Common Stock
The first type of security offered by a corporation
When a firm issues stock, it divides its ownership into essentially millions of equal parts, which are the individual shares. Each share has an equal claim on the firm’s profits and an equal say in the management of the company. The more shares you buy the more you receive of the company’s profits and the more influence you have on company decisions. If you buy a stock, you’ll have to sell it sometime if you want to convert it to cash. Stocks have no maturity dates.
When a company (known as the “issuer”) sells its shares to the public for the first time, this is called the “initial public offering” (IPO). The issuer partners with an investment banker, (the underwriter) to register the security with the SEC for sale to the public.
Shares have to be:
Authorized for sale 100,000,000
When they are sold:
- Issued 70,000,000
- Treasury 20,000,000
- Outstanding 50,000,000
- Unissued/Unsold 30,000,000
Outstanding shares = issued shares – treasury stock
Ownership is calculated by your percentage of the issued shares
Treasury Stock
An issuer may decide to repurchase its stock in the market to either help increase the demand (and the price) of the stock trading in the market or to avoid a hostile takeover. The stock remains dormant in the corporate treasury. The stock has no voting rights. There are no dividends paid on treasury stock. Treasury stock may be acquired by purchase, gift, or bequest
Common Stock Ownership Rights
Right to Inspect Corporate Books
- Reports are required to be sent to the investor
Right to Transfer Ownership
- Stocks can be sold at anytime
Residual Claim to Assets
- Common shareholders are the last to receive payment in the event of a dissolution of the company
Right to take legal action against Management or Board of Directors
Limited Liability
- The maximum a common shareholder may lose is the purchase price of the stock
Preemptive Right
- A stock right to maintain ownership position in a company
- If an investor owns a 5% equity position in a corporation, should the corporation have another issue of the same stock, the existing owner has a right to purchase 5% of the new issue to maintain their equity position in the company. They may purchase the stock at a discount, called the subscription price
Voting Rights: One share = one vote
Statutory Voting
100 shares
- 4 director seats
- 100 votes toward each seat
Cumulative Voting: beneficial to smaller share owners
100 shares
- 4 director seats
- 400 shares applied to one seat
Voting by Proxy: having another party cast your vote
Purchasing Securities
Trade Date: The date on which the security transaction takes place. The price, security, and the number of shares are established orally
Confirmation Statement: This is sent to the investor verifying the relevant information regarding the transaction. Includes the price, number of shares, date and time of the transaction along with the commission, etc.
- Settlement Date: Date the securities bought must be paid for. This is included on the Confirmation Statement
Regular Way Corporate and Municipal Securities (RW)
- Trade date plus 1 business days (T+1)
Regular Way Treasury Securities
- Next business day (T+1)
Cash Trades settle on the same day
Margin (buying on credit)
- Allows 5 business days to complete the transaction on a margin call (T+5)
Buying securities with respect to dividends
When a company makes a profit, it may pay the profits out to the shareholders or hold onto the profits and reinvest them into new projects. If the projects are great and offer high returns, then the shareholder should be glad to let the company keep the profits, reinvest them, and pay out even more profits later.
If you are a long-term buy and hold investor, a good reason to be interested in dividends is DRiP. The dividend reinvestment program is a stockholding plan in which any dividends earned are automatically reinvested in the shares. Some companies offer DRiP’s for their shares as a way to develop a solid base of long-term shareholders.
Dividends are only paid when the board of Directors declares it.
Board of Directors meet
- Declaration Date (The board declares paying a dividend and sets the record date)
- Ex-dividend Date (1 business day before the record date)
- Record Date (date you must own the securities to be entitled to the dividend)
- Payable Date
June/July
| Sunday | Monday | Tuesday | Wednesday | Thursday | Friday | Saturday |
| 25 | 26 | 27 | 28 | 29 | 30 | 1 |
| 2 | 3 | 4 | 5 | 6 | 7 | 8 |
Example: If the record date is July 6, the ex-dividend date would be July 3
Dividends may be paid as:
- Cash
- Stock or stock split
- Products
- Scrip
Common Stock Advantages
Safety: backed by Issuing Company (The basic rule of stock investing boils down to finding companies that invest in successful projects)
Liquidity: easily Traded on an Exchange or OTC Markets
How you may make a profit from purchasing stock:
- Capital Appreciation
- Increasing Dividends
Common Stock Risk
- Permanent Loss in Capital
- Stock Market Risk
Preferred Stock
If you are really interested in collecting dividends, an alternative that you could use is preferred shares. These are stocks that have a higher priority claim on the company’s profits than the common shares do. A company cannot pay a dividend on its common shares unless its dividend payments on its preferred shares are up to date. Not all companies choose to issue preferred stock. Preferred shares promise an explicit dividend; it’s written in the stock contract. There are many variations of preferred stocks.
- Cumulative Preferred
- Noncumulative Preferred (Straight)
- Participating Preferred
- Convertible
- Callable
Preferred Stock Advantages
- Safety
- Appreciation
- Liquidity
- Preferred Dividends (if declared)
Common Versus Preferred Comparison
| Common Equity Position First Security issued by a Corporation Voting Rights Income in the form of Dividends (maybe) Possible higher degree of growth and appreciation Not callable One form Preemptive rights | Preferred Equity Position Not necessarily issued by a Corporation Usually no Voting Rights Income in the form of Dividends (maybe) More Conservative, focus is on income May be callable Issued in different forms No Preemptive Rights |
American Depository Receipts
ADR’s are negotiable receipts that represent a specific number of shares (between 1 and 10) of a foreign stock. An ADR investor may or may not have voting rights. Since U.S. banks issue them, dividends are paid in U.S. dollars. ADR owners are subject to currency risk.
- Facilitates buying foreign stock in the U.S.
- Trades are subject to U.S. Securities laws
- Certificates are held by Custodian Banks
- Backed by SIPC
Stock Rights
Offered to common shareholders as part of their preemptive rights
Allows you to purchase shares of a primary issue before the public gets a chance
Allows purchase below the public offering price, called the subscription price.
- Can be used
- Can be sold for value in the marketplace
- Will expire in 30-60 days after issue
Stock Warrants
Similar to a Stock Right except it is long term (several years or perpetual)
Usually attached to a bond issue
Can be detached and sold in the open Market
No intrinsic value initially
Selling Short
An investor with a margin account selects a stock they feel is overpriced. They borrow the shares from their Broker/Dealer, with an obligation to return an identical block at a future date. The borrowed stock is then sold. If the price drops like they thought it would, they purchase the stock at a lower price, thus making a profit. If the price of the stock stays high, they will have to pay more for the stock to replace it. Thus, a loss will occur.
Options
An option is a contract between two parties that determines the time and price at which a stock may be bought or sold. The two parties of the contract are the buyer and seller. The buyer of the option pays money, called premium, to the seller. For this premium, the buyer obtains a right to buy or sell the stock depending on what type of option is involved in the transaction. The seller, because of receiving the premium from the buyer, now has an obligation to perform under the contract. Depending on the option involved, the seller may have an obligation to buy or sell the stock.
Call option is the right to buy round lots at a set price. A call option gives the buyer the right to buy or to “call” the stock from the option seller at a specific price for a certain period of time. The sale of a call option obligates the seller to deliver or sell the stock to the buyer at that specific price for a certain period of time. (bullish mentality)
Put option is the right to sell round lots at a set price. A put option gives the buyer the right to well or to “put” the stock to the seller at a specific price for a certain period of time. The sale of a put option obligates the seller to buy the stock from the buyer at the specific price for a certain period of time. (bearish mentality)
There are always two parties to an option contract.
The set price is called the “strike” or “exercise” price.
Options have an expiration date, usually 30, 60, or up to 9 months.
Covered call is an option on stock that you own.
Naked call is an option on stock that you do not own.
| Calls | Puts | |
| Bullish | Bearish | |
| Buyers | Have the right to buy stock, they want the price to rise | Have the right to sell stock, they want the price to fall |
| Bearish | Bullish | |
| Sellers | Have the obligation to sell stock, they want the price to fall | Have the obligation to buy stock, they want the price to rise |
| Buyer | Seller | |
| Owner | Known as | Writer |
| Long | Known as | Short |
| Rights | Has | Obligations |
| Maximum speculative profit | Objective | Premium income |
| With an opening purchase | Enters the contract | With an opening sale |
| Exercise | Wants the option to | Expire |
Possible outcomes for an option:
- Exercised
- Sold: Most individuals elect to sell their rights to another investor
- Expire
Corporate Bonds/Debt Securities
Bonds are contracts in which a borrower (the issuer of the bond) promises to make a set of payments to the buyer of the bond. The buyer of the bond lends money to the issuer of the bond and wants to prevent the borrower from defaulting. The buyer of the bond can make the issuer agree to a large set of terms and conditions called “restrictive covenants.” Covenants may require the issuer to keep a certain amount of cash in a reserve fund that can be used to pay off part of the loan. There are 3 types of bond issuers: governments, companies, and individuals. Each level of government may issue its own bonds. Local government units are called municipal bonds (muni’s). A general term for federal government bonds is called sovereign bonds. The term bonds and debt can be used interchangeably.
- They must be registered
- Book Entry
- Originally issued in “Bearer” form
Coupon Bonds
- Bond is registered
- Coupons were not
Zero Coupon Bonds
Most bonds make regular interest or “coupon” payments—but not zero-coupon bonds. Zeros, as they are sometimes called, are bonds that pay no coupon or interest payment. With a zero, instead of getting interest payments, you buy the bond at a discount from the face value of the bond and are paid the face amount when the bond matures. For example, you might pay $3,500 to purchase a 20-year zero coupon bond with a face value of $10,000. After 20 years, the issuer of the bond pays you $10,000. For this reason, zero coupon bonds are often purchased to meet future expenses such as college costs or an anticipated expenditure in retirement.
A nice feature of STRIPS is that they are non-callable, meaning they can’t be called to be redeemed should interest rates fall. This feature offers protection from the risk that you will have to settle for a lower rate of return if your bond is called, you receive cash, and you need to reinvest it (this is known as reinvestment risk).
That said, zero coupon bonds carry various types of risk. Like virtually all bonds, zero coupon bonds are subject to interest-rate risk if you sell before maturity. If interest rates rise, the value of your zero coupon bond on the secondary market will likely fall. Long-term zeros can be particularly sensitive to changes in interest rates, exposing them to what is known as duration risk. Also, zeros may not keep pace with inflation. And while there is little risk of default with Treasury zeros, default risk is something to be mindful of when researching and investing in corporate and municipal zero coupon bonds.
- Accretion is the increase of the cost basis of the bond
- Accretion amounts must be claimed as taxable income
- US Government zero-coupon bonds are called treasury STRIPS
Federal agencies, municipalities, financial institutions and corporations issue zero coupon bonds. One of the most popular zeros goes by the name of STRIPS (Separate Trading of Registered Interest and Principal Securities). A financial institution, government securities broker or government securities dealer can convert an eligible Treasury security into a STRIP bond. As the name implies, the interest is stripped from the bond.
Examples of Secured Bonds:
- Mortgage Bonds
- Equipment Trust Bonds
- Collateral Trust Bonds
Examples of Unsecured Bonds
- Debentures
- Subordinate Debentures
- Income or Adjustment Bonds
Junk Bond involves high-yield or non-investment grade debt
Banks can purchase investment grade bonds (bonds that are rated BBB or higher on the Standard and Poor rating scale. BB or lower is non-investment grade or “junk bonds”
Redemption of bonds
- Sinking fund
- Refunding
- Serial Bonds
Convertible
Conversion ratio = the number of shares that the bond may be converted into
Conversion price is the price of the shares based on the current price of the bond
Parity is when the value of the bond is equal to the stock that it may be converted into
Callable
The issuer may buy back the bond issue, typically when interest rates decline
Bond Price – vs. – Interest Rates
- Bond prices have an indirect relationship to interest rates
- Bond yields have a direct relationship to interest rates
- Coupon rate is the same as nominal yield
Bond Payments and Rate of Return
Coupon Yield is the set interest rate on a bond
- Coupon rate / Par
Current Yield is the annual rate of return on a security
- Coupon rate / Market Price
Yield to Maturity is what the investor can expect on a bond if they hold it until maturity
Reading Bond Listings
- Bonds are sold in $1,000
- Bonds are quoted in 100’s
- Each point represents $10
- An eighth of a point represents $1.25
$10.00 divided by 8 equals $1.25
- 1/8 = $ 1.25
- 2/8 = $2.50
- 3/8 = $3.75
- 4/8 = $5.00
- 5/8 = $6.25
- 6/8 = $7.50
- 7/8 = $8.75
- Again, 1 point = $10.00
An example of an exam question could be:
A bond is quoted at 101 and 3/8. What is the actual price of the bond?
$10 X 101 + $10 X (3/8)
$1010 + $10 X .375
$1010 + $3.75
$1013.75
Corporate Bankruptcy
1. Wages and Taxes
2. Secured bonds
3. General Creditors
4. Unsecured bonds
A. Debentures
B. Subordinate Debentures
5. Cumulative Preferred Shareholders
6. Noncumulative (straight) Preferred Shareholders
7. Common Shareholders
Preferred stocks and bonds are known as Senior Securities because of their prior claim to assets.
Municipal Bonds
Two Main Types
General Obligation Bonds or GO (Taxes)
Backed by the taxing authority issuing the bond
City and counties pay from property taxes
State pays from cigarette and gasoline taxes
Revenue Bonds (Income)
Revenue bonds are used to finance projects such as airports, hospitals, toll bridges and turnpikes
Industrial Revenue Bonds are used to finance business parks
Investors are paid by business that move in and pay rents
Tax Implications
Incomes received from municipal bonds are exempt from federal income taxation, however, they may be subject to state and local taxes.
Any capital gains are taxable
As far as investment return (ordinary income tax on returns)
- Federally issued securities are federally taxable and state income tax exempt
- State issued securities are State taxable and federal income tax exempt
- They tax their own
For an investor to determine their specific tax benefit from a municipal bond investment, they must calculate their tax-equivalent yield.
This is done by dividing the tax-free yield by 100% minus the investor’s tax rate
Example:
An investor in a 28% tax bracket is considering buying a muni with a 5.3% yield.
What would be the equivalent corporate yield?
5.3% divided by (100% – 28%)
.053 divided by .72
7.36%
Mortgage-Backed Securities
Sometimes called “Pass-through” Securities
Mortgage securities represent an ownership interest in mortgage loans made by financial institutions to finance the borrower’s purchase of a home or other real estate
These loans are packaged, or “pooled” by issuers for sale to investors.
As the mortgage loans are paid off by the homeowners, the investors receive payments of interest and principal
The most basic mortgage securities represent a direct ownership interest in a pool of mortgage loans
These mortgage securities may be pooled again to create collateral for a more complex type of mortgage security called a Collateralized Mortgage Obligation (CMO), Collateralized Debt Obligation (CDO), or since 1986 called a Real Estate Mortgage Investment Conduit (REMIC)
Backed by an underlying pool of mortgages and are issued with varying short, medium, and long-term maturities (known as tranches). Each tranche is paid semiannual at a fixed interest rate
Only one maturity at a time receives principal payments
The payment process continues until all the tranches are sequentially retired
Real Estate Investment Trusts
REIT is similar to a closed-end mutual fund
It sells shares once and then uses proceeds to invest in a portfolio of real estate assets,
REIT’s are required to pay out 90% of their income as dividends as well as the possibility of capital gains
Equity REITS
Invests directly in real estate (Asset Based)
Mortgage REITS
Invests in mortgages and mortgage-backed securities (Asset Backed)
More highly leveraged
Government Securities
Also called Treasury Securities
Are considered extremely safe because they represent direct obligations of the US government
They are highly liquid
Subject to federal taxation only, not to state and local tax
Any capital gains realized are fully taxable
Treasury Securities
Two categories
| Marketable | Non-Marketable |
| Treasury Bills (T-bills) | Series EE |
| Treasury Notes (T-notes) | Series HH |
| Treasury Bonds (T-bonds) |
T-bills
Government issues with maturities of 1 year or less
Ownership is evidenced by book entry
Minimum denomination is $1,000 with increments of $1,000
Bought at a discount
Non-interest bearing
T-notes
Government issues with maturities of no less than one year and no greater than 10 years
Issued with denominations beginning at $1,000
Have stated interest (coupon) rates
Pay semiannual interest to the owner
Known as interest-bearing securities
T-bonds
Maturities greater than 10 years and a fixed interest
Issued in book entry form
Issued with denominations beginning at $1,000
Have stated coupon rate
Interest bearing securities
Quotes for T-notes and T-bonds
Quoted in points as a percentage of par
Points are broken down into 1/32 increments and the fractional part is expressed as a decimal
A T-bond is quoted as 102.20
Quote as a fraction 102 20/32
Convert the fraction to a decimal 102.625
Quote as a percent of par value 102.625 X 10 = $1,026.25
Non-Marketable Issues
Known as U.S. savings bonds
Non-marketable issues cannot be negotiated in the marketplace
The owner must redeem them
There are 2 types:
| Series EE | Series HH |
| Non-interest bearing | Interest bearing |
| Sold at a discount | Sold at face value |
| Face amount is from $ 50.00 to $ 10,000 | Face amount is from $ 500.00 to $ 10,000 |
| Federally Taxable | Federally Taxable |
US Government zero-coupon bonds are called treasury STRIPS
TIPS Treasury Inflation Protection Securities
With normal (or nominal) fixed-income investments, investors bear inflation risk in that the purchasing power of interest payments could be eroded by inflation over and above their original expectations. TIPS, however, are guaranteed to keep pace with inflation as defined by the Consumer Price Index (CPI). This is what makes them unique and defines their behavior.
Agency Bonds
Most mortgage securities are issued and/or guaranteed by an agency of the U.S. government.
Government National Mortgage Association
Known as “Ginnie Mae”
Government-owned Corporation that buys mortgages from private sources and guarantees payment to investors who subsequently purchase securities in the mortgage pool bonds offered by the association
Government-Sponsored Enterprise
Federal National Mortgage Association
Known as “Fannie Mae”
A publicly held corporation that provides mortgage capital when credit is tight
Along with conventional mortgages, they purchase mortgages from agencies like VA, the FHA and Farmers Home Administration
Government-Sponsored Enterprise
Federal Home Loan Mortgage Corporation
Known as “Freddie Mac”
Buys existing mortgages and resells them to the general investing public
Not backed by the U.S. government
They are backed by VA, FHA, and privately guaranteed mortgages
Money Market Instruments
Characteristics include:
- Short-term (matures within or up to one year)
- Liquid (easily converted to cash)
- Safe
Examples of money market instruments include:
- T-bills
- Certificate of Deposit
- Negotiable CD’s or Jumbo CD’s
- Commercial Paper = Letter of Credit of up to 270 days
- Bankers’ Acceptance = Promissory Note used in the import/export business
- Repurchase Agreement
Special Securities
Exchange Traded Funds
Basically, a clone fund of a stock market index, such as the S&P
Second largest pooled investments next to mutual funds
The main difference is ETFs may be traded at any time versus mutual funds using the forward pricing method
Hedge Funds
High risk strategies to provide a hedge against inflation
Uses leverage such as: options, short sales, and other speculative investment strategies