Jackson Mills- FI 301 Exam 2 (CH 7, 3, 10, 12)
nominal yields
The tax-exempt status allows many municipal bonds to offer lower _______ than treasury bonds of the same maturity - despite higher risk, lower liquidity
Short and Long Term Yields - possible terms to maturity - the annualized yield for debt security - at a specific moment in time - while holding other factors constant
The term structure of interest rates describes the relationship between...
OTC
Transactions happen through dealers (decentralized, less transparency) - Bonds and smaller stocks typically trade ______
- Promise semiannual interest payments - Minimum denomination of municipal bonds is usually $5,000 - Most municipal bonds contain a call provision
Typical characteristics of Municipal Bonds
call provision
allows issuers to buy bonds back before maturity
call provision
allows the issuer to repurchase the bonds before the maturity date - if interest rates decline, firms may issue new bonds with lower coupon rates, use capital raised to call previously issued bonds with higher coupon rates
Treasury Notes
are issued with maturities between 2 and 10 years
Treasury Bonds
are issued with with 20 and 30 year maturities
Revenue bonds
are supported by revenues of the project for which the bonds were issued - toll highway, toll bridge, state college dormitory, etc.
General Obligations Bond
are supported by the municipal government's ability to tax
antitakeover measures
barriers for takeover attempts
Laddering
brokers encourage investors to place first-day bids for the shares that are above the offer price. This helps to build upward price momentum.
common stock
carry voting rights - one vote per share (normally) - vote on issues such as electing directors, approving mergers & acquisitions, dividend payouts, major changes to corporate policies - shareholders can vote by proxy (absentee voting)
low credit risk, high liquidity, favorable tax treatment, etc.
characteristics that make a bond a more attractive investment ____, _____, ____.
preemptive rights
corporations sometimes direct their secondary sales of stock toward their existing shareholders by giving them
-credit (default) risk -liquidity -tax status -other features -term to maturity
factors that can affect bond yields
Treasury Notes and Bonds
finance federal government expenditures
Exchanges
for securities listen on an ___, all orders are routed through it - larger stocks tend to trade on these - largest ____ are New York Stock Exchange (NYSE) and Nasdaq - more transparency about order flow and executed trades
Preferred Habitat Theory
implications of the segmented markets theory
federal taxes, state taxes
interest income earned on corporate bonds represents ordinary income to the bondholders and is therefore subject to _________ and _________
tax deductible
interest paid by the corporation for corporate bonds is a ______________ expense to the corporation
shareholders
job of managers in publicly traded firms
bond indenture
legal document which specifies rights and obligations of issuing firms and bondholders
Term to Maturity
length of time a security has until maturity
some borrowers and savers have the flexibility to choose among various maturities
limitation of the segmented markets theory
Corporate Bonds
long-term debt issued by corporations, that promise the owner coupon payments (interest) on a semiannual basis
Federal Agency Bonds
long-term debt securities issued by federal agencies
increasing the price investors are willing to pay
low credit risk, high liquidity, favorable tax treatment, etc. make a bond a more attractive investment by...
higher yields
lower value by investors implies
Spinning
occurs when the underwriter allocates shares from an IPO to corporate executives who may be considering an IPO or to another business that will require the help of a securities firm
Venture Capital Investments
often obtain capital from wealthy individuals and institutional investors such as pension funds - investors are willing to maintain the investment for a long-term period such as 5-10 years - not allowed to withdraw their money before a set deadline
cumulative provision
prevents dividends from being paid on common stock until all preferred stock dividends have been paid
Dividend Yield
= annual dividend / price per share
IPO
A first-time offering of shared by a specific firm to the public
Segmented Markets Theory
According to this theory, there is (or should be) no connection between short- and long term interest rates - investors choose securities with maturities that satisfy their forecasted cash needs - investors only change the behavior if cash flow needs to be changed - short and long term markets are segmented
Before tax yield
After Tax Yield / (1 - Tax Rate)
convertibility
Allows investors to exchange the bond for a stated number of shares of the firm's common stock
bond collateral
Bonds can be classified according to whether they are secured by collateral and by the nature of that collateral - Mortgage bond (secured) vs. debenture (unsecured)
Municipal Bonds
Bonds issued by state and local governments
valued less by investors
Bonds with higher credit risk, lower liquidity, and unfavorable tax treatments are...
- Dow Jones Industrial Average - Standard & Poor's - Willshire 5000 total market index - New York Stock Exchange Index - Nasdaq Stock Indexes
Common stock indexes include
Protective Covenants, Sinking Fund Provision, Call Provision, Bond Collateral, Low and Zero Coupon Bonds, Variable Rate Bonds, Convertibility
Corporate Bond Features
Shelf Registration
Corporations can publicly place securities without the time lag often caused by registering with the SEC
credit (default) risk
How likely is an issuer to make all debt payments? - prospective bond investors must consider the creditworthiness of the security issuer - all else being equal, securities with a higher degree of default risk must offer higher yields - especially relevant for longer term securities
Price to Earnings Ratio (P/E)
price per share/earnings (net income) per share - higher ratio means investors consider the stock to be more valuable relative to its currently profitability - often results from perception of lower risk and/or higher growth potential
Ownership and Management
publicly traded firms have a separation of
protective covenants
restrictions placed on the issuing firm that are designed to protect bondholders from being exposed to increasing risk during the investment period - may limit dividends, salaries, ability to issue new debt, etc.
monitor changes in its value (as measured by its share price)
simplest way to monitor management of firm
- they can obtain financing to support the firm's growth - they can "cash out" by selling their original equity
some business owners hope to go public so that...
Investing in stocks, Issuing stocks as a means of raising capital, place newly issued shares of stock, offer brokerage and advisory services
some financial institutions participate in...
competitive bid
specify a price and a dollar amount of securities to be purchased - max 36% of offering amount
noncompetitive bid
specify only a dollar amount of securities to be purchased - max $10m per auction
exchanges, over the counter
stocks can trade on ____ or _______
after-tax yield
the amount of interest income remaining after the investor pays taxes on it
Willshire 5000 Index
tracks all actively traded public stocks, the broadest index of the U.S. stock market
- minimum denomination is $1,000 - maturity is typically between 10 and 30 years
typical characteristics of corporate bonds
'firm commitment"
underwriter actually purchases the bonds from issuer, then sells them to investors
preffered stock
usually does not allow for significant voting rights - a cumulative provision on (most) of this stock -dividends are typically paid in a fixed amount per share year
higher default risk and less liquidity than treasury bonds
what is the relationship between municipal bonds and treasury bonds when it comes to risk and liquidity
slight upward sloping yield curve
what shape yield curve is "normal"
flat or inverted (downward slopping) yield curves
what shape yield curves commonly preceded recessions
"best efforts"
work to find buyers willing to pay the highest prices
Fannie Mae and Freddie Mac
During the credit crisis in 2008, these two federal agency bonds had purchased risky subprime mortgages that had high frequency of defaults. They were then bailed out by the federal government so the they could resume issuing bonds and continue to channel funds into the mortgage market
Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Association (Freddie Mac)
Federal Agency Bonds are issued by federal agencies such as the ___ and ___ who use the proceeds to purchase mortgages in the secondary market
Issue bonds to raise capital, buy bonds to hold as investments, & place bonds
Financial Institutional Involvement in Bond Markets...
mutual funds, pension funds, insurance companies
Financial Institutions that invest in stocks
banks, insurance companies, securities firms
Financial institutions that issue stock as a means of raising capital
Securities firms
Financial institutions that offer brokerage and advisory services
securities firms (investment banks)
Financial institutions that place newly issue shared of stock
Stock repurchases
Firms tend to repurchase some of their shares when share prices are at very low levels - many stock repurchase plans are viewed as favorable signal; some investors may ask why the firm does not use it funds to expand its business instead of buying back its stock
- owners must invest their own capital into the firm - may supplement with borrowed funds - at some point, owners may solicit venture capital investments
How do Private Equity Companies Grow?
liquidity
How easy can a bond be sold? - refers to the ease with which a security can be bought and sold - highly liquid securities can be sold quickly without needing to lower the asking price - the lower a securities liquidity, the higher the yield required by an investor
Treasury Inflation Protected Securities
( TIPS) The principle value is increased by the amount of the U.S. Inflation Rate - coupon payments from TIPS also increase with inflation - provide returns tied to the inflation rate
secondary stock offering
- a new stock offering by a specific firm whose stock is already publicly traded
Buy bonds to hold as investments
- commercial banks - savings institutions - bond mutual funds - insurance companies - pension funds
Issue bonds to raise capital
- commercial banks - savings institutions - finance companies
New York Stock Exchange Index
- composite index - specific indexes for various industry sectors (energy, healthcare, financial, industrial)
Place Bonds
- finding Byers for newly-issued corporate and government bonds - investment banks (and commercial banks) - Best efforts - Firm Commitment
registered bonds
- ownership is recorded in a central database and transferred through an electronic system
yield to maturity from the investors perspective
- the rate of return an investor would earn from buying a bond and holding it through maturity (1) a set of coupon payments (2) the difference between the par value the issue must pay to investors at maturity and the price it received when selling the bonds
yield to maturity from the issuers perspective
- the rate required in the market on a bond - represents the cost of borrowing for the issuer
Bearer bond (coupon bond)
- whoever physically holds the paper on which the bond is issued is the presumptive owner of the instrument - effectively outlawed in the 1980's, no longer issued
lockup provision
-Prevents the original owners of the firm and the VC firms from selling their shares for a specified period. -Prevents downward pressure that could occur if the original owners or VC firms immediately sold their shares in the secondary market.
tax status
-investors are more concerned with after-tax income - taxable securities must offer a higher before-tax yield
1. segmented markets theory 2. pure expectations theory 3. liquidity premium theory
3 Theories of the relationship between short-term and long-term interest rates
- raise cash - more owners - debt-to-equity changes
IPO effect on a firm
- expected increases in short-term yields would cause yield curve to have an upward slope - long-term yields > short-term yields - expected decreases in short term yields would cause yield curve to have downward slope - long-term yields < short-term yields
If the term structure of interest rates were influenced solely by the expectations of future interest rates, we would observe the following...
Dividends
In mature companies, common shareholders are paid ____ from firms after-tax profits - as opposed to bondholders and preferred shareholders who receive fixed income
Free from credit default risk
In terms of risk, Treasury bonds are...
- forward rates calculated according to PE tend to be higher than actual future interest rates - implies upward-sloping YC is not due solely to expectation of increasing rates in future
Problem with pure expectations theory
Liquidity Premium Theory
The preference for the more liquid short-term securities places upward pressure on the slope of a yield curve - higher preference for short term securities means investors are willing to pay more for them, therefore these yields will be lower
Yield Curve
Term Structure of Interest Rates is depicted graphically on the _______
Exempt
The income earned from a municipal bond is ____ from federal taxes and normally ____ from state taxes
Exempt
When it comes to treasury bonds, interest is taxed by the federal government as ordinary income, but it is ____ from any state and local taxes
Private Equity
a business that is privately held and the owners cannot sell their shares to the public
- the owners want to sell at least $50 million in stock - the shareholder base will be large enough to support an active secondary market
a public offering is feasible if...
sinking fund provision
a requirement that the firm retire a certain amount of the bond issue each year
Stock Indexes
a stock index that tracks performance of group stocks
Flipping
a strategy adopted by some investors who know about the unusually high initial returns on many IPOs attempt to purchase the stock a the offer price and sell the stock shortly after - to discourage this securities make more shares of future IPOs available to institutional investors that retain shares for a relatively longer period of time
Pure Expectations Theory
according to this theory, borrowers and lenders are indifferent to maturity, care only about maximizing expected returns - the term structure of interest rates is determined solely by expectations of future interest rates - exact opposite of segmented markets theory