©2015, College for Financial Planning, all rights reserved.

Session 12Features of Fixed-Income, Preferred Stocks, and Convertibles

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning

Session Details

Module 6

Chapter(s)

1, 2, 3

LOs 6-1 Explain terminology, characteristics, and sources of risk of debt securities and preferred stock, including convertible issues of both.

6-2 Explain terminology and characteristics of preferred stock.

6-3 Evaluate the investment implications of yield curves.

12-2

Basic Terminology of Bonds• Indenture

(governing document)• Principal

(face amount, maturity value, par value)

• Coupon (or nominal rate)

• Callable bonds• Convertible bonds• Debentures

(unsecured)• Basis points (1% =

100 b.p.) 12-3

Bond RatingsFour major

agencies1. Standard & Poor’s2. Moody’s3. Duff & Phelps4. Fitch

Investment grade: top four ratings• Standard & Poor’s:

AAA, AA, A, and BBB

• Moody’s: Aaa, Aa, A, Baa

12-4

Bond RisksPrimary risks when investing in bonds• Default risk (credit risk)• Reinvestment risk• Interest rate risk• Purchasing power risk

Potential additional risks• Call risk• Liquidity risk• Endogenous risk• Financial risk• Exchange rate risk

12-5

Major Bond Issuers• U.S. government

and its agencies

• Municipal government

• Corporations

• Foreign governments and corporations

12-6

Bond Maturity Classifications• Short term

o one- to three-year maturities

• Intermediate termo three- to ten-year

maturities

• Long termo more than ten-

year maturities

12-7

U. S. Treasury Obligations

Type

Minimum Denomination

s Initial Maturity

Treasury bills $100 Up to 52 weeks

Treasury notes

$100 More than 1 year to 10 years

Treasury bonds

$100 More than 10 years to 30 years

12-8

U.S. Treasury Obligations: TIPS

Treasury Inflation-Protection Securities• Minimum face amount of $100• Fixed interest rate• Principal adjusted semiannually for

inflation• Index used is CPI-U• Principal adjustment subject to federal

income tax even though not received until maturity

12-9

U.S. Savings Bonds

• Series EE and Series I Savings Bondso $25 or moreo $10,000 annual purchase limit per Social

Security # for each; as of 1/1/12, paper bonds no longer sold at financial institutions

• Series EEo fixed rate announced by the Treasury

• Series Io earns a fixed rate

plus a semiannual inflation rate based on CPI-U

12-10

U.S. Government Agency Issues

Pass-Through Securities• GNMA: Ginnie Mae

o Direct obligation of U.S. government• FHLMC: Freddie Mac• FNMA: Fannie Mae• CMO: collateralized mortgage obligations

o Divided into classes (tranches)o “A” tranche pays off first, then “B,” etc.

12-11

Municipal BondsGeneral Obligations(GO)• full faith and credit of

issuer backing

Revenue (Private Activity)• backed by a specific

project• “riskier” since only backed

by project

• interest subject to AMT (some private activity bonds issued in 2009 and 2010 are not subject to AMT)

12-12

Other Bond Types

• Zero coupon bonds

• Collateralized debt obligations (CDO’s)

• Credit default swaps (CDS’s)

• High-yield bonds (junk)

• International bonds

o Yankee bonds

o Eurodollar bonds

12-13

Preferred Stock• Fixed dividend (not tax

deductible by corporation)

• Dividend paid from earnings, generally cumulative

• Qualified dividends are eligible for capital gains tax rates

• Dividend exclusion for a corporation holding preferred stock (70% or more depending upon percentage of ownership)

12-14

Preferred Stock• In event of bankruptcy,

bond holders come first, then preferred shareholders, then common stock shareholders

• Preferred stock is riskier than debt (no maturity date)

• Some issues are convertible into common stock

• Do not confuse with “trust preferreds,” which are structured as debt and pay “interest,” not “dividends”

12-15

Preferred Stock: Valuation

Use the zero-growth model

Example:$1.50 dividend and interest rates currently

at 6%$1.50/.06 = $25

What if interest rates change to 7%?$1.50/.07 = $21.43 (decline of $3.57 or

14.28%)

oD / r

12-16

Yield CurvesHypothetical Yield Curve

Return

30

Rf

0 Years until maturity

12-17

Positive (Normal) Yield Curve

Return

30

Rf

0 Years until maturity

12-18

Negative (Inverted) Yield Curve

Return

30

Rf

0 Years until maturity

12-19

Term Structure of Interest Rates

12-20

Changes in Yield Curve

Discuss change over time from YC1 to YC2 % Yield

Years to maturity

YC1

YC2

12-21

Question 1

Which of the following are characteristics of mortgage-backed securities?I. stable cash flowII. ordinary incomeIII.tax-sheltered incomeIV.capital gains and losses

a. I and II onlyb. II and IV onlyc. I, II, and III onlyd. II, III, and IV only

12-22

Question 2

Which of the following is an advantage of investing in convertible bonds?a. There is minimal financial and business

risk.b. The yield-to-maturity tends to be lower

than that of similar nonconvertible bonds.c. The potential for capital gains is greater

than that for the underlying stock.d. Its value as a bond, assuming it did not

have the convertible feature, provides downside protection.

12-23

Question 3Kathleen is risk-averse, and is considering the purchase of some short-term fixed income investments. Which of the following are reasons why Kathleen should consider U.S. Treasury bills?I. They may sell at a premium over face value.II. The longest maturity available is 52 weeks.III. They can be purchased for as little as $1,000.IV. The interest income is exempt from state income

taxes.a. I and III onlyb. II and IV onlyc. III and IV onlyd. I, III, and IV onlye. II, III, and IV only

12-24

Question 4

Which of the following features distinguish GNMA mortgage-backed securities from corporate bonds?

I. Distributions of GNMA mortgage-backed securities are made semiannually, reducing reinvestment risk.

II. GNMA mortgage-backed securities are free of default risk.

III. Distributions from GNMA mortgage-backed securities are comprised of both interest and principal.

IV. Because GNMA mortgage-backed securities are government guaranteed, investors cannot lose money on them.a. I and II onlyb. II and III onlyc. III and IV onlyd. I, II, and III onlye. II, III, and IV only

12-25

Question 5

Ken Kannopolis has come to you for advice about investing in municipal bonds.

Which of the following statements is (are) correct?

I. A revenue bond relies on the general taxing ability of the issuing municipality for repayment of the debt.

II. Municipal securities have a relatively thin market, with only moderate activity in the secondary market.

III. Municipal bonds are free from default risk.IV. The interest from general obligation bonds may be

subject to the alternative minimum tax (AMT).a. II onlyb. I and II onlyc. II and III onlyd. II and IV onlye. III and IV only

12-26

Question 6

Which of the following are similarities between long-term corporate bonds and preferred stock?

I. Both offer favorable tax treatment to the corporation on the dividends and interest paid out.

II. Both have a maximum maturity of 30 years or less.III. Both are subject to interest rate risk and

purchasing power risk.IV. Both bond interest and preferred stock dividends

must be paid before common stock dividends may be paid.a. I onlyb. I and II onlyc. III and IV onlyd. I, II, and III onlye. II, III, and IV only

12-27

Question 7

You are considering the purchase of XYZ preferred for your client. XYZ pays an annual dividend of $2.50, and the yield on current comparable preferred is 8.2%. The current risk-free rate is 4%. Which of the following is closest to the intrinsic value of XYZ preferred?a. $25.00b. $30.49c. $59.25d. $62.50

12-28

Question 8

Your client has noticed that short-term interest rates are currently lower than long-term interest rates. You explain to her that one of the reasons that this may be the case is because of one of the following theories, which attempts to explain the term structure of interest rates.

Which answer correctly matches a theory with its appropriate definition?

a. The market expectations theory states that investors expect long-term rates to be higher than short-term rates.

b. The liquidity preference theory states that the longer the maturity, the less liquidity; so long-term rates are higher to compensate for the reduced liquidity.

c. The market segmentation theory states that the long-term portion of the bond market is not influenced at all by the short-term portion of the market.

d. The positive yield curve theory states positive yields are considered normal.

12-29

©2015, College for Financial Planning, all rights reserved.

Session 12End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning