10/11- Part 2

Question 1

Junk Bonds (High-Yield Bonds):

Answer 1

• highly speculative
• have low or below grade ratings (some may even be in default)
• typically offer very high yields because they are sold at a discount from their face value due to the very high risk

Question 2

Global Bonds:

Answer 2

• Potentially higher returns than U.S. bonds
• Interest rate trends in other countries may not follow U.S. rates
• Currency exchange rate can impact returns in U.S. dollars

Question 3

Convertible Securities:

Answer 3

• Allows holder to convert the security into a specified number of shares of common stock
• Two Major types of convertible securities
  - convertible bonds
  - convertible preferred stock

Question 4

Equity Kicker

Answer 4

• another name for the conversion feature that allows holder to convert the security into a specified number of shares of common stock, can “kick up” the potential return on the bond
  
  • Why would company do this? could lower the interest on a bond due to investors payoff, if company converts bond on stock they don’t have to give bond value back causing no refund.

Question 5

Bond Ratings:

Answer 5

• check out table 10.2 in the txt book, Moodys and S&P rate bonds based upon perceived risk of a bond; highest rated bonds are AAA; Junk Bonds start at Speculative issues and proceed downwards

Question 6

Basic Bond Investing Strategy:

Answer 6

• if you expect interest rates to increase, buy short term bonds
• if you expect interest rates to decrease, buy long term non callable bonds
• this is why bonds have outperformed stocks over the past thirty years
• ladder bonds for protection against interest changes; stagger the maturities spread them out
• changes in interest rates are not as important if you intend to hold the bond to maturity

Question 7

The Pricing of Bonds:

Answer 7

• bonds are priced according to the present value of their future cash flow streams.

• Bond Price= Present Value of the annuity of annual interest income+ present value of the bond’s par value

Question 8

Bond Duration:

Answer 8

• a measure of bond price volatility
• indicates how a bond will react in different interest rate environments
• average amount of time it takes to receive the interest and the principal
• if a bond has a duration of 6, then a 1% increase in interest rates will result roughly a 6% decline in bond value- 2% increase would cause a 12% decline- this all does not matter if you hold the bond to maturity
• if interest rates drop the opposite effect happens and the bond value would increase by 6%

Question 9

The Concept of Duration:

Answer 9

• generally speaking, bond duration possesses the following properties:
  - bonds with higher coupon rates have shorter durations
  - bonds with longer maturities have longer durations
  - bonds with higher YTM lead to shorter durations
• bond duration is a better indicator than bond maturity of the impact of interest rates on bond price (price volatility).
  - if interest rates are going up you wanna hold bonds with shorter durations
  - if interest rates are going down, hold bonds with long durations

Question 10

Characteristics of Preferred Stocks:

Answer 10

• Hybrid security- characteristics of both stocks and bonds
• like a bond in that it has a stated dividend and provides a fixed income
• trades just like a common stock (pricing)
• like a stock in that it has no fixed face value
• like a stock in the sense that default does not force bankruptcy
• potential for a price appreciation
• investment quality for the stock is rate like bonds

Question 11

Advantages of using Preferred Stock:

Answer 11

• dividend income is highly predictable
• dividend yields are similar to yields on high credit quality bonds
• should pay slightly more due to the fact that the risk is slightly higher
• corporations are able to exclude 70% of preferred dividends from income taxes
• generally safe, not as safe as bonds because if a company goes bankrupt bondholder are the first to receive payments
• low unit cost

Question 12

Disadvantages of Preferred Stock

Answer 12

• many preferred stock dividends do not qualify for the new preferential tax rate of 15%
• behave like a bond
  - if inflation and interest rates rise, the value of the preferred stock drops
  - if inflation and interest rates drop, the value rises
• investors don’t participate in the capital gains that common stockholders receive.
• preferred stock doesn’t have the safety of a bond

Question 13

Valuing Preferred Stock

Answer 13

• value is a function of the dividend yield provided
• the lower the investment quality, the higher the yield.
• risk exposure of preferred stocks includes:
  - business risk
  - interest rate risk

Question 14

Issue Characteristics of Preferred Stock

Answer 14

• Conversion feature at the desire of the stockholder not the company
• Cumulative provision- all past unpaid dividends must be paid before common stock dividends are paid

Question 15

Key Measures of Preferred Stock:

Answer 15

• Dividend Yield= annual dividend income/ current market price of the preferred stock
• book value
• agency ratings
• ability of the company to cover the dividend

Question 16

Investment Strategies using Preferred Stock:

Answer 16

• Two Major Strategies
  
  • going after higher levels of current income
  • seeking capital gains when market rates are falling

Question 17

Why Choose a Mutual Fund?

Answer 17

• immediate diversification- money spread out through many companies
• liquidity- if you need some of the money its easy to sell part of the fund
• professional management- people who are watching the fund constantly
• continuous supervision- they do this everyday, help when your unavailable to view your portfolio
• easy record-keeping
• automatic reinvestment of dividends-
• easy to change investment strategies- sell out of one mutual fund and move the money into another

Question 18

Close-End Funds

Answer 18

• limit the number of investors, limit the amount of money and people… Why limit investors? may have to depart from investment guidelines

Question 19

Open-Ended Funds

Answer 19

• permit an unlimited amount of investors, will always find a place for money

Question 20

Load Fund

Answer 20

• approx 5.5% up front fee charged at the time of the initial investment- will not receive the full fund due to the sales charge

Question 21

Light Load Funds

Answer 21

• 2-3% up front fee charged at initial investment

Question 22

No Load Fund

Answer 22

• no up front fee; still has an annual expense charge at a max of 3%

Question 23

money market funds:

Answer 23

• a cash substitute- putting money in another account other than a bank
• highly liquid
• usually have check-writing privileges
• while they are low risk they are not risk free and there is the possibility of losing money, bc money market funds make short term loans to corporations
• maintain a constant Net Asset Value of $1
• type and average maturity of fund will determine the rate of return

Question 24

Sector of Specialty Funds:

Answer 24

• focus on a special industry or investment vehicle; transportation, health care, computers software, internet etc.

Question 25

Ethical or Social Responsible Funds:

Answer 25

• avoid the investment of the “four sins”
• smoking, drinking, gambling, pornography
• biblically responsible investments
• avoid 4 sins and anything that is involved with abortion and lifestyle issues

Question 26

politically correct funds

Answer 26

• mutual fund that will look for company’s that provide for gay and lesbian couples, exclude companies that don’t provide those type of investments