SIE Exam (Chapter 2 , Section 2.1)

If a preferred stock is described as XYZ 6% preferred participating to 9%, the company pays its holders up to _____ in additional dividends in profitable years if the Board of Directors (BOD) declares so.

3%

Common maturities are in the _________ year range

5-30

A preferred stock with a par value of $100 that pays $6 in annual dividends is known as a ______________. The dividend of a preferred stock with no par value is stated as a _________________.

6% preferred ($6 dividend / $100 par) / $6 no-par preferred

Yield to maturity

A bond's yield to maturity (YTM) re ects 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 the bond is pur- chased at a premium, the investor loses money at maturity; in other words, the premium amount decreases the return.

Convertible preferred

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. Convertible preferred is generally issued with a lower stated dividend rate than nonconvertible preferred of the same quality because the investor may have the opportunity to convert to common shares and enjoy greater capital gain potential. The concept of a convertible security will be discussed in greater detail later in this unit when we cover convertible bonds.

Put feature

A put feature for a bond is the opposite of a call feature. Instead of the issuer calling in 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 bene ts the bondholder.

Common stock and growth (capital gains)

An increase in the market price of securities is capital appreciation. Historically, owning common stock has provided investors with returns in excess of the in ation rate. For this reason, most investors with a long-term investment horizon have included common stock in their portfolios as a hedge against in ation. Of course, it must be mentioned that stock prices can decline, particularly over the short run.

Balloon bond

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 nal maturity date, as with a serial maturity, but pays off the major portion of the bond at maturity. This bond has a balloon, or serial and balloon, maturity.

Call feature

As noted previously, 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 bene ts the issuer.

_______________ is 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.

Bankruptcy (court will protect them from creditors during the bankruptcy proceedings)

Callable preferred

Corporations often issue callable (or redeemable) preferred, which a company can buy back from investors at a stated price after a speci ed 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 money has gone down. This is similar to refinancing a mortgage. When a corporation calls a preferred stock, dividend payments cease on the call date. In return for the call privilege, the corporation may pay a premium exceeding the stock's par value at the call, such as $103 for a $100 par value stock.

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

Cumulative preferred stock accrues payments due its shareholders in the event dividends are reduced or suspended. (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

______________ represents money borrowed by corporations, the federal government, or local governments (municipalities) from investors.

Debt capital

Participating preferred

In addition to fixed dividends, 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.

Common stock and income

Many corporations pay regular quarterly cash dividends to stockholders. Dividends are declared by the board of directors (BOD) and may increase over time as profitability increases. Dividends, which can be a signi cant source of income for investors, are a major reason many people invest in stocks. Issuers may also pay stock dividends (additional shares in the issuing company) or property dividends (shares in a subsidiary company or a product sample).

Convertible

Much like our discussion of convertible preferred stock, 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 Limited Liability

One of the most important features of equity ownership is limited liability. In the event of a corporation's bankruptcy, when corporate assets are not adequate to meet corporate obligations, personal assets are not at risk. One cannot be forced to sell any personal assets to help pay the debts of the business.

____________ is an equity security because it represents a class of ownership in the issu- ing corporation. Although it is an equity security, it does share some characteristics with a debt security.

Preferred stock

Yield to call

Some bonds are issued with what is known as a call feature. 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 re ect the early redemp- tion date and consequent acceleration of the discount gain if the bond was originally pur- chased at a discount, or the accelerated premium loss if the bond was originally purchased at a premium.

Adjustable-rate preferred

Some preferred stocks are issued with adjustable (or variable) dividend rates. Such dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bills and money market rates, and can be adjusted as often as quarterly. Because the payment adjusts to current interest rates, the price of the stock remains relatively stable. (For investors looking for income through preferred stocks, this would be their least appropriate choice)

Straight preferred (noncumulative)

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

The ______________ determines the quantity and types of government securities it must issue to meet federal budget needs. The ___________ determines the interest rates those securities will pay.

U.S. Treasury Department / marketplace

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

Unsolicited

Each share of stock entitles its owner to...

a portion of the company's earnings and dividends and a proportionate vote in major management decisions.

Normally a preferred stock is identified by its ________________ stated as a percentage of its par value. Always assume preferred par value is _______ unless stated differently.

annual dividend payment / $100

Restricted securities

are those acquired through some means other than a registered pub- lic offering. A security purchased in a private placement is a restricted security. Restricted securities may not be sold until they have been held fully paid for six months.

Control securities

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

These securities are classified as _______________ which distinguish each issue's term to maturity _________________.

bills, notes, and bonds / (short, intermediate, and long-term)

Common stockholders have a right to limited access to the corporation's ________. For the most part, common stockholders have the right to examine the minutes of meetings of the board of directors and the right to examine ___________.

books / the list of stockholders

Most common bond features are the following:

call feature, put feature, convertible

Shares represent ownership in the corporation. They can benefit from an increase in the price of the shares __________ and by sharing in earnings through the receipt of dividends _____________.

capital appreciation / distributed profits

Different issuers of bonds include:

corporate, federal government, and municipal governments

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

coupon

Though the price of the bond will react to market forces (interest rate sensitivity and general supply and demand) the ___________ is always the same.

coupon (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)

While the ___________ (nominal or stated) yield never changes regardless of price, the ______________ do.

coupon / CY, YTM, and YTC

The interest rate the bond pays is still called the _____________.

coupon rate (also referred to as the stated or nominal yield)

The investor, in the position of lender, is acquiring no ownership in the entity as he would when purchasing stock, but instead is now a _________ of the borrowing entity.

creditor

Established customers are exempt from the suitability statement requirement but not from the __________________.

disclosure requirements

Separate categories of preferred may differ in several ways, including...

dividend rate and profit participation privileges.

__________ securities represent ownership in an issuing company and ________ securities represent a loan to the issuing company, while a number of derivative products such as _________ represent neither.

equity / debt / options

If a bond is purchased for $900 (a discount) and is held to maturity, at maturity the investor will receive $1,000 (par). The amount of the discount ($100) increases the investor's return. On the other hand, if a bond is purchased for $1,100 (a premi- um) and is held to maturity, at maturity the investor will receive $1,000 (par) and the amount of the premium paid ($100) reduces the investor's return.

example (yield to maturity)

Common stockholders also have the right to receive an audited set of _______________ of the company's performance each year.

financial statements (annual reports)

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

fluctuate

Common stock is ______________ to anyone who wants to buy it or receive it as a gift.

freely transferable (shareholders have the right to sell or give away their shares without permission of the corporation)

Preferred stock does not typically have the same ____________ potential as common stock

growth

If a corporation wants to issue additional shares, existing shareholders...

have the right to purchase those shares in an amount that would keep their proportionate ownership in the corporation unchanged.

When bonds are issued with features that benefit the issuer, like a call feature, the issuer generally will need to pay a slightly ___________ 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 _____________ of interest as the feature will compensate for the lower return.

higher coupon rate / lower coupon rate

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 ____________ family members, then all those family members owning voting stock are control persons.

immediate

Bond prices can be impacted by the usual market forces that impact securities in general, such as supply and demand. However, because they are debt instruments they have a particular sensitivity to changes in market ____________.

interest rates

Generally, bond prices have an _________ relationship to interest rates.

inverse If interest rates go up, bond prices for those trading in the secondary markets will go down. Conversely, if interest rates are falling, bond prices for those trading in the secondary market will be going up.

Term bond

is 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.

The federal government is the nation's ____________ as well as the best ___________.

largest borrower / credit risk

In the corporate liquidation priority, common shareholders are paid _________ 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.

last

Each bond has its own _______________. This is the date the investor receives the loan principal back.

maturity date

Regardless of activity in the account, if the account holds penny stocks, broker-dealers must provide a ___________ account statement to the customer. This must indicate the _________________ for each penny stock held in the account as well as the issuer's name.

monthly / market value and number of shares

A company issues stock to raise capital. Investors who buy the stock also buy a share of ownership in the company's ______________.

net worth

Current Yield, Yield to Maturity, and Yield to Call Chart

page 55

The coupon rate is calculated from the bond's...

par value, usually stated as a percentage of par. Par value, also known as face value for a bond, is normally $1,000 per bond, meaning each bond will be redeemed for $1,000 when it matures. Therefore a bond with a 6% coupon is paying $60 in interest per year (6% × $1,000 Par value = $60)

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

penny stock (highly speculative)

When an investor buys a bond, the investor is lending the borrowing entity money for a set ______________ at a _________________.

period of time / fixed annual interest rate

By contrast, a partner or sole proprietor risks not only the amount personally invested in the business but also ______________ should the business not be able to pay off its obligations.

personal assets

Securities issued by the U.S. government are backed by its full faith and credit, based on its ___________.

power to tax

Common stockholders usually have the __________ right to maintain their proportionate share of ownership in the corporation.

preemptive

Two final characteristics of preferred stock are that unlike common shareholders...

preferred shareholders generally have no voting rights nor do they have preemptive rights.

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

preferred stock

Once a bond is trading in the secondary markets they can trade at a price of par, a _________ to par, or a _________ to par.

premium / discount

If it is not possible for the stockholder to attend the stockholder's meetings to personally cast a vote. An absentee ballot, known as a ___________, is made available

proxy (Those voting by proxy can generally do so by mail or online)

The _____________ on a preferred stock is fixed rather than subject to variation as with common stock

rate of return (A preferred stock's annual dividend represents its fixed rate of return)

Selling shares under Rule 144 effectively _____________ the shares. In other words, buyers of stock being sold subject to Rule 144 are not subject to any restrictions if they choose to resell.

registers

SEC Rule 144

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

In this light, SEC rules require that customers, before their initial transaction in a penny stock, be given a copy of a _____________. The member must receive a signed and dated acknowledgment from the customer that the document has been received.

risk disclosure document

Securities issued by the U.S. government are considered to be among the highest in quality regarding ______________.

safety of principal

Serial bond

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

Interest is usually paid on a _______________ basis.

semi-annual

Net worth is calculated by...

taking the business' assets less its liabilities (creditors' claims). The resulting net worth belongs to the business owners (its stockholders).

While the priority standing can differ slightly depending upon which chapter of bankruptcy a company is filing under, the basic structure should be noted as being divided into three simple categories:

taxes and wages, debt holders (bonds), and equity holders (stocks)

Maturities come in different types:

term, serial, and balloon.

By electing a board of directors, stockholders have a say in the company's management but are not involved in ______________

the day-to-day details of its operations

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)

After the six-month holding period, affiliated persons are subject to the volume restrictions for as long as they are affiliates. For ______________, the stock may be sold completely unrestricted after the six-month holding period has been satisfied.

unaffiliated investors

Common shareholders enjoy a number of benefits including _______________

voting rights, the opportunity for capital appreciation, and current income as well as limited liability.

A bond's __________ expresses the cash interest payments in relation to the bond's value.

yield

Price discount or premium from par is taken into consideration when calculating a bond's overall _________.

yield

Rule 144 on Control Stock (registered) held by an affiliate (insider)

• no hold • volume limits always apply

Rule 144 on Restricted Stock (unregistered) held by a nonaffiliate (noninsider)

• six-month hold • sell freely thereafter

Rule 144 on Restricted Stock (unregistered) held by an affiliate (insider)

• six-month hold • volume limits thereafter

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. In any 90-day period, an investor may sell the greater of:

■ 1% of the total outstanding shares of the same class at the time of sale; or ■ the average weekly trading volume in the stock over the past four weeks on all exchanges or as reported through Nasdaq.

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 (discussed shortly)

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

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

The risks of owning common stock are...

■ Market risk- The chance that a stock will decline in price is one risk of owning common stock (known as market risk). A stock's price uctuates daily as perceptions of the company's business prospects change and in uence the actions of buyers and sellers. Investors have no assurance whatsoever that they will be able to recoup the investment in a stock at any time. The price of a stock when an investor wishes to sell shares may be higher or lower than when the shares were initially purchased. ■ Decreased or no dividend income- A risk of stock ownership is the possibility of divi- dend 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. ■ Low priority at dissolution- If a company enters bankruptcy, the holders of its bonds and preferred stock have priority over common stockholders. A company's debt and preferred shares are considered senior securities. Common stockholders have residual rights to corporate assets upon dissolution. If after debt holders and preferred shareholders are paid, only then would common shareholders be paid if there were any funds left to divide among them.

The following risks are associated with preferred stocks:

■ Possible loss of purchasing power ■ Interest rate (money rate) risk ■ Business difficulties leading to possible reduction or elimination of the dividend and even bankruptcy leading to loss of principal

In summation, 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 ■ Business difficulties leading to possible reduction or elimination of the dividend and even bankruptcy leading to loss of principal

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

Preferred stockholders advantages over common stockholders include:

■Dividend preference—When the Board of Directors declares dividends, owners of preferred shares must be paid prior to any payment to common shareholders. ■Priority at dissolution over common stock—If a corporation goes bankrupt, preferred stockholders have a priority claim over common stockholders on the assets remaining after creditors have been paid.

Risks of preferred include:

■Purchasing power risk—The potential that, because of inflation, the fixed income produced will not purchase as much in the future as it does today. ■Interest rate sensitivity—Like a xed income security, when interest rates rise, the value of preferred shares declines. (This will be discussed in greater detail later in this unit.) ■Decreased or no dividend income—Like common stock ownership, there is the possibil- ity of dividend income decreasing or ceasing entirely if the company loses money. The decision to pay a dividend rests with the Board of Directors (BOD) and it is not guaranteed. ■Priority at dissolution—While preferred shareholders are paid before common sharehold- ers if a company enters bankruptcy, they are paid behind all creditors.

Two basic types of bankruptcy are...

■Reorganization- 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 speci ed time frame. ■Liquidation- keeping property or continuing business will not occur and all property will be taken and sold to repay all debts.

Penny Stock Cold-Calling Rules

■The representative must first determine suitability on the basis of information about the buyer's financial situation and objectives ■The customer must sign and date this suitability statement before any initial penny stock trades can be effected. In addition, the broker-dealer must disclose: ■ the name of the penny stock; ■ the number of shares to be purchased; ■ a current quotation; and ■ the amount of commission that the rm and the representative received.