Securities Industry Essentials Exam

Bonds can be issued with different features. What are the three features?

- Call feature - Put feature - Convertible

Two categories of municipal securities exist:

- General obligation (GO) Bonds - Revenue Bonds

Municipal notes fall into several categories.

- Municipalities issue tax anticipation notes (TANs) to finance current operations in anticipation of future tax receipts. This helps municipalities to even out cash flow between tax college periods. - Revenue anticipation notes (RANs) are offered periodically to finance current operations in anticipation of future revenues from revenue producing projects or facilities. - Tax and revenue anticipation notes (TRANs) are a combination of the characteristics of both TANs and RANs. - Bond anticipation notes (BANs) are sold as interim financing that will eventually be converted to long-term funding through a sale of bonds. - Tax-exempt commercial paper is often used in place of BANs and TANs for up to 270 days, though maturities are most of thirty, sixty, and ninety days. - Construction loan notes (CLNs) are issued to provide interim financing for the construction of housing projects. - Variable rate demand notes have a fluctuating interest rate and usually issued with a put option. - Grant anticipation notes (GANs) are issued with the expectation of receiving grant money from the federal government.

Why would you include preferred stock in a client's portfolio?

- fixed income from dividends - prior claim ahead of common stock - convertible preferred sacrifices income in exchange for potential appreciation In doing so, the client would be incurring the following risks: - possible loss of purchasing power - interest rate risk - Business difficulites leading to possible reduction or elimination of the dividend and even bankruptcy leading to loss of principal

Why would you include common stock in a client's portfolio?

- potential capital appreciation - income from dividends - hedge against inflation In doing so, the client would be incurring the following risks: - market risk - business difficulites leading to possible reduction or elimination of the dividend and even bankruptcy leading to loss of principal

In the event a company liquidates, the priority of claims on the company's assets that will be sold are as follows:

1. IRS (taxes) and employees (unpaid wages) 2. Secured debt (bonds and mortgages) 3. Unsecured liabilities and general creditors (suppliers and utilities) 4. Subordinated debts (debt holders who agreed to be paid back last of all debt holders in the event a liquidation ever needed to occur) 5. Preferred stockholders 6. Common stockholders

Rights of Common Stockholders

1. Voting for members of the board of directors 2. A share in the corporation's earnings 3. A share in the assets if the corporation is dissolved 4. Preemptive right - the right to buy more shares of stock if the corporation issues new shares of stock.

Yield to Call

A bond with a call feature may be redeemed before maturity at the issuer's option. Essentially, when a callable bond is called in by the issuer, the investor receives the principal back sooner than anticipated (before maturity). Yield to call (YTC) calculations reflect the early redemption date and consequent acceleration of the discount gain if the bond was originally purchased at a discount, or the accelerated premium loss if the bond was originally purchased at a premium.

Yield

A bond's yield expresses the cash interest payments in relation to the bond's value. Yield is determined by the issuer's credit quality, prevailing interest rates, time to maturity, and any features the bond may have, such as a call feature. Bond's yield in several ways: - Nominal yield - Current yield - Yield to maturity - Yield to call

Yield to Maturity

A bond's yield to maturity (YTM) reflects the annualized return of the bond if held to maturity. In calculating yield to maturity, the bondholder takes into account the difference between the price that was paid for a bond and par value received when the bond matures. If the bond is purchased at a discount, the investor makes money at maturity; in other words, the discount amount increases the return. If a bond is purchased at a premium, the investor loses money at maturity; in other words, the premium amount decreases the return.

Cold Call

A broker-dealer's representative contacts a potential customer to purchase penny stocks. If this happens, the broker-dealer must disclose in a statement to the new client that includes: - the name of the penny stock - the number of shares to be purchased - a current quotation - the amount of commission that the firm and the representative received

Call Feature

A call feature allows an issuer to call in a bond before maturity. Issuers will generally do this when interest rates are falling. From the issuers' perspective, why pay 6% interest to investors on an existing bond if current interest rates have fallen to 4%? It is better to call in the 6% bond and simply issue a new bond paying the lower current interest rate. This feature benefits the issuer!

Debentures (Unsecured Bonds)

A debenture is a debt obligation of the corporation backed only by its word and general creditworthiness. Debentures are written promises of the corporation to pay the principal at its due date and interest on a regular basis. Although this promise is as binding as a promise for a secured bond such as a mortgage bond,

Bankruptcy

A general term for a federal court procedure that allows both individuals and businesses to get relief from their debts or make a plan to repay their creditors. Though the are different classifications of bankruptcy, they can be broken down into two types: reorganization and liquidation.

Government National Mortgage Association (GNMA or Ginnie Mae)

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.

Farm Credit System (FCS)

A national network of lending institutions that provides agricultural financing and credit. The system is a privately owned, government-sponsored enterprise that raises loanable funds through the sale of Farm Credit Securities to investors. These funds are made available to farmers through a nationwide network of banks and Farm Credit lending institutions. The Farm Credit Administration (FCA), a government agency, oversees the system.

Penny Stock

A penny stock is an unlisted (not listed on a U.S. stock exchange) security trading at less than $5 per share.

Convertible Preferred Stock

A preferred stock is convertible if the owner can exchange the shares for a fixed number of shares of the issuing corporation's common stock. This stock is generally issued with a lower stated dividend rate than non-convertible preferred if the same quality because the investor may have the opportunity to convert to common shares and enjoy greater capital gain potential.

Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)

A public corporation that was created to promote the development of a nationwide secondary market in mortgages by buying residential mortgages from financial institutions and packaging them into mortgage-backed securities for sale to investors.

Federal National Mortgage Association (FNMA or Fannie Mae)

A publicly held corporation that provides mortgage capital. FNMA purchases conventional and insure mortgages from agencies such as the FHA and the VA. The securities it creates are backed by FNMA's general credit.

Put Feature

A put feature for a bond is the opposite of a call feature. Instead of the issuer calling a bond before it matures, with a put feature the investor can put the back to the issuer before it matures. Investors will generally do this when interest rates are rising. From the investors' perspective, why accept 6% interest on a bond one owns if current interest rates have risen to 8%? It is better to put the 6% bond back to the issuer, take the principal returned, and invest it in a new bond paying the current interest rate of 8%. This feature benefits the bondholder!

TAKE NOTE

All corporations issue common stock, but not all corporations issue preferred stock.

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 interest on debt obligations and if the board of directors declares that the interest payment be made. Falls under the unsecured debt securities.

TAKE NOTE

Although debentures are unsecured, there are issuers whose credit standing is so good that their debentures might be considered safer than secured bonds of less creditworthy companies.

Proxy

An absentee ballot that is made available for those shareholders who want to vote but can't attend shareholder meetings. They can do so by mail or online.

Preferred Stock

An equity security because it represents a class of ownership in the issuing corporation. A preferred stock's annual dividend represents its fixed rate of return. Normally a preferred stock is identified by its annual dividend payment stated as a percentage of its par value. Always assume preferred par value is $100 unless stated differently.

Established Customer

An established customer is someone who: - has held an account with the broker-dealer 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.

Growth (Capital Gains)

An increase in the market price of securities is capital appreciation.

Balloon or Serial and Balloon (Type of Maturity)

An issuer sometimes schedules its bond's maturity using elements of both serial and term maturities. The issuer repays part of the bond's principal before the final maturity date, as with a serial maturity, but pays off the major portion of the bond at maturity.

Guaranteed Bonds

Are backed by a company other than the issuing corporation such as a parent company. The value of the guarantee is only as good as the strength of the company making the guarantee.

Secured Debt Securities

Are backed by various kinds of assets owned by the issuing corporation.

Unsecured Debt Securiteis

Are backed only by reputation, credit record, and financial stability of the corporation. Commonly referred to as being backed by the corporation's full faith and credit.

Restricted Securities

Are those acquired through some means other than a registered public offering (Ex. a security purchased in a private placement). Restricted securities may not be sold until they have been held fully paid for six months. According to rule 144, after holding restricted stock fully paid for six months, an affiliate may begin selling shares but is subject to the volume restriction rules as enumerated following.

Control Securities

Are those owned by directors, officers, or persons who own or control 10% or more of the issuer's voting stock.

TAKE NOTE

Because the value of a convertible preferred stock is linked to the value of a common stock, the convertible preferred share price tends to fluctuate in line with the common.

Treasury Receipts

Brokerage firms can create a type of bond known as a Treasury receipt from United States Treasury notes and bonds. Broker-dealers buy Treasury securities, place them in trust at a bank and sell separate receipts against the principal and coupon payments, essentially, separating the coupon interest payments from the principal.

Revenue Bonds

Can be used to finance any municipal facility that generates sufficient income. These municipal bonds are considered to be self-supporting debt because principal and interest payments are made exclusively from revenues generated by the project or facility for which the debt was issued, such as: - utilities (water, sewer, and electric) - housing (public housing projects) - transportation (airports and toll roads) - education (college dorms and student loans) - health (hospitals and retirement centers) - industrial (industrial development and pollution control) - sports (stadium facilities) Do not require voter approval.

Convertible

Convertible bonds are issued by corporate issuers allowing the investor to convert the bond into shares of common stock. Giving the investor the opportunity to exchange a debt instrument for one that gives the investor ownership rights (shares of common stock) is generally considered a benefit for the investor.

Common Stock

Corporation's basic ownership share; also generically called capital stock. A company issues stock to raise capital. Investors who buy the stock also buy a share of ownership in the company's net worth.

Callable (Redeemable) Preferred Stock

Corporations often issue callable preferred, which a company can buy back from investors at a stated price after a specified date. The right to call the stock allows the company to replace a relatively high fixed dividend obligation with a lower one when the cost of the money has gone down.

Equipment Trust Certificates (ETCs)

Corporations, particularly railroads and other transportation companies, finance the acquisition of capital equipment used in the course of their business. Another example of a secured loan; the obligation to pay the investor is secured by the equipment.

Nominal Yield

Coupon, nominal, or stated yield is set at the time of issue. Remember that the coupon is a fixed percentage of the bond's par value.

Cumulative Preferred Stock

Cumulative preferred stock accrues payments due its shareholders in the event dividends are reduced or suspended. When the company resumes dividend payments, cumulative preferred stockholders receive current dividends plus the total accumulated dividends-dividends in arrears-before any dividends may be distributed to common stockholders.

Current Yield

Current yield (CY) measures a bond's annual coupon payment (interest) relative to its market price, as shown in the following equation: annual coupon payment ÷ market price = current yield

Par Value

Face value for a bond, is normally $1,000 per bond, meaning each bond will be redeemed for $1,000 when it matures.

TEST TOPIC ALERT

For investors looking for income through preferred stocks, this would be their least appropriate choice.

Subordinated Debenture

Has a claim that is behind (junior to) that of any other creditor. However, no matter how subordinated the debenture, it is still senior to any stockholder.

EXAMPLE

Here is an example of the order or priority a trustee would follow if liquidating a corporation's securities due to bankruptcy: - Secured creditors' debt instruments (mortgage bonds, equipment trust certificates, collateral trust bonds, and mortgages) - Unsecured creditors' debt instruments (general creditors such as suppliers and utilities, debenture holders, guaranteed bonds, and income bonds) - Subordinated debt (debt holders who agree to be paid back last of all debt holders in the event a liquidation ever needs to occur) - Preferred stockholders - Common stockholders

Low Priority at Dissolution Risk

If a company enters bankruptcy, the holders of its bonds and preferred stock have priority over common stockholders. If after debt holders and priority stockholders are paid, only then would common stockholders be paid IF there are any funds left to divide among them.

Priority at Dissolution Over Common Stock (Benefit)

If a corporation goes bankrupt, preferred stockholders have a priority claim over common stockholders on the assets remaining after creditors have been paid.

TAKE NOTE

If an unaffiliated individual owns 7% of the voting stock of XYZ, that person is NOT a control person. However, if that person's spouse owns 4% of the voting stock, then both would be considered control persons. In other words, if there is a 10% or more interest held by immediate family members, then all those family members owning voting stock are controlled persons.

TAKE NOTE

In owning common equity, the investor stands to lose current income through dividend reduction or suspension, as well as capital loss, should the market price decline. In return, however, the shareholder has limited liability; that is, the liability is limited to the amount invested.

TAKE NOTE

In the corporate liquidation priority, common stockholders are paid last of all bond and stockholders. Consider that only in cases where there are funds remaining after all others are paid do common stockholders receive anything; such cases can be rare.

TEST TOPIC ALERT

Income bonds are a true oxymoron. If an investor is seeking income; an income bond is NOT likely a suitable recommendation.

TAKE NOTE

Interest is generally paid on a semi-annually basis. A 6% coupon bond would pay $30 in interest every six months, a total of $60 per year.

Mortgage Bonds

Just as the owner of a home pledges a real asset (the home and land) as collateral for a loan (the mortgage), a corporation will borrow money backed by real estate and physical assets of the corporation. Just as a home ordinarily would have a market value greater than the principal amount of its mortgage, the value of the real assets pledged by the corporation will be in excess of the amount borrowed under the bond issue. This is a secured loan.

TAKE NOTE

Key points to remember regarding T-bills include: - Treasury bills are the only Treasury security issued at a discount - Treasury bills are the only Treasury security issued without a stated interest rate - Treasury bills are highly liquid - 13 week (also referred to as a 90-day) Treasury bills are used in market analysis as the stereotypical "risk-free" investment

Interest Rate Sensitivity (Risk)

Like a fixed income security, when interest rates rise, the value of preferred shares declines.

Income

Many corporations pay regular quarterly cash dividends to stockholders. Dividends, which can be a significant source of income for investors, are a major reason many people invest in stocks.

Corporate Debt Securities

May either be secured or unsecured

Liquidation

Means that keeping property or continuing business will not occur and all property will be taken and sold to repay all debts.

Debt Capital

Money borrowed by corporations, the federal government, or local governments (municipalities) from investors. The loan is evidenced by a bond which is a certificate representing the borrowers indebtedness to the investor. These certificates state the borrower's obligation to pay back a specific amount of money on a specific date to the investor.

Short-term Municipal Obligations (Anticipation Notes)

Municipal anticipation notes are short-term securities that generate funds for a municipality that expects other revenues soon. Usually municipal notes have less than twelve month maturities, although maturities may range from three months to three years. They are repaid when the municipality receives the anticipated funds.

General Obligation Bonds (GO bonds)

Municipal bonds issued for capital improvements that benefit the entire community. Typically, these projects do not produce revenues, so principal and interest must be paid by taxes collected by the municipal issuer. Because of this backing, general obligation bonds are known as full faith and credit issues and are backed by the municipality's taxing power. Bonds issued by states are backed by incomes taxes, license fees, and sales taxes. Bonds issued by towns, cities, and counties are backed by property (ad valorem) taxes, license fees, fines, and all other sources of direct income to the municipality. School, road, and park districts may also issue municipal bonds backed by property taxes. GO Bonds are often associated with requiring voter approval.

TEST TOPIC ALERT

Never be fooled by the apparent strength of the word "guaranteed" as it relates to guaranteed bonds. These are unsecured debt securities.

Limited Liability

One of the most important features of equity ownership. In the event of a corporation's bankruptcy, when corporate assets are not adequate to meet corporate obligations, personal assets are not at risk. An individual cannot be forced to sell any personal assets to help pay the debts of the business. Shareholders are personally at risk only for the amount that was invested. A partner or sole proprietor risks not only the amount personally invested but also personal assets should the business not be able to pay off it's obligations.

Participating Preferred Stock

Participating preferred stock offers its owners a share of corporate 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.

SEC Rule 144

Regulates the sale of control and restricted securities, stipulating the holding period, quantity limitations, manner of sale, and filling procedures.

Serial Bond Issue (Type of Maturity)

Schedules portions of the principal to mature at intervals over a period of years until the entire balance has been repaid.

Municipal Bonds

Securities issued either by state or local governments of by United States territories, authorities, and special districts. Investors that by such bonds are lending money to the issuers for the purpose of public works and construction projects (such as roads, hospitals, civic centers, sewer systems, and airports).

Adjustable-Rate Preferred Stock

Some preferred stocks are issued with adjustable (or variable) dividend rates. Can be adjusted as often as quarterly.

Collateral Trust Bonds

Sometimes a corporation wants to borrow money and has neither real estates (to back a mortgage bond) nor equipment (to back an equipment trust) to use as collateral. Instead, it deposits securities it owns into a trust to serve as collateral for the lenders. Collateral trust certificates are secured by the securities deposited, and obviously, the better the quality of the securities, the better the quality of the certificate.

Straight (Noncumulative) Preferred Stock

Straight preferred had no special features beyond the started dividend payment. Missed dividends are not paid to the holder.

Term Bond (Type of Maturity)

Structured so that the principal of the whole issue matures at once. Because the entire principal is repaid at one time, issuers may establish a sinking fund account to accumulate money to retire the bonds at maturity.

Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities)

The Treasury Department designates certain issues as suitable for stripping into interest and principal components. Banks and broker-dealers perform the actual separation of interest coupon and principal and trading of the STRIPS.

Treasury Securities

The United States Treasury Department determines the quantity AND types of government securities it must issue to meet federal budget needs. The marketplace determines the interest rates those securities will pay. Securities issued by the United States government are backed by its full faith and credit, based on its power to tax. In this light, securities issued by the United States government are considered to be among the highest in quality regarding safety of principal. These securities are classified as bills, notes, and bonds which distinguish each issue's term to maturity (short, intermediate, and long-term).

Market Risk

The chance that a stock will decline in price. Investors have no assurance whatsoever that they will be able to recover the investment in a stick at any time.

Coupon

The coupon represents the interest rate the issuer has agreed to pay the investor.

Maturity Date (Bond Characteristic)

The date the investor receives the loan principal back. Common maturities are in the five to thirty year range but some can be much shorter (short-term debt securities) and other can be longer. Three different types: term, serial, and balloon.

Reorganize

The entity will likely be able to retain property and continue doing business but must submit and stick to a plan that will allow the repayment of some or all of its existing debts within a specified time frame.

Coupon Rate

The interest rate the bond pays. It is also referred to as the stated or nominal yield. It is calculated from the bond's par value, usually stated as a percentage of par.

Decreased or No Dividend Income Risk

The possibility of dividend income decreasing or ceasing entirely if the company loses money. The decision to pay a dividend rests with the board of directors and it is not guaranteed.

Purchasing Power Risk (Risk)

The potential that, because of inflation, the fixed income produced will not purchase as much in the future as it does today.

TAKE NOTE

The provisions of the penny stock rules apply only to unsolicited transactions like those that might occur during a cold-call. Unsolicited transactions (those not recommended by the broker-dealer or registered representative) are exempt.

Senior

The relative priority of a security claim. For example. every preferred stock has a senior claim to common stock. In this regard, it is important to know that every debt security has senior claim to preferred stock. Secured bonds have a senior claim to unsecured bonds.

TAKE NOTE

The settlement of agency-issues securities occurs regular way - two business days (T+2). These securities are generally known as asset-backed or mortgage-backed securities.

Decreased or No Dividend Income (Risk)

There is a possibility of dividend income decreasing or ceasing entirely if the company loses money. The decision to pay a dividend rests with the board of directors and it is not guaranteed.

Rights of Preferred Stockholders

They generally do NOT have voting rights and they do NOT have preemptive rights.

TAKE NOTE

Though the price of the bond will react to market forces (interest rate sensitivity and general supply and demand) the coupon is always the same. The coupon is a fixed percentage of par value; a 6% coupon pays $60 of annual interest no matter what the current market value of the bond is.

TEST TOPIC ALERT

Treasury STRIPS are backed in full by the United States government. Treasury Receipts are NOT.

Treasury Bills (T-Bills)

United States Treasury bills are direct short-term debt obligations of the United States government. They are issued with maturities of four weeks, thirteen weeks, twenty-six weeks, and at times, fifty-two weeks. Though the maximum maturity for T-bills is subject to change, they are always short term instruments' that is one year or less. They pay no interest in the way other bonds do; rather, they are issued at a discount from par value and redeemed at par.

Treasury Bonds (T-Bonds)

United States Treasury bonds are direct debt obligations of the United States government. They pay semiannual interest as a percentage of the stated par value and mature at par value. These government obligations have long-term maturities, greater than ten years and up to thirty years.

Treasury Notes (T-Notes)

United States Treasury notes are direct debt obligations of the United States government. They pay semiannual interest as a percentage of the stated par value. T-notes have intermediate maturities (two to ten years).

Subordinated

Used to describe a class of debt securities. This means "belonging to a lower or inferior class or rank; secondary". It is usually used in describing a type of debenture.

TAKE NOTE

When bonds are issued with features that benefit the issuer, like a call feature, the issuer generally will need to pay a slightly higher coupon rate of interest to make the bond attractive to new investors. Conversely, when bonds are issued with features that benefit the bondholder, like put or conversion features, the issuer can usually pay a slightly lower coupon rate of interest as the feature will compensate for the lower return.

Dividend Preference (Benefit)

When the board of directors declares dividends, owners of preferred shares must be paid prior to any payment to common stockholders.

Priority at Dissolution

While preferred shareholders are paid before common shareholders if a company enters bankruptcy, they are paid behind all creditors.