Chapter 7: Types of Investment Products and How They Are Traded

Describe the various measures of yield and explain the relationship between bond prices and interest rates.

- IR and bond prices have an inverse relationship: the value of a bond will decrease as IR increase, and v.v - this tendency of bonds to change in value with changing interest rates is called interest rate risk - two types of return calculation were presented for bonds: the current yield and the yield to maturity - current yield is the coupon payment for one year divided by the market price of the bond - yield to maturity shows the return you would expect to earn over the life of a bond starting today, assuming you are able to reinvest the coupons you receive at the yield to maturity - yield curve represents the relationship between the IR and the time to maturity for a given borrower

Margin

- amount that an investor is required to leave on deposit when using borrowed funds to purchase securities - margin is usually a fixed percentage of the value of the securities

Cash Account

- an account in which no borrowing is permitted - client is expected to make full payment for purchases on or before the required settlement date—usually three business days after the transaction date

Instalment Debenture

- bond or debenture issue in which a predetermined amount of principal matures each year - instrument that most municipalities use to raise capital from market sources

Convertible Bond

- can be converted to a given number of common shares, generally of the same company - conversion is usually permitted during periods determined by the issuer or the issuer can force conversion if market conditions warrant it - when the value of the firm's shares is high, the convertible bond's value is directly linked to the value of the shares - when the value of the shares is very low, then the value of the convertible bond is based on its value as a bond only

Bankers' Acceptance

- commercial draft (i.e., a written instruction to make payment) drawn by a borrower for payment on a specified date - a BA is guaranteed at maturity by the borrower's bank - like T-bills, BAs are sold at a discount and mature at their face value, with the difference representing the return to the investor - BAs may be sold before maturity at prevailing market rates, generally offering a higher yield than Canada T-bills - they trade in $1,000 multiples, with a minimum initial investment of $25,000, and generally have a term to maturity of 30 to 90 days, although some may have a maturity of up to 365 days

Describe the features and characteristics of common and preferred shares.

- common shares are issued by corporations and are expected to earn either dividends or capital gains, or both - preferred shares are issued by corporations to raise capital for investment projects and are generally issued at a fixed par value per preferred share - preferred shares have a stated dividend amount or, alternatively, a stated dividend yield - preferred shares are subject to default risk and this default risk is higher for preferred shares than for bonds - preferred shareholders are owners of the firm and not creditors (as are bondholders) and like common shares, preferred shares pay dividends - like bonds, the cash flow (the dividend) from preferred shares is fixed unlike with common shares

Current Yield

- computed by dividing the coupon or dividend payment for one year by the current market price of the security - current yield is used to compare the short-term return on different securities - for a money market mutual fund it is the last seven days' annualized yield; it does not assume compounding of returns

Determinants of bond quality

- credit quality and market conditions - credit quality of a province - the degree of certainty that interest will be paid and the principal repaid when due - depends on such factors as the amount of existing debt in the province per capita, the level of federal transfer payments, the stability of the provincial government and the wealth of the province in terms of natural resources, industrial development and agricultural production (deb)

Government Bond

- debt security that is issued by the federal, provincial, and municipal governments in order to finance public spending - these bonds trade OTC, they have a wide range of maturities, and they are considered to have little or no default risk - no default risk because the governments can simply increase taxes to make good on the promise to make the coupon payment or repay the par value at maturity - prov bond more risky than fed bonds

Guaranteed Investment Certificate (GIC)

- deposit instrument most commonly available from trust companies, requiring a minimum investment at a predetermined rate of interest for a stated term - generally nonredeemable prior to maturity but there can be exceptions - both principal and interest payments are guaranteed - IR on redeemable GICs are lower than standard GICs of the same term - Canada Deposit Insurance Corporation (CDIC) does not cover GICs of more than five years - not all GICs are eligible for RRSPs - GICs can be used as collateral for loans

Compare and contrast the basic features and characteristics of derivative securities and the various market transactions investors can carry out in the derivatives markets.

- derivative securities include calls and puts, and futures contracts - puts and calls are exchange-traded options giving the owner the option to buy (for calls) or to sell (for puts) a number of shares at a fixed price (the exercise or strike price) at any time prior to the option's expiration date - futures are contracts that are negotiated to buy or sell commodities, stock indices or bonds at some future date but at currently negotiated prices - all derivatives provide the possibility of leveraged gains and losses - MF managers are allowed to incorporate derivatives as part of their portfolios under certain conditions - most prominent applications of derivatives among MF managers are to hedge against risk and to facilitate market entry and exit and they are not allowed to use derivatives to speculate (bet)

Cumulative Preferred

- dividends not paid in one period accumulate and are paid in another period - common shareholders do not have a right to receive any dividends unless the preferred dividends in arrears are paid to the preferred shareholders - some preferred shares are non-cumulative in that dividends not paid are lost forever

GICs with special features

- escalating-rate GICs: interest rate increases over the GIC's term - laddered GICs: investment is evenly divided into multiple term lengths (for ex, a five year $5,000 GIC can be divided into one-, two-, three-, four- and five-year terms of $1,000 each). As each portion matures, it can be reinvested or redeemed. This diversification of terms reduces IR risk - instalment GICs: an initial lump sum contribution is made, with further minimum contributions made weekly, bi-weekly or monthly - index-linked GICs: guarantee a return of the initial investment upon expiry and some exposure to equity markets. They are insured by the CDIC. They may be indexed to particular domestic or global indexes or to a combination of benchmarks - interest-rate-linked GICs: offer interest rates linked to the changes in other rates, such as the prime rate, the bank's non-redeemable GIC interest rate, or money market rates

Standard Trading Unit

- fixed number of shares that constitute a trading unit - common size is 100 shares but it may be as large as 1000 shares depending on the stock exchange and the stock price

Describe and distinguish between the characteristics and features of the different types of fixed-income securities such as Governments bonds, T-Bills, corporate bonds, bankers' acceptances and commercial paper.

- fixed-income securities are considered loans that investors make to governments and corporations - types of fixed-income securities include gov and corporate bonds, GICs, treasury bills, bankers' acceptances and commercial paper - gov bonds have virtually no default risk but are subject to interest rate risk - corporate bonds are subject to both interest rate risk and default risk - bonds can have a number of features including a redemption (or call) feature - convertible bonds can be converted into common shares of the issuing company - bankers' acceptance (BA) is a commercial draft (i.e., a written instruction to make payment) drawn by a borrower for payment on a specified date - commercial paper is an unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets

Yield Curve

- graph showing the relationship between yields of bonds of the same quality but different maturities - normal yield curve is upward sloping depicting the fact that short-term money usually has a lower yield than longer-term funds - when short-term funds are more expensive than longer term funds the yield curve is said to be inverted (inverse yield curve)

Given the yield and the coupon rate, the following relationships hold:

- if the yield is greater than the coupon rate, the bond is trading at a discount - if the yield is equal to the coupon rate, the bond is trading at par - if the yield is lower than the coupon rate, the bond is trading at a premium

The most important bond pricing characteristics you must understand about the volatility of mutual funds are:

- inverse relationship between bond prices and interest rates - impact of maturity and coupon on price volatility (longer-term bonds are more volatile in price percentage change than shorter-term bonds for the same yield change)

Long Position

- investor purchases a security and then holds it in the hope of selling it later at a higher price

Corporate Bond

- issued by corporations mainly to finance the acquisition of equipment - subject to interest rate risk but, unlike government bonds, are also subject to default risk -often, specific assets are pledged as collateral to guarantee repayment of the debt - credit rating agencies use scales to indicate the quality of corporate bonds, with AAA (or A++) bonds having the best protection against default

Bond yield

- it is inverse to its price: as bond prices increase, bond yields fall - interest paid divided by par value

Prospectus

- legal document which must accompany all new security issues - primarily outlines the financial condition of the issuer, the use to which the funds raised will be put, and the risk associated with the securities - prospectus must be registered with each provincial securities commission in every province in which the underwriter intends to solicit offers to purchase

Street certificate form

- meaning they are registered in the name of the securities firm rather than the beneficial owner - this increases the negotiability of the shares, making them more readily transferable to a new owner

Call Premium

- measured by the difference between a security's par value and the price the issuer must pay to call it for retirement - call feature is always a disadvantage to the bondholder, as the corporation usually calls a bond for redemption when interest rates have fallen below the coupon rate on outstanding bonds - when bondholders reinvest the par value plus the premium, they are faced with lower coupon rates

Effects of drop in bond prices

- mutual fund that includes long term bonds will drop more in price if general interest rates in the market rise from 4% to 5% than another mutual fund that holds bonds with shorter terms to maturity (ppl's expectations) - when yields rise, all bonds drop in price, but, for the same yield change, low coupon bonds drop more than high coupon bond. The larger the difference between coupons, the more significant the difference in volatility

Short Selling

- occurs when an investor sells a security that he does not own - this transaction is undertaken in order to benefit from a fall in the price of the security - profits are made whenever the initial sale price exceeds the subsequent purchase cost - investor sells the security first, and then waits in the hope of buying it back later at a lower price - since the seller does not own the securities sold, the seller in effect creates a "deficit" or short position where he or she owes securities, and the subsequent purchase covers or "repays" this deficit - buying on margin and selling short are allowed only by full brokerage firms who are licensed to do so on behalf of their clients, but mutual funds are prohibited from buying on margin and selling securities short

Discount

- occurs when the price of a mutual fund is below its net asset value - bond prices are quoted using an index with a base value of 100 - bond trading at 100 is said to be trading at face value, or par - bond trading below par, say at a price of 98, is said to be trading at a discount

CDS Clearing and Depository Services Inc (CDS)

- offers computer-based systems to replace certificates as evidence of ownership in securities transactions - this system almost eliminates the need to handle securities physically

Benefits of common share ownership

- potential for capital appreciation - right to receive any common share dividends paid by the company - voting privileges, including the right to elect directors, to approve financial statements and auditor's reports, and vote on other important issues - favourable tax treatment in Canada of dividend income and capital gains - marketability - shareholdings can easily be increased, decreased or sold, for most public companies - right to receive copies of the annual and quarterly reports, and other mandatory info pertaining to the company's affairs - right to examine certain company documents such as the by-laws and register of shareholders at specified times - right to question management at shareholders' meetings - limited liability

Preferred Shares

- preferred shareholders will receive a fixed dividend before common shareholders - they are granted voting rights only under special circumstances, and will receive a predetermined dollar amount (par value) should the company dissolve - if a preferred share, or any security for that matter, offers attractive features to investors, then the yield on that security tends to be lower

Underwriting

- process of bringing new securities to market 1) first, it advises the issuing corporation in the preparation of the prospectus—the document that provides a complete description of the firm and the securities to be offered 2) second, the underwriter often arranges for the purchase of the new issue and bears the risk that some of the securities might remain unsold at the specified price - in contrast to corporate issues, government bonds are not underwritten by an investment dealer - instead, investment dealers bid for the bonds that the government is issuing in the expectation of selling them to the investing public at a profit

Hedging

- process of reducing the risk of loss from fluctuations in market prices — effectively locking in the value of a portfolio - derivative securities can be used for this purpose

Canada Premium Bond (CPB)

- relatively new type of savings product that offers a higher interest rate compared to the Canada Savings Bond and is redeemable once a year on the anniversary of the issue date or during the 30 days thereafter without penalty - like CSBs, the bonds are issued with a three-year term with interest rates on the bonds set at the start of each period - the bonds are redeemable at any time throughout the year with the bondholder receiving the face value plus interest earned up to the last anniversary date of issue at the time or redemption - CPBs can be purchased directly through most financial institutions across Canada, including banks, credit unions and caisses populaires, trust companies and most investment dealers - CSBs and CPBs are not transferrable and therefore have no secondary market - as a result, CSBs and CPBs do not rise and fall in price as market conditions change - no interest is earned on CSBs or CPBs redeemed within the first three months following the issue date

Common Share

- represent residual ownership of the issuing company and is therefore entitled to a vote at shareholder meetings - it does not have a stated maturity date and is only paid dividends once preferred shareholders have been paid

Derivative Securities

- securities whose value depends on the value of another security or asset - they are contracts created between two investors: a buyer and a seller

Callable Preferred

- shares that can be bought back at discretion of the issuing company prior to the redemption date of the issue - similar to callable bonds, callable preferred shares are redeemed earlier than their maturity date when interest rates fall and the current coupon of the preferred share is far higher than market rates - at that point, the callable price is lower than the price of a standard preferred share without the call feature

Convertible Preferred

- shares that can be exchanged for common shares of the issuing corporation - number of common shares to be received by trading in the preferred shares is set before the preferred shares are issued - all convertible preferred shares also have a call or redemption feature

Participating Preferred

- shares that pay a regular fixed dividend but also pay an additional dividend along with the common shares 1) first, the preferred dividend is paid; 2) next, common shareholders receive a particular amount of common dividend; 3) last, any remaining funds available for a dividend payment are distributed on a share-by-share basis to both common and preferred shareholders

Treasury Bill (T-bill)

- short term debt security issued by the government - do not pay interest, instead they are sold at a discount and are redeemed for their par value at maturity - offered in denominations from $1,000 up to $1 million so they appeal to institutional and retail investors - under the Income Tax Act, this return is taxable as income, not as a capital gain - every two weeks, T-bills are sold at auction by the Minister of Finance through the Bank of Canada - these bills have original terms to maturity of approx 3 months, 6 months and 1 year

Commercial Paper

- short-term debt security whose issuer promises to pay the maturity value by a stated date - issued by very creditworthy companies and is therefore quite liquid - unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets - issue terms range from less than 3 months to one year - most corporate paper trades in $1,000 multiples with a minimum initial investment of $ - like T-bills and BAs, commercial paper is sold at a discount and matures at face value - issued by large firms with an established financial history - may be bought and sold in a secondary market before maturity at prevailing market rates and generally offers a higher yield than Canada T-bills

Yield to Maturity

- shows the return expected over the life of a bond assuming the periodic coupon payments are reinvested at the yield to maturity - it takes into account the current market price of a bond, the time remaining to maturity, the par value, and the coupon rate

Three types of Ontario Savings Bonds (OSBs)

- step-up bond (interest paid increases over time) - variable-rate bond - fixed-rate bond

Futures Contract

- transferable agreement to deliver or take delivery of a fixed quantity of an asset for a specific price by a specific future date - to initiate this agreement, the investor is required to put up only a small fraction of the futures contract's underlying value

Canada Savings Bond (CSB)

- type of savings product that pays a competitive rate of interest and that is guaranteed for one or more years - not to be confused with marketable government bonds, CSBs do not trade on the secondary market — they are sold back to the government at par value plus accrued interest at any time - CSBs are registered in the name of an individual and, because of their redemption features, are not subject to interest rate risk like ordinary bonds - Canadians who invest in CSBs have the flexibility to redeem their bonds at any time throughout the year - when redeemed, the bondholder receives the face value plus interest earned for each full month that has elapsed since the issue date - CSBs can only be purchased through the Payroll Savings Program - this program allows employees to purchase CSBs at their place of work through automatic payroll deductions (more than 10000 organizations participate in the program)

Differentiate among the various market transactions that investors can undertake in the equities market.

- underwriters aid firms in bringing new securities to market - once issued, securities trade on exchanges or OTC - different types of market transactions exist for different purposes - most common transaction is the purchase in which an investor buys a security in the expectation of a price increase - in some cases, investors expect prices to fall and in that case, they may consider a short sale - in addition, investors may buy securities on margin; that is, they may borrow a percentage of the value of the investment - an investor would buy on margin with the expectation that the price of the underlying securities will rise in price - an investor would short sell securities with the expectation that the share price will fall

Perpetual Preferred

- unique type of preferred security that has no maturity date - because perpetual preferred shares have no maturity date, they are far more sensitive to interest rate changes than coupon-paying bonds

What is the difference between a call and a put?

A call is an option to buy shares at a fixed price prior to the call's expiration. A put is different in that it is an option to sell rather than to buy.

How are coupon bonds taxed?

Bonds are taxed in two ways. First, any interest income received is taxed at the regular income rate. Second, the gain between the sale price and purchase price would be taxed as a capital gain. Generally, when you receive a higher price upon sale than you paid upon purchase, you have a capital gain.

Why do perpetual preferred shares have greater interest rate risk than coupon bonds?

Perpetual preferred shares have greater interest rate risk than coupon bonds because they have no set term to maturity. Alternatively, we could say that their term to maturity is infinite. The longer the term to maturity, the higher the interest rate risk.

How do preferred shares differ from common shares?

Preferred shares do not appreciate in price the same way that common shares do. Preferred shareholders do not participate in the profits of the company in the same way as common shareholders are entitled to. When you buy a preferred share, what you are essentially buying is a cash flow, i.e., the promise of a fixed dividend payment on a regular basis.

How are T-bills taxed?

The government deems that the difference between your purchase price and maturity price is considered interest income, and is taxed at your regular income tax rate.

Why do commercial paper and bankers' acceptances have higher yields than Treasury Bills?

Treasury bills have the lowest yield of any of the money-market instruments because they also have the lowest risk. There is virtually no risk of the issuer defaulting because they are issued by the government. Bankers' Acceptances (BAs) are the next lowest, because a bank has "guaranteed" that the money will be repaid at maturity. This virtually eliminates the risk of default, unless a financial catastrophe of such magnitude occurs that both the corporation and the bank cannot repay the funds. With commercial paper, the default risk is higher as it is based strictly on the ability of the corporation issuing the paper to repay the funds at maturity. There is no additional "guarantee" provided by a bank, and a corporation simply doesn't have the same degree of security as a government.

Is margin a good strategy for all investors? Explain why or why not.

Using margin is not a good strategy for all investors, especially if they are risk averse. Using borrowed funds increases the risk of any security purchase. This is because the investor does not put up the full cost of the security but is exposed to the risk of the entire purchase. Once again, this is the principle of leverage.

Margin Account

an account that uses money borrowed from a stockbroker to buy securities

Limit Order

an order to buy or sell a security at a specific price or better

Market Order

an order to buy or sell a security at the current market price

Interest Rate Risk

basic feature of interest rate risk is that as interest rates rise (fall), the value of all fixed-income securities will decrease (increase)

Serial Bond

bond or debenture issue in which a predetermined amount of principal matures each year

Marketable Government Bond

bonds for which there is a ready market (i.e., clients will buy them because the prices and features are attractive)

Debentures

bonds that have no assets pledged as collateral in the case of default (prov bonds)

Secured Bond

bonds that include a promise to turn over an asset to the bondholders for liquidation if the corporation fails to make its coupon payments or pay the par value at maturity

Maturity Date

date at which the bond matures or expires

Fixed-Income Security

debt issued by an entity in the financial market and sold to investors

Option contract

derivative security which gives the holder the right, but not the obligation, to buy or sell the underlying asset within a fixed period for a fixed price - if the price goes up of a security, you'd want to exercise the option and buy the share for the cheaper price and then sell it for the current higher market price - if the price went down you'd be losing out

Extra Dividend

dividend paid in addition to the regular dividend

Dividend Yield

dividends earned during ownership of shares

Material Fact

fact that, if correctly stated, would likely lead investors to change their purchase decision

Redemption

feature that allows the issuing corporation to redeem, or pay back, the bondholders before the stated maturity date

Call option

gives its owner the option of buying shares (usually 100 shares per option contract) at the fixed exercise price prior to the call's expiration date

Par Value

original amount issued (principal)

Coupon Rate

periodic (almost always semi-annual) interest payment that the issuer of a bond has promised to pay the bondholder (usually fixed over the entire life of the bond at issuance—for example, 6% of the par value over the term of the bond)

Premium

price of a fund is above the net asset value

Shelf Registration

registration of only a simplified prospectus for new issues

Coupon

regular payments made from the issuer to the holder of the debt

Collateral

secures a bond by a pledge of an asset in the case of default

Hybrid Security

securities, usually preferred shares, that have features of both bonds and common shares

Regular Dividend

term that indicates the amount a company usually pays on an annual basis

Option Premium

the price an investor pays for an option

Default Risk

the risk that a mortgage, bond, or preferred share will not make its anticipated interest or dividend payment, or principal will not be repaid at maturity (in the case of mortgages and bonds)

Odd Lot

transaction in less than a board lot

Leverage

use of borrowed funds to invest

Coupon rate vs. yield

while the coupon rate, along with the face value and maturity date, do not change, the price and yield of a bond fluctuates from day to day