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