying assets to be diversified because each security will now represent only a fraction of the total value of the diverse pool of underlying assets. CMOs pool a large number of mortgages, usually on single-family residences. A pool of mortgages is structured into maturity classes called tranches (the French word for slice). CMOs are issued by private-sector financing corporations and are often backed by Ginnie Mae, Fannie Mae, and Freddie Mac pass-through securities. As a result, CMOs backed by government agency securities have historically been rated high.
A CMO pays principal and interest from the mortgage pool monthly; however, it repays principal to only one tranche at a time. In addition to interest payments, investors in a short- term tranche must receive all of their principal before the next tranche begins to receive principal repayments. Principal payments are made in $1,000 increments to randomly selected bonds within a tranche. Changes in interest rates affect the rate of mortgage prepayments, and this, in turn, affects the flow of interest payment and principal repayment to the CMO investor.
Principal only CMos
The flow of income from underlying mortgages is divided into principal and interest streams and directed to the owners of POs and interest-only CMOs (IOs), respectively. For a PO, the income stream comes from principal payments on the underlying mortgages—both scheduled mortgage principal payments and prepayments. Thus, the security ultimately repays its entire face value to the investor.
A PO sells at a discount from par; the difference between the discounted price and the principal value is the investor’s return. Its market value, like all deeply-discounted securities, tends to be volatile. POs, in particular, are affected by fluctuations in prepayment rates. The value of a PO rises as interest rates drop and prepayments accelerate, and its value falls when interest rates rise and prepayments decline.
Interest only cms
IOs are by-products of POs. Whereas POs receive the principal stream from underlying mortgages, IOs receive the interest. An IO also sells at a discount, and its cash flow declines over time, just as the proportion of interest in a mortgage payment declines over time. Unlike POs, IOs increase in value when interest rates rise, and they decline in value when interest rates fall because the number of interest payments changes as prepayment rates change. Thus, they can be used to hedge a portfolio against interest-rate risk.
When prepayment rates are high, the owner of an IO may receive fewer interest payments than anticipated. Because the entire CMO series receives more principal sooner, and therefore less overall interest, the IO owner does not know how long the stream of interest payments will last.
Planned amortization class
PACs have targeted maturity dates; they are retired first and offer protection from prepay- ment risk and extension risk (the chance that principal payments will be slower than antici- pated) because changes in prepayments are transferred to companion tranches, also called support tranches.
Targeted amortization class
A TAC structure transfers prepayment risk only to a companion tranche and does not offer protection from extension risk. TAC investors accept the extension risk and the resulting greater price risk in exchange for a slightly higher interest rate.
zero tranche
A Z-tranche CMO receives no payment until all preceding CMO tranches are retired (the most volatile CMO tranches).
Z-tranche CMOs would not be suitable for
an investor needing funds in a specified amount of time, due to the unpredictable nature of when payment will be received
CMO characteristics
Because mortgages back CMOs, they are considered relatively safe. However, their susceptibility to interest rate movements and the resulting changes in the mortgage repayment rate mean CMOs carry several risks. ■ The rate of principal repayment varies. ■ If interest rates fall and homeowner refinancing increases, principal is received sooner than anticipated (prepayment risk). ■ If interest rates rise and refinancing declines, the CMO investor may have to hold his investment longer than anticipated (extended maturity risk).
Yields
CMOs yield more than Treasury securities and normally pay investors interest and principal monthly. Principal repayments are made in $1,000 increments to investors in one tranche before any principal is repaid to the next tranche.
taxation
Interest from CMOs is subject to federal, state, and local taxes.
liquidity
There is an active secondary market for CMOs. However, the market for CMOs with more complex characteristics may be limited or nonexistent. Certain tranches of a given CMO may be riskier than others, and some CMOs in certain tranches carry the risk that repayment of principal may take longer than anticipated.
denominations
CMOs are issued in $1,000 denominations.
suitability
Some varieties of CMOs, such as PAC companion tranches, may be particularly unsuit- able for small or unsophisticated investors because of their complexity and risks. The customer is required to sign a suitability statement before buying any CMO. Potential investors must understand that the rate of return on CMOs may vary because of early repayment. Also note that the performance of CMOs may not be compared with any other investment vehicle.
cmo’s are
not backed by the us government, they are corporate instruments
interest paid is
taxable at all levels
cmos are backed by
mortgage pools
cmo yield more than
treasury securities
cmos are subject to
interest rate risk
cmos are issued
in 1,000 denominations and trade otc
pacs have
reduced prepayment and extension risk
tacs are
protected against prepayment risk but not extension risk
pacs have lower
yields than comparable TAC’s
Collateralized Debt obligations
CDOs are typically complex asset-backed securities. While CDOs do not specialize in any single type of debt, usually their portfolios consist of nonmortgage loans or bonds. The assets backing the CDOs can be a pool of bonds, auto loans, or other assets such as leases, credit card debt, a company’s receivables, or even derivative products of any of the assets listed. While the individual assets may be small and not very liquid, pooling the assets facilitates them being sold to individual investors in the secondary markets. This pooling or repackaging of assets is sometimes called securitization. Securitization allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the entire diverse pool of assets.
Similar in structure to CMOs, CDOs represent different types of debt and credit risk. Like CMOs, the different types of debt and risk categories are often called tranches. Each tranche has a different maturity and risk associated with it. The higher the risk, the more the CDO pays. In practice, investors will choose a tranche with a risk-and-return combination that is suitable for them.
Cautions when investing with CDOs should include the following.
■ Some CDOs are so complex that individual investors may not fully understand the product and, therefore, do not understand what they are purchasing. While the securitization of the assets easily enables their sale to individual investors, the product is recognized as being more suitable to institutional or sophisticated investors.
■ The sale of the individual assets from the originators of the loans to those who are repackaging them allows the originators to avoid having to collect on them when they become due because they are now owned by someone else. In this case, the issuer of the CDO owns the assets. In turn, this may lead to originators of loans being less judicious and disciplined in adhering to sound lending practices when the loans are made.
T bills
maximum of 52 week maturity
issued at a discount; priced on a discount basis
book entry form
t notes
2 to 10 years maturity
priced as a percentage of par
book entry
T bonds
greater than 10 years
priced at a percentage of par
book entry
treasury receipts
Brokerage firms can create a type of zero-coupon bond known as Treasury receipts from U.S. Treasury notes and bonds. BDs buy Treasury securities, place them in trust at a bank, and sell separate receipts against the principal and coupon payments. The Treasury securities held in trust collateralize the Treasury receipts. Unlike Treasury securities, Treasury receipts are not backed by the full faith and credit of the U.S. government.
Separate Trading of Registered Interest and Principal of Securities (STRIPS)
In 1984, the Treasury Department entered the zero-coupon bond market by designating certain Treasury issues as suitable for stripping into interest and principal components.
These securities became known by their acronym, STRIPS. Although the securities underlying Treasury STRIPS are the U.S. government’s direct obligation, major banks and dealers perform the actual separation and trading.
stripes are
STRIPS are backed in full backed in full by the U.S. government. Receipts are not. Treasury receipts are created by BDs and sold under names like Certificates of Accrual on Treasury Securities (CATS) and Treasury Income Growth Receipts (TIGRS). Both are quoted in yield.
treasury inflation protection securities
A type of Treasury issue, known as TIPS, helps protect investors against purchasing power risk. These notes are issued with a fixed interest rate, but the principal amount is adjusted semiannually by an amount equal to the change in the Consumer Price Index (CPI), the standard measurement of inflation.
The interest payment the investor receives every six months is equal to the fixed interest rate times the newly adjusted principal. In times of inflation, the interest payments increase, while in times of deflation, the interest payments fall. These notes are sold at lower interest rates than conventional fixed-rate Treasury notes because of their adjustable nature.
Like other Treasury notes, TIPS are exempt from state and local income taxes on the interest income generated, but they are subject to federal taxation. However, in any year when the principal is adjusted for inflation, that increase is considered reportable income for that year even though the increase will not be received until the note matures.
Congress authorizes the following agencies of the federal government to issue debt securities:
Farm Credit Administration
■ Government National Mortgage Association (GNMA or Ginnie Mae)
Other agency-like organizations operated by private corporations include the following:
■ Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)
■ Federal National Mortgage Association (FNMA or Fannie Mae)
■ Student Loan Marketing Association (SLMA or Sallie Mae)
yields and maturities
Agency issues have higher yields than direct obligations of the federal government but lower yields than corporate debt securities. Their maturities range from short- to long-term.
Agency issues are quoted as percentages of par and trade actively in the secondary market.
taxation for agency issues
Government agency issues that are backed by mortgages are taxed at the federal, state, and local levels. Other agency securities are generally taxed at the federal level only.
ginnie mae
The GNMA is a government-owned corporation that supports the Department of Housing and Urban Development. Ginnie Maes are the only agency securities backed by the full faith and credit of the federal government.
types of GNMA issues
Ginnie Mae does not originate mortgage loans, nor does it purchase, sell, or issue securities. Instead, private lending institutions approved by GNMA originate eligible loans, pool them into securities, known as pass-through certificates, and sell the GNMA mortgage-backed securities (MBS) to investors. These lending institutions can include mortgage companies, commercial banks, and thrift institutions of all sizes, as well as state housing finance agencies. Ginnie Mae guarantees only MBS backed by single and multifamily home loans insured by government agencies, primarily the Federal Housing Association (FHA) and the Department of Veteran Affairs (VA) as well as others. Like the principal on a single mortgage, the principal represented by a GNMA certificate constantly decreases as the mortgages are paid down.
Know the following GNMA features:
■■ $1,000 minimums ■■ Monthly interest and principal payments ■■ Taxed at all levels ■■ Pass-through certificates ■■ Significant reinvestment risk
the series 7 expects you to know that MBS are
susceptible to reinvestment risk
reason is
When interest rates fall, mortgage holders typically refinance at lower rates. This means that they pay off their mortgages early, which causes a prepayment of principal to holders of MBS. The early principal payments cannot be reinvested at a comparable return.
Sometimes the test asks which instruments are not subject to reinvestment risk.
Of the answer choices given, the best answer is typically a zero-coupon bond. No interest is paid on a current basis, so the investor has no reinvestment risk.
Farm credit system
The FCS is a national network of lending institutions that provides agricultural financing and credit. The system is a privately owned, government-sponsored enterprise that raises loan- able funds through the sale of Farm Credit securities to investors.
These funds are made available to farmers through a nationwide network of eight banks and 225 Farm Credit lending institutions. The Farm Credit Administration (FCA), a government agency, oversees the system.
The federal FCS issues discount notes, bonds, and master notes. The maturities range from one day to 30 years. The proceeds from the sale of securities are used to provide farmers with real estate loans, rural home mortgage loans, and crop insurance. Interest paid on these securities is exempt from state and local taxation.
Freddie mac
The FHLMC is a public corporation. It was created to promote the development of a nationwide secondary market in mortgages by buying residential mortgages from financial institutions and packaging them into MBS for sale to investors.
Pass-Through Certificates
A pass-through security is created by pooling a group of mortgages and selling certificates representing interests in the pool. The term pass-through refers to the mechanism of pass- ing homebuyers’ interest and principal payments from the mortgage holder to the investors. Fannie Mae, Ginnie Mae, and Freddie Mac function this way.
FHLMC sells two types of pass-through securities: mortgage participation certificates (PCs) and guaranteed mortgage certificates (GMCs). PCs make principal and interest pay- ments once a month; GMCs make interest payments twice a year and principal payments once a year.
taxation for freddie mac
Income from FHLMC securities is subject to federal, state, and local income taxes.
Types of FNMA Issues
FNMA issues debentures, short-term discount notes, and MBS. The notes are issued in denominations of $5,000, $25,000, $100,000, $500,000, and $1 million. Debentures with maturities from three to 25 years are issued in minimum denominations of $10,000 in increments of $5,000. Interest is paid semiannually. Just as with negotiable Treasury issues, no physical certificates are issued. Records of ownership are kept electronically. This is referred to as being issued in book-entry form.
open end management companies
An open-end management company (mutual fund) only issues one class of security and that’s a common share. It does not specify the exact number of shares it intends to issue, but registers an open offering with the SEC. In other words, mutual funds conduct a continuous primary offering of common shares. You should understand that mutual funds can purchase common stock, preferred stock, and bonds for their investment portfolios, but investors who invests in the ABC Bond Fund, or any mutual fund, can only purchase common shares of the fund. With this registration type, the fund can raise an unlimited amount of investment capi- tal by continuously issuing new shares. Conversely, when investors want to sell their holdings in a mutual fund, the fund itself redeems those shares. Mutual fund shares do not trade in the secondary market.
Technically defined as an “open-end management company,” a mutual fund is an investment company that pools money from many investors and invests it based on specific investment goals. The mutual fund raises money by selling its own shares to investors. The money is used to purchase a portfolio of stocks, bonds, short-term money market instruments, other securities or assets, or some combination of these investments. Each share represents an ownership slice of the fund and gives the investor a proportional right, based on the number of shares the investor owns, to income and capital gains that the fund generates from its investments.
The particular investments a fund makes are determined by its objectives and, in the case of an actively-managed fund, by the investment style and skill of the fund’s professional manager or managers. The holdings of the mutual fund are known as its underlying investments, and the performance of those investments, minus fund fees, determine the fund’s investment return.
Student Loan Marketing Association
Sallie Mae issues discount notes and short-term floating rate notes. The floaters have six- month maturities. The proceeds from the securities sales are used to provide student loans for higher education. Interest paid on Sallie Mae securities is taxable at the federal level and is exempt from taxation in most states.
Sallie Mae was once an agency issue of the U.S. government but is now privately owned with its common stock (symbol SLM) trading on Nasdaq. It might still be improperly grouped with agency issues on a test question.
money market instruments
Money market instruments are debt securities with short-term maturities, typically one year or less. Because they are short-term instruments, money market securities are highly liquid and they provide a relatively high degree of safety because most issuers have high credit rat- ings. For that reason, they are ideally suited for emergencies and to take advantage of investing opportunities.
Money market securities issued by the U.S. government and its agencies include the following:
■ Treasury bills
■ Treasury and agency securities with remaining maturities of one year or less
■ Short-term discount notes issued by various smaller agencies
Money market portfolios that include municipal securities are considered tax-exempt money market instruments.
The primary risk that investors face with these types of investments, including U.S. Treasury bills and money market mutual funds, is losing ground to inflation, known as infla- tion risk, constant dollar risk, or purchasing power risk. In addition, you should be aware that money in money market funds offered by investment companies is not insured. While such funds have rarely resulted in investor losses, the potential is always there.
money market mutual funds
Money market mutual funds (MMF) for retail investors are designed to have a stable NAV of $1. per share. They are not guaranteed, nor are they protected by FDIC insurance. It is rare, but it is possible to lose money in a money market mutual fund as a retail investor.
bankers acceptance
Certain corporations in the import-export business will often use BAs as a short-term time draft with a specified payment date drawn on a bank—essentially a postdated check or line of credit. The payment date of a BA is normally between one and 270 days.
American corporations use bankers’ acceptances extensively to finance international trade—that is, a BA typically pays for goods and services in a foreign country.
comercial paper
Corporations issue short-term, unsecured commercial paper, or promissory notes, to raise cash to finance accounts receivable and seasonal inventory overages. Most commercial paper interest rates are lower than bank loan rates. Commercial paper maturities range from one to 270 days, although most mature within 90 days. Commercial paper is issued at a discount from face value.
Typically, companies with excellent credit ratings issue commercial paper. The primary buyers of commercial paper are money market funds, commercial banks, pension funds, insurance companies, corporations, and nongovernmental agencies.
negotiable CD’s((jumbo cds)
Negotiable CDs represent unsecured time deposits that banks offer (issue). They have minimum face values of $100,000, but most are issued for $1 million or more. These CDs are subject to FDIC insurance coverage up to the current limits ($250,000).
Most negotiable CDs mature in one year or less, with the maturity date often set to suit a buyer’s needs. Because the CDs are negotiable, they can be traded in the secondary market.
investment company
An investment company is a corporation or trust that pools investors’ money and then invests that money in securities on their behalf. By investing these pooled funds as a single large account jointly owned by every investor in a company, the investment company man- agement attempts to invest and manage funds for people more efficiently than the individual investors could themselves. Additionally, it is expected that a professional money manager should be able to outperform the average investor in the market.
investment company purpose
Investment companies allow investors to pool their money together and have a professional invest the money to a clearly defined investment objective.
Like corporate issuers, investment companies raise capital by selling shares to the pub- lic. Investment companies must abide by the same registration and prospectus requirements imposed by the Securities Act of 1933 on other issuers. Investment companies are subject to regulations regarding how their shares are sold to the public, and they are regulated by the Investment Company Act of 1940.
The Investment Company Act of 1940 is the federal law that established the fact that there are three types of investment companies, only two of which are covered here because the third is not relevant for the exam. Those two are unit investment trusts and management companies.
unit investment trusts
UITs and management companies are investment companies, which means they pool money from many investors and invest it based on specific investment goals.
The key feature of UITs, however, is that once a UIT sets its portfolio, it remains the same for the life of the fund (barring any major corporate events, such as a merger or bankruptcy proceeding) and the term is fixed.
UITs raise money by selling shares known as “units” to investors, typically in a one-time public offering. Each unit represents an ownership slice of the trust and gives the investor a proportional right to income and capital gains generated by the fund’s investments, typically either stocks or bonds.
The performance of a UIT’s underlying investments, minus fund fees, determines the trust’s investment return. Those investments are generally fixed, with a UIT generally holding the securities in which it invests for the life of the fund, which is determined at the time of the fund’s initial offering.
A UIT typically issues redeemable securities (or “units”), like a mutual fund, which means that the UIT will buy back an investor’s “units,” at the investor’s request, or at their approximate NAV.
management companies
The most familiar type of investment company is the management investment company, which actively manages a securities portfolio to achieve a stated investment objective. A management investment company is either open-end or closed-end. Both closed- and open- end companies sell shares to the public in an initial public offering; the primary difference between them is that a closed-end company’s initial offering of shares is limited (it closes after its authorized number of shares number have been sold) and an open-end company is perpetu- ally offering new shares to the public (it is continually open to new investors).
closed end management companies
A closed-end management company will raise capital for its portfolio by conducting a common stock offering, much like any other publicly-traded company that raises capital to invest in its business. In the initial offering, the company registers a fixed number of shares with the SEC and offers them all to the public with a prospectus for a limited time through underwriters.
Once all the shares have been sold, the fund is closed to new investors. Many times, a fund elects to be a closed-end company because the sector in which it intends to invest has a limited amount of securities available. Closed-end investment companies may also issue bonds and preferred stock.
Closed-end investment companies are often called publicly traded funds. After the stock is sold in the initial offering, anyone can buy or sell shares in the secondary market (i.e., on an exchange or OTC) in transactions between private investors. Supply and demand determine the bid price (price at which an investor can sell) and the ask price (price at which an investor can buy). Closed-end fund shares may trade above (at a premium to) or below (at a discount to) the shares’ NAV. A highly testable point is that the price of a closed-end fund is independent of its NAV. When buying and selling closed-end investment companies in the secondary market, there will be a commission paid to execute the trade.
closed end company shares once issued
trade in the secondary market where price is determined by supply and demand. There is no prospectus delivery requirement once they trade in the secondary market.
diversified
Under the Investment Company Act of 1940, a diversified investment company is one that meets the following requirements of the 75-5-10 test.
■ At least 75% of the fund’s total assets must be invested in securities issued by companies other than the investment company itself or its affiliates.
■ The 75% must be invested in such a way that
— no more than 5% of the fund’s total assets are invested in the securities of any one
issuer, and
— nomorethan10%oftheoutstandingvotingsecuritiesofanyoneissuerisowned(by the 75%).
if a security represents 5% or less of the funds total assets at the time of the purchase and thereafter exceeds 5% due to capital appreciation
no action is required in order to maintain a diversified status
non diversified
As stated in the Investment Company Act of 1940, ‘‘Non-diversified company means any management company other than a diversified company”. The most common examples of nondiversified investment companies are the sector, or specialized, funds that will be discussed shortly.
both open and closed end companies can be
diversified or non diversified
Exchange traded funds
ETFs are investment companies that are legally classified as open-end companies or UITs, but differ from traditional open-end companies and UITs. ETFs issue their shares in large blocks (blocks of 50,000 shares, for example) that are known as creation units. Those who purchase creation units are frequently large institutional traders or investors. The creation units can then be split up and sold as individual shares in the secondary markets. This permits individual investors to purchase individual shares (instead of creation units).
Investors who want to sell their ETF shares have two options: they can sell individual shares to other investors in the secondary market, or if they own creation units, they can sell the creation units back to the ETF. In addition, ETFs generally will redeem creation units by giving investors the securities that comprise the portfolio, instead of cash. It is important to remember that because of the limited redeemability of ETF shares, ETFs are not considered to be, nor may they call themselves, mutual funds.
For purposes of Series 7 testing, we will consider individual investors who own ETFs shares (not creation units) purchased in the secondary market. Understanding that ETF shares are not mutual fund shares, it should be expected and is common that they are often compared to mutual fund shares. In that light, ETFs have some advantages and disadvantages to be considered when compared to open-end (mutual funds).
Following are some advantages of ETFs when compared to open-end (mutual funds).
■ Pricing and ease of trading—because individual ETF shares are traded on exchanges, they can be bought or sold anytime during the trading day at the price they are currently trading at, as opposed to mutual funds, which use forward pricing and are generally priced once at the end of the trading day.
■ Margin—ETFs can be bought and sold short on margin like other exchange-traded products. Mutual funds cannot be bought on margin nor can they be sold short.
■ Operating costs—ETFs traditionally have operating costs and expenses that are lower than most mutual funds.
■ Tax efficiency—ETFs can and sometimes do distribute capital gains to shareholders like mutual funds do, but this is rare. Understanding that these capital gains distributions are not likely, there are no further tax consequences with ETF shares until investors sell their shares. This may be the single greatest advantage associated with ETFs.
Following are some disadvantages of ETFs when compared to open-end (mutual funds).
■ Commissions—The purchase or sale of ETF shares is a commissionable transaction. The commissions paid can erode the low expense advantage of ETFs. This would have the greatest impact when trading in and out of ETF shares frequently or when investing smaller sums of money.
■ Overtrading—Given the ability to trade in and out of ETFs easily, the temptation to do so is possible. Excessive trading can eliminate the advantages associated with investing in a diversified portfolio and add to overall commissions being paid by the investor, further eroding any of the other expense and operating advantages associated with ETFs
real estate investment trusts
REITs are not an investment company security but are extensively regulated in ways simi- lar to the Investment Company Act of 1940. REITs allow investors to pool their money and form a trust to invest as it relates to real estate. REITs can be set up to have different portfolio structures. When the trusts own property, they are known as equity REITs. When the trusts own mortgages on property, they are known as mortgage REITs. Those that hold both are hybrid REITs.
Reasons that an investor might include REITs in their investment portfolio include the following.
■ REITs allow investors the opportunity to invest in real estate without incurring the degree of liquidity risk historically associated with real estate because REITs trade on exchanges and OTC.
■ REITs can provide some hedge to price movements in other equity markets. While it isn’t always the case, real estate prices historically have had a negative correlation to stock prices.
■ REITs provide a reasonable expectation of income from dividends and capital appreciation due to the appreciation of the assets the trust holds.
Risks generally associated with REITs include the following.
■ The investor has no direct control over the portfolio and relies on professional management to make all purchase and sale decisions. While the expectation of having a professionally- managed portfolio should be considered advantageous, the quality of the portfolio lies with the quality of the professional management.
■ Problematic loans within mortgage REIT portfolios can cause decreases in income flow and diminish capital returns.
■ Dividends paid by the trusts do not meet the requirements of qualified dividends and therefore are taxable at full ordinary income tax rates to the investor.
summary of reits
Not a limited partnership
■■ Not an investment company
■■ Pass-through income, not losses
■■ 75% of total investment assets in real estate
■■ 75% of gross income from rents or mortgage interest
■■ Must distribute 90% or more of income to shareholders to avoid taxation as a corporation
■■ Trade on exchanges or OTC
■■ Dividends received from REITS are taxed as ordinary income
balanced funds invest in
combination of stocks and bonds
performance
Securities law requires that each fund disclose the average annual total returns for 1-, 5-, and 10-year periods, or since inception if less than 10 years. Performance must reflect full sales loads with no discounts. The manager’s track record in keeping with the fund’s objectives in the prospectus is also important.
Fund quotations of average annual return must be
for 1-, 5, and 10 year periods or as long at the fund has operated
expense ratio=
fund expenses +average net assets
Mutual fund investors pay taxes
any dividends or capital gains the fund distributes. Even if the investor elects to reinvest some or all of the distribution, the total amount is taxable in the year earned by the fund.
portfolio turnover
The costs of buying and selling securities, including commissions or markups and markdowns, are reflected in the portfolio turnover ratio. It is not uncommon for an aggressive growth fund to reflect an annual turnover rate of 100% or more. A 100% turnover rate means the fund replaces its portfolio annually. If the fund achieves superior returns, the strategy is working; if not, the strategy is subjecting investors to undue costs.
The portfolio turnover rate reflects a fund’s holding period. If a fund has a turnover rate of 100%, it holds its securities, on average, for less than one year. Therefore, all gains are likely to be short-term and subject to the maximum tax rate; a portfolio with a turnover rate of 25% has an average holding period of four years and gains are likely taxed at the long-term rate.
services offered by mutual funds
The services mutual funds offer include: ■ retirement account custodianship; ■ investment plans; ■ check-writing privileges; ■ telephone transfers; ■ conversion privileges; ■ combination investment privileges; and ■ withdrawal plans.
stock funds
A mutual fund, which uses stock to meet its stated objectives, can generally be referred to as a stock fund. Common stock is normally found in the portfolio of any mutual fund that has growth as a primary or secondary objective. Equity funds have historically outpaced inflation over most 10-year time horizons.
growth funds
Growth funds invest in stocks of companies whose businesses are growing rapidly. Growth companies tend to reinvest all or most of their profits for research and development rather than pay dividends. Growth funds are focused on generating capital gains rather than income.
Growth managers may consider stocks that many feel are overvalued because there may still be upside potential. As such, funds managed for growth tend to have elevated levels of risk.
market cap
Market cap, as it is usually referred to, is the total number of shares of common stock outstanding multiplied by the current market value per share. So a listed company with 300 million shares outstanding where the share price is $50 would have a market cap of $15 billion and would be considered a large-cap stock. Funds investing in stocks like this are sometimes called large-cap funds (their portfolio consists of companies with a market capitalization of more than $10 billion). These types of funds can be more stable and less volatile in a turbulent market.
aggressive growth fund
are sometimes called performance funds. These funds are will- ing to take greater risk to maximize capital appreciation.
small cap funds
Some of these funds invest in newer companies with relatively small capitalization (less than $2 billion capitalization) and are called small-cap funds.
mid cap funds
are somewhat less aggressive and have in their portfolios shares of compa- nies with a market capitalization of between $2 billion and $10 billion.
large cap funds
have market capitalization of greater than $10 billion. The lower the market cap, the greater the volatility.
value funds
Value funds (and, therefore, value managers) focus on companies whose stocks are currently undervalued (earnings potential is not reflected in the stock price). These undervalued companies are expected to perform better than the reports indicate, thus providing an opportunity to profit. Value stocks typically have dividend yields higher than growth stocks. Funds managed for value are considered more conservative than funds managed for growth.
(equity) income funds
An income fund, also known as an equity income fund, stresses current income over growth. The fund’s objective may be accomplished by investing in the stocks of companies with long histories of dividend payments, such as utility company stocks, blue-chip stocks, and preferred stocks. These are managed for value, not growth.
option income funds
Option income funds invest in securities on which call options can be sold (known as covered calls). They earn premium income from writing (selling) the options. They may also earn capital gains from trading options at a profit. These funds seek to increase total return by adding income generated by the options to appreciation on the securities held in the portfolio.
growth and income funds
A growth and income fund (combination fund) may attempt to combine the objectives of growth and current income by diversifying its stock portfolio among companies showing long- term growth potential and companies paying high dividends. Often, both value and growth management styles are utilized.
specialized sector funds
Many funds attempt to specialize in particular economic sectors or geographic areas. These funds must have a minimum of 25% of their assets invested in their specialties. Sector funds offer high appreciation potential, but may also pose higher risks to the investor as a result of the concentration of investments. These funds are speculative in nature. They include gold, technology, pharmaceutical, and biotechnology funds, but can also be geographic, such as investing in companies located in the Pacific Basin or Silicon Valley.
special situation funds
Special situation funds buy securities of companies that may benefit from a change within the companies or in the economy. Takeover candidates and turnaround situations are common investments. These funds are also speculative (high risk).
blend core funds
Blend/core funds are stock funds with a portfolio comprising a number of different classes of stock. Such a fund might include both blue-chip stocks and high-risk/high-potential-return growth stocks. Both growth and value management styles are used. The purpose is to allow investors to diversify their investment via management and securities in a single fund.
inde funds
Index funds invest in securities that mirror a market index, such as the S&P 500. An index fund buys and sells securities in a manner that mirrors the composition of the selected index.
The index may be broad, such as the S&P 500, or narrow, such as a transportation index. The fund’s performance should closely track the underlying index performance. Turnover of
securities in an index fund’s portfolio is minimal, because the only trades that take place are triggered by a change in the index (one company is replaced by another company). As a result, an index fund generally has lower management costs than other types of funds.
global funds
Global and worldwide funds invest in the securities of both U.S. and foreign countries. The risks involved in a fund concentrating in foreign securities are somewhat different than those for a domestic fund. When a portfolio has a large percentage of foreign securities, currency risk and political risk becomes paramount. These risks are elevated when investing in frontier funds, which invest in pre-emerging economies, because accounting and regulatory schemes are often much less rigorous than what we are used to here in the United States.
Foreign and international stock funds are often purchased in order to diversify an investor’s portfolio. After all, investing inside and outside the United States provides a more diversified portfolio than just investing within the United States.
Balanced funds
Balanced funds, also known as hybrid funds, invest in stocks for appreciation and bonds for income. In a balanced fund, different types of securities are purchased according to a for- mula the manager may adjust to reflect market conditions.
A balanced fund’s portfolio might contain 60% stocks and 40% bonds.
asset allocation funds
Asset allocation funds split investments between stocks for growth, bonds for income, and money market instruments or cash for stability. Fund advisers switch the percentage of holdings in each asset category according to the performance (or expected performance) of that group. These funds can also hold hard assets, such as precious metals like gold and silver, and real estate.
A fund may have 60% of its investments in stock, 20% in bonds, and the remaining 20% in cash. If the stock market is expected to do well, the adviser may switch from cash and bonds to stock. The result may be a portfolio of 80% in stock, 10% in bonds, and 10% in cash.
Conversely, if the stock market is expected to decline, the fund may invest heavily in cash and sell stocks.
Many asset allocation funds are target funds (see the following) that target a specific goal, such as retirement, in a 5-, 10-, 15-, or 20-year period. As the target year gets closer, the mix of investments becomes more conservative.
target date funds
One increasingly popular investment option is a target-date fund, sometimes called a life- cycle fund. According to a report by a large retirement plan provider, target-date funds are offered by nearly 90% of employer-sponsored defined contribution plans, such as 401(k) plans.
Target-date funds are designed to help manage investment risk. This is done by selecting a fund with a target date in mind that is closest to the year an investor anticipates needing the money (i.e., retiring in 2030). For example, a 2030 fund gradually reduces risk by changing the investments within the fund to a more conservative mix as the target date approaches. That said, target-date funds are not risk-free, even when the target date has been reached.
bond funds
Bond funds have income as their main investment objective. Some funds invest solely in investment-grade corporate bonds. Others, seeking enhanced safety, invest only in govern- ment issues. Still others seek to maximize current income by investing in lower-rated (junk) bonds for higher yields.
bonds pay
interest, bonds funds pay dividends if declared by funds BOD
dividends are typically paid
on a quarterly or semiannual basis, but there are income funds(both equity- and oriented) that pay monthly dividends
corporate bond funds
in general, have higher credit risk than various government issues but can still be classified as investment-grade (safer) or non-investment-grade (riskier) portfolios.
high yield bond funds
The greater the risk, the greater the yield. High-yield bond funds provide the highest yields due to their increased credit risk and are considered speculative investments.
tax free(tax exempt) Bond funds
Municipal bond funds invest in municipal bonds or notes that produce income (dividends) exempt from federal income tax. These funds are appropriate for investors in a high marginal tax bracket seeking income.
u.s. government funds
U.S. government funds purchase securities issued by the U.S. Treasury or an agency of the U.S. government, such as Ginnie Mae. Investors in these funds seek current income and maximum safety.
agency security funds
Agency security funds are not considered quite as safe from default risk as U.S. government funds; therefore, the yields on agency security funds will be higher than U.S. government fund yields.
government sponsored enterprises
The word “agencies” is a generic term used to describe two types of bonds: bonds issued or guaranteed by U.S. federal government agencies, and bonds issued by government-sponsored enterprises (GSEs)—corporations created by Congress to foster a public purpose, such as affordable housing.
GNMA
Bonds issued or guaranteed by federal agencies such as the GNMA are backed by the “full faith and credit of the U.S. government,” just like Treasuries. This is an unconditional com- mitment to pay interest payments and to return the principal investment in full to you when a debt security reaches maturity.
FNMA and the FHLMC
Bonds issued by GSEs, such as the FNMA and the FHLMC, are not backed by the same guarantee as federal government agencies.
principal protected mutual funds
Principal-protected mutual funds offer investors a guarantee of principal, adjusted for fund dividends and distributions, on a set future date (maturity) while providing opportunities for higher returns through investment in higher risk and higher expected return asset classes such as equities. The basic guarantee is that the investor’s return will never be less than the original investment, less any sales load.
The guarantees are sometimes provided by third-party insurers and at other times through investments in U.S. Treasury zero-coupon bonds. These appealing properties have led to considerable interest on the part of investors who have invested billions of dollars in such mutual funds in recent years. The usefulness and attractiveness of these principal-protected mutual funds is limited by three factors.
guarantee principal
Most principal-protected funds guarantee the initial investment minus any front-end sales charge even if the stock markets fall. In many cases, the guarantee is backed by an insurance policy.
Lock-up period
If you sell any shares in the fund before the end of the “guarantee period”—a period of anywhere from five to 10 years—you lose the guarantee on those shares and could lose money if the share price has fallen since your initial investment.
hold a mixture of bonds and stocks
Most principal-protected funds invest a portion of the fund in zero-coupon bonds and other debt securities, and a portion in stocks and other equity investments during the guarantee period. To ensure the fund can support the
guarantee, many of these funds may be almost entirely invested in zero-coupon bonds or other debt securities when interest rates are low and equity markets are volatile. Because this allocation provides less exposure to the markets, it may eliminate or greatly reduce any potential gains the fund can achieve from subsequent gains in the stock market. It also may increase the risk to the fund of rising interest rates, which generally cause bond prices to fall.
Principal-protected funds are typically front-end loaded, and their operating expense ratios tend to be higher than comparable funds.
index tracking funds
Some funds are designed to track the performance of an underlying investment portfolio or index.
While they are not investment company products, they do have characteristics similar to both open-end and closed-end funds.
Like closed-end funds, index fund shares trade and are priced like shares of stock. Like open-end funds, they can create (issue) additional shares.
Investors use index funds for:
asset allocation;
■ following industry trends;
■ balancing a portfolio;
■ speculative trading; and
■ hedging.
Remember that index funds are different from mutual funds in the following ways.
■ Intraday trading—Investors do not have to wait until the end of a trading day to purchase or sell shares. Shares trade and are priced continuously throughout the day, making it easier for investors to react to market changes.
■ Margin eligibility—Index fund shares can be purchased on margin, subject to the same terms that apply to common stock.
■ Short selling—Index funds can be sold short at any time during trading hours. Popular index tracking funds include those that track the S&P 500 Index.
■ Spiders—There are also Spiders on various components of the S&P 500.
leveraged funds
These funds attempt to deliver a multiple of the return of the benchmark index they are designated to track. For instance, a 2X leveraged fund would try to deliver two times the return of whatever index it is tracking. With leveraged funds, there are no limits by rule or regulation as to the amount of leverage that could be applied to a portfolio. Currently there are numerous 2X and 3X leveraged funds available to investors.
The risk associated with leverage is that it is always a “double-edged” sword. Therefore, the risk to be recognized regarding this fund strategy is that if the benchmark index is falling, then the fund’s returns will be, in theory, the designated leverage amount (perhaps two or three) times the loss. In addition, most of these funds use derivatives products such as options, futures, and swaps to enable them to achieve the stated goal. As these products are not suitable for all investors, so too can it be said of the leverage fund portfolio containing them. Ultimately, as always, suitability becomes an issue when recommending these products.
inverse(reverse) funds
Inverse funds, sometimes called reverse or short funds, attempt to deliver returns that are the opposite of the benchmark index they are tracking. For example, if the benchmark is down 2%, the fund’s goal is to be up 2%. In addition, inverse funds can also be leveraged funds, or said another way, two or three times the opposite of the indices return.
Why buy inverse funds? If an investor is bearish on a particular market such as transportation, or even the stock market as a whole, an investor could purchase an inverse fund or ETF. When the value of the index declines, the fund’s objective is to rise in value.
hedge funds
are similar to mutual funds in that investments are pooled and professionally managed, but they differ in that the fund has more flexibility in the investment strategies employed, and are unregulated by U.S. securities laws. They are aggressively-managed portfoliosof investments that use advanced investment strategies. Generally, these investment vehicles are considered suitable for sophisticated investors—those meeting the standard of accredited investors. While hedging is the practice of attempting to limit risk, most hedge funds specify generating high returns as their primary investment objective. Some of the more common strategies employed by hedge funds are:
■ highly-leveraged portfolios;
■ the use of short positions;
■ utilizing derivative products such as options and futures;
■ currency speculation;
■ commodity speculation; and
■ investing in politically unstable international markets.
hedge fund lock up provisions
This provision provides that during a certain initial period, an investor may not make a withdrawal from the fund. The period when the investor cannot withdraw investment dollars is known as the actual lock-up period. Generally recognized as one way the manager of the hedge fund portfolio can have capital retained in the fund, it is also seen to be another factor adding to the unique risk of hedge funds—in this case, shares being illiquid for that specified length of time.
Lock-up periods are generally associated with new or start-up hedge funds and can differ in length from one fund to another. The length of the lock-up period will largely be dependent on what the investment strategy of the fund is and how long the portfolio manager anticipates it will take to implement the strategy and then see results of that implementation.
funds of hedge funds
Though hedge funds discussed later in this unit are generally available to and suitable for highly qualified or sophisticated (accredited) investors, there are registered mutual funds available to all investors that invest primarily in unregistered hedge funds known as funds of hedge funds. They can target and diversify among several hedge funds and, in this way, give non-accredited investors access to hedge funds. These funds share some of the benefits and risks associated with hedge funds. One benefit could be that lower initial investments might be required than when investing directly in a hedge fund. In contrast, one risk to note is that
blank check or blind pool hedge fund
Some hedge funds target blank-check companies to invest in. Blank-check companies, sometimes known as special purpose acquisition companies, carry their own unique risks. Blank-check companies are companies without business operations that raise money through IPOs in order to have their shares publicly traded for the sole purpose of seeking out a business or combination of businesses. When a business is located, they will present proposals to holders of their shares for approval.
Some hedge funds target blind-pool companies. Similar to blank-check companies, these issuers raise capital by selling securities to the public without telling investors what the specific use of the proceeds will be, but might target a particular industry or sector.
Some characterize blank-check companies as a type of blind pool, with one discernable difference. While the blind-pool company will usually provide at least some indication of what general industry the funds will be invested in, blank-check offerings do not identify any proposed investment intent.
While some hedge funds target these types of holdings for their portfolios, it should be noted that they might be included within any hedge fund portfolio and, in both cases, should be considered when assessing risk and determining suitability.
mutual fund distributions and taxation
Most monies received by an individual are subject to income tax. This includes salaries, bonuses, commissions, gratuities, dividends, and interest.
Receipts from selling something for more (or less) than was originally paid for it fall under the capital gains tax. If there was a gain, tax must be paid on it. If there was a loss, it can be used to offset gains and income.
Mutual funds receive income in the form of dividends from the stocks in which they invest and interest from bonds. They may also realize capital gains from the sale of securities, which were held in the portfolio, that have appreciated in price.
dividend distributions
A mutual fund may pay dividends to each shareholder in much the same way corporations pay dividends to stockholders. The Investment Company Act of 1940 requires a written statement to accompany dividend payments by management companies. Every written statement made by or on behalf of a management company must be made on a separate paper
and clearly indicate what portion of the payment per share is made from. Mutual fund dividends are typically paid from the mutual fund’s net investment income, usually on a quarterly basis. Dividends may be identified as qualified or nonqualified. Qualified dividends are taxed at
the lower long-term capital gains rate. Nonqualified dividends are distributed as short-term capital gains and are taxed as ordinary income.
net investment income
NII includes gross investment income—dividend and interest income from securities held in the portfolio—minus operating expenses. Advertising and sales expenses are not included in a fund’s operating expenses when calculating net investment income, but management fees, custodian bank charges, legal and accounting fees, and transfer agent costs are included.
net investment income = dividends + interest – expenses of the fund
the conduit theory
Because an investment company is organized as a corporation or trust, you might correctly assume its earnings are subject to tax. Consider, however, how an additional level of taxation shrinks a dividend distribution value.
Triple taxation of investment income may be avoided if the mutual fund qualifies under
subchapter m of the Internal Revenue Code (IRC)
if a mutual fund acts as a conduit(pipeline) for the distribution of net investment income, the fund may qualify as a
regulated investment company, subject to tax only on the amount of the investment income the fund retains.
To avoid taxation under Subchapter M, a fund must distribut
at least 90% of its net investment income to shareholders. The fund then pays taxes only on the undistributed amount.
capital gains distributions
The appreciation or depreciation of portfolio securities is unrealized capital gain or loss if the fund does not sell the securities. Therefore, shareholders experience no tax consequences. When the fund sells the securities, the gain or loss is realized. A realized gain is an actual profit made.
Capital gains distributions are derived from realized gains. If the fund has held the securities for more than one year, the gain is a long-term capital gain, taxed at the long-term capital gains rate. The mutual fund may retain the gain or distribute it to shareholders. A long-term capital gains distribution may not be made more often than once per year.
long term capital gain
Holding period of more than one year, taxed as a capital gain, which is (generally) lower than ordinary income tax rates for an investor.
short term capital gain
Holding period of one year or less, taxed at ordinary income tax rates for an investor.
realized gain vs unrealized gain way to think about it
unrealized gain as a paper profit
realized gain as actual profit made
reinvestment of distributions
Dividends and capital gains are distributed in cash. However, a shareholder may elect to reinvest distributions in additional mutual fund shares. The automatic reinvestment of distributions is similar to compounding interest. The reinvested distributions purchase additional shares, which may earn dividends or gains distributions.
A mutual fund that is being formed today must offer the reinvestment of dividends and capital gains back into the fund without a sales charge (at NAV). This means that investors are able to buy new shares without a sales load—a significant advantage that results in faster growth to the investor.
taxation of reinvested distributions
Distributions are taxable to shareholders whether the distributions are received in cash or reinvested. The fund must disclose whether each distribution is from income or capital gains. Form 1099-DIV, which is sent to shareholders after the close of the year, details tax information related to dividend distributions for the year. This enables the investor to enter the proper information on the investor’s Form 1040.
other tax considerations
Mutual fund investors must consider many tax factors when buying and selling mutual fund shares.
cost basis of shares inherited/gifted
The cost basis of inherited property is either stepped up or stepped down to its FMV at the date of the decedent’s death. In the case of open-end investment companies, this would be the NAV. Shares inherited are always considered to have a holding period that is long-term for tax purposes; therefore, the sale of inherited shares are subject to more favorable long-term tax rates, no matter how long (or short) they have been held.
If a gift of securities is made, under federal gift tax rules, the donor’s cost basis becomes the donee’s cost basis.
Estate and gift taxes
Taxes can be levied upon the estate of a deceased person and upon those gifting securities to others. This section discusses these unique scenarios.
donor taxes
When a person dies, tax is due on the estate. This tax is payable by the estate, not by heirs who inherit the estate (although certain other taxes may apply to heirs). Likewise, if a person gives a gift, tax is due on the gift. Gift tax is payable by the donor, not the recipient. Estate and gift taxes are progressive taxes. For tax purposes, the valuation of the estate is the date of death; the valuation of a gift is the date it is given.
gift tax exemption
Individuals may give gifts up to a maximum amount per year to any number of individuals without incurring gift tax. The amount of the exclusion is subject to change depending on current tax law. Interspousal gifts, no matter the size, are not subject to tax. If a gift tax is due, it is paid by the donor.
estate tax exclusion
The estate of a deceased person is allowed to exclude some of that person’s estate from taxation. The amount of the exclusion is subject to change depending on current tax law.
unlimited marital deduction
Married couples are allowed to transfer their entire estate to the surviving spouse at death. This unlimited marital deduction results in taxes being owed at the death of the survivor.
wash sales
Capital losses may not be used to offset gains or income if the investor sells a security at a loss and purchases the same or a substantially identical security within 30 days before or after the trade date. The sale at a loss and the repurchase within this period is a wash sale.
The rule disallows the loss or tax benefit from selling a security and repurchasing the secu- rity or one substantially identical to it in this manner. The term substantially identical refers to any other security with the same investment performance likelihood as the one being sold.
Examples are:
■ securities convertible into the one being sold;
■ warrants to purchase the security being sold;
■ rights to purchase the security being sold; and
■ call options to purchase the security being sold.
the wash sale rule covers
30 days before and after the trade date. including the trade date, this is a total time period of 61 days.
fund share liquidations to the investor
When an investor sells mutual fund shares, he must establish his cost base, or basis, in the shares to calculate the tax liability. A simple definition of cost base is the amount of money invested. Upon liquidation, cost base represents a return of capital and is not taxed again.
valuing fund shares
The cost base of mutual fund shares includes the shares’ total cost, including sales charges plus any reinvested dividend and capital gains distributions. For tax purposes, the investor compares cost base to the amount of money received from selling the shares. If the amount received is greater than the cost base, the investor reports a taxable gain. If the amount received is less than the cost base, the investor reports a loss.
accounting methods
If an investor decides to liquidate shares, she determines the cost base by electing one of three accounting methods: first in, first out (FIFO); share identification; or average basis. If the investor fails to choose, the IRS assumes the investor liquidates shares on a FIFO basis.
FIFO
When FIFO shares are sold, the cost of the shares held the longest is used to calculate the gain or loss. In a rising market, this method normally creates adverse tax consequences.
Share identification
When using the share identification accounting method, the investor keeps track of the cost of each share purchased and uses this information when deciding which shares to liquidate. He then liquidates the shares that provide the desired tax benefits.
average basis
The shareholder may elect to use an average cost basis when redeeming fund shares. The shareholder calculates average basis by dividing the total cost of all shares owned by the total number of shares.
close end funds
After the initial public offering, closed-end funds do not have a sales charge embedded in the share price. In the secondary market, an investor pays a brokerage commission (in an agency transaction) or pays a markup or markdown (in a principal transaction). Closed-end funds may trade at a premium (above) or discount (below) relative to their NAV.
open-end funds
All sales commissions and expenses for an open-end fund are embedded in the POP or other fees. Sales expenses include commissions for the managing underwriter, broker-dealers, and their registered representatives, as well as all advertising and sales literature expenses. Mutual fund distributors use different methods to collect the fees for the sale of shares and one to compensate reps on an ongoing basis (trailer commissions):
■ Front-end loads (difference between POP and NAV)
Back-end loads (contingent deferred sales loads)
■ Level loads (asset-based fees—provide trail commissions to the registered representative
servicing the account)
class a shares
Shares sold with a front-end load are called Class A shares. Front-end sales loads are the charges included in a fund’s POP. The charges are added to the NAV at the time an investor buys shares. Front-end loads are the most common way of paying for the distribution services that a fund’s underwriter and BDs provide.
breakpoints
Breakpoints are available to any person. For a breakpoint qualification, person includes married couples, parents and their minor children, corporations, and certain other entities. Investment clubs or associations formed for the purpose of investing do not qualify for breakpoints.
The following are breakpoint considerations.
■ Breakpoint levels vary across mutual fund families. There is no industry standardized breakpoint schedule.
■ Mutual funds that offer breakpoints must disclose their breakpoint schedule in the prospectus and how an account is valued for breakpoint purposes.
■ The SEC further encourages that breakpoint discount availability information be accessible through various means of communication, including websites.
■ Discounts may be the result of a single large investment, a series of aggregated investments, or a promise to invest via a letter of intent (LOI).
■ Purchases made by the same investor in various accounts can be aggregated to qualify for a breakpoint discount. Eligible accounts include traditional brokerage, accounts held directly with a fund company, 401(k), IRA, and 529 college savings.
■ Shares purchased in the same fund family other than money market accounts are eligible to be aggregated together to qualify for a breakpoint discount, including those held at separate BDs.
who is eligible for breakpoints
Married couples, parents with minor children, and corporations are eligible. Parents combined with adult children (even if they are legally considered dependents) and investment clubs are not eligible.
breakpoint sale
FINRA prohibits registered representatives from making or seeking higher commissions by selling investment company shares in a dollar amount just below the point at which the sales charge is reduced. This violation is known as a breakpoint sale, and is considered contrary to just and equitable principles of trade. It is the responsibility of all parties concerned, particularly the principal, to prevent deceptive practices.
LOI
A person who plans to invest more money with the same mutual fund company may immediately decrease her overall sales charges by signing a LOI. In the LOI, the investor informs the investment company that she intends to invest the additional funds necessary to reach the breakpoint within 13 months.
The LOI is a one-sided contract binding on the fund only. However, the customer must complete the investment to qualify for the reduced sales charge. The fund holds some of the shares purchased in escrow. If the customer invests enough of the money to complete the LOI, she receives the escrowed shares. If not, she is given the choice to either pay the sales charge difference or have the underwriter liquidate enough of the escrowed shares to do so. Appreciation and reinvested dividends or capital gains do not count toward the LOI.
backdating the letter
A fund often permits a customer to sign a LOI as late as the 90th day after an initial purchase. The LOI may be backdated by up to 90 days to include prior purchases but may not cover more than 13 months in total. A customer who signs the LOI 60 days after a purchase has 11 months to complete the letter.
letters of intent are good for a maximum of
13 months and may be backdated 90 days
if the loi is not completed
the sales charge amount that applies is based on
the total amount actually invested.
share appreciation and income paid by the fund
do not count toward completion of the letter
rights of accumulation
Rights of accumulation, like an LOI, allow an investor to qualify for reduced sales charges by reaching a breakpoint. The major differences are that rights of accumulation:
■ allow the investor to use prior share appreciation and reinvestment to qualify for breakpoints; and
■ do not impose time limits.
The customer may qualify for reduced charges when the total value of shares previously purchased and shares currently being purchased exceeds a certain dollar amount. For the purpose of qualifying customers for rights of accumulation, the mutual fund bases the quantity of securities owned on the higher of current NAV or the total of purchases made to date.
combination privilage
A mutual fund company frequently offers more than one fund and refers to these multiple offerings as its family of funds. An investor seeking a reduced sales charge may be allowed to combine separate investments in two or more funds within the same family to reach a breakpoint.
exchanges within a family
Many sponsors offer exchange or conversion privileges within their families of funds. Exchange privileges allow an investor to convert an investment in one fund for an equal investment in another fund in the same family without incurring an additional sales charge.
Mutual funds may be purchased at NAV under a no-load exchange privilege. The following rules apply.
■ Purchase may not exceed the proceeds generated by the redemption of the other fund.
■ The redemption may not involve a refund of sales charges.
■ The sales personnel and dealers must receive no compensation of any kind from the reinvestment.
■ Any gain or loss from the redemption of shares must be reported for tax purposes.
class Bs shares
Class B shares do not charge a front-end sales charge, but they do impose an asset-based 12b-1 fee greater than those imposed on Class A shares.
Class B shares also normally impose a contingent deferred sales charge (CDSC), also called a back-end load, which is paid when selling shares. Because of the back-end load and 12b-1 fee, Class B shares may not be referred to as no-load shares. The CDSC normally declines and eventually is eliminated over time. Once the CDSC is eliminated, almost all Class B shares convert into Class A shares. When they convert, they will be charged the same (lower) asset- based 12b-1 fee as the Class A shares.
Class B shares do not impose a sales charge at the time of purchase, so unlike Class A share purchases, 100 cents of the invested dollar are invested.
class c shares
Class C shares typically have a one-year 1% CDSC, a .75% 12b-1 fee (discussed shortly), and a .25% shareholder services fee. Because these fees are relatively high and never go away, C shares are commonly referred to as having a level load. Class C shares are appropriate for investors who have short time horizons because they become quite expensive to own if invest- ing for more than four to five years.
12B-1 asset based fee
■■ 12b-1 fee is expressed as an annual amount but is charged and reviewed
Expect questions about 12b-1 fees and know the following points. quarterly.
■■ Charges covered by 12b-1 fees include advertising, sales literature, and prospectuses delivered to potential customers, not fund-management expenses.
As an asset-based fee, 12b-1 fees are often called asset-based distribution fees. Named after the SEC rule that allows them, 12b-1 fees are used to cover the costs of marketing and distributing the fund to investors. These 12b-1 fees are also used to compensate registered representatives for servicing an account (trailer commissions) but shouldn’t be confused with sales charges. The fee is deducted quarterly as a percentage of the fund’s average total NAV.
■ The maximum 12b-1 fee is .75% for distribution and promotion.
■ The fee must reflect the anticipated level of distribution services.
misuse of no load terminology
A fund that has a deferred sales charge or an asset-based 12b-1 fee of more than .25% of average net assets may not be described as a no-load fund. To do so violates the conduct rules; the violation is not alleviated by disclosures in the fund’s prospectus.
no load funds
As the name implies, this means that the fund does not charge any type of sales load. However, not every type of shareholder fee is a sales load. No-loads may charge fees that are not sales loads. For example, a no-load fund is permitted to charge purchase fees, account fees, exchange fees, and redemption fees, none of which is considered to be a sales load. (Although a redemption fee is deducted from redemption proceeds just like a deferred sales load, it is not considered to be a sales load.) In addition, under FINRA rules, a fund is permitted to pay its annual operating expenses and still call itself no-load. However, the combined amount of the fund’s 12b-1 fees or separate shareholder service fees cannot exceed .25% of the fund’s average annual net assets.
Accumulation and withdrawal plans
Mutual funds have a number of arrangements to implement an investment program. A voluntary accumulation plan allows a customer to deposit regular periodic investments on a voluntary basis (minimum amounts found in the prospectus). The plan is designed to help the customer form regular investment habits while still offering some flexibility.
Voluntary accumulation plans may require a minimum initial purchase and minimum additional purchase amounts. Many funds offer automatic withdrawal from customer checking accounts to simplify contributions. If a customer misses a payment, there is no penalty because the plan is voluntary. The customer may discontinue the plan at any time.
dollar cost averaging
involves investing a fixed amount of money every period, regardless of market price
fluctuation.
If the market price of shares is up, fewer shares are purchased; if the market price of shares is down, more shares are purchased. Over time, if the market fluctuates, dollar cost averaging will achieve a lower average cost per share than average price per share.
One method of purchasing mutual fund shares is called dollar cost averaging, where a per- son invests identical amounts at regular intervals. This form of investing allows the individual to purchase more shares when prices are low, and fewer shares when prices are high. In a fluc- tuating market and over a period of time, the average cost per share is lower than the average price of the shares. However, dollar cost averaging does not guarantee profits in a declining market because prices may continue to decline for some time. In this case, the investor buys more shares of a sinking investment.
withdrawal plans
In addition to lump-sum withdrawals, whereby customers sell all their shares, mutual funds offer systematic withdrawal plans. Withdrawal plans are normally a free service. Not all mutual funds offer withdrawal plans, but those that do may offer the plan alternatives described here.
fixed dollar
A customer may request the periodic withdrawal of a fixed-dollar amount. Thus, the fund liquidates enough shares each period to send that sum. The amount of money liquidated may be more or less than the account earnings during the period.
fixed percentage or fixed shares
Under a fixed-percentage or fixed-share withdrawal plan, either a fixed number of shares or a fixed-percentage of the account is liquidated each period.
fixed time
Under a fixed-time withdrawal plan, customers liquidate their holdings over a fixed period. Most mutual funds require a customer’s account to be worth a minimum amount of money before a withdrawal plan may begin. Regardless of the option chosen, it is rare for a fund to permit continued investment once withdrawals start.
withdrawal plan disclosures
Withdrawal plans are not guaranteed. With fixed-dollar plans, only the dollar amount to be received each period is fixed. All other factors, including the number of shares liquidated and a plan’s length, are variable. For a fixed-time plan, only the time is fixed; the amount of money the investor receives varies each period.
Because withdrawal plans are not guaranteed, the registered representative must: ■ never promise an investor a guaranteed rate of return;
■ stress to the investor that it is possible to exhaust the account by overwithdrawing;
■ state that during a down market it is possible that the account will be exhausted if the investor withdraws even a small amount; and
■ never use charts or tables unless the SEC specifically clears their use.
annuity
An annuity is an insurance contract designed to provide retirement income. The term annuity refers to a stream of payments guaranteed for some period of time—for the life of the annuitant, until the annuitant reaches a certain age, or for a specific number of years. The actual amount to be paid out may or may not be guaranteed, but the stream of payments itself is. Because an annuity can provide an income for the rest of someone’s life, the contract has a mortality guarantee. When you think about a retiree’s greatest fear, it is typically outliving her income. This product can take away that fear.
TYPES OF ANNUITY CONTRACTS
annualization exception
Withdrawals before the age of 591⁄2 result in a 10% penalty, in addition to full income tax on anything over cost basis taken out of the account. Exceptions to the 10% penalty include death and annuitization under Rule 72t. Annuitization is discussed later in this unit.
Usually 100% of the money goes into the annuity; however, surrender charges will be applied if the contract is canceled within a stated number of years such as 7 or 10 years from issue.
fixed annuities
In a fixed annuity, investors pay premiums to the insurance company that are, in turn, invested in the company’s general account. The insurance company is then obligated to pay a guaranteed amount of payout (typically monthly) to the annuitant based on how much was paid in.
Note that the insurer guarantees a rate of return and, therefore, bears the investment risk. Because the insurer is the one at risk, this product is not a security. An insurance license is required to sell fixed annuities, but a securities license is not.
Purchasing power risk (inflation risk) is a significant risk associated with fixed annuities. The fixed payment that the annuitant receives loses buying power over time due to inflation.
index annuity
In an effort to overcome the purchasing power risk of fixed annuities, but without the market risk of a variable annuity, the industry developed the index annuity.
Index annuities are currently popular among investors seeking market participation but with a guarantee against loss. Unlike a traditional fixed annuity, an index annuity credits interest to the owner’s account, using a formula based on the performance of a particular stock index, such as the S&P 500. If the index does well, the annuitant is credited with a specified percentage of the growth of the index—typically 80% or 90% of the growth. This is known as the participation rate. If the index does poorly, the annuitant may receive a guaranteed minimum interest rate such as 1% or 2%.
To give you an idea of how an index annuity might work, consider a participation rate of 80% and a minimum guarantee of 1%. If the index shows growth of 9% during the measure- ment period, the annuitant would be credited with 7.2% growth (80% of 9%). If the index performed at –9%, the annuitant would receive the minimum guarantee of 1%.
In addition to the participation rate, there is usually a cap rate. A typical cap might be 12%. This means that if the index annuity was pegged to the S&P 500 and that index increased 30% during the year, your gain would be capped at 12%. One other negative characteristic of these products is that they tend to have longer surrender charge periods (as long as 15 years)
than other annuities, especially if there is a front-end bonus.
variable annuties
Insurance companies introduced the variable annuity as an opportunity to keep pace with inflation. For this potential advantage, the investor assumes the investment risk rather than the insurance company. Because the investor takes on this risk, the product is considered a security. It must be sold with a prospectus by individuals who are both insurance licensed and securities licensed.
The premium payments for variable annuities are invested in the separate account of the insurer. The separate account comprises various subaccounts that behave like mutual funds (we just can’t call them mutual funds). These accounts will have a variety of investment objectives to choose from, such as growth, income, and growth and income. The returns in the separate account are not guaranteed, and therefore a loss of principal is possible.
As with all recommendations, suitability of any purchase is number one. However, in light of the large number of cases involving variable annuities where there was failure to supervise egregious unethical behavior, FINRA Rule 2330 evolved. This rule applies to recommended purchases and 1035 exchanges of deferred variable annuities (not immediate) and recom- mended initial subaccount allocations.
combination annuity
Although annuitants of variable annuities can choose a guaranteed monthly income for life, the amount of monthly income received is dependent on the performance of the separate account. Monthly income either increases or decreases, as determined by the separate account performance.
Investors may purchase a combination annuity to receive the advantages of both the fixed and variable annuities. In a combination annuity, the investor contributes to both the general and separate accounts, which provides for guaranteed payments, as well as inflation protection.
Whenever you see the term variable, as in variable annuity or variable life (discussed later), two licenses are required for the sale—
an insurance license and a securities license. Suitability must be determined and a prospectus must be delivered prior to or with solicitation of the sale.
purchasing annuities
Insurance companies offer a number of purchase arrangements for annuities. The various purchasing plans are discussed next. Aggregate fees include not only sales charges on the front end, but also those levied upon surrender, commonly called conditional deferred sales loads.. In many cases, there is no-load to purchase, but if surrender, other than through annuitization, occurs during the early years of the contract, the charges can be significant.
An investor is offered a number of options when purchasing an annuity. Payments to the insurance company can be made either with a single lump-sum payment or periodically on a monthly, quarterly, or annual basis.
A single premium deferred annuity is purchased with a lump sum, but payment of benefits is delayed until a later date selected by the annuitant.
A periodic payment deferred annuity allows investments over time. Benefit payments for this type of annuity are always deferred until a later date selected by the annuitant.
An immediate annuity is purchased with a lump sum, and the payout of benefits usually commences within 60 days.
what type of annuity is there no such thing as
immediate annuity
bonus annuities
Direct financial benefits are sometimes offered with annuities, called bonus annuities. These benefits include enhancement of the buyer’s premium, with the insurance company contributing an additional 3–5% to the premium payment. This comes with a cost, of course, in the form of higher fees and expenses, and longer surrender periods than the typical 7–10 years of standard contracts. Recommendations to customers must include the additional costs, as well as the benefits of the bonuses and enhancements.
sales charges
Although there are no stated maximum sales charges on variable annuities, the SEC has charged FINRA with the responsibility of ensuring that they are fair and reasonable. As a practical matter, most annuities, both fixed and variable, are sold with little or no sales charge.
Instead, there is a surrender charge (think CDSC or CDSL) for early termination. This surrender period is longer for bonus annuities and generally the longest for index annuities.
accumulation phase
A variable annuity has two distinct phases. The growth phase is its accumulation phase, while the payout phase is its annuity phase. A contract owner’s interest in the separate account is known as either accumulation units or annuity units, depending on the contract phase.
Accumulation units vary in value based on the separate account’s performance.
the payout phase
When the annuitant decides to begin receiving payments from the annuity, the annuitant may choose to annuitize the contract and choose the desired settlement option. Although not required, if annuitized, the owner enters into a contractual obligation with the insurance company for the systematic distribution of the asset.
Once annuitized, the money will be distributed per the payout option chosen (discussed later). At that point, the accumulation units purchased over time will be converted into a fixed number of annuity units. This becomes one of the factors used to calculate the payout each month during retirement.
Annuity units vary in value based on the separate account performance.
receiving distributions from annuities
An annuity offers several payment options for money accumulated in the account. The investor can withdraw the funds randomly, in a lump sum, or annuitize the contract (receive monthly income).
If the investor chooses annuitization, the amount of the monthly check is dependent on several factors:
■ Amount of money in the contract (more money equals a bigger check)
■ Age (the older one is, the larger the check will be)
■ Sex (females live longer than males; therefore, the check would be less for a female)
■ Payout option (reviewed in this segment)
■ Investment return versus assumed interest rate for variable annuities (see the following)
assumed interest rate
If the annuity is variable, the actuarial department of the insurance company determines the initial value for the annuity units and the amount of the first month’s annuity payment. At this time, an assumed interest rate (AIR) is established. The AIR is a conservative projection of the performance of the separate account over the estimated life of the contract.
he value of an annuity unit and the annuitant’s subsequent monthly income will vary, depending on separate account performance as compared to the AIR. To determine whether the monthly payment will increase, decrease, or stay the same as the previous month, the following rules apply.
■ If separate account performance is greater than the AIR, next month’s payment is more than this month’s.
■ If separate account performance is equal to the AIR, next month’s payment stays the same as this month’s.
■ If separate account performance is less than the AIR, next month’s payment is less than this month’s.
surrender
If he wishes, the annuitant may simply cash in his annuity. In this case, his cost base is the total amount he has invested. He will be liable for income tax on the growth, plus a 10% penalty on the growth if he is under the age of 591⁄2.
death of annuitant
If the annuitant dies during the accumulation period, the death benefit takes effect. His beneficiary is guaranteed either the total value of the annuity or the total amount invested, whichever is greater, and is liable for income tax on any growth.
annuitization
If the annuitant wishes to receive scheduled payments for life, he may annuitize, in which case, he must select a payout option, such as:
■ life annuity (also known as straight life or life only);
■ life annuity with period certain;
■ joint life with last survivor annuity; and
■ unit refund option.
This is a separate contractual obligation that is entered into, and once annuitized, the decision is final.
life annuity/Straight life
If an annuitant selects the life income option, the insurance company will pay the annuitant for life. When the annuitant dies, there are no continuing payments to a beneficiary. Money remaining in the account reverts to the insurer. Because there is no beneficiary during the annuitization, this represents the largest monthly check an annuitant could receive for the rest of the annuitant’s life. (The insurance company has no further obligation at death.)
life annuity with period certain
The following options are a little less risky because they allow for payments to a beneficiary. To guarantee that a minimum number of payments are made even if the annuitant dies, the life with period certain option can be chosen. The contract will specifically allow the choice of a period of 10 or 20 years, for instance. The length of the period certain is a choice that is made when a payout option is selected. The annuitant is guaranteed monthly income for life with this option, but if death occurs within the period certain, a named beneficiary receives payments for the remainder of the period. Because there is a named beneficiary for the period certain, the size of this check will be smaller than a straight life option. (The insurance company is obligated to pay the named beneficiary an income if death occurs during the period certain.)
joint life with last survivor annuity
The joint life with last survivor option guarantees payments over two lives. It is often used for spouses. Because the insurance company is obligated to pay a check over two lifetimes, this check is considered to be smaller than a life with period certain option.
E *X A M P L E
unit refund option
If the annuitant chooses the unit refund option, a minimum number of payments are made upon retirement. If value remains in the account after the death of the annuitant, it is payable in a lump sum to the annuitant’s beneficiary. This option may be added as a rider to one of the others.
taxation of annuities
All contributions to annuities are made with after-tax dollars, unless the annuity is part of an employer-sponsored (qualified) retirement plan or held in an IRA.
Assume an annuity is nonqualified unless a question specifically states otherwise. When contributions are made with after-tax dollars, these already taxed dollars are considered the investor’s cost basis and are not taxed when withdrawn. The earnings in excess of the cost basis are taxed as ordinary income when withdrawn.
just read
variable annuity suitability
A variable annuity can be a very important part of one’s financial well-being if utilized correctly. However, there are suitability issues to consider. Variable annuities are meant to bring supplemental income into the household at a time in one’s life when the income is needed.
Therefore, supplemental income for retirement, not preservation of capital, should be the catalyst to considering a variable annuity. Here are some general rules of thumb regarding the suitability of variable annuities.
■ Variable contracts are considered most suitable for someone who can fund the contract with cash. In other words, enticements to cash out a life insurance policy or an existing annuity (either of which might come with high surrender charges) is considered abusive and not a suitable recommendation. Refinancing a home or withdrawing equity from a home to fund a purchase could never be considered suitable.
Variable contracts are not suitable for anyone who might need the lump sum of cash invested in the VA at a later time for any reason. Anticipating buying a home, needing cash for your children’s college education, or any other upcoming expense would need to be considered outside the variable annuity investment.
■ Investing in a variable annuity within a tax-deferred account, such as an IRA may not be a good idea. Because IRAs are already tax-advantaged, a variable annuity will provide no additional tax savings. It will, however, increase the expense of the IRA compared with other funding choices, such as stocks, bonds, or mutual funds.
— If the annuity is within a traditional (rather than a Roth) IRA, the IRS requires that you start withdrawing income no later than the April 1 that follows your 701⁄2 birthday, regardless of any surrender charges the annuity might impose.
■ Variable annuity contracts are insurance company products that invest in a portfolio of securities via their separate account. If someone has a low-risk tolerance or is wary of the stock market, a variable annuity is not likely a very suitable recommendation for that individual.
■ Maximum contributions to all other retirement savings vehicles available to an individual should be made before a variable annuity is considered a suitable recommendation. In other words, they are best considered supplements to retirement income one can already anticipate, such as pensions and IRA or 401(k) distributions.
1035 exchange
A 1035 exchange is a tax-free exchange between like contracts. The IRS allows annuity and life insurance policyholders to exchange their policies without tax liability. For example, if a life insurance policyholder wanted to exchange his policy for one from another company, he could transfer all cash values from the old policy into the new policy without recognizing any tax consequences. This 1035 exchange provision applies to transfers of cash values from annuity to annuity, life to life and life to annuity. It cannot be used for transfers from an annu- ity to a life insurance policy.
Finra is concerned about section 1035 exchange abuses where the registered rep
representative emphasizes the tax-free nature of the exchange without pointing out
possible disadvantages. Those include:
possible surrender charges on the old policy;
■■ a new surrender charge period on the new policy; and
■■ possible loss of a higher death benefit that existed on the old policy.
The representative and a principal of the firm must believe that the customer has been informed, in general terms, of various features of deferred variable annuities, such as:
■ the potential surrender period and surrender charge;
■ potential tax penalty if customers sell or redeem deferred variable annuities before reaching
the age of 591⁄2;
■ mortality and expense fees;
■ investment advisory fees;
potential charges for and features of riders;
■ the insurance and investment components of deferred variable annuities; and
■ market risk.
In addition, the firm must inquire as to whether the customer has had an exchange of a variable annuity at another BD within the last 36 months.
life insurance
Life insurance provides a death benefit to a named beneficiary in the event of an insured’s premature death. There are many variations of whole life and term insurance, each serving different needs. We will review these policies and focus on one considered a security.
Whole life insurance is designed to last until at least age 100 or the death of the insured, whichever occurs first. These policies also accrue cash value that may be borrowed for living needs. An insurance license is required to sell life insurance.
The premium for whole life insurance is calculated according to the policyowner’s health, age, and sex, as well as the policy’s face amount at issue. Whole life insurance is not a security and is not sold as an investment.
variable life insurance
Variable life (VL) insurance has a fixed, scheduled premium but differs from whole life insurance in that the premiums paid are split; part of the premium is placed in the general assets of the insurance company. These general assets are used to guarantee a minimum death benefit. The balance of the premium is placed in the separate account and represents the cash value of the policy. Because the cash value is invested in the separate account, which fluctuates in value, its cash value is not guaranteed. The policy’s death benefit may increase above the minimum guaranteed amount as a result of investment results, but may never fall below the minimum (as long as premiums are paid).
VL prospectus delivery
Because a VL insurance policy is considered a security as well as an insurance product, a prospectus is required, just as with any new issue. The prospectus must be delivered before or at the time of solicitation and may not be altered in any way (no highlighting or writing in the prospectus).
Air and variable death benefit
The death benefit payable under a VL insurance policy is adjusted on an annual basis and can increase or decrease based on the performance of the separate account compared with an AIR. One of the benefits of VL is that the death benefit may adjust upward and possibly keep pace with inflation. Another benefit is that, as with other forms of life insurance, in most cases, the death benefit is received by the beneficiary free of income tax. In addition, if the policy is owned by someone other than the insured, the proceeds will not be included in the decedent’s estate.
If the separate account returns are greater than the AIR, these extra earnings are reflected in an increase in death benefit and cash value. If the separate account returns equal the AIR, actual earnings meet estimated expenses, resulting in no change in the death benefit. Should the separate account returns be less than the AIR, the contract’s death benefit will decrease; however, it will never fall below the amount guaranteed at issue.
loans
Like traditional whole life (WL), a VL contract allows the insured to borrow against the cash value that has accumulated in the contract. Loans are not considered constructive receipt of income and therefore are received income tax-free. However, certain restrictions exist. Usually, the insured may only borrow a percentage of the cash value. The minimum percentage that must be made available is 75% after the policy has been in force for three years. There is no scheduled repayment of a loan. However, if the death benefit becomes payable and a loan is outstanding, the loan amount is deducted from the death benefit before payment. The interest rate charged is stated in the policy. If an outstanding loan reduces cash value to a negative amount, the insured has 31 days to deposit enough into her account to make it positive. If she fails to do so, the insurance company will terminate the contract. If this happens, the loan, of course, need not be repaid.
contract exchange
During the early stage of ownership, a policyowner has the right to exchange a VL contract for a traditional fixed-benefit WL contract. The length of time this exchange privilege is in effect varies from company to company, but under no circumstances may the period be less than 24 months (federal law).
The exchange is allowed without evidence of insurability. If a contract is exchanged, the new WL policy has the same contract date and death benefit as the minimum guaranteed in the VL contract. The premiums equal the amounts guaranteed in the new WL contract (as if it were the original contract).
two testable facts about the contract exchange provision are
The contract exchange provision must be available fora minimum of two years.
■■ No medical underwriting (evidence of insurability) is required for the exchange.
Sales charges
The sales charges on a fixed-premium VL contract may not exceed 9% of the payments to be made over the life of the contract. The contract’s life, for purposes of this charge, is a maximum of 20 years. For those of you familiar with life insurance compensation, the effect of this is that renewal commissions are earned up to the 20th anniversary of policy issue.
Refund provisions
The insurer must extend a free-look period to the policyowner for 45 days from the execution of the application, or for 10 days from the time the owner receives the policy, whichever is longer. During the free-look period, the policyowner may terminate the policy and receive all payments made.
■■ The maximum sales charge over the life of the contract is
■■ A policyowner who wants a refund within 45 days receives
■■ After a VL policy has been in effect for two years, the surrender value of the policy is
9%
all money paid.
the cash value.
suitability of VL insurance
There must be a life insurance need.
■ The applicant must be comfortable with the separate account and the fact that the cash
value is not guaranteed.
■ The applicant must understand the variable death benefit feature.
■ A prospectus must be delivered prior to or at the time of solicitation.
529 planss
Section 529 plans are a tax-advantaged savings plan offering benefits to those saving for future education costs. These plans are generally under the auspices of states or their agencies and are technically considered municipal fund securities.
There are two basic types of 529 plans: prepaid tuition plans and college savings plans. Both plans are funded with after-tax dollars, and earnings grow tax deferred. Withdrawals taken for qualified education expenses are generally tax-free. If the money is used for anything other than qualified education expenses, the earnings portion of the distribution will be tax- able on your federal (and possibly state) income tax return in the year of the distribution. Also, you generally must pay a 10% federal penalty on the earnings portion of your distribu- tion. (There are a couple of exceptions to the 10% penalty. The penalty is usually not charged if you terminate the account because your beneficiary has died or become disabled, or if you withdraw funds not needed for college because your beneficiary has received a scholarship.) Any person can open a 529 plan for a future student; the donor does not have to be related to the student.
prepaid tuition plan allows
allow donors to lock in future tuition rates at today’s prices, thus offering inflation protection.
college savings plan
The college savings plan allows the donor to invest a lump sum or make periodic pay- ments. The money is typically invested into target-date funds. As the target date approaches (the date the money is needed) the portfolio gets more conservative. When the student is ready for college, the donor withdraws the amount needed to pay for qualified education expenses (e.g., tuition, room and board, and books). These plans do have investment risk, in other words, they can lose money.
coverdell education savings account
are not municipal securities. They can be funded with traditional types of securities. These plans allow after-tax contributions of up to $2,000 per student per year for children until their 18th birthday.
Contributions may be made by any person, provided the total contribution per child does not exceed $2,000 in one year. Earnings grow tax deferred, and distributions are tax-free as long as the funds are distributed prior to the beneficiary’s 30th birthday and used for qualified education expenses.
coverdell education savings account contribution limit
contributions must cease after
taxable?
distributions tax free if
if money not used for education or money is distributed after age 30, earnings are subject to
$2,000 per year per child under age 18.
childs 18 birthday
contributions are not tax deductable
taxen before age 30 and used for education expenses
10% penalty and charged as ordinary income
