CFP - Investment- Ch. 1: Investment Vehicles

What is the minimum size of an individual GNMA?

$25,000

If a bond (Par = $500) has a conversion price of $38.75 per share and the market price of the stock is $32, what is the conversion value?

$412.90 ($500 / $38.75) x $32

Describe the interest of I-bonds

-Accumulate interest monthly -Interest is compounded every 6 months on the semiannual anniversary of the bond's issue date -Interest is composed of 2 parts: a fixed base rate and an inflation adjustment

What does an indenture cover?

-Form of bond (coupon or zero) -Amount of the issue -Property pledged (if not a debenture issue) -Protective covenant, including any provision for a sinking fund -Working capital and current ratio -Redemption rights or call, put, or conversion provisions

What is an I-bond's interest rate composed of?

-Interest is composed of 2 parts: a fixed base rate and an inflation adjustment -Fixed base rate stays the same for the life of the bond -Inflation adjustment is updated every 6 months to track inflation as measured by the CPI -Fixed rates and inflation adjustments are announced by the Treasury Dept on May 1 and Nov 1 for the following 6-month period

Describe the following characteristics for Notes: -Maturities -Issued -Risk -Default risk -Callable -Interest paid -Taxation -Auction

-Maturities: 1-10 YEARS -Issued: $1,000 to more than $100,000 at par -Risk: Reinvestment, Interest rate, Purchasing Power (RIP) -Default risk: None -Callable: Not callable -Interest paid: Semiannually -Taxation: Subject to federal income tax; Exempt from state and local income tax -Auction: Monthly

Describe the following characteristics for Bonds: -Maturities -Issued -Risk -Default risk -Callable -Interest paid -Taxation -Auction

-Maturities: 10-30 YEARS -Issued: $1,000 to more than $1,000,000 at par -Risk: Reinvestment, Interest rate, Purchasing Power (RIP) -Default risk: None -Callable: Callable* 15 years prior to maturity -Interest paid: Semiannually -Taxation: Subject to federal income tax; Exempt from state and local income tax -Auction: Quarterly

Describe the following characteristics for T-Bills: -Maturities -Issued -Risk -Default risk -Callable -Interest paid -Taxation -Auction

-Maturities: 3, 6, and 12 months -Issued: $100 to $1,000,000 (discount yield basis) -Risk: None/safest (benchmark for "risk free rate of return) -Default risk: None -Callable: N/A -Interest paid: No coupon interest (interest is the discount) -Taxation: Subject to federal income tax; Exempt from state and local income tax -Auction: Weekly

Describe CMOs

-They are multiclass pass-through securities -Do not view mortgage pools as a means of passing through payments to certificate holders in exactly the same form as received -Instead, the mortgage payments are looked at on a "cash flow" basis -Based on the basis of expected cash flow to be received over the life of the pool, separate classes of securities called "tranches" are created

Name 3 municipal bond insurers

1. AMBAC: American Municipal Bond Assurance Corp. 2. MBIA/National: Municipal Bond Insurance Association Corp./National 3. BAM: Build America Mutual Insurance

A $1,000 par corporate bond quoted at 110 is selling at a premium of _____ points over par

10

A $1,000 par corporate bond quoted at 90 is selling at a discount of ____ points from par

10

Mortgage bonds (corporate)

= Considered the safest among long-term corporate issues = Backed by specific real property (land and building) owned by the issuing corporation = Real land can be sold if the issuer defaults

Identify the true statements regarding T-Bills. Select all that apply. A. They are sold on a discounted yield basis B. They are only sold in denominations of $1,000 or higher C. They all mature in 3 months D. They are sold at par E. They are sold by competitive bids

A and E

Discount bond

A bond sells at a discount when its par value is in excess of the bond's purchase price

Premium bond

A bond sells at a premium when the bond's purchase price is in excess of par value

High-yield corporate bonds

A bond that has a rating of BB or lower and pays a higher yield to compensate for its greater risk (also called a junk bond) THESE ARE SELDOM A CORRECT ANSWER ON THE EXAM!

Debenture

A corporate debt obligation backed only by the integrity of the issuer

What is a Bond?

A debt security which obligates the issuer to pay interest (usually semiannually) and to repay the PRINCIPAL amount when the debt matures at the end of its term

Eurodollars

A deposit in ANY foreign bank that is denominated in dollars

Inez Inflation Worrier bought a TIPS 6 years ago for $1,000. Since then, it has paid $180 in interest and has increased principal by $360. If Inez sells the security for $1,400, what amount must he report to the IRS?

A gain of $100 Interest is taxable to the holder when received (no change in basis) Any increase in the inflation adjusted principal amount is treated as OID (taxable)

What is a negotiable CD?

A marketable deposit of liability of the issuer who must sell new CDs on demand Deposit is maintained in the bank until maturity, at which time the holder receives the deposit plus interest They're negotiable in that they can be sold in the open market before maturity, thus they carry interest rate risk

Describe phantom income & how it relates to OIDs

A zero-coupon bond owner must report interest income although the bond pays no interest before maturity

Identify the true statements regarding Treasury Bonds. Select all that apply. A. Interest paid is subject to federal income tax B. Interest paid is subject to state and local income tax C. They're sold on a yield to maturity basis D. Issued bonds can be callable E. They are riskless investments

A, C, and D

Which of the following securities is insured by a direct guarantee of the US government? A. GNMA B. FNMA C. CATS D. TIGRS E. FHLMC

A. The federal govt insures GNMAs as to the timely payment of principal and interest

Identify the features of a mortgage-backed certificate. Select all that apply. A. It is a security backed by mortgages B. Investors receive payments sourced from the interest and principal on the underlying mortgages C. It is a pass-through security D. It represents pooled debt obligations repackaged as securities

All the above! As homeowners pay down principal, it is "passed through" to the holders of the mortgage-backed securities. Examples of mortgage-backed certificates include GNMA, Fannie Mae and Freddie Mac securities.

Which of the following is true about TIPS? A. They are issued in minimum denominations of $1,000 B. The interest rate is fixed C. Interest payments vary as the principal is adjusted for inflation and deflation D. The are obligations of the federal government

All the above! Remember: the interest rate is fixed, but the interest payments will vary depending on inflation-related adjustments to principal

Indenture

Also called a deed of trust A formal agreement between an issuer of bonds and the trustee Indenture contract also provides for the appointment of a trustee to act on behalf of the bondholders

How long must EE bonds be held? What happens if they're held less than 5 years from the issue date?

At least 1 year There is a 3-month interest penalty applied to bonds held less than 5 years

When is an issuing corporation most likely to call its bonds? A. When interest rates are expected to drop B. When the bonds are selling at a premium C. When interest rates have declined D. When interest rates are flat

B If the bonds are selling at a premium, newly issued bonds are offered with lower coupons. The corporation can now call its callable bonds and replace them (recapitalize) with lower coupon bonds.

Jody is hired to design an investment portfolio for the company's new pension assets. Company trustees are very conservative. Money market assets total $100,000. How should Jody position the assets? A. Treasury bonds B. Negotiable CD C. GNMAs D. EE bonds E. FHLMC

B. CDs have the least risk (insured up to $250,000)

Revenue Bonds

Backed by a specific source of revenue to which the full faith and credit of the issuer is NOT pledged Since they're backed by a single source of funds (like toll roads, hospitals, or nuclear power plants), they present a greater risk than GO bonds. As such, they trade at higher yields.

General obligation bonds (GO)

Backed by the full faith, credit, and taxing power of the issuing municipality Issuer promises (if necessary) to raise taxes WITHOUT LIMIT in order to pay off the bondholders

Why were Collateralized Mortgage Obligations (CMOs) developed?

Because principal repayments vary as homeowners refinance their homes, the amount of principal repayment received by the investor changes every month CMOs were developed to eliminate these risks

Par value

Bonds are issued with a stated par value (face value usually $1,000) and a stated rate of interest (coupon rate or nominal rate)

For GNMA yields, each payment received represents what 2 things?

Both interest and a return of principal (no par at maturity)

Government National Mortgage Association (GNMA)

Buys FHA, VA, and Farmer's Home Administration insured mortgages from banks and places them into mortgage pools It then issues PASS THROUGH certificates representing individual interests in the pool

T-Bills are issued carrying all of the following terms except: A. 3 months B. 6 months C. 9 months D. 12 months

C. 9 months

Which of the following accurately reflects a characteristic of a Z tranche CMO? A. Duration is lowest amount all the tranches B. Interest rate risk is lower than any other tranche C. The yield should be higher than any other tranche D. It is suitable for an investor who needs yearly income

C. The Z tranche has the longest duration of all the classes (like a zero). It receives interest and principal only after all the other tranches have been liquidated. Since it has the longest duration, it will have the highest interest rate risk. Because it is the last class to be paid, it receives a higher yield than the other classes.

Which of the following correctly applies to US Treasury Bonds? A. They do not have interest rate risk because the govt guarantees the coupon rate B. They have default risk because they are not guaranteed by the govt C. They have purchasing power risk due to their long maturities D. They do not have reinvestment risk because interest payments are semiannual

C. They are exposed to RIP. Long maturity instruments with fixed coupon rates carry significant inflation risk.

What is the formula for computing the conversion value of a convertible bond?

CV = (PAR / CP) x Ps CV = conversion value PAR = par value of a bond (presume $1,000 if not stated otherwise) CP = Conversion price Ps = Current market price of underlying stock

Describe the tax-free redemption of both EE and I bonds

Can be used for qualified college education expenses Bonds must be owned by an adult at least 24 years old (normally the parent) Bonds CANNOT be held in a UTMA/UGMA custodial account and qualify for the interest exclusion (these accounts are owned by the minor, not the custodian) A grandparent may claim the interest exclusion IF the grandchild/student is a dependent of the grandparent

Which of the following statements is true about Series EE and Series HH bonds? A. EE and HH bond interest is taxed at maturity B. EE bonds are purchased at face value; HH bonds were purchased at par (when they were being issued) C. EE and HH bonds can be purchased directly or on the secondary market D. Interest on EE bonds are not subject to state and local taxes; interest on HH bonds is subject to federal tax

D

Which of the following statements is true about I bonds? A. I bonds and TIPS are different names for the same bond B. I bonds provide a fixed rate of interest C. I bonds are original issue discount bonds (OID) D. Interest is added to the bond monthly and paid when the holder cashes the bond

D.

Monty Monthyincome purchased a GNMA fund one year ago for $25,000 and has received all the distributions in cash. It is now worth $24,001. Why is its current value lower than the purchase price? A. Mortgage interest rates are increasing B. Mortgage debtors are defaulting on their mortgage payments C. Principal is being paid off D. A and/or C

D. A and/or C Increasing market rates will cause a decline in the NAV of the GNMA portfolio (rates up, bonds down). Principal is less likely to be paid off in a rising interest rate environment. However, as people move, principal is repaid causing NAV to decline. (If repaid principal is paid to the investor and not reinvested in new mortgages, the investor's account value will decline, too)

Regarding OIDs, which statement is not true? A. Municipal discount bonds must be accreted B. Corporate discount bonds must be accreted C. Zero coupon bonds must be accreted D. Zero coupon bonds do not need to be accreted

D. Accretion is performed on a compound interest basis. The accretion generates phantom income but enables the bondholder to raise the basis accordingly.

Which of these securities below is subject to default risk? A. T-bills B. STRIPS C. GNMA D. FNMA E. Treasury bonds

D. FNMA Although the Treasury would probably not permit a govt-sponsored agency to default, FNMA arguably carries some default risk. The other securities are govt-guaranteed.

What are the risks of corporate and municipal bonds?

DRIP Default risk: A creditor may seize the collateral and sell it to recoup the principal (credit risk) Reinvestment risk: As payments are received from an investment, interest rates have fallen. When the funds are reinvested, the investor receives a lower yield. Interest rate risk: Rising interest rates cause bond prices to fall Purchasing power: Inflation may lower the purchasing power of fixed bond interest

Describe the default, interest rate, and reinvestment rate risks of GNMAs

Default risk: None Interest rate risk: Fixed interest rate means price falls when interest rates rise Reinvestment rate risk: Reduced certainty of the monthly payment due to homeowners repaying their mortgage loans prematurely when interest rates fall (prepayment)

Original Issue Discount (OID) Bond

Discounted from PAR VALUE when it is issued Many are zero-coupon bonds originally issued far below par value They pay no interest until maturity

Yankee Bonds

Dollar-denominated bonds issued in the US by foreign banks and corporations Issued in the US when market conditions are more favorable than on the Eurobond market or in domestic markets overseas

What is the price (or intrinsic value) of a bond with a $1,000 face value, a 7% coupon, and 5 years to maturity if comparable bonds of the same maturity and grade are yielding 8%

FV = $1,000 PMT = $35 n = 10 i = 4 PV = ? = $959.35.

Judy owns a bond with a par value of $1,000. The bond matures in 12 years. The bond has a 8% coupon (paid semiannually). Comparable debt is yielding 10%. What is the intrinsic value of this bond?

FV = $1,000 PMT = $40 n = 24 i = 5 PV = ? = $862.01

Name 3 other agency securities

Federal Home Loan Bank (FHLB) Federal National Mortgage Association (FNMA). Fannie Mae is a profit-making organization. Federal Home Loan Mortgage Corporation (FHLMC). Is a privatized company issues Freddie Mac. The US govt does NOT directly back these issues. They are backed IMPLICITLY through lines of credit.

For TIPS: The higher the inflation rate, the _____ the face value of the bond and the (fixed percent but not fixed amount) semi-annual interest payment

Higher

What are convertible bonds?

Hybrid debt securities Like most bonds, they pay interest The owner of the bond may convert the bond into a specific number of shares of the issuer's common stock

Why are GO bonds generally considered the safest type of municipal credit?

In the event of default, GO bondholders have the right to compel a tax levy to make payment on the debt

What are I-bonds?

Inflation-indexed accrual securities of the US govt

How does Standard & Poor's rate investment grade and speculative grade bonds?

Investment grade: AAA, AA, A, and BBB Speculative: BB and below (junk bonds)

How does Moody's rate investment grade and speculative grade bonds?

Investment grade: Aaa, Aa, A, Baa Speculative grade: Ba and below (junk bonds)

Describe the tax treatment of TIPS

Investor is taxed annually on the interest payment plus the appreciation in face value. Both are taxed at the investor's ordinary income tax rate. Income is taxable in the year it accrues. Only federal tax applies. The increase in face value is imputed or "phantom income" income that is taxable now but now collectible until the bond is sold or matures

Describe the interest rate of EE bonds

It's fixed (guaranteed) and applies for the 30-year life of each bond, which is 20 years but also adds a 10-year extended maturity period Rates for new issues will be adjusted May 1 and November 1, with each new rate effective for all bonds issued through the following 6 months Interest accrues monthly and is compounded semiannually

Who issues municipal bonds?

Municipal securities are issued by states, cities, counties, and other (non-fed) govt units in order to raise capital

The annual accretion amount on OIDs is considered to be _____ income. If held to maturity, there is no _______.

Non-taxable interest; there is no capital gain or loss

What are some characteristics of EE bonds?

Non-traded debt of the US govt They are fixed income securities -Savings bonds are nonmarketable, nontransferable, and nonnegotiable, and cannot be pledged for collateral Issued at face value Earn fixed interest rates Denominations are as low as $50

Money Market Deposit Accounts (MMDAs)

Offered by commercial banks Insured up to 250k (individual) by the FDIC 6 pre-authorized transfers are allowed each month, which may be made by check

Money Market Mutual Funds (MMFs)

Offered by open-end investment companies Money market funds are fixed income mutual funds that invest in debt securities characterized by short maturities and minimal credit risk. Consist of nationally diversified funds that are in short-term municipal securities Money market mutual funds are among the lowest-volatility types of investments. Income generated by a money market fund is either taxable or tax-exempt, depending on the types of securities the fund invests in. NOT insured

What are the risks of government bonds?

RIP = Reinvestment, interest rate, and purchasing power. Govt bonds DO NOT have default or credit risk (use RIP for all government bonds except zeros)

What can a TIPS holder do to correspond with the phantom income that must be recognized?

Raise basis A decrease will first reduce the income attributable to the semi-annual interest and if there is excess, the excess will be an ordinary deduction

Treasury Bills

Short-term securities with maturities of 1 year or less Issued at a discount from face value

Commercial Paper

Short-term, unsecured promissory note issued by large, well-known, and financially strong companies Denominations start at $100k Maturity is 270 days or less Normally sold at a discount and is rated by a rating service as to quality

What are the 2 main rating agencies?

Standard & Poor's (S&P) and Moody's

Rank the following debt type instruments from the lowest to the highest credit risk. 1. CD with a 6-month maturity 2. Tax-exempt money market account 3. Money market fund 4. T-bill

T-bills --> CD --> money market fund --> tax-exempt money market account Treasury securities carry no credit/default risk since they're issued by the US Treasury. Tax-exempt money market accounts have slightly more risk than MMFs.

What types of assets does a MMF hold?

T-bills, negotiable CDs, and prime commercial paper

At minimum, what does the Treasury guarantee for EE bonds? What happens if it doesn't?

That a bond's value will double after 20 years & that it will continue to earn the fixed rate set at the time of issue unless a new rate structure is announced If it doesn't double in 20 years, the Treasury will make a one-time adjustment at maturity to make up the difference

What is a security's intrinsic value?

The PRESENT VALUE of its expected cash flows

Is the I bond inflation adjustment subject to tax each year?

The owner of the bond determines that I bonds are taxed like EE bonds - the owner will generally choose to defer tax

What is credit risk?

The risk that the issuer cannot make interest and principal payments The rating agencies only rate bonds for credit risks

Nominal yield

The stated rate of interest on the bond (the coupon rate)

Describe the tranches that a CMO offers

The typical CMO offers A to Z tranches, representing fast pay, medium pay, the slow pay bonds plus an issue (Z tranche) that bears no coupon but receives the cash flow from the collateral remaining after the other tranches are satisfied

Describe I-bonds

They are nonmarketable, nontransferable, and nonnegotiable and cannot be pledged for collateral They're sold at face value Issued in the same denominations as EE bonds

What are HH bonds?

They were only available by exchanging at least $500 in Series EE bonds They pay interest semiannually (by check) and are nonmarketable After August 2004, EE bonds are no longer exchangeable into HH bonds. However, investors may still be holding previously issued HH bonds because they have 20-year maturities

Describe the coupon rate and semi-annual interest payment of TIPS

They're issued with a stated coupon rate that is low relative to conventional Treasuries The amount of the semi-annual interest payment rises as the face value is adjusted upward for inflation

What are TIPS and what is their purpose? What denomination are they sold in?

Treasury inflation-protection securities. They protect against inflation. The face value (principal) is adjusted semiannually to keep pace with inflation as measured by the CPI over a 6-month period $1,000

How is the discount on STRIPS taxed?

Treated as taxable income, earned annually

T or F: Each year the portion of the discount that has been earned is included as taxable interest income, and the bond's basis is increased.

True!

T or F: For an OID municipal bond, the discount must be accreted on a straight-line basis over the life of the bond.

True!

T or F: GNMAs are a direct guarantee of the US goverment

True!

T or F: Unlike EE bonds, I-bonds do NOT have a guaranteed interest rate

True!

T or F: For bonds, interest is usually accrued by the bondholder daily

True! If a bondholder sells a bond between interest payments, the purchaser of the bond must compensate the seller for the interest "earned" by the seller since the last interest payment

T or F: Yankee Bonds are registered with the SEC

True! They must be registered like other bonds sold to the public in the US

Banker's accetance

Used to finance imports and export transactions Before a foreign exporter will ship goods to the US, they want assurance of payment when the goods arrive They're bearer securities and can be held to maturity Maturity = 9 months or less Trades at a discount to face value

Insured Municipal Bonds

When municipal bonds are insured, they are virtually AAA rated The insurers pay TIMELY interest and principal when the issuer is in default

For GNMAs, describe what happens when 1) interest rates increase and 2) when interest rates decrease

When they increase: People will continue their previously issued mortgages --> GNMA holder is stuck with an investment that pays lower than market rates --> value of investment falls When rates decrease: Homeowners will pay off their mortgages and would receive the principal --> principal would have to be reinvested --> new investment pays a lower rate of return

Are GNMAs subject to local, state, and federal taxes?

Yes because they are not ISSUED BY the Treasury Dept

Are TIPS marketable?

Yes!

Are negotiable CDs insured?

Yes, up to $250,000 (per individual) by the FDIC

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

Zero-coupon bonds issued by the The Treasury Investors who purchase them acquire a DIRECT OBLIGATION of the federal govt

If certain requirements are met, interest on I bonds & EE bonds redeemed for ______ is tax-exempt

education expenses

The market price of the convertible security depends on: ____ and ____

the value of the stock & the interest that the bond pays