Investment Alternatives

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Investment Alternatives

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

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Categories of Investments

• Previously, we have distinguished between two
  types of assets
• Financial Assets
• Real Assets
• We can further subdivide these into two
  categories
• 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

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Money Market Instruments

• The money market is comprised of high quality,
  short-term, large denomination debt instruments
• 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.

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Types of Money Market Instruments

• Treasury Bills (T-bills) and short-term agencies
• Short-term Municipals
• Commercial Paper
• Bankers Acceptances
• Jumbo CDs (brokered CDs, large CDs)
• Repurchase Agreements

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T-Bills and Short-term Agencies

• Treasury bills (and short-term agencies) are used
  to provide short-term 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.

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Calculating Yields on T-bills

• 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

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Calculating Yields on T-bills (cont.)

• The Bank Discount Yield is a little misleading
  for two reasons
• 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
  interest-bearing securities, we can calculate the
  Bond Equivalent Yield by adjusting the BDY or
  directly

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Calculating Yields on T-bills (cont.)

• Heres an example Suppose you just bought a
  26-week (182 days) T-bill at auction for a price
  of 975. What is the BDY and BEY?

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Short-term Municipals

• 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.

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Taxable Equivalent Yield

• 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
• Or, we can discount the taxable yield
• Once weve made the adjustment, the yields are
  comparable

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Commercial Paper

• 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.

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Commercial Paper (cont.)

• CP is issued by firms in one of two ways
• 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 dealers 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.

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Bankers Acceptances

• 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 importers bank guaranteeing
  payment (or vice versa).
• The exporter may either take payment from the
  importers bank after delivery, or it may take
  payment immediately (at a discount) from its own
  bank.

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Bankers Acceptances (cont.)

• The exporters bank presents the letter to the
  importers bank which stamps it Accepted.
• The exporters bank may then keep it (and collect
  later), return it to the importers 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
  importers 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.

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Jumbo CDs

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

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Repurchase Agreements

• 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.

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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

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Long-term Bonds

• 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

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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 weve already
  discussed, the U.S. Treasury issues
• 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).

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Agency Securities

• 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.

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Agency Security Issuers

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

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

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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
• 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.

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Corporate Bonds

• 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
• 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

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A Bond Certificate
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Preferred Stock

• 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.

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Common Stock

• 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.

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A Stock Certificate
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Foreign Stocks

• 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.

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Indirect Investments

• 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)

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Mutual Funds

• 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.

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Closed-end Funds

• 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.

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Exchange Traded Funds

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

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Hedge Funds

• 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
• 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.

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Real Estate Investment Trusts (REITs)
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Derivative Securities

• Derivative Securities derive their value from
  other securities.
• Convertible bonds and convertible preferred stock
• Warrants
• Stock Options
• Futures

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Convertible Securities

• Convertible bonds and preferred stock are similar
  to regular bonds and preferred but they also have
  an embedded call option on the companys 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.

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Warrants

• 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.

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Options

• 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
  whos common stock may be the underlying security.

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Futures

• 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.

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Real Assets

• Real Estate and REITs
• Precious Metals
• Gems
• Collectibles
• Coins