Investment

Investment Alternatives

FIN 3600: Chapter 3 Timothy R. Mayes, Ph.D.

Categories of Investments 

Previously, we have distinguished between two types of assets:  

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Financial Assets Real Assets

We can further subdivide these into two categories: 

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Direct Investments – These are investments where you take actual direct ownership of the assets Indirect Investments – These are investments where you have indirect ownership, such as mutual funds, ETFs, and REITs

Money Market Instruments 

The “money market” is comprised of high quality, shortterm, large denomination debt instruments: 

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High Quality – Generally the issuers have very high credit ratings (U.S. Government, money center banks, large finance companies, blue chip corporations). Short-term – Most money market instruments mature within one year, and many within a few days. Large Denomination – Most of these securities have a face value greater than $100,000. Additionally, most of these investments are discount securities. They do not pay interest. Rather, they are sold at a discount to face value and later redeemed at full face value.

Types of Money Market Instruments      

Treasury Bills (T-bills) and short-term agencies Short-term Municipals Commercial Paper Banker’s Acceptances Jumbo CDs (brokered CDs, large CDs) Repurchase Agreements

T-Bills and Short-term Agencies   

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Treasury bills (and short-term agencies) are used to provide shortterm liquidity for the U.S. government. T-bills are backed by the “full faith and credit” of the U.S. government. They are issued with original maturities of 4 weeks (new as of 31 July 2001), 13 weeks (3-month or 91 days), 26 weeks (6-month or 182 days). 52-week (1 year or 365 days) bills used to be regularly auctioned, but this practice was discontinued on 27 Feb 2001. Occasionally, they also issue cash management bills (CMBs) with variable, but usually less than 3-months, maturities. They do not pay interest, instead they are sold at a discount to face value and are redeemed at maturity for their full face value. The face value of T-bills is $1,000 and multiples thereof.

Calculating Yields on T-bills 

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Since T-bills are sold on a discount basis, their returns are not directly comparable to interest bearing bonds. Returns on T-bills are quoted on a “bank discount basis”:

( FV − PP ) 360 360 BDY = × = Discount % × FV

M

M

Calculating Yields on T-bills (cont.) 

The Bank Discount Yield is a little misleading for two reasons:  

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It uses a 360-day year (12 months, 30 days each) It is based on face value, not the actual price

For these reasons, and comparability with interestbearing securities, we can calculate the Bond Equivalent Yield by adjusting the BDY or directly: BEY = BDY ×

FV 365 FV − PP 365 × = × PP 360 PP M

Calculating Yields on T-bills (cont.) 

Here’s an example: Suppose you just bought a 26week (182 days) T-bill at auction for a price of $975. What is the BDY and BEY? 1000 − 975 360 BDY = × = .04945 = 4.945% 1000 182 BEY = .04945 ×

1000 365 × = 0.5142 = 5.142% 975 360

Short-term Municipals 

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Cities, counties, and states all frequently have a need for short-term funds to provide for liquidity needs. They can issue securities that are similar to T-bills called anticipation notes (in anticipation of some revenue, usually taxes). The advantage of these securities is that the income they provide is free of federal taxation. The disadvantage is that they are backed only by the taxing authority of the district that issues them. For this reason, they are not as safe as T-bills.

Taxable Equivalent Yield 

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When comparing tax-exempt yields to taxable yields, we need to adjust for the tax rate. We can either gross up the tax-free yield: Tax Exempt Yield TEY = (1 − t )

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Or, we can discount the taxable yield: After Tax Yield = Taxable Yield × (1 − t )

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Once we’ve made the adjustment, the yields are comparable

Commercial Paper  

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Commercial paper (CP) is very high-quality, unsecured, short-term corporate debt. Generally, it matures in less than 9 months and is exempt from SEC registration (more than 270 days and it would have to be registered). In practice, most CP matures in 30 days or less. There are about 1,500 companies (Bloomberg) that issue CP, but about 75% (NY Fed) of CP is issued by financial companies (the largest being GE Capital, GMAC, and Ford Motor Credit). CP is not very liquid as it tends to be held to maturity by purchasers, though it can be traded in the secondary market if necessary.

Commercial Paper (cont.) 

CP is issued by firms in one of two ways: 

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Direct – CP is sold directly to investors. This method is usually used by financial firms with frequent, large needs for short-term cash. Direct issuance lowers interest costs by 1/8 of a percentage point ($125,000 per $100 million issued, NY Fed estimate). This more than pays for having a full-time staff. Indirect – CP is sold to a dealer at a discount (higher interest rate), and is then either held in the dealer’s own account, or resold to investors at a profit. Firms which do not regularly issue CP use dealers.

CP interest rates are usually lower than on bank loans, making it an attractive alternative for some firms. CP defaults are rare, but they do occasionally occur. As of January 2002, there was about $1.44 trillion in outstanding CP.

Bankers’ Acceptances 

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Bankers’ acceptances (BAs) are like a certified check from a bank, except that it is payable on some future date whereas a check is payable immediately. Bankers’ acceptances are usually created in the process of international trade and are sold by banks. A BA results when an importer buys from a foreign exporter and provides the exporter with a letter of credit from the importer’s bank guaranteeing payment (or vice versa). The exporter may either take payment from the importer’s bank after delivery, or it may take payment immediately (at a discount) from its own bank.

Bankers’ Acceptances (cont.)  

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The exporter’s bank presents the letter to the importer’s bank which stamps it “Accepted.” The exporter’s bank may then keep it (and collect later), return it to the importer’s bank (and collect the present value now), or sell it to an investor (also collecting now). Once accepted, the BA becomes a liability of the importer’s bank, and they take the risk of non-payment by the importer (who is liable to the bank). Banks charge a fee for this service, and borrowers must also pay the discount. BAs typically mature in 30 to 180 days, but they may extend to 270 days. Usually the time to maturity covers the time to ship and sell the goods purchased.

Jumbo CDs 

Jumbo (or large or brokered) Certificates of Deposit (CDs) are similar to small CDs, except:    

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They are larger (duh!). Minimum face value is $100,000 They are not federally insured (beyond $100,000) In some cases, they may be sold in the secondary market Terms range from 7 days to 5 years or longer, most are 1 to 6 months

Some banks now offer mini-jumbo CDs with minimum investments of $25,000 to $100,000. These are federally insured up to $100,000.

Repurchase Agreements 

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A repurchase agreement (Repo or RP) is not actually a security. Instead, it is a method of financing that involves money market securities. Typically, a firm needing cash overnight or for a short time period (term RP) and having money market securities will pledge them as collateral for a short-term loan. These deals are structured not as a loan, but a sale and repurchase. Usually, a dealer is involved and charges a fee. The security pledged is sold and repurchased at the same price. Additionally, when the securities are repurchased, there is also an interest payment.

Non-Money Market Financial Instruments 

There are many securities with longer terms that governments, banks, and corporations use to raise funds:    

Long-term bonds Preferred stock Common stock Derivatives

Long-term Bonds 

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Bonds are interest bearing debt securities with original maturities greater than one year. Bonds are issued to raise capital by the following types of issuers:     

Federal government Federal agencies State and local governments Corporations Various foreign issuers

Treasury Notes and Bonds  

The U.S. Treasury is the largest issuer of long-term bonds in the world. In addition to the T-bills we’ve already discussed, the U.S. Treasury issues:  

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Notes – These have original maturities of 2 to 10 years and are not callable. Bonds – These have original maturities of more than 10 years and may be callable.

Both notes and bonds pay interest (originally determined at auction) semi-annually and may be purchased with face values of $1,000 or more. They are backed by the full faith and credit of the U.S. government (and its ability to print money).

Agency Securities 

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Many U.S. Government agencies and Government Sponsored Enterprises (GSEs) also raise money in the debt markets. These securities are not generally backed by the full faith and credit of the U.S. government, but most believe that the treasury would not allow a default. They may be callable.

Agency Security Issuers 

Federal Agencies 

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Tennessee Valley Authority (TVA) U.S. Agency for International Development (US Aid) International Bank for Reconstruction and Development (IBRD) Government National Mortgage (Ginnie Mae)

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Government Sponsored Enterprises: 

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Federal Farm Credit Bank (FFCB) Federal Agricultural Mortgage Association (Farmer Mac) Federal Home Loan Mortgage Corp (Freddie Mac) Fannie Mae

Municipal Bonds  

Municipal bonds are issued by state and local governments. The interest paid by these bonds are exempt from federal income taxes. There are two categories: 

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General Obligation (GOs) – These are backed by the taxing authority of the issuer. In 2004 about 35% of muni bonds were issued as GOs. Revenue Bonds – These are backed by specific sources, such as Denver International Airport. In 2004 about 65% of muni bonds were issued as revenue bonds.

Municipal bonds are subject to credit risk, and there have been some high-profile defaults (Orange County, CA and Washington Power) and feared defaults that never occurred (State of California most recently). Muni bonds may be insured against defaults by MBIA, Ambac, FSA and others.

Corporate Bonds 

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Corporations issue bonds that typically have original maturities of 5 to 30 years, and occasionally as long as 100 years (Coca-Cola and Disney). There are several possible categorizations:  

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Debentures – Unsecured debt Subordinated Debentures – Unsecured and have lower claim than regular debentures Mortgage Bonds – Secured by specific assets Income Bonds – Pay interest and principal based on income produced by specific assets

A Bond Certificate

Preferred Stock  

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Preferred stock is a hybrid of debt and equity, but it legally represents an ownership claim and is not debt. Preferred stockholders have a lower claim on assets than bondholders (creditors), but higher than common stockholders. Dividends are usually fixed, but failure to pay cannot trigger bankruptcy. There is no specified maturity date, but most are eventually called or converted to common stock. Preferred stock generally carries no voting rights. Preferred stock is not a frequently used financing tool.

Common Stock 

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Common stock represents an actual ownership position in the firm, and stockholders are residual claim holders (they get paid last in a liquidation). Many common stocks pay dividends, but they are not required and payout ratios have diminished greatly in recent years. Common shareholders get to vote on major issues of importance.

A Stock Certificate

Foreign Stocks 

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Many foreign common stocks are listed on U.S. stock exchanges. Some are directly listed (not many) and others trade in the form of an American Depositary Receipt (ADR). ADRs are created by a U.S. Bank (Bank of New York is the largest) and usually contain more than one foreign share per ADR.

Indirect Investments 

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An indirect investment is a professionally managed portfolio in which investors can buy shares. Investors do not have a direct claim on the individual assets in the portfolio. Examples include:     

Mutual Funds (open-end) Closed-end funds Exchange-traded funds Hedge funds Real Estate Investment Trusts (REITs)

Mutual Funds 

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Mutual funds are professionally managed portfolios of securities that are owned by the shareholders and managed by a fund management firm. For example, Fidelity branded mutual funds are managed by Fidelity Management & Research, but the portfolios are owned by the shareholders. Each mutual fund has an investment style that is described in its prospectus. Funds may invest in stocks, government bonds, municipal bonds, etc.

Closed-end Funds   

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Closed-end funds are like mutual funds, except that they have a fixed number of shares and are traded on a stock exchange. They are traded all day during regular market hours and the price changes continuously throughout a trading session. Closed-end funds may trade at a premium or discount to the net asset value of the underlying portfolio. There are likely many reasons for this, but there is currently no complete explanation for the phenomenon. Funds that continually trade at a discount to NAV are occasionally liquidated and the money returned to shareholders. This gives shareholders an immediate gain equal to the amount of the discount.

Exchange Traded Funds  

Its arguable whether ETFs are derivatives, but I’ll consider them one type. An ETF is very similar to a mutual fund (especially a closed-end fund) except for several important features:  

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They are traded on a stock exchange and may be bought, sold, and sold short at any time. Mutual funds can only be bought or sold at the end of the day. They may trade at a slight premium or discount to their NAV. This premium or discount is kept small by arbitrage mechanisms built into ETFs (unlike closedend funds). ETFs are typically passively managed portfolios which results in them being much more tax and capital gains efficient than actively managed mutual funds. There will be some actively managed ETFs in the near future. Until June 2002 all ETFs were based on equity market indexes (S&P 500, Nasdaq 100, etc.). Now, there are a few debt market ETFs based on debt indexes such as the Lehman Brothers 1-3 year US Treasury Index.

Examples of ETFs would include SPDRs, HOLDRS, iShares, VIPERS, and more seemingly introduced every day. As of August 2005, there were more than 190 ETFs with assets of over $260 billion. New actively managed ETFs will be coming to the market soon.

Hedge Funds 

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Hedge funds are limited partnerships that use strategies that most mutual funds are not allowed to use. For example, many hedge funds short sell securities or have heavy exposure to derivatives. Hedge funds are subject to little government regulation, as long as they adhere to certain restrictions:   

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No public advertising Only “accredited investors” may own shares Limited number of investors

Hedge fund managers generally charge between 1% and 2% of assets as a management fee plus an incentive fee of as much as 20% of profits.

Real Estate Investment Trusts (REITs)

Derivative Securities 

Derivative Securities derive their value from other securities.    

Convertible bonds and convertible preferred stock Warrants Stock Options Futures

Convertible Securities 

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Convertible bonds and preferred stock are similar to regular bonds and preferred but they also have an embedded call option on the company’s common stock. The owner of a convertible security has the right, but not the obligation, to convert the security into a pre-specified number of common shares at a specific price on or before the maturity date. Part of the value of these securities is therefore derived from the value of the stock. The higher the stock price (among other factors), the more attractive conversion becomes.

Warrants 

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Warrants are very similar to call options (see next slide), but they are issued by a company as a sweetener to entice investors to purchase a bond or preferred stock issue. Warrants give the owner the right, but not the obligation, to purchase a certain number of common shares at a specified price. Warrants usually have a life measured in years. Warrants are frequently traded separately from the bond or preferred issue that they were issued with.

Options 

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Options are contracts that give the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying security at a specified price on or before the expiration date (can be up to 9 months in the future). Options are not created or sold by the company who’s common stock may be the underlying security.

Futures 

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A futures contract, unlike an option, carries with it the obligation to buy (for a long position) or sell (for a short position) the underlying commodity at expiration of the contract. If you have not sold a long position, or covered a short, by expiration you must take or make delivery of the commodity at the specified price. Futures contracts are different from forward contracts in that they are traded on an exchange, and are standardized as to quantity and quality of the commodity.

Real Assets     

Real Estate and REITs Precious Metals Gems Collectibles Coins