Investment Alternatives

FIN 3600: Chapter 3

Timothy R. Mayes, Ph.D.
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
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.
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

 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.
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”:

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

FV 365 FV − PP 365
BEY = BDY × × = ×
PP 360 PP M
Calculating Yields on T-bills (cont.)

 Here’s 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?

1000 − 975 360

BDY = × = .04945 = 4.945%
1000 182

1000 365
BEY = .04945 × × = 0.5142 = 5.142%
975 360
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.
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:
Tax Exempt Yield
TEY =
(1 − t )
 Or, we can discount the taxable yield:
After Tax Yield = Taxable Yield × (1 − t )
 Once we’ve made the adjustment, the yields are
comparable
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.
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 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

 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.)

 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:
 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

 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

 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:
 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

 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  Government Sponsored

 Tennessee Valley Enterprises:
Authority (TVA)  Federal Farm Credit Bank
 U.S. Agency for (FFCB)
International  Federal Agricultural
Development (US Aid) Mortgage Association
 International Bank for (Farmer Mac)
Reconstruction and  Federal Home Loan
Development (IBRD) Mortgage Corp (Freddie
 Government National Mac)
Mortgage (Ginnie Mae)  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:
 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

 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
A Bond Certificate
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.
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.
A Stock Certificate
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.
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)
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.
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.
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:
 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 (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

 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.
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

 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

 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

 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

 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