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Understanding Securities Exchange
A security is a document that evidences specific claims
on a stream of income and/or to particular assets. Debt securities include
bonds and mortgages. Ownership securities include common stock certificate
sand the titles to marketable assets. In addition preferred stock is
a hybrid security which entitles its owner to a mixture of both ownership
and creditorship privileges.
Debt, according to the dictionaries, is a condition that exists when
one person owes something to another person .the dictionaries go on
to explain that security is a paper that is given as a pledge of repayment
,or as evidence of debt or ownership. These definitions suggest that
the phrase debt securities must refer pieces of paper that evidence
certain parties owe something to certain other parties.
Investors buy securities in order to earn to earn interest income from
the security .that is the investor lends money to the borrower who issued
the security. But the investor expect to have the loan rapid with interest.
There are many different kinds of marketable debt securities .they pay
different rates of interest, they are available in different denominations,
they have different length of time until they come due for repayment.
Dictionaries explain that things which are liquid flow freely from one
place to another without being significantly compressed or exchanged
. Following this general definition, money is the most liquid of all
securities because it is readily acceptable at its face value in markets
everywhere . Essentially, money is a perfectly liquid asset that flows
freely from hand to hand without losing any of its value in the process
.money is more liquid than, say long-term bonds ,which have uncertain
market pieces that can deviate significantly from their face values
and thus can be difficult to convert back into the amount of money which
was paid for the bond .thus bonds may be an illiquid investment, especially
when they are not traded in active markets .highly marketable securities
that have short terms until they mature and involve little or no risk
of default are said to be moneylike and are called money market securities
.
Negotiable certificate of deposit are called negotiable CDs in the financial
world are receipts from a federally insured commercial for a deposit
of 100,000 usd or more with special provisions attached . One of the
provisions is that the deposit will not be withdrawn from the bank before
some specific maturity date. Negotiable CDs are bought and sold in active
secondary markets similar to the way treasury bills are traded.
BANKER,S ACCEPTANCES are written premises to repay borrowed funds
which borrowers give to banks then if the potential borrower takes down
the loan (that is actually borrows the money )the lending bank is said
to accept the banker’s acceptances. later if the lending bank wants
to withdraw the money before the loan expires, it sells the written
promise to repay the loan (that is the banker’s acceptance) to another
investor . banker’s acceptances may be resold to any number of new investors
before the loan comes due and is repaid ;there is an active secondary
market in these moneylike pieces of debt .
COMMERCIAL PAPER refers to the short promissory notes issued
by blue cheap corporations. commercial paper is a form of unsecured
corporate borrowing that typically has an original maturity of between
5 to 270 days, with 30 days the most in common .most commercial papers
are bought by institutional investors, especially money market mutual
funds, but non financial firms and state an local governments also buy
significant amounts .commercial papers does not have much of a secondary
market.
FED FUNDS the common name for federal funds loans are the overnight
loans between commercial banks. Fed funds are simply bank reserve loaned
from banks with excess reserves to banks with insufficient reserves.
The interest rate on these 1-day bank loans are called the federal fund
rate.
REPURCHASE AGREEMENTS are commonly known as repos are devices
that
are usually used by security dealers to help finance part of their multimillion
dollar inventories of marketable securities for one or few days .repos
that last longer than overnight are also in common . These longer term
repos are called term repos and can span 30 days.
TREASURY BILLS are extremely liquid short term notes that mature
in 13, 26 or 52 weeks from the date of issue .the treasury usually offer
new bills every week selling them on a discount from face value basis
.furthermore, T-bills are issued only on a "book entry" basis - the
buyer never actually receives the security, only a receipt.
CERTIFICATE OF INDEBTEDNESS are issued at par (or face) value.
Later after they are issued ,certificates are traded in the market at
prices which vary minute by minute. certificate usually bears fixed
interest rate. The fixed interest rate is printed on the certificate
and never varies. It is called the COUPON RATE.
TREASURY NOTES are similar to certificate of indebtedness except
with regard to their time until maturity , T-notes are bonds that typically
have a maturity of from 1 to 7 years. They are marketable debt security
that pays coupon interest semiannually, just like the certificate
Euro-dollar loans are also sometimes called petrodollar loans, Asian
dollar loans, or hot money flows .all these terms refer to large, short
term loans which are dominated in dollars. These loans are usually arranged
with banks with large international operations.
Treasury bonds differ from notes and certificates with respect to maturity.
They generally run from 7 to 30 years from date of issue to maturity.
Another significant difference is that some issues are callable at time
prior to maturity.
Repurchase agreements are commonly known as repos. Repos are
devices that are usually used by securities dealers to help finance
part of their multimillion dollar inventories of marketable securities
for one or a few days. In repo transactions the investor is essentially
making a short –term loan to the securities dealer that employs part
or all of the securities dealer’s inventory as collateral for the loan.
Repos that last longer than overnight are common too. These longer term
repos are called term repos and can span 30 days, or even longer sometimes.
These repurchase agreements, especially the term repos, are marketable
securities that are actively traded by telephone calls between the money
market trading desks of different banks and brokerages across the United
States.
U.S. Government Securities
Government securities represent the amount of indebtedness of our governmental
bodies. The owners of securities are creditors; the governmental bodies
and debtors. United States government securities are of such high quality
that their yield is often used as an example of a default-free interest
rate.
Nonmarketable Issues
Approximately 30 percent of the public debt consists of nonmarketable
issues. These can not be traded in securities market; they are not transferable;
they can not be used as collateral for a loan; they can be purchased
only from the treasury and they can be redeemed only by the treasury.
Marketable Issues
These issues make up 70 percent of the federal debt. They are usually
purchased from outstanding supplies through a dealer or broker. However
the purchaser may subscribe for new issues through any one of the twelve
Federal Reserve banks in the United States. The holder of marketable
government securities stands to gain not only from the interest Paid
on these bonds, like the owner of nonmarketable bonds, but also from
the price appreciation (higher selling price that purchase price), unlike
the owner of nonmarketable bonds. The bid-and-ask prices for these marketable
issues are published daily in newspapers like the New York Times and
the Wall Street Journal.
Treasury bills are extremely liquid short-term notes that mature in
13, 26, or 52 weeks from the date of issue. The treasury usually offers
new bills every week, selling them on a discount from face value basis.
Further more, T-bills are issued only on a “book entry” basis—the buyers
never actually receive the security, only a receipt. The treasury agent
records the purchasers, transactions and issues receipt to the Treasury
bill buyers instead of an actual T-bill security.
T-bills are never sold at a premium over their face values—only at a
discount. The discount to the investors is the difference between the
price they have paid and the face amount they will receive at maturity.
Certificate of indebtedness are issued at par (face) value. Later, after
they are issued, certificates are traded in the market at prices which
vary minute by minute. Certificates usually bear fixed interest rates.
The fixed interest rate is printed on the certificate and never varies—it
is called the coupon rate. The coupon rate tells what percent of the
certificate’s face value will be paid out in two semi annual coupon
interest payments each year.
Treasury notes are similar to certificate of indebtedness except with
regard to their time until maturity. T-notes are bonds that typically
have a maturity of from 1 to 7 years. They are marketable debt securities
that pay coupon interest semiannually, just like the certificates. The
treasury issues T-notes periodically, and some issues are currently
outstanding and are traded actively.
Treasury bonds comprise about 10 percent of the federal debt. Bonds
differ from notes and certificates with respect to maturity; they generally
run from 7 to 30 years from the date of issue to maturity. Another significant
difference is that some issues are callable at times prior to maturity.
If the bonds are selling in the market above par, their yield to maturity
is calculated to the nearest call date. If they are selling at a discount,
the yield to maturity is calculated on the basis of their maturity date.
The yield to maturity is a compound average rate of return calculated
over the bond’s entire life.
Municipal Securities
The bonds of states, counties, parishes, cities, towns, townships, boroughs,
villages, and any special municipal corporation tax districts (such
as toll bridge authorities, college dormitory authorities, sewer districts,
ad infinitum) are all referred to by security traders as municipals.
They include the obligations of state and local commissions, agencies,
and authorities as well as state and community colleges and universities.
Federal laws provide that the income derived from the obligation of
a political subdivision be exempt from federal income taxes. This tax
exemption applies to the coupon interest income, but not to any capital
gains which may be earned, from municipal bonds. Thus, munis, as they
are commonly called, are widely held by wealthy individuals and partnerships
whose income may be taxed at the high personal tax rates.
The interest on municipal bonds can be paid in two ways – by giving
a check to the bond registered owner or by cashing in the coupons attached
to a bearer bond as they come due.
General obligation bonds often referred as to full faith and
credit bonds because of the unlimited nature of their pledge, general
obligation securities originate from government units that have unlimited
power to tax property to meet their obligations and that promise to
pay without any kind of limitation.
Limited obligation bonds the term limited obligation bonds is
applied when the issuer is in some way restricted in raising revenues
used to pay its debts. Revenue bonds are the most significant form of
limited obligation. The distinguishing aspect of such bonds is that
they are entitled to the revenue generated only to the specific property
that is providing service for which rates or fees are paid. These bonds
are widely used to finance municipally owned utilities, such as water
works, electricity, gas, swage disposal systems, and even public swimming
pools.
Municipal bonds pay income to their investors in two forms—interest
payments and capital gains (or losses). They are just like the marketable
U.S treasury bonds in this respect.
Bonds Issued By Corporations
Essentially a bond is what is commonly called an "I owe you". More particularly,
a bond is a marketable, legal contract that promises to pay whoever
owns it a stated rate of interest for a defined period and then to repay
the principal at the specific date of maturity. Bonds differ according
to their term concerning provisions for repayment, security pledged,
and other technical aspects. They represent the formal legal evidence
of debt and are the senior securities of the firm.
The Indenture, or deed of trust, is the legal agreement between the
corporation and the bondholders. Each bond is part of a group of bonds
issued under one indenture. Thus, they all have the same rights and
protection from issuing company. Sometimes, however, bonds of the same
issue may mature at different dates and have correspondingly different
interest rates.
The indenture is a long, complicated legal instrument made up of careful
worded phrases containing the restrictions, pledges, and promises of
the contract;The trustee also takes any appropriate legal action to
see that the terms of the contract are kept and that the rights of the
bondholders are upheld. Because the individual bond holders are usually
not in a position to make sure that the company does not violate its
agreements and because the bondholders can not take substantial legal
action, if the firm does violate them, the trustee does assumes these
responsibilities.
Bond interest is usually paid semiannually, though annual payments are
also popular. The method of payment depends upon weather the bond is
a registered or coupon bond. The interest on registered bonds is paid
to the holder by check. Therefore, the holder must be registered with
the trustee of the bond issue to ensure proper payment. The registered
bonds can be transferred only by registering the name of the new owner.
In contrast, coupon bonds have a series of attached coupons that are
clipped off at the appropriate times and sent to a bank for collection
of the interest.
If the coupon interest is paid to whoever may happen to be the bearer
of the bond without checking to see who is its registered owner, the
bonds are called bearer bonds. The ownership of bearer bonds may be
transferred simply by physically handing them over to the new owner.
Coupon Rate ;The coupon rate is the interest paid on the face
value of a corporate or a U.S. treasury bond. It is one fixed dollar
amount that is paid annually as long as the debtor is solvent. (Corporations,
income bonds or adjustment bonds are the only exceptions.) The coupon
rate is decided upon after the issuing corporation's investment banker
has taken into account risk of default, the credit standing of the company,
the convertible options, the investment position of the industry, the
security backing of the bond, and the market rate of interest for the
firm's industry, size, and risk class. After all these factors have
been taken into account, a coupon rate is set. With the objective that
it will be just high enough to attract investors to pay the face value
of the bond. Later the market price of the bond may change from its
face value, as market interest rate change, while the contractual coupon
rate remains fixed.
Generally, the higher (or effective rate of return,
as it is also called), the riskier the security. Yield rather than coupon
rate is more significant in buying bonds. If the bond is selling at
a discount, its market price is below its face value. In this case,
the yield is higher than the coupon rate. If it is selling at a premium,
the market price of the bond is above its face value. In this case the
coupon rate is higher than the yield.
Maturity Maturities vary widely. The actual term to maturity of a new
bond issue changes after the bond is issued because as long-term bonds
come closer and closer to their maturity dates, they become medium-term
and then short-term bonds. Nevertheless, a bond is usually grouped by
its maturity that existed on the date the bond was newly issued. Short-term
bonds are any bonds maturing within 5 years. They are common in industrial
financing and may be secured or unsecured. Medium-term bonds mature
in 5 to about 10 years. If the bond is originally issued as a medium-term
bond, it is usually secured by a real estate, or equipment mortgage,
or it may be backed by other security. Long-term bonds may run 20 years
or more. Capital heavy industries with long expectations of equipment
life, such as railroads and utilities, are the greatest users of these
forms of bonds.
Call Provision A call provision may be included in the indenture.
This provision allows the debtor to call or redeem the bonds at a specified
amount (above par) before maturity date. The difference between the
par value of the bond and the higher call price is called the call premium.
The call provision is advantageous to the issuing firm but potentially
harmful to the investor. If interest rates should decline, it may be
wise for the firm to call in its bonds and issue new ones at the lower
market interest rate. This action, however, leaves investors with funds
they can invest only at the lower interest rate.
Sinking Funds Sinking fund bonds are not special type of bonds
but just a name given to describe the method of repayment. Thus any
bond can be sinking fund bond if it is specified as such in the indenture.
Sinking fund bonds arise when the company decides to retire its bond
issue systematically by setting aside a certain amount each year for
that purpose. Sinking fund bonds have been in common in industrial financing
that involve some risk because risky debt issues are more attractive
to investors with a promise of faster payments.
Serial Maturities Serial bonds are appropriate for issuers that
wish to divide their bond issue into a series, each part of the series
maturing at a different time.
Secured bonds
The most important classification of corporate bonds is whether they
are secured or unsecured. That is, what security, if any, has been pledged
to help pay investors if the company should be unable to live up to
its obligations, or should default?
If the indenture provides for a lien on a certain designated property,
the bond is a secured bond. A lien is a legal right given to the bond
holders, through the trustee, to sell the pledged property to obtain
the amount of money necessary to satisfy the unpaid portion of interest
or principal. Pledged security is naturally used to make the bonds more
attractive to investors by making them safer investments.
Mortgage bonds
A bond issue secured with a lien on real property or buildings is a
mortgage bond. If all the assts of the firm are collateral under the
terms o the indenture, it is called a blanket mortgage. The total asset
need not be pledged, however; only some of the land or buildings of
the company may be mortgage for the issue. They can be first, second,
or subsequent mortgages each with its respective claim to the assets
of the firm in case of default. A first mortgage is the most secure
because it enjoys first claim to assets. A mortgage bond may be open-end,
limited open-end, or closed-end, or may contain an after acquired property
clause.
An open-end mortgage means that more bonds can be issued on the same
mortgage contract. The creditors are usually protected by restrictions
limiting such additional borrowing. The open-end mortgage will normally
also contain an after acquire property clause, which provides that all
property acquired after the first mortgage was issued, be added to the
property already pledged as security by the contract. A limited open-end
mortgage allows the firm to issue additional bonds up to a specified
maximum (for example, up to 50 percent of the original cost of the pledged
property). A closed–end mortgage means no additional borrowing can be
done on that mortgage.
Collateral Trust Bonds
When the security deposited with the trustee of a bond issue consists
of the stocks and bonds of other companies, these newly issued secured
bonds are called collateral trust bonds. Since the assets of holding
companies are usually largely in the form of stocks and bonds of their
subsidiaries, holding companies are the main issuers of these bonds.
Unsecured bonds
Debenture bonds, or more simply, debentures, are unsecured bonds. They
are issued with no lien against specific property provided in the indenture.
They may be seen as a claim on earnings and not assets. This is not
to say that the bondholders are not protected in case of default but,
rather, that they are general creditors.
Subordinated debentures
Subordinated debentures are simply debentures that are specifically
made subordinate to all other general creditors holding claims on assets.
These other creditors are usually suppliers of financial institutions
that have granted credit and loans to the firm.
Bonds with special characteristics
Several types of bonds have special characteristics of bonds plus some
special distinguishing characteristic. These types of bonds are given
special names. For example, if a mortgage bond is secured so that it
covers only part of the property of the firm or only a specific section
of a railroad, it is called a divisional bond.
Direct lien bonds These are special bonds secured by one piece
of property such as a railroad terminal, dock, or bridge. Such a bond
might then be referred to as a terminal bond or bridge bond. If two
or more companies own the property that is securing the bond, such as
a railroad bridge, it is called a joint bond.
Prior lien bonds These are bonds that have been places ahead
of the first mortgage, usually during the recognization of a bankrupt
firm. Only with the permission of the first mortgage bondholders can
prior lien bonds be issued, taking priority over the first mortgage
claim on asset.
Junior mortgage bonds These bonds have a secondary claim to asset
and earnings behind senior mortgage bonds. Because it is poor public
relations for an issue to bear the title second mortgage, these issues
typically have names such as refunding mortgage or consolidated mortgage.
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