Investment by Charles P Jones Chapter No. 2

Investment: Analysis and Management

By Charles P. Jones

Chapter 2-Investment Alternatives

Q 2-1: What is meant by indirect investing?

Indirect investing refers to the buying and selling of securities issued by investment companies that hold the portfolio of securities that are traded in financial markets. By investing in securities of investment companies, the investors are relieved from making decisions about the portfolio. Investors who purchase shares of a particular portfolio managed by an investment company are purchasing an ownership interest in that portfolio of securities and are entitled to a pro rata share of dividends, interest and capital gains generated by the portfolio. Shareholders of the investment company must also pay a pro rata share of the company’s expenses and management fee, which will be deducted from the portfolio’s earnings  as it flows back to the shareholders.

Q 2-2: What does it mean for Treasury bills to be sold at discount?

Treasury bills are short term, highly liquid and risk-free money market security, which are offered at a price less than its face value. Here is no interest payment made to the security holder till the maturity of the security. At the time of maturity the holder of the security receives the face value of the bill. The rate of return on the security (interest rate) is the underlying spread between discounted purchase price and the maturity value (face value).

Q 2-3: Distinguish between a negotiable certificate of deposit and the certificate of deposit in the section “non-marketable securities?

A certificate of deposit is a security issued in exchange of a deposit. A negotiable certificate of deposit is a marketable security that can be sold in the open market on the other hand a non-negotiable certificate of deposit cannot be sold in the market. The holder of such a security has to wait till maturity for principal.

Q 2-4: Name four issuers of bonds. Which do you think is the most risky as a general proposition?

The four issuers of bonds are

Federal government

Federal agencies

Municipal government

corporations

The bonds issued by corporations are considered to be the most risky since the probability of a default by a corporation is greater than any of the other three issuers. The securities issued by federal government in the denomination of local currency are free from default risk since the federal government can print notes to avoid a default on payment. The federal agency and municipal government securities are backed by the federal government and in case the agency or the municipal government defaults, the federal government will bail them out by providing them with additional funds. The corporations may default on interest payments and therefore are considered the most risky as a general proposition.

Q 2-5: From an issuer standpoint, what is the distinction between Fannie Mae and Ginnie Mae?

Fannie Mae (Federal National Mortgage Association) was created as a federally sponsored credit agency. Ginnie Mae (Government National Mortgage Association) is a government agency. The securities of government agency are guaranteed by government while those of the federally sponsored credit agencies are not.

Q 2-6: Name and explain the difference between two types of municipal securities?

The two types of municipal securities are general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith and credit of the issuer. The funds raised by these bonds may not produce revenues and the issuer taxes the residents to pay for the bond interest and principal. On the other hand, revenue bonds are repaid from the revenues generated by the project, for which these securities were issued. Since the interest payments on the revenue bonds are linked to the cash flows generated by the project that the municipal government has funded through issuance of bonds, the revenue bonds are considered to be more risky than the general obligation bonds.

Q 2-7: What does it mean to say that investors in Ginnie Mae face the risk of early redemption?

Ginnie Mae (Government National Mortgage Association) purchases mortgages from the bank and thrift institutions and issues securities against the assets bought. Although, by securitization, the default risk of these securities is minimized, they pose uncertainty to the investors as they can receive varying amounts of monthly payments depending on how quickly the owners of the assets pay of their mortgages. Due to this fact, while the stated maturity can be as long as 40 years, the average life of the security is much shorter and many such securities experience early redemption as the mortgages are paid off before maturity of the mortgage.

 

Q 2-8: What are the advantages and disadvantages of Treasury bonds?

The government issues treasury bonds for a long maturity ranging from 10 to 30 years. These bonds carry very low risk as the bonds are issued by the government and the return on these bonds is also very low as compared to bonds of other issuers. These bonds generally experience a liquid market. Where the liquidity and the low risk of the security can be viewed as advantages of the bond, low return and usually long maturity can be considered as disadvantages. Owing to the longer maturity, these securities are more sensitive to interest rate changes. The newer types of Treasury bonds have more advantages as they provide investors protection against inflation and deflation. These bonds guarantee face value if the consumer prices drop—a guard against deflation. Taxes are paid according to inflation adjustments, although the actual cash is not received till maturity—a guard against inflation.

Q 2-9: Is there any relationship between a saving bond and a US Treasury bond?

A saving bond is a non-traded debt of the US government, is non-marketable, non-transferable and non-negotiable. These bonds cannot be used for collateral. When saving bonds are held for at least five years, the investor receive higher of the market-based rate or a guaranteed minimum rate. The market-based rate is calculated as 85 percent of the average return on treasury securities with five years maturity. Hence, the rate of saving bond is tied to the rate offered by Treasury securities.

Q 2-10: Why is preferred stock referred to as ‘hybrid’ security?

Preferred stock is an equity security with an intermediate claim (between the bondholders and the common stockholders) on a firm’s assets and earnings. Preferred stock is considered a hybrid security because it carries the features of both equity and fixed-income instruments. As an equity security, preferred stock usually has an indefinite life and pays dividends, although some of the preferred stocks may have a maturity of 50 years.  The dividend is fixed in amount and known in advance, providing a stream of income very similar to that of a bond.

Q 2-11: Why is the common stockholder referred to as a residual claimant?

The common stockholders are referred to as residual claimants as they are entitled to the remaining income after the fixed income claimants (including the preferred stockholders) are paid in full. In case of liquidation also, the stockholders would be considered as the residual claimants, i.e. they would be paid if the claims of the bondholders and preferred stockholders are paid off.

Q 2-12: Do all common stocks pay dividends? Who decides?

Dividends are payments regularly made by corporations to their stockholders. They are decided upon and declared by the board of directors  and can range from zero to 100 percent of present and past net earnings. The common stockholder has no specific promises to receive any cash from the corporation since the stock never matures and dividends are not mandatory to be paid.

Q 2-13: What is meant by the term derivative security?

Securities that derive their value in whole or in part by having a claim on some underlying security are known as derivative securities. Options and future contracts are popular derivative securities.

Q 2-14: What is meant by the term securitization?

Securitization refers to the transformation of illiquid, risky loans into more liquid, less risky securities by backing them up with assets.

Q 2-15: Give at least two examples of asset-backed securities?

Asset-backed securities are those securities which have been converted into more liquid and less risky assets through the process of securitization. Pass-through securities and collateralized mortgage obligations are two examples of asset-backed securities, which differ in maturity, yields and face value.

Q 2-16: Why should we expect six-month Treasury bill rates to be less than six months CD rates of six month commercial paper rates?

The Treasury Department is the issuer of treasury bills, while banks and other financial institutions issue CDs and commercial papers. The US government has no risk of default, whereas banks and other financial institutions may default. Since the Treasury bill is a risk-free security, the return offered on it would be lesser than any other security that carries some risk, no matter how little.

Q 2-17: Why is the call provision on a bond generally a disadvantage to a bondholder?

The call provision gives the issuer the right to call in the bonds, thereby depriving the investors of that particular fixed-income security. Exercising the call provision usually takes place when market rates drop sufficiently below the coupon rate on the bonds. Exercising call provision helps the bond issuer to save money, by avoiding payments on a rate higher than the market interest rates. Costs are incurred to call the bonds, such as call premium and administrative expense. However, issuer expects to sell new bonds at a lower interest rate, thereby replacing existing higher interest cost bonds with new, lower interest cost bonds. However, some investors who purchase the bond at a price above the face value may suffer losses when the bond is unexpectedly called in and paid off.

Q 2-18: Is a typical investor more likely to hold zero-coupon in a taxable account or a non-taxable account? Why?

A typical investor would prefer to hold zero-coupon bonds in a non-taxable account since the actual return of a security in a taxable account is expected to be lesser than that of a non-taxable account. Zero coupon securities make no coupon payments and the bond holder gets the benefit only at the time of maturity when the implied interest is paid; however, the bondholder is taxed every year

Q 2-19: What are the potential advantages and disadvantages of DANs (Direct Access Notes) to investors compared to the conventional bonds?

To make bonds more accessible to individual investors, high credit quality forms have started issuing direct access notes.  These notes eliminate some of the traditional details associated with conventional bonds by issuing them at par value, which means no premium, discount or accrued interest. Coupons are usually fixed on these notes and maturities range from nine months to 30 years. The company issuing the bonds typically “posts” the maturities and rates that it is offering for one week, allowing the investors to shop around. Some companies act as the wholesalers of these bonds to their extensive network of brokerage firms, from which the investors would buy the bond. The brokerage firm buys the notes from the wholesaler at a discount and pays the broker’s commission.

One potential disadvantage of these notes is that they are best suited for buy-and-hold investor. A seller has no assurance of a good secondary market for the bonds, and therefore there is no assurance of the price that may be received by selling these notes in the secondary markets.

Q 2-20: What is an ADR? What advantages do they offer to investors?

American Depository Receipts (ADRs) represent indirect ownership of a specified number of foreign company shares. These shares are held on deposit in a bank, in the issuing company’s home country, while the US banks, known as depositories, issue the ADRs. In effect, ADRs are tradable receipts issued by depositories that have physical possession of the foreign securities through their correspondent banks or custodian abroad . The bank holding the securities collect the dividends, pays any applicable foreign withholding taxes, converts the remaining funds into dollars and pays the amount to the ADR holders. Holders can choose to convert their ADRs into specified number of foreign shares represented by paying a fee. This simplifies the process of investing in companies outside US for investors.

Q 2-21: Of what value to investors are stock dividends and splits?

Stock dividend and stock splits attract considerable investor’s attention. With a stock split the book value and the par value of the equity are changed. On practical basis, there is a little difference between a stock split and a stock dividend. The real question before the investor is that although the number of shares owned has increased, but has anything of real value been received or not? Other things being equal, these additional shares do not represent additional value because proportional has not changed. Regardless of the above mentioned fact, there is ample evidence that the stock price receives a boost following a split. The company, which announces a split, seems confident about its future prospects, which boosts the confidence of the investor.

Q 2-22: What are the advantages and disadvantages of being a holder of a common stock of IBM as opposed to being a bondholder?

As a bondholder of IBM, the investor would not find it hard to forecast the returns as despite being a corporate bond, its ranking as investment grade security suggests that the bond carries a little default risk. However, the returns on the common stocks of IBM would be higher than that of bonds. Still there is no certainty that the stream of dividends would remain stable. The risk involved in common shares may be greater, but so is the return. The shareholders also participate in the growth of the company’s profits. As the profits will grow so would the dividend earned by the shareholders. However, the bondholders do not get any such benefit with the growth of the company.

Q 2-28: Assume that a company in whose stock you are interested will pay regular quarterly dividend soon. Looking in the Wall Street Journal, you see a dividend figure of $3.20 listed for this stock. The board of directors has received dividend payable on September 1, with a holder of record date of August 15. When must you buy the stock to receive this dividend, and how much will you receive if you buy 150 shares?

To receive a declared divided, an investor must be holder of record on the specific date a company closes its stock transfer book and compiles the list of stockholders to be paid. The brokerage industry has established a procedure according to which the right to dividend remains with the stock until four days before the holder of record date. On fourth day , the right to dividend leaves the stock. To be entitled to the dividend the stock needs to be bought before August 12. If 150 stocks were to be bought a dividend of $3.20 per share would provide the investor with 150 X 3.20 = $480

Problems

2-1: Assuming an investor is in the 15 percent tax bracket, what taxable equivalent yield on must be  earned on a security to equal a municipal bond yield of 9.5 percent?

The taxable equivalent yield can be calculated using the following formula.

TEY = Tax-exempt municipal yield/ 1­ – Marginal tax rate

TEY = 0.095/ (1 – 0.15) = 0.095/0.85 = 0.111764 or 11.1764 percent

Q 2-2: Assume an investor is in the 36 percent tax bracket. Other things being equal, after taxes are paid, would this investor prefer a corporate bond paying 12.4 percent or a municipal bond paying 8 percent?

We can compare the two bonds by finding the taxable equivalent yield of the municipal bond

TEY = Tax-exempt municipal yield/ 1­ – Marginal tax rate

TEY = 0.08/ (1 – 0.36) = 0.08/0.64 = 0.125 or 12.5 percent

Comparing the rates of the two bonds, a municipal bond offering 8 percent is a better choice.

Q 2-3: Assume an investor is in 31 percent federal tax bracket and faces a 7 percent marginal tax rate. What is the combined TEY for a municipal bond paying six percent?

To calculate the TEY in such cases, first determine the effective state rate

Effective state rate = marginal state tax rate X (1 – federal marginal rate)

Effective state rate = 0.07 X (1 – 0.31) = 0.0483 = 4.83 percent

Then calculate the combined tax rate

Combined tax rate = effective state rate + federal rate

Combined tax rate = 0.0483 + 0.31 = 0.3583 or 35.83 percent

Taxable equivalent yield (TEY) = Tax-exempt municipal yield/ (1 – marginal tax rate)

Taxable equivalent yield (TEY) = 0.06/ (1 – 0.3583) = 0.06/0.6417 = 0.0935 or 9.35 percent