What describes the number of common shares for which a convertible bond may be exchanged?
conversion ratio
The conversion ratio is the number of common shares for which a convertible bond may be exchanged.
Which of the following statements about the risk characteristics of a convertible bond are true?
A convertible bond is less risky than a similar straight bond
A convertible bond is more risky than common stock
A convertible bond is more risky than a straight bond but less risky than common stock
A convertible bond is as risky as common shares
3 only
A convertible security provides more upside potential and risk than a straight bond, but less upside potential and less risk than the common stock.
You are the owner of a $1,000 convertible bond that was issued at par. The conversion option allows you to exchange the bond for 10 shares of common stock. What is the bond's conversion price?
$100
A convertible bond's conversion price is calculated by dividing its issue price by the conversion ratio (number of shares for which it may be exchanged). In this case the issue price of $1,000 is divided by 10 to obtain the conversion price of $100.
What is the purpose of a balance sheet?
A one-time snapshot of the company's assets and liabilities.
The formula for the balance sheet is:
Assets - Liabilities = Net Worth
What are assets or liabilities easily accessible or payable within one year called?
"Current" Assets and Liabilities
These assets include cash on hand, prepayments, and accounts receivable with terms less than one year. This also applies to short-term loans or accounts payable.
What is the purpose of separating short-term assets and liabilities?
Evaluate a Company's Liquidity
By separating short term assets and liabilities, we can create a set of ratios that give insight to the short term access to cash or the amount of upcoming liabilities that must be paid.
Acid Test
The acid test is an even more conservative analysis of the liquidity of a company. The formula is:
Acid Test = (Current Assets - Inventory) / Current Liabilities
The idea here is, inventory is considered a current asset but is not necessarily easily convertible into cash. By removing it from current assets, it gives a more conservative estimate of the cash available to pay liabilities.
Secured Bonds
What are the three major types?
Collateral Trust Bonds - secured by placing financial collateral with a trustee
Mortgage Bonds - the bond is secured by property, such as real estate
Equipment Trust Bonds - backed by equipment
What is another name for a company's unsecured debt?
Debentures
How do zero coupon bonds differ from coupon bonds?
They are issued at a deep discount and make no regular coupon payments.
Their risk profile is also different: their market price is much more sensitive to rate changes than that of coupon bonds.
Zero coupons pay no interest; how does the IRS capture taxes?
In a zero coupon bond, even though the investor does not receive any income until maturity, they are still required to pay taxes each year on the annual accretion.
Why are zero coupon bond prices so volatile?
Because zero coupon bonds do not pay annual cash flows, they do not provide a buffer to changing rates and therefore are more volatile to changing rates.
What is a suitable use of zero coupon bonds from an investor's point of view?
Since zeros mature at par, they are suitable for long term planning purposes where the investor wants a known lump sum available in the future.
Example: A parent wants to have a $50,000 lump sum available in 20 years to pay for their child's graduate education. It would be suitable for them to buy $50,000 zero bonds now at a deep discount, knowing they will mature at $50,000.
What are Euro Dollar bonds?
Euro Dollar bonds are US dollar denominated bonds that are issued and/or traded outside of the US.
How does the money market differ from the bond market?
Much Shorter Maturity
Although money markets have shorter maturities than the bond market, by defintion usually one year or less, they are just as important to funding the day-to-day operations of corporations and represent a very liquid, multi-billion dollar market.
Who issues commercial paper?
Corporations
Commerical paper is issued by corporations as is used to raise short-term cash. These securities typically have a maximum maturity of nine months (270 days).
For what purpose are bankers acceptance (BA) notes typically used?
To Finance International Trade
What is a repo agreement and why do banks use them?
To Raise Short Term Cash
If a broker-dealer needs to raise cash, it can sell collateral to another party with an agreement to repurchase that same collateral at a defined price at some point in the future. The difference between the original sale price and the repurchase price is the interest charged for this loan.
What are the specific tax benefits of U.S. government treasury bonds?
U.S. Treasuries are exempt from state and local taxes.
For what return objective are T-Bills unsuitable for some investors?
T-Bills are very short term instruments sold at a discount and they provide no coupon payments. Because they have no cash flows, T-Bills, like zeroes, offer no current income. Investors seeking current income during a given period, such as retirement income, should avoid T-Bills.
Describe the auction process of T-Bills.
T-Bills are offered weekly at auction, where primary dealers bid for the bills using their own capital and orders from customers. T-Bills are bought at discount in amounts of $1,000 to $1 million and mature in 13 and 26 weeks. The purchase price of T-Bills at auction is expressed as a percentage: a bid of 10 means that dealer is bidding that auction at a 10% discount to par.
Describe how Treasury notes differ from T-Bills.
Notes mature between 2 and 10 years versus T-Bills, which mature in one year or less
Notes are issued with coupons and pay interest, unlike T-Bills, which are zeros
T-Bills are quoted as a discount off of par, while T-Notes are quoted as a percentage of par in increments of 1/32
Describe how Treasury bonds differ from T-Bills.
Treasury bonds typically mature in 30 years whereas T-Bills have maturities of one year or less
T-Bonds are issued with coupons and pay interest, unlike T-Bills, which are zeros
T-Bills are quoted as a discount off of par, while T-Bonds are quoted as a percentage of par in increments of 1/32
What are Treasury Receipts and how are they created?
Synthetic Zero Coupon Bonds
Treasury receipts are created by selling another security backed by the interest payments and principal of T-Bills and T-Notes. They are sold at a discount and pay no interim cash flows. Even though they are backed by treasuries, they do not carry any guarantee.
What are STRIPS and how are they created?
Separate Trading of Registered Interest and Principal of Securities (STRIPS)
STRIPS work almost exactly like treasury receipts. but are backed by the government. A simple bond is split into two parts, its interest payment and it's principal amount, and sold separately. The principal-only security works just like a zero coupon bond and is sold at a discount.
What are TIPS?
Treasury Inflation Protection Securities (TIPS)
TIPS are issued with a fixed coupon, but in order to protect against inflation, the notional is linked to the Consumer Price Index.
Although the coupon is fixed, the interest payment will change as the notional changes and can both increase or decrease with inflation or deflation.
What type of investor is suitable for TIPS?
Long-term investors
Investors who buy and hold TIPS usually are investing for things far into the future and are concerned about inflation eroding their purchasing power.
Where do TIPS trade relative to other Treasury securities?
TIPS trade at lower yields
Anytime a fixed income instrument has some feature that will benefit the investor, it will trade at a lower yield relative to a nearly identical asset without that feature. So two-year TIPS always will trade with a lower yield than the two-year Treasury note.
What types of government securities have no secondary market?
U.S savings bonds
There is no secondary market for these bonds and to be sold must be redeemed with the U.S. Treasury.
What are the two government-sponsored enterprises (GSE)?
Freddie Mac - Federal Home Loan Mortgage Corporation (FHLMC)
Fannie Mae - -Federal National Mortgage Association (FNMA)
As GSEs, they are not formally backed by the government but are presumed to carry government backing – a presumption tested during the financial crisis.
How is Ginnie Mae (GNMA) different from Fannie and Freddie?.
Fannie and Freddie are both government sponsored enterprised that have an implied but not explicit backing of the US government. Ginnae Mae is a government agency, which has an explicit backing of the US government and thus would be considered safer.
What are the general yield characteristics of government sponsored enterprise debt relative to treasury or corporate debt?
Higher than treasuries - lower than corporates
Because the debt is not a direct obligation of the government, investors demand a higher yield for that small risk. Because GSE's debt is significantly safer than corporate debt, they will carry a lower yield.
What are the characteristics of GNMA debt?
Higher yield than treasuries
Even though backed by the U.S. Government, GNMA debt trades with a higher yield than do treasuries.
As mortgages that make up GNMA debt pay down, the principal notional of the bond is reduced every month and GNMA debt also pays interest every month.
The reason for the higher yield is the uncertainty of maturity.
What is a significant risk characteristic of GNMA pass-through securities?
Re-investment risk when rates fall
GNMA pass-through securities are comprised of bundles of individual mortgages. In a falling rate environment, more home owners re-finance and that means more of the bonds' notional is returned to investors, who are then forced to invest that money in the new lower-rate environment.
What was the stated purpose of Freddie Mac?
Create a secondary mortgage market
In the past, there was no secondary market within which to sell the mortgages that local and community banks created. This limited the credit available for the housing market. FHLMC buys individual mortgages from these community banks, bundles them, and creates mortgage-backed securities from them.
Describe the basic structure of a Collateralized Mortgage Obligation (CMO).
CMOS are mortgage backed securities that have been structured by broker-dealers and cut up into different pieces called tranches. The various tranches will all vary in credit quality, expected maturity, and exposure to pre-payments.
What was the primary motivation of creating the CMO security?
Pre-payment risk management
Other pass through securities simply "pass through" interest and principal payments every month. This makes them very sensitive to interest rates aas well as to shortened duration of the securities as more and more mortgages fare pre-payed via re-financing.
By creating tranches by credit risk and expected maturity, investors would have more certainty about what they actually were buying.
How does a CMO control the expected maturity of a particular tranche?
Re-distributing cash flows
When principal payments are made by a mortgage holder, the CMO trustee will distribute those payments toward the retirment of the first tranch. By estimating the payments, it is possible to control the expected time when that tranche will be paid off. Once each tranche is paid ofg, the cash flow is directed toward paying off the next tranche.
Note: only the principal payments are re-directed. Normal interest payments are distributed to all the tranches.
What type of CMO is the least extension risk?
Planned Amortization Class (PAC)
This type of CMO was created to fill the need for more specific maturity dates even in the event of mortgage prepayments. This prepaid cash is sent to other tranches referred to as a support tranche and the PAC is paid off on a defined schedule.
Income taxes are assessed on which types of income?
The IRS taxes all income from wages and salaries, also called "ordinary income". Investment income - capital gains, interest income, and dividends - are also taxable.
How are cash dividends from stock taxed?
If an investor holds the stock for greater than 60 days during the 121 day period surrounding the ex-dividend date, the dividend will be classified as a qualified cash dividend and taxed at a preferential rate. If the investor does not meet that holding period, it will be defined as an ordinary cash dividend and taxed at the investor's ordinary income rate.
What types of capital gains are there?
There are short-term capital gains and long-term capital gains.
How are short-term capital gains defined and taxed?
A short-term capital gain is one for which the asset was held 12 months or less. It is taxed as ordinary income, which is the same rate as an investor's salary.
How are long-term capital gains defined and taxed?
Long-term capital gains are assessed on assets held over 12 months. Long-term capital gains are taxed at a preferential rate, meaning a lower rate than what investors pay on their salary.
What is the cost basis of a stock?
The cost basis is the effective price for the purpose of calculating taxes. Commissions will increase the cost basis of a stock. The taxable income will be the sale price minus the cost basis.
What law governs how investment companies are regulated?
The Investment Company Act of 1940
A Unit Investment Trust (UIT) is defined and regulated by the Investment Company Act of 1940. What is a UIT's typical investment strategy?
A UIT will purchase a defined and fixed portfolio from a broad range of securities (often including stocks, bonds and munis) and has no restrictions on what kind of securities it can buy. Importantly, once the portfolio is created, it is fixed, meaning whatever is in the portfolio stays there. It is not actively managed.
What are the fees that investors pay when they purchase UITs?
Similar to mutual funds, because UITs offer redeemable shares, investors pay sales charges when they purchase the units. They do not pay commissions as UITs are not exchange traded products.
What is the termination date of a UIT?
The termination date of a UIT is the date when the trust ends and investors receive their proportionate share of the UITs net assets. For a bond UIT, the termination date often coincides with the maturity date of the bonds. For an equity UIT, the termination date is established when the UIT is created.
If a UIT is a fixed portfolio of securities but consists of callable bonds, how does the portfolio change if that bond is called away?
The called bond is not replaced by another and will simply be taken out of the basket by the call. In this event, the investor will receive a cash distribution of proceeds. This is also the case as bonds mature. The trust can make any kind of interest payment: monthly, quarterly, or semi-annual.
On what exchange can an investor sell their UIT?
None. There are no exchanges for UITs, they must be redeemed with the issuer.
What types of management fees are UITs allowed to charge?
UITs are not allowed to charge any management fees since the UIT is fixed and there is no active buying and selling of securities.
What are the benefits of a management investment company for investors?
In a management investment company, the investors' funds are actively managed to acheive an investment objective. This means that the management company hires an investment adviser that will actively trade the portfolio to meet the fund's goals.
There are two types of management companies. What are they?
Open-end funds (aka mutual funds) and closed-end funds
A closed-end fund trades most like what security?
Common stock. Similar to shares of a corporation, a closed-end fund have a one time initial public offering for shares that are actively traded on an exchange. Because the shares of a closed-end fund are exchange-traded, similar to common stock, the price of each share is based on supply and demand.
An investor that is looking to buy an actively managed investment company security that trades throughout the day would most likely purchase which type of shares?
Closed-end funds would be most appropriate for investors as they combine active management with exchange-trading. Mutual funds also provide active management, but do not issue exchange-traded shares. Instead, the shares are only redeemable with the issuing investment company.
What are the two key characteristics of a mutual fund?
Mutual funds, also referred to as open-end funds, register a continuous offering of redeemable shares. This means that there is no secondary market for mutual funds, the shares are redeemable, meaning bought and sold directly with the mutual fund itself. Also, importantly, mutual funds are actively managed
On what exchange do open-ended funds trade?
Mutual funds do not trade on a secondary market. Instead, the shares are reedeemed by the investor with the fund.
What defines a diversified investment company?
For an investment company to qualify as diversified, the following 75-5-10 test must be met:
At least 75% of the fund's total assets must be invested in securities issued by companies other than the investment company itself
Of that 75%,
No more than 5% of the fund's total assets can be investment in the securities of any one issuer, and
No more than 10% of the outstanding voting securities of any one issuer can be owned.
One of the benefits of open-end investment companies is professional management. Who hires the manager?
Fund managers are generally hired by the board of directors of the investment company.
advance/decline trend
The difference in up and down days of a security - used in technical analysis as a market movement indicator. When declines outnumber advances by a large amount, that is typically a bearish indicator and when advances outnumber declines by a large amount, that is typically a bullish indicator.
The top of a stock's normal trading range
Resistance
The bottom of a stock's normal trading range
Support
Price-weighted index of 30 "blue chip" U.S. stocks of industrial companies
Dow Jones Industrial Average
Capitalization-weighted index of 500 stocks, regarded as the standard for measuring large-cap U.S. stock market performance
S&P 500
Defines and regulates investment companies, including mutual funds
Investment Company Act of 1940
Share value of OTC, non-NASDAQ stock subject to the Penny Stock Cold Calling Rules
Less than $5 per share
Under penny stock rules, an established customer is
1) Someone who has made at least three penny stock purchases of different issuers on different days or
2) someone who has held an account with the broker-dealer for at least one year.
An unsecured corporate bond
Debenture
Security with the most junior claim in a corporate liquidation
Common stock
Agency debt that is backed in full by the U.S. government
Ginnie Mae
Considered the safest form of debt issued in the U.S.
U.S. Government bonds, notes and bills
Taxable at the federal level; may be exempt from taxation at the state level
U.S. Government bonds and notes
Of long-term and short-term bonds, which generally pays a higher interest amount?
Long-term bonds
Of long-term and short-term bonds, which generally has lower price volatility?
Short-term bonds
The degree of risk associated with an issuer's ability to repay the principal
Credit or default risk
A bond that is rated BBB or above by Standard and Poor's
Investment Grade
Risk that a bond may be called prior to maturity
Call risk
Specific time period from date of issue when a bond cannot be called
Call Protection Period
Type of bond issue that is not typically callable
U.S. Government bonds (Treasury bonds)
Risk that proceeds from a called bond cannot be invested as favorably
Reinvestment risk
Bonds backed only by the good faith of the issuing corporation
Unsecured bonds or debentures
Typically backed by real estate holding of a corporation
Mortgage bond
Typically secured by other securities owned by the corporation
Collateral Trust bond
Secured by physical assets owned by the company
Equipment trust certificates
Allow for the exchange of debt for equity issued by the same corporation
Convertible debt
The stated number of common shares a bondholder receives upon conversion
Conversion ratio
The point at which there is neither profit or loss in a conversion
Conversion parity
Purchased at a deep discount; pays no interest during the life of the bond
Zero-coupon bond
The amount of interest paid prior to maturity on a Treasury Bill
None, T-Bills are zero coupon securities
U.S. Government instrument that matures in 1 year or less
Treasury Bill
U.S. Government instrument sold through weekly auctions
Treasury Bill
U.S. Government instrument that is quoted on an annualized discounted yield basis
Treasury Bill
U.S. Government instruments that matures within 2 -10 years
Treasury Note
U.S. Government instruments that typically mature in 20 - 30 years
Treasury Bonds
U.S. government instruments that are quoted in 32nds
Treasury Notes and Treasury Bonds
Inflation-indexed bonds issued by the U.S. Treasury
TIPS
U.S. government zero-coupon bond instrument that has no reinvestment risk
STRIP
issue mortgage-backed securities
Ginnie Mae, Fannie Mae and Freddie Mac
Agency that provides student loans
Sallie Mae
Investment risk most associated with mortgage-backed securities
Prepayment risk
Investment risk that coincides with early payment of a mortgage-backed securities
Reinvestment risk
Distinct maturity categories of CMOs
Tranches
Frequency of interest payments on mortgage-backed securities
Monthly
Mortgage-backed securities with the implied backing of the U.S. government
Fannie Mae and Freddie Mac
Debt securities that provide immediate term financing
Money market securities
Denomination of CMOs
$1,000
Protects convertible bondholders from a reduction in ownership percentage
Anti-dilution covenant
The relationship of the coupon rate of a corporation's convertible debt to its non-convertible debt
Lower
The type of risk rated by Moody's, Standard & Poor's and Fitch
Default or Credit Risk
The risk that the issuer will not be able to pay the principal and interest owed on outstanding debt securities
Default or Credit Risk
A bond which can be sold at face value back to the issuer prior to maturity at pre-determined times
Puttable bond
Corporate secured bonds that have the highest priority claim
Mortgage bonds
Type of corporate security that is backed by the title to newly acquired equipment
Equipment trust certificate
Two companies that rate bond issues
Moody's and Standard and Poor's (also Fitch)
Type of bonds often issued by corporations emerging from bankruptcy that pay interest only if income is available
Income bond
The stock price at which a convertible bond can be exchanged for shares of common stock
Conversion price
Zero coupon securities created from U.S. Treasury notes and bonds by brokerage firms
Treasury receipts
Percentage of net investment income that a REIT must distribute to avoid corporate taxation
90%
For a REIT, the minimum percentage of investment assets that must be invested in real estate
75%
The minimum percentage of gross income that a REIT must derive from rents or mortgage interest
75%
Where REIT shares or certificates of beneficial interest can be purchased
OTC or on a stock exchange
Type of investment that passes through real estate income but not losses
REIT
Permit after-tax contributions of up to $2,000 per student for children under age 18 for educational purposes
Coverdell Education Account (Education Savings Account)
Age at which funds from Coverdell accounts must be distributed or rolled into an ESA for another family member
30
Federal tax status of contributions made to Section 529 plan
After-tax
Tax advantage available for 529 plan contributions in many states to state residents
Contributions to 529 plan sponsored by that state are tax deductible on state tax returns
Tax rate increases as income increases
Progressive tax
Taxes that are levied equally regardless of income
Regressive taxes
An example of a regressive taxes
Sales taxes
Two examples of progressive taxes
Income, estate
Three types of income subject to taxation
Earned, passive, portfolio
Three taxable forms of portfolio income
Interest, dividends and capital gains
Minimum holding period for lower long-term capital gains tax rate
1 year and 1 day
Short-term holding period for capital gains tax computation
1 year or less
Maximum amount of capital loss that can be used to offset current income each year
$3,000
Period of time for which capital losses can be carried forward
Indefinitely
Transaction which disqualifies capital loss because substantially similar securities are repurchased within 30 days
Wash sale
Number of days before or after a sale for a loss for which a purchase of substantially similar securities must be avoided
Thirty days
Under the wash sale rule, purchases of any of these four securities of the same issuer are considered substantially identical to purchases of the issuer's stock
Long calls, rights, warrants and convertible bonds
Three accounting methods available for determining which shares to liquidate
FIFO, share identification, average basis
Method of share identification assigned by the IRS if no other method is chosen
FIFO
How are qualified cash dividends taxed?
They are taxed at a preferential rate (meaning lower rate) than the investors ordinary income
Cash dividends that are eligible for taxation at the same rate as long-term capital gains
Qualified
Minimum holding period of stock for dividends to be classified as qualified
Sixty-one days during the 121-day period surrounding the ex-dividend date
Tax implication of stock splits and stock dividends
Reduction to cost basis; no current taxation
The amount of investment in property; used to determine the gain or loss at time of sale
Cost basis
The accounting method that allows an investor to select which shares to liquidate for tax purposes
Share identification
Shares that would be liquidated first to result in the lowest possible capital gain
Shares with highest cost basis
The date which determines the amount of the tax deduction for charitable donations of appreciated property
Date the donation is made
The amount of tax deduction available for gifts of securities made to family members or others
None, as only charitable donations receive a tax deduction
The recipient's cost basis for gifts of securities from family members or others
Original cost basis of the donor
The cost basis of securities that are left to an heir
Market value of the securities on the date of the death of the owner
The current annual gift tax exclusion amount
$15,000
The tax provision that allows married persons to transfer their entire estate to the surviving spouse at death without taxation
Unlimited marital deduction
The person responsible for payment of gift taxes due
Donor
Interest on bonds of these two issuers is taxable at the federal, state and certain local levels
Corporations and agencies
Interest on bonds of this issuer is taxable at the federal level but exempt from taxation at the state and local level
U.S. Government
Amount of gift tax that applies on gifts between spouses
No gift tax regardless of amount
Tax treatment of withdrawals from Section 529 Plans
Tax free withdrawals (after-tax contributions)
Tax nature of contributions to Section 529 Plans
After tax contributions
Annual contribution to a Coverdell ESA is
$2,000 per beneficiary (non-deductible)
Investment requirement and pass-through requirement for REITs to qualify for favorable tax treatment
75% of assets invested in real estate and 90% of income passed through to investors
Two types of Investment Companies defined by the Investment Company Act of 1940
Unit Investment Trust and Management Company
Management company shares that may trade at a price more or less than their net asset value
Closed-ended Investment companies
Three types of securities that closed-end companies can issue
Common shares, preferred shares and bonds
An investment company that meets the 75-5-10 test
Diversified
Type of management company that can issue shares continuously
Open-end
Type of management company that issues a fixed number of shares in a single offering
Closed-end
Type of management company that can issue only equity shares
Open-end
Type of management company that can issue both equity and debt
Closed-end
Type of management company shares that are redeemed by the issuer
Open-end
Type of management company shares that trade in the secondary market
Closed-end
