Series 7 Study Guide
Post 8 of 14
- 1.1 Contact with potential and current customers
- 1.2 Describing investment products to customers
- 2.1 Tells potential customers about the account types
- 2.2 Secures and updates information about customers
- 2.3 Gather customer investment profile information
- 2.4 Get necessary supervisory approval to open accounts
- 3.1 Passing on all investment strategy information to customers
- 3.2 Analyze customer's portfolio of investments
- 3.3 Disclose to clients characteristics and risks of investment products
- 3.4 Communications with customers
- 4.1 Providing current quotes for investors
- 4.2 Processing and confirming customer transactions
- 4.3 Notifies the correct supervisor, helps with solving issues
- 4.4 Dealing with margin issues
Post 8 of 14 in the Series 7 Study Guide
Analyze customer’s portfolio of investments as well as product options to work out if recommended investments are of an applicable standard
Registered representatives are tasked with making suitable investment suggestions to their clients.
But they also have to advise clients by providing them with information that’s appropriate to their investment needs and goals.
In Module 2, we covered suitability requirements for clients.
In this module, we look at matching the client’s investment objectives to the perfect kind of investment product.
We start with equity securities.
Common stock fundamentals
To begin, we look at the types of common stock available in the securities market.
But let’s first look back a little.
Common stock origins
We know that there are two basic types of equity securities: common and preferred stocks.
When purchased, these are seen as ownership positions in the corporations they have been purchased in.
That’s because by owning common stock, an investor will receive some of the company’s profit through dividends while holding a vote on critical matters, like electing a board of directors.
Common stock comes in a few formats including authorized, issued, outstanding, and treasury.
Corporations raise money by issuing securities, that’s something we all know.
It’s through their corporate charter that we can find what they are allowed to issue in terms of the number of shares.
That decision is something made by the originators of the business.
So who does authorized stock work?
A company will rarely provide 100% of its stock for purchase at any time.
Instead, they see how much capital they need to raise for whatever project they want it for and then issue the stock that corresponds to that, based on its current price.
If a company does sell all of its allocated authorized stock and then issue more, a stockholder vote is needed to amend the company charter to do so.
When authorized stock has been sold, it becomes issued stock.
In other words, a transaction has taken place as the company has received the payment for the stock that investors now own.
At times, not all the authorized stock will be purchased.
These unissued shares could be sold in the future for various reasons such as:
- Raising capital for a future project
- Stock dividend payment
- Stock exchange, for example, common stock for convertible bonds that are outstanding or preferred stock
When working out the total capitalization of a company, stock that is authorized but uninsured is not considered.
That’s because it doesn’t have the same privileges as what issued shares have.
Essentially, it’s waiting to be used when the time is right.
Shares that are in the hands of investors after it was issued by the company are known as outstanding stock.
Surely then all stock that is issued is then seen as outstanding stock?
Well, securities are complex, so the answer to that is yes and no.
For example, a company can buy back outstanding stock, or in some cases, it’s donated by the owners back to the organization that issued it.
When this happens, the stock is no longer considered to be outstanding.
When a corporation has issued stock and that has been reacquired at some point down the line, that’s known as treasury stock.
There are a few options when it comes to this type of stock.
The corporation can choose to:
- Hold it
- Reissue it
- Retire it
Unlike other outstanding common shares, treasury stock does not carry certain rights.
For example, it doesn’t provide the right to receive dividends or provide the holder with any voting rights.
Common stock characteristics
In this section, we look specifically at some of the characteristics of common stock.
- Limited liability
- Residual claims to assets
- Stock splits
- Stock dividends
Owners of stock in a particular corporation cannot be punished for the debts of that company.
That’s where limited liability comes in.
In other words, if they have bought a particular stock and those prices crash, the amount an investor loses can never be more than what they invested.
So should a company fold, the shareholders are not going to be liable to any creditors that come looking for money.
When a company does fold, common stockholders have some rights.
Residual right to claim assets
That means that after all the debts of the company have been paid following the liquidation, if there are any assets left, they can claim them to recoup their losses.
Note that common stock is the last in line when it comes to corporate liquidation.
For that reason, it’s also known as the most junior security.
A rise in stock price will please the executives and stockholders in a corporation.
But it’s a double-edged sword as well.
That’s because should the price get too high, other new investors might be scared off from purchasing new stock.
In this case, to keep stock prices attractive, the company might decide on a stock split.
There are two ways in which this can happen:
- A forward stock split
- A reverse stock split
With a forward stock split, the number of shares are increased but their price is reduced.
So if one share was $10, a forward stock split would now mean that it is broken into two shares but they would cost $5 each.
In this way, those who already own shares in the company lose absolutely no value on them.
In a reverse stock split, the opposite occurs.
Now, investors own fewer shares but the price of them has increased.
Note that stock splits can be even or uneven.
With an even split, the ratio of shares is often 2:1 or 3:1.
In an uneven split, that ratio could be 5:4 or 4:3.
That’s an option open to a company as a way to pay stockholders.
It does this by issuing additional shares of stock to them.
In this way, they save on paying the shareholders their dividends in cash as it occurs at no cost to the company.
Much like a stock split, this doesn’t mean that the overall value of the shares drops, but their pricing will.
This ensures that the overall value of the shares before and after the stock dividend stays the same.
What about the transferability of shares?
Well, for the most part, shares can be transferred for free.
Don’t get confused by this.
All it means is that if a shareholder wants to sell their shares on the open market, they are free to do so.
They do not need the permission of the issuer first.
Shares traded on major stock exchanges all over the world are exactly like this and it helps ensure that they have excellent liquidity.
Remember that all liquidity means is that someone holding a certain share can sell it quickly if they want to and get a fair price for it.
Of course, there are restrictions when it comes to the transferability of shares.
For example, restricted stock cannot just be traded like this and must meet requirements as set out in Rule 144 of the SEC.
That’s something that’s covered later in this guide.
Common stock ownership rights
When you own stock in a company, your ownership interests are protected by certain rights.
Let’s look at a few of these rights.
Shareholders get to vote on important company decisions as well as having a say in who sits on the board of directors of a company.
These votes usually take place at the annual general meeting of a company and voting topics could include:
- Whether the company should issue additional common stock or convertible securities
- Pressing issues such as potential acquisitions, mergers, or any other potential changes of significance
- Stock split declarations
Usually, there are two types of voting systems that a company can use in these situations.
Statutory voting sees votes allowed at one vote per every share they have in the company.
This is often used to vote for members of a board.
So if there are four board positions open and the shareholder owns 40 shares, they have 40 votes for each of the four positions.
With cumulative voting, the stockholder is allowed to use any manner they want to allocate their total number of votes.
Should stockholders not be able to attend a meeting where voting is allowed, they can use a proxy in the form of an absentee ballot.
They can also send someone as a proxy to vote in their place but this obviously has to be done along official channels.
This is known as a proxy solicitation.
From time to time, a company may issue stock that does not come with voting rights or limits them.
This is known as nonissue common stock.
This is done so voting power isn’t diluted but so that needed capital can be raised should the company require it.
In some cases, stockholders might have preemptive rights on a stock that a company wants to issue.
That means that before the securities are offered to the general public, they must first be offered to common stockholders.
In some cases, this is required by law and in others, it might actually be written into the company charter.
Stockholders aren’t forced to buy the stock, they are just given the first bite of the cherry, so to speak.
This is often called an anti-dilution provision.
Lastly, in this section, we look at corporate books and the rights of stockholders to inspect them.
All this means is that a company should send financial statements and other pertinent information to its stockholders.
Stockholders, however, do not have the right to see minutes of the board of director meetings or other detailed financial records.
Other types of equity securities
Now that we’ve looked at common stock in great detail, let’s move on to the next type of company ownership and that’s preferred stock.
Preferred stock, which also provides equity in a company, does not have the same appreciation potential as common stock has and it’s not something that’s issued by all companies.
In the exam, you should also treat preferred stock issues with a fixed or stated rate of return and they come with no voting rights.
What that means is that the dividend paid to stockholders is fixed.
Because of this, stockholders buy preferred stock to help generate a form of income for themselves.
We’ve mentioned that the dividend for this stock is fixed but there are exceptions.
For example, some can be issued as adjustable-rate preferred stock.
This means that they are issued with a variable dividend payout.
Similar to other fixed-income assets, when it comes to prices for preferred stock, they will move opposite to interest rates.
Because the growth potential is not the same as you will find in common stock, this type of stock is considered to be an inflation risk.
It does offer two distinct advantages though:
- Owners of preferred stock will receive their dividends before owners of common stock
- Owners of preferred stock have a priority claim on assets over those owning common stock when a company goes into liquidation
You can see how those investors who are a safe form of income would choose this kind of stock, right?
Preferred stock fixed rate of return
Let’s move on to the fixed rate of return that you will find applies to preferred stock.
As we’ve mentioned, for investors that are looking for income from their stock, the fixed dividend that preferred stock offers is an attractive prospect.
Usually, the annual dividend payout, which is stated as a percentage, is used to identify a preferred stock.
So if a stock valued at $100 that provides a dividend of $10 per annum would be called a 10% preferred stock.
Sometimes it might also be known as a $10 preferred.
For exam purposes, all dividends are paid per annum but for each quarter.
Note that dividends aren’t a sure thing either.
A corporation is not obligated in any way to pay them.
Dividends are declared following a vote by the board of directors.
As for the relation between preferred stock and dividend stock, well we touch on that briefly.
The price of this kind of stock will drop when interest rates rise and vice versa.
Categories of preferred stock
When it comes to categories for preferred stock, there are several different types.
The most common is straight or noncumulative preferred stock.
Other than a stated dividend payout, this has no real extra features.
Note that should a company not be able to pay a dividend, or only pay stockholders part of it, in future years, the missing amount that wasn’t paid will not have to be made up to stockholders.
Next up, there is cumulative preferred stock.
The difference with cumulative preferred stock comes in the fact that should dividends be skipped (also known as in arrears) or partially paid, before a common dividend is laid out, this must be paid.
Note that if an investor has bought this type of stock, there is a downside.
Generally, a stock like this when compared to straight preferred stock, will have a stated dividend that’s lower.
This all comes down to the fact that because they are less risky, the rewards aren’t as great.
A company must keep a record of any dividends not paid and when they can, make them up to the stockholders of cumulative preferred stock.
Note that another name for dividends in arrears is arrearage.
Should the company want to pay common stock dividends too, then the current dividend must be paid as well.
Cumulative stock is a far better option than straight stock for those investors who want their securities to produce income for them.
The next stock type we are going to look at is convertible preferred stock.
Purchasing this kind of stock provides an investor with the right to swap preferred shares they own for common stock shares.
Should this happen, at the time of issue, the conversion rate will be fixed.
It can be shown in two ways.
- As the number of shares, for example, convertible into four shares, or
- At the price at which the investor is allowed to convert
To see the number of shares in common, the investor simply needs to take the par value and divide it by the conversion price.
Note that shares that are convertible in this manner will have a lower dividend rate.
That’s because they have a growth potential that is not in any other way available to preferred stockholders thanks to the ability to convert from preferred to common stock.
Because they will track the price of common stock, convertible preferred stock are less of an interest rate risk as well.
Note that when convertible preferred stock is at its parity price when it has the same stock value as underlying common stock.
Next up, let’s talk about participating preferred stock.
Starting with the dividend, this stock type sees that fixed, just like all the other preferred stocks we’ve already looked at.
Added to this is the fact that this type of stock can receive a common dividend percentage.
When the stock is issued, the maximum percentage in this regard will be stated.
A common dividend, however, must be declared before the participating dividend is paid out.
Sometimes a corporation will issue callable preferred stock also known as redeemable preferred stock.
All this means is that on the call date, or any date afterwards, the company is allowed to buy back the stock at the stated price from investors if they choose to sell it.
For the most part, this call feature will become an option if there is a drop in interest rates.
When that happens, a company can have a lower dividend on a new preferred stock that they have issued and call in the old stock from the money raised.
This is much like when interest rates drop and you opt to refinance a loan.
When preferred stock is called by a corporation, it doesn’t exist anymore.
On the call date, all conversion rights, as well as dividend payments, will end.
Note that in most cases, when compared to the par value, the call price on the stock will be slightly higher.
That extra value will be provided as compensation to investors who now have to search for new stock to replace that which was recalled by the corporation.
The last kind of stock we are going to look at is adjustable-rate preferred stock.
This is an option for how preferred stock can be issued by a corporation and the issues of these stocks are made on a chosen standard, for example, U.S. Treasury Bills interest rates.
But when do the adjustments take place?
Well, for the most part, it’s four times a year (quarterly).
Compared to other fixed-income securities, the adjustable-rate preferred stock is not fixed so there isn’t an interest-rate risk.
In other words, the dividend on this stock will go up when the interest rates rise.
Stock rights or preemptive rights are something that all existing stockholders have.
What these rights provide is for them to hold onto their ownership in a company.
Of course, this ownership is proportionate to the number of stocks they hold.
But there is another advantage to these rights.
That comes in the fact that before a company offers newly issued shares to the public, current stockholders must be given first option to buy them.
This is known as a rights offering and it comes with a further advantage and that’s the fact that if the stockholders want to purchase newly issued shares, they can do so for below the current market price.
These rights trade during the subscription period in the secondary market and are valued separately from the stock.
It’s important to note that these rights described above, although commonly called an equity security, are not a form of ownership.
It’s at the point that they are exercised that there are now more shares for the investor.
What about dividends and voting rights?
Well, yes, they do provide both of those to stockholders but it’s not the rights that pay dividends or vote.
The rights received by a stock owner allow to:
- Buy stock by exercising those rights. To do so, they have to pay the price for the number of shares they want to buy and send the rights certificate to the rights agent.
- Make a profit from the market value of the rights by selling them
- Have the rights expire. In this way, they lose all their value
Those who do not exercise their rights can trade them on the secondary market.
The privilege to buy additional shares in a corporation is provided by a subscription right certificate.
Everyone who is a common stockholder would have received these from the corporation, one right for each stock owned.
They don’t last forever, however.
In fact, from the day they were issued, these rights have a lifespan of just 30 to 45 days.
Within the subscription right certificate is found the terms of the offering.
This not only contains the subscription price, but also the number of shares a stockholder may purchase.
The date on which the new shares will be issued is shown and this is the final date for exercising the rights in most cases
Here’s a brief recap of what we have learned about rights:
- They are short-term
- The exercise price is below the market price when rights are issued
- They can trade with common stock or seperate from it
- Existing shareholders with preemptive rights are offered rights first
Rights that aren’t purchased and the role of stand by underwriters
Not every stockholder is going to take up the opportunity to use their rights and purchase new issues at the time they are released.
There could be any number of reasons for that.
When this happens, the role of a standby underwriter comes into play and their task is usually carried out by the broker-dealer underwriting the offering.
So what do they do?
Well, when preemptive rights are not exercised by stockholders, as a result of the rights expiring, the company will purchase the shares that remain unsold.
When carried out in this manner, it is a firm commitment offering.
Now that we’ve covered preemptive rights, let’s move to warrants.
What is a warrant?
Well, it takes the form of a certificate.
The holder of that certificate can now purchase securities at a specified price from the issuer of those securities.
As they are often confused with rights, let’s look at the differences (and similarities) between them.
The first major difference is that a warrant is considered a long-term instrument whereas rights are short-term.
While they often don’t have a standard length, the expiration date on a warrant is generally two years from the point it was issued.
In most cases, however, the length of a warrant will be longer, with a typical example being five years.
And then you get perpetual warrants as well and these never expire.
There’s a difference in price, too.
When compared to the current market price, on the date that they are issued, warrants will have a purchase price that is higher.
While they are known as an equity security, warrants don’t grant any form of ownership.
An investor will only have more shares if they choose to exercise their warrants.
While they do have dividend and voting rights, it’s not the warrants themselves that pay the dividends or allow a vote.
Origination of warrants
Usually, warrants are offered to the public in connection with other securities, like preferred stock or bonds.
They are seen as an inducement or sweetener to make the stock they are associated with look more attractive.
The fixed dividend or the interest cost of debt of the preferred stock is then reduced but the issuer as the warrant and stock are bundled together as units.
As there is a chance to benefit from stock price increases, many investors find these offerings attractive.
Once they have been issued, warrants become detachable.
This means they can be separately traded.
We’ve already seen that warrants are issued with an exercise price that is higher than the market price of the stock.
Should the stock price increase and move above the exercise price, the warrant can be exercised by the owner.
Now, they can either sell the warrant in the market or buy the stock lower than the market price.
A question often asked is if a warrant enables a stock to be purchased at a higher price than the current market price?
Well, that’s got all to do with their overall time value.
Typically, they have a life span from two to five years and in that time, the market price of the stock may rise significantly which will make owning the warrant worthwhile.
Here’s a brief recap of what we have learned about warrants:
- They are long-term
- The exercise price is above the market price when rights are issued
- They can trade with units or seperate from it
- They act as a sweetener for other securities
American Depositary Receipts (ADRs)
This takes the form of a receipt, similar to a stock certificate but is related to foreign stock.
When shares of a foreign stock are deposited, ADR is provided as a receipt.
While ownership in company stock is shown by a stock certificate, an ADR is different.
It is an indication of ownership in a deposited security.
The specific number of shares held by a custodian in a foreign country is represented by each ADR.
But who are the custodians in this scenario?
More often than not, they are a bank in the country in which the company is located.
While ADRs are outstanding, the stock that they represent must remain on deposit.
They act as the depository bank’s guarantee and indicate that the stock is held by them.
Rights of ADR owners
When it comes to the rights of ADR owners, they are very similar to those that common stock owners have.
So when dividends are declared by a company, the ADR gives the owner the right to receive them.
Note, that these dividends will be in U.S Dollars which helps simplify things and makes ADRS more attractive to investors.
While most ADRs don’t include voting rights, some will pass them on to their holders.
Also, the issuing bank will sell off the preemptive rights on the ADR and holders will have the proceeds distributed to them pro-rata.
Should they wish – although it is rarely done – the foreign shares that ADRs represent can be exchanged for their certificates by the ADR owners.
To do this, the depositary bank will deliver the underlying stock when the ADRs are returned to them.
The ADRs will be canceled during that process.
Regarding withholding taxes on ADRs, that comes in the form of a foreign income tax.
Owners of ADRs can take that as a credit against U.S. income taxes.
Along with the risk that comes with owning stocks, there is also a currency risk that is part of owning ADRs.
It’s something that we will cover in more detail in the guide a little later but you’ve got to remember that dividends are paid by a foreign company in their local currency.
So if that drops against the U.S. dollar, the investor will receive less money.
That’s true if the dividend stays level as well.
Also, while the local market stock price may increase in the foreign country where the stock is held, the value of the ADR can still fall if the currency falls.
There is a political risk too in terms of holding ADRS as local politics in the country in which they are held could also have a significant effect on stock and currency prices.
ADR registered ownership
Let’s talk about registered ownership for ADRs.
The U.S. banks that hold them are responsible for them as they are registered on their books.
In other words, the stock’s registered owners are not those individuals who have invested in the ADRs.
As for the dividends, well they are paid to the registered owners, in other words, the banks.
These are converted into U. S. dollars once converted.
Finally, note that when it comes to ADRs, they are all sponsored.
The foreign company is seeking to increase its ownership by sponsoring the issues.
It’s also important to note that sometimes these are called American Depositary Shares (ADS).
Also, you do get nonsponsored ADRs as well.
There is no participation or assistance from the issuer when they are nonsponsored.
The bank acts as the issuer.
Market places for securities (trading places)
We know that securities are traded on the primary and secondary markets.
A new issuer of securities sold gets the proceeds thereof in the primary market,
The secondary market is where securities that were previously issued can be resold by holders and bought by other investors.
That’s the market we will focus on in this section
Stocks are bought and sold on stock exchanges (for example, the New York Stock Exchange) following their initial offering.
The process used to do this is a two-way auction.
That’s not the only place they can be traded, however.
An over-the-counter market (OTC) exists across the United States too.
This is made up of a network of broker-dealers.
The NYSE exchange and others where listed securities are traded are often called the exchange market.
Should they want to list securities on an exchange, each corporation will need to meet certain standards.
These differ from exchange to exchange, but the most stringent are found on the NYSE.
When compared to OTC markets, the sheer volume of trading in terms of dollars is far greater on exchanges.
That’s helped by the fact that on the NYSE for example, much of the traded stock is blue-chip.
That refers to stock issued by respected companies that over the years have shown not only growth but impressive payouts when it comes to dividends.
Exchanges are subject to many rules and regulations.
They must be registered with the SEC according to the Securities Exchange Act (1934).
Most modern stock markets now have electronic trading only unlike in the past when there were physical trading floors, although the NYSE still has one of these.
For exam purposes, it’s critical to note that in the past, these stock exchanges operated as auction markets.
In this scenario, trades were executed at the most favorable price by floor brokers and on some exchanges, this still exists.
The person in charge of these auctions is called the designated market maker (DDM).
We’ve mentioned the over-the-counter market already, but let’s study it in greater detail.
While the dollar value is higher on the exchange market for securities trade, in terms of volume, the largest market in the U.S. is the OTC market.
Here, securities not listed on any exchange, or unlisted securities as they are known, are traded.
The OTC market is an interconnected network of computers and telephones linking security dealers.
This is known as an interdealer network.
Various types of securities, including corporate bonds, municipal and U.S. government securities, and stocks are traded over this network.
An example of the OTC market and two of the best known are the OTC Bulletin Board and OTC Link.
In the latter, for example, deals in thinly traded stocks, or those that aren’t traded very often.
These are highly speculative stocks not eligible for margin trading that must be registered with the SEC.
So how do trades work?
Well, they are facilitated by market makers.
These market markers will only deal in certain OTC stocks of their choice which they will keep in their inventory.
They are always looking to buy more shares in the stocks they currently hold but they will sell them too, at the right price.
Market dealers compete among themselves to post the best possible prices, both when it comes to buying and selling.
Note that the exam might include questions with the term negotiated market.
That refers specifically to an OTC market.
There are other aspects of the OTC market that we need to touch on.
To start, let’s look at the electronic communications network (ECN).
This allows broker-dealers to bypass the market maker and send their orders directly through the ECN.
It then looks for specified prices and matches the buy and sell orders to them.
These matches are carried out on the ECN not as principals but as agents and take place 24-hours a day.
Known as an alternative trading system, the ECN is sanctioned by the SEC.
Next up, let’s look at dark pools.
Also known as a dark pool of liquidity, this is a trading volume not available to the public.
These large trades take place away from the exchange markets and are carried out by trading desks and institutional traders.
For the most part, it’s the ECN on which these large volume trades will take place but the orders are not routed to the marketplace, so the last sale price and volume information is never displayed.
Institutions that choose to use dark pools don’t affect public quotes or prices when executing large block orders.
This helps them keep their investment strategy close to their chest as the public simply cannot view what they sell or buy share-wise.
The identity of the entity placing the order can be kept anonymous if they so wish.
Some people do have a concern regarding dark pools however linked to the fact that the trade, volume, and prices agreed to cannot be seen by others in the above scenario.
They remain popular, however.
Around 17% of all trading volume on the U.S. stock market is traded on dark pools.
Equity securities taxation
Taxes are something that all investors who buy stock have to think about.
In this section, we focus specifically on equity securities and their tax considerations.
The most obvious place to start when it comes to taxes is with portfolio income.
This can be accumulated in many ways including dividends, the sale of securities generating net capital gains, interest, and more.
All of these will be taxed.
This will be for the year in which the income was earned by the investor.
Let’s look at each of these in turn.
Any holders of equity securities will find that dividend payouts are a critical source of income.
In some cases, like with preferred stock and in some cases, common stock, the main reason for the investment is to generate dividends.
For preferred stock, dividends are paid out to investors in the form of cash, while with common stock, it can be both cash or in the form of additional stock or a stock dividend.
For the Series 7 exam, any cash dividends will be qualified for the most part.
All that means is that when compared to nonqualified dividends, the tax rates are lower.
Tax rates for qualified cash dividends are around 15% but can move up to 20% for those in higher tax brackets.
For nonqualified dividends, however, normal tax rates would be applied.
Always assume a cash dividend in the exam is qualified unless you are told otherwise in the question.
Earlier, we mentioned stock dividends as well.
Instead of paying dividends in cash, a corporation can choose this option instead. In this way, investors who are owed a dividend get paid out in shares of common stock.
According to IRS rules, when paid out, stock dividends are not taxable.
The cost basis of the shareholding, however, must be adjusted.
This means that if the stockholder received additional shares through a stock dividend, there is no real change to the overall value but the stock market price will drop.
That new price is called the investor’s cost basis and because the value doesn’t change, no tax can be applied to stock dividends.
Capital gains and losses
Tax certainly comes into play with capital gains and losses, however.
When securities are sold for a higher price than what they were purchased for, a profit is made.
Tax lingo calls this a capital gain.
Conversely, a capital loss is when securities are sold for a lower price than what they were purchased for.
Both losses and profits can be further split into two categories:
If sold within 12 months of purchase, the securities holding period is said to be short-term.
Anything over 12 months becomes long-term
This is important because it’s long-term gains that get more favorable tax treatment.
To work out a net gain or loss for the tax year, all the gains and losses must be calculated at the end of it.
Should it be a net gain, the taxing works in the following ways.
A short-term gain means it will be taxed using regular income rates.
A long-term gain, however, will be taxed at 15% (more for those in the higher tax brackets.
Note that all of the net gain amounts will be taxed.
When it comes to capital losses, however, things are different.
Against earned income, this is deductible to an annual maximum amount of $3,000 per year.
If there is an excess of over $3,000, this can be used as a deduction to offset capital gains in the years ahead.
Any short-term losses carried forward will remain with that status.
Sale of equity securities: Rules
In this section, we start by looking at penny stocks and the risks that are associated with them.
Penny stock risks
Before we can start, let’s first talk about what exactly penny stocks are.
When a stock is not listed on a major stock exchange and trades at less than $5 it is known as a penny stock.
That’s the basic definition which is fine for what we need to know.
And yes, while some can trade for just under $5 per share, there are still those that trade for pennies.
Penny stocks are equity securities and therefore have all of the same risks as other common stocks would have.
But there are other unique risks that trading in highly speculative securities brings to the fore.
To begin with, they have a real lack of transparency.
Traded on OTC Link and the OTC Bulletin Board, which we covered earlier, trading in penny stocks is far less stringent than on a large stock exchange like the NYSE, for example.
Getting information on these equities can be difficult as they are not covered by analysts as much as listed stock is.
There’s a lack of liquidity associated with penny stocks as well.
Because sometimes they don’t trade very often, on occasions, penny stock shares can be difficult to sell when you need to.
There might be buyers, but not at the price that the investor who holds the stock wants.
Penny stocks fall under the blanket of thinly traded securities.
This means the spread between the buy and sell price can be pretty large.
Another issue when it comes to penny stocks is the fact that many companies trading in them don’t have much of a track record.
This can be a major problem as they simply don’t have an operating history to check on which makes trading in their stock risky.
Lastly, penny stocks are often subject to pump and dump scenarios.
This describes the dissemination of fraudulent information about stock in the form of rumors.
This is so the stock price will rise, or to “pump” it in other words.
Once that happens, the stock is sold for profit, hence the use of the word “dump”.
That causes the price to drop significantly and other investors will make huge losses.
Penny stock rules
There are special rules in place to protect investors who buy and sell penny stocks.
That’s because they are of a highly speculative nature so these rules – called 15g – are needed.
Found under Section 15g of the Securities Exchange Act, let’s cover some of them that might pop up in the exam.
The first rule covers risk disclosure documents and is known as Rule 15g-2.
It states that a Risk Disclosure Document must be given to all investors before they make their first transactions in penny stock.
Not only that, but the member firm needs to receive an acknowledgment from the customer, both signed and dated that they have received it.
There must be a period of two days from the member firm having provided the document to the investor and before they carry out the first trade for them.
The second rule we will cover concerns disclosure of quotations or Rule 15g-3.
This states that a current bid and asked quote must be provided to purchasers of penny stock.
This stops prices from being quoted that are nowhere near what the current market says.
Before any transaction is effected, the quote must be provided, either in writing or orally.
When the trade confirmation is sent, the quote is again sent with it in writing.
The third rule we are going to look at is the disclosure of compensation or Rule 15g-4 and 15g-5.
Member firms have to provide information on compensation received under these rulings.
This is for both compensation that the registered representative and the member firm will receive from any transaction on penny stocks.
The main reason for this disclosure is to stop both parties from adding excessive markups to penny stock transactions.
The fourth rule pertains to the frequency of customer account statements or Rule-15g-6.
This states that monthly statements covering each penny stock purchased and showing their estimated market value must be sent to the purchasers of those penny stocks.
The fifth rule covers customer suitability determination or Rule 15g-9.
This is aimed at helping to stop abusive sales practices and says that when soliciting new customers, members must carry out a suitability determination.
This involves finding out pieces of information like:
- Their level of income
- Their tolerance for risk
- Their overall net worth
- Their investment objectives
From this, a suitability statement must be prepared and that gauges whether penny stock investments should be carried out with each potential new customer.
This document must be sent to the customer and then returned with their signature before any trading can take place.
Established customers, however, can trade without a suitability statement having been carried out.
A client is considered an established customer if:
- They have made a deposit of funds/securities at least a year or more before they want to trade penny stocks
- They have made no penny stock transactions
- They have over three separate days made three penny stock purchases (unsolicited) involving three separate issues
Note, that the suitability statement no longer covers a client who has made three separate penny stock purchases.
If a customer turns in an unsolicited order to trade, the penny stock suitability statement doesn’t apply to them either.
That’s because without the firm making a penny stock recommendation, these customers have initiated trades.
FINRA Rule 2121 – Fair Prices and Commissions
This rule, also known as the 5% policy, helps ensure that the investing public is treated fairly by member firms.
Not only that but it also ensures that services are charged at reasonable rates by them too.
It is, however, more of a guideline than anything else and covers equity securities and the transactions (both buying and selling but not prospectus offerings) on them for both exchange and OTC markets.
Prospectus offerings aren’t covered, as they are outside of the 5% policy.
This pertains to mutual funds, variable annuities, DPPs, and new issues.
If you see an expense ratio of 1.51% that means for every $100 of invested assets, $1.51 is spent from the fund.
Features of mutual funds
There’s no denying that mutual funds are popular.
One of the reasons for that is that investors are drawn to the special features that they offer.
Here are some of those special features that could appear in the Series 7 exam.
Cost of entry
Because they offer low initial investments -$1,000 in some cases – mutual funds are available to a wide range of investors including those who are new to the game.
Also, once the initial investment has been made, follow-up investments are cheap too.
With IRAs, the initial investment is even lower – just $100 for some.
That allows investors to diversify their portfolios to include hundreds of different securities.
Even those who own just one share are said to have an undivided interest in the whole fund portfolio.
That’s a term that might come up on your exam.
Dollar cost averaging
A purchasing method where the investor buys the same amounts at fixed intervals is known as dollar cost averaging.
In this manner, when prices are low they purchase more shares, and when they are higher, fewer shares.
Over time and in a fluctuating market, the average cost per share will be lower than the average price per share.
This doesn’t always bring profits, however, especially in a market that has been declining for some time.
But in that situation, the investor will be buying more shares due to the lower price and if they are willing to ride out the downturn, it will be profitable for them when share prices rise again.
The critical thing here is that regardless of market fluctuation, the investor continues to invest a fixed amount of money at regular intervals.
Also, this doesn’t protect from losses nor guarantee profits.
It does, however, result in a cost per share price that is lower than the average share price.
Mutual funds offer several ways to withdraw your funds, for example, lump-sum withdrawals when all shares are sold by an investor as well as systematic withdrawal options.
One of these is a fixed-dollar withdrawal that sees a customer ask that funds be withdrawn periodically.
So whenever that moment arrives, the fund will liquidate the shares to make up that fixed-dollar amount as stipulated by the investor.
Note that this amount doesn’t depend on the account earnings during that period.
In other words, it might be more than what they are, or even less.
Another plan is called the fixed-percentage withdrawal (or sometimes a fixed-share withdrawal plan).
With this plan, it’s not a dollar amount that’s periodically liquidated from the fund but either a fixed percentage of the account or a fixed number of shares as stipulated by the investor.
Then there is a fixed-time withdrawal.
This one is relatively simple and sees a fixed period in which an investor will liquidate his holdings in a mutual fund.
Disclosures for withdrawal plans
While these withdrawal plans are a popular way of utilizing mutual funds, they don’t offer any guarantee.
If we look at a fixed-dollar plan, there are lots of variables in the plan.
The only thing that is fixed is the time period when the withdrawals should happen, for example, every quarter.
Things like the amount of money they will receive each time aren’t fixed at all, it’s variable.
Note that for a withdrawal plan to be put in place, mutual funds will require that customer accounts have a certain balance.
Once withdrawals start, mutual funds tend not to permit continued investment, for the most part.
All registered representatives dealing with withdrawal plans must:
- Never say that there is a guaranteed rate of return
- Explain that over-drawing is a possibility that can exhaust the investor’s account
- Explain that accounts can be exhausted during a downturn in markets even if the investor is only making small withdrawals
- Not use charts, tables, or other such items unless they are cleared by the SEC
Voluntary accumulation plans
With a voluntary accumulation plan, investors can, voluntarily, deposit regular periodic investments.
The prospectus for the specific mutual fund will highlight the minimum amounts allowed for this.
Other than offering flexibility, this type of plan is all about helping investors make regular investing a habit and it’s the perfect coupling for dollar cost averaging which we spoke of above.
Note, that some of these plans might need investors to make an initial purchase at a specified minimum amount.
Also, they might want minimum purchase amounts at further points after that.
In terms of withdrawals, well that’s made easy for customers too with most mutual funds allowing funds to be taken from customer checking accounts of the investor and placed in their mutual fund investment account.
This helps to simplify contributions significantly.
Another huge advantage for investors is that because the plan is voluntary, there is no penalty should they miss a payment.
Should they wish to, an investor is allowed to stop the voluntary accumulation plan at any point they see fit.
The overall flexibility of these plans is what makes them very popular.
Exchanges found within a family of funds
Sponsors often have a family of funds in which they will offer exchange or conversion privileges.
When a single sponsor (or distributor) has more than one fund, this is called a mutual fund family or a fund complex.
There can be a lot of different funds found here.
Some funds will have double figures and above when it comes to a fund complex while others might even have 100 and more.
With a fund complex, an investor may convert their investments from one fund to another.
There isn’t any sales charge added to this either and the conversion between funds is an equal investment amount.
As an example, an investor might choose to move their investment from a growth fund to something far more conservative as they close in on retirement age.
To do this, shares are simply exchanged from one fund to the other in the mutual fund family.
Note that if a gain (or loss) should occur, for tax purposes, this must be reported.
This is often a question that pops up in the Series 7 exam.
For a no-load exchange between funds to take place:
- The proceeds made from the redemption of the fund may not be exceeded by the new fund purchase
- A refund of sales charges cannot occur during the redemption
- No compensation can be charged by the dealer or registered representative who is handling the reinvestment
Mutual fund tax treatments
The way in which mutual funds are taxed makes them different from other investment vehicles.
Income tax is a way of life.
We are taxed on our salaries and so many other things.
In investing, dividends are also taxed.
In all of the examples above, they are taxed as ordinary income.
But investors have to think about capital gains tax as well.
This is when they pay tax on securities that they have sold for more (or less) than they paid for it.
Any gains will need to be paid for, while a loss can be offset against income and other gains they may have received.
For mutual funds, income comes in the form of dividends (stocks) or interest (bonds) received.
Of course, as we have described above, these will need taxes paid on them.
And don’t forget capital gains tax from any sales of securities that are part of their investment portfolio.
Dividend distributions in mutual funds
Shareholders in dividend funds will receive dividends in the same way as someone who invests as a stockholder will receive from the corporation they have invested in.
Management companies must include a written statement with dividend payments as highlighted by the Investment Company Act (1940).
The payment per share and where it is made from must be indicated in this statement.
In the case of a mutual fund, dividends are usually paid from the net investment income.
For most funds, this will take the form of a quarterly payment.
Net investment income (NII)
Two aspects make up net investment income (NII).
- Gross investment income (from dividends and interest)
- Operating expenses
To work it out, use this equation: NII = dividends + interest – fund expenses.
Note that fund expenses include legal fees, accounting fees, management fees, and bank charges.
They do not include sales and advertising expenses.
Also, any capital gains made won’t form part of the NII either.
Sometimes, triple taxation is a real possibility in securities.
A fund – XYZ – has bought shares in another company, ABC Fasteners.
Before it pays dividends on earnings to shareholders, ABC will be taxed on their earnings made.
The dividends that XYZ receives are taxed as well.
The third taxation comes in when income tax is paid by the investor on the distribution from the fund.
To avoid triple taxation of investment income, investors can choose to put their money into a fund that qualifies under IRC’s Subchapter M.
It may qualify as a regulated investment company (RIC) if it acts as a pipeline or conduit for the distribution of net investment income.
In this way, only the NII the fund retains is going to be subject to tax.
At the mutual fund level, the NII portion that’s passed on to shareholders isn’t taxed.
Under Subchapter M, funds can avoid taxation by making sure that shareholders will receive at least 90% of the NII.
Taxes are then only paid on the amount that has not been distributed.
Note that BDCs and most other closed-end companies do qualify as RICs and do provide a tax benefit to their investors.
Capital gains distributions of mutual funds
If a fund does not sell its securities, the appreciation or depreciation on them is either a capital gain or loss.
In the above situation, there are no tax consequences for the shareholders.
A gain or loss will be realized, however, as soon as the fund sells the securities at a gain resulting in a profit.
Note that net realized gains are what any capital gain distributions are derived from.
The net result here comes from gains being compared against losses.
If the fund distributes 90% of any net gain it achieves, it can qualify as a RIC and by doing so, will avoid extra taxations.
Note that most funds distribute capital gains made over the long-term term.
Investors must report this as long-term gains on their tax returns as required by the IRS.
This is because of the distribution’s conduit nature.
The time frame from the point of distribution, even if the investor purchased the shares only a month beforehand, doesn’t matter in this case.
Long-term fund distributions are only allowed to happen once per annum.
What happens to net short-term capital gains?
Well, they are taxed at ordinary income rates as they are a nonqualified dividend.
Lastly, it’s easy to get confused by the two terms, unrealized gain and realized gain.
When it comes to realized gain, well that’s a profit that’s already been made.
With unrealized gain, it’s the forecast profit that will be made, also often called a paper profit.
An unrealized gain is not subject to tax.
A realized gain, however, will be taxed as capital gains.
If a realized gain is distributed to shareholders, they have one of two options.
Firstly, they can take the distribution in the form of cash and be taxed on it.
Secondly, they can opt to rather reinvest it by purchasing additional shares.
Note that should they choose the second option, they will also have to pay a capital gains tax.
Reinvestment of distributions
Many investors take the route of reinvesting distributions that they receive from a mutual fund which is similar to compounding interest.
That’s because those distributions will purchase even more shares which will lead to more dividends earned and more distribution gains in the future.
Investors won’t have to pay a sales charge either should the mutual fund they invest in have been formed after April 1, 2000.
In reality, most mutual funds, even those formed before this, don’t have their investors pay a sales charge if they reinvest their distributions back into the fund and experience faster growth because of it.
Ultimately, that’s what they would prefer, right?
In other words, all distributions that are put back into mutual funds by investors are done so without a sales load.
Reinvested distribution taxation
As we’ve mentioned, no matter if a distribution is received as cash by an investor, or if they decide that they want to reinvest it, it will be subject to taxation.
For this, the IRS makes use of constructive receipt.
But what does that mean?
Well, it covers dividends and other forms of income.
Although they might not be physically received by a taxpayer, during the taxable year, they will be constructively received and credited to the account or in some other way, be made available.
The requirement for this is that it could have been drawn upon by the taxpayer during the taxable year should they have given an intention to withdraw.
At all times, mutual funds will disclose if their distributions are capital gains or if they come from income.
Shareholders are sent a Form-1099-DIV at the close of each tax year.
This will detail dividend distributions for that period and the tax information related to them.
With this form, investors are provided with the information they need on their Form 1040.
Mutual fund suitability
There are a fair amount of questions on the Series 7 exam that covers suitability and selecting the right mutual fund for a potential investor.
While there are thousands of mutual funds to choose from, they will all fall under a few major fund categories:
- Stock funds where investments are made in stocks
- Bond funds where investments are made in bonds
- Balanced funds where investments are made in a combination of both stocks and bonds
- Money market funds that invest in short-term investments
When stocks are used by a mutual fund to meet their stated objective, it’s known as a stock fund because it’s in stock where the investment made by investors will lie.
Most mutual funds will include some kind of common stock, especially when their primary or secondary objective is growth.
There is a range of fund types that fall under the general banner of stock funds, so let’s look at a few of the most important.
Starting off, let’s talk about growth funds.
These actively seek out companies that are growing at a rapid rate and invest in their stocks.
Their main aim is to not generate income but instead, capital gains and the growth companies they invest in will not pay dividends but reinvest profits in the company.
These funds do have higher levels of risk, however.
That’s because often, growth managers buy into stocks that seem to be overvalued due to their upside potential.
But there are more conservative growth funds as well, that while there is less risk, still achieve growth, albeit slower.
These tend to invest in companies that have large market capitalization, or market cap as it is more commonly known.
This takes the market value per share currently and multiplies it by the number of outstanding common stock shares.
The larger the cap stock (the result of this equation), the bigger the market capitalization, and funds that invest in these companies are sometimes called large-cap funds.
Generally, these large-cap funds will only invest in a company where the market capitalization is over $10 billion, making them far less volatile in turbulent markets.
Should an investor want a minimum investment of five to seven years, this might be the perfect option.
Aggressive growth funds
Also known as performance funds, these seek to maximize capital appreciation by taking greater risks.
They do this by looking to invest in newer companies.
More specifically, they target those with small capitalization, less than $2 billion.
These funds are called small-cap funds.
If they target companies with a capitalization of between $2 and $10 billion, they are medium-cap funds.
While not as aggressive as large-cap funds we covered previously, they are riskier than small-cap funds.
Investors wanting high potential returns and are willing to invest for a period of 10-15 years might be interested in these types of funds.
It’s important, however, that they do understand that there is significant risk involved.
These mutual funds target stocks that are considered to be undervalued.
Undervalued means that their stock price does not reflect their earnings potential.
Fund managers of value funds see the potential for profit in these companies and therefore invest in them.
When compared to growth stocks, value funds, for the most part, will have higher dividend yields.
These are also considered to be more conservative than growth funds
Value funds should be for investors wanting to take a moderate risk over a 7-10 year period.
Equity income funds
When mutual funds are mostly made up of stocks, they are known as equity income funds.
The aim of this type of fund isn’t growth but more about current income.
Companies that this type of fund will invest in are those that have paid out dividends over years and years.
These included those with preferred stock, blue-chip stocks as well as utility companies.
Those investors that want low to moderate risk while wanting income from dividends will be interested in a fund like this.
Option income funds
Option income funds are invested specifically where call options are sold.
These are also known as covered calls.
When the options are written (sold), premium income can be earned.
Should the options trade at a profit, they can earn capital gains as well.
The main aim of option income funds is to increase the total return for investors.
This is done thanks to the option-generated income as well as the appreciation of the securities that form part of the portfolio.
Compared to other income funds, however, option income funds come with far greater risk.
Growth and income fund
When income and growth is the option of a mutual fund, it’s called a growth and income fund or a combination fund.
The objectives of growth and income are targeted through diversification.
In this fund, the stock portfolio includes both companies that have high dividend returns and those that have huge growth potential over a long-term period.
These are the perfect funds for investors who want moderate risk for their investments that will provide both capital appreciation as well as dividends.
Specialized or sector funds
When funds operate in a specific economic or geographic sector, they are known as specialized or sector funds.
At least 25% of the assets invested by these funds will be in the sector that they specialize in.
Because the concentration of investments are managed in this way, sector funds do pose higher risks for an investor.
Having said that, the advantage of these funds, which are speculative in nature, is that they provide high appreciation potential as well.
Economic sector funds include those that invest in pharmaceutical, technological and precious minerals.
Some work geographically as we have mentioned, for example, ones that will invest in companies located in Silicon Valley.
If an investor has a specific sector that they would prefer to invest in, this is the perfect kind of fund for them to do so.
Special situation fund
If a fund looks at a situation as its point of investment, it’s called a special situation fund.
Without a doubt, these are highly speculative, and see the mutual funds that buy into them look for companies that could gain an advantage from a specific situation.
This could be an internal change in the company, perhaps a merger or takeover, or a change in economic conditions, for example.
Investors might identify an industry in which they think they could score on their investments if there is a change.
They would therefore be looking to mutual funds that offer investments like this.
When a portfolio comprises several different stock classes, it is said to be a blend/core fund.
So what kind of stocks could you find in a fund like this?
Well, anything from high-risk//high-return investments like growth stocks to more stable blue-chip stocks.
In a fund like this, both value and growth management styles are the order of the day.
The main aim here is to give investors a platform using management and securities to diversify their investments in a single fund.
Funds that invest in securities that mirror the S&P 500 and other market indexes are called index funds.
What funds like these do is mirror the selected funds in buying and selling index securities.
Depending on what the fund has chosen to mirror, the index can be broad or more narrow.
These funds have minimum securities turned over.
The trades that do take place happen because of a change in the index when one company replaces another.
Because of this, when compared to other types of mutual funds, the management costs of index funds are extremely low.
These funds are an excellent option for investors who think it’s difficult to outperform the market and don’t want a managed fund’s wide stock selection.
Foreign stock funds
As we now live in a global economy, investing in foreign securities is an attractive prospect.
And there’s certainly nothing wrong with investing in large foreign companies that have become household names not only in the country they are from but in America and other parts of the world as well.
In this section, we are going to look at some specific mutual funds where foreign investment is a possibility.
When an investor opts for one of these, they will be buying securities of foreign companies that although they may have a presence in the United States, are based outside of the country.
While some funds will look to make current income, most of these international funds will have their primary objective set as long-term capital appreciation.
Also known as worldwide funds, investments are made not only in foreign countries but also in the United States.
There are extra risks involved with these funds, particularly when it comes to foreign securities.
That’s because they can be influenced in several ways, for example, political and currency risks.
Also, in many pre-emerging economies, rules and regulations aren’t as stringent as they are in the United States, so investors aren’t protected as much because organizations like FINRA or the SEC have no jurisdiction in foreign countries.
Often, these funds are purchased as a way to offer some diversification to the portfolio of investors.
As for balanced funds, these look to two particular types of investments: bonds and stocks.
The stock option helps with appreciation within the portfolio while the bonds are there to generate income.
With balanced funds, these different types of securities are bought using a formula.
This might have to be adjusted from time to time, depending on current market conditions.
For example, a portfolio of this type of fund might be made up of around 60% stock and 40% bonds.
This type of fund is for those investors who specifically want a balance between stocks and bonds in their portfolios.
Asset allocation funds
Generally, these look to invest in three specific areas: stocks, bonds, and money market instruments.
The stocks provide growth within the portfolio, bonds are all about income and finally, the money market instruments offer stability through cash.
Those who manage the funds often will change the holdings percentage in each of these categories of assets based on their current or expected performance in the future.
Note that hard assets such as real estate or precious metals can be part of this type of fund.
A breakdown for asset allocation funds could be 60% in stocks, 20% in bonds, and another 20% in cash.
This can easily be switched around depending on which asset allocation is expected to perform well in the future.
That’s at the discretion of the fund manager.
A large portion of these funds are considered target funds with specific goals in mind.
This could be retirement, for example, and the funds have target periods, like 20 years from retirement, 15 years, 10 years, and 5 years.
When the investor gets close to the end of their working days, the fund allocations will change and the investment mix will be far more conservative when compared to other investors that are many years still from stopping working.
Most employer-sponsored defined contribution plans, including 401 (k) offerings, and others offer these funds, also known as life-cycle funds.
The idea behind target-date funds is that they focus on managing the risk of investment.
To carry this out, funds with a certain target date are selected based on when the investor will require the money from their investment.
You can immediately see how those planning for their retirement would use a target-date fund to do so.
The other advantage of these funds is that as the target date approaches, the fund itself slowly but surely will reduce risk.
It does this by altering fund investments to something more conservative.
Of course, however, no mutual fund is considered to be completely risk-free and that’s the case here as well as these funds don’t necessarily generate a guaranteed income.
So if stock and bonds that are owned by the fund drop in value, target-date funds are susceptible to losing money.
Target funds might have the same target date but operate very differently.
That’s because they will almost certainly have varying investment strategies as well as asset allocations.
All of these things will affect what they will be worth when the target date arrives as well as the overall risk.
The main focus of this type of mutual fund is that of income.
A large portion of these types of funds target investment-grade corporate bonds as a way to generate income.
But that’s not the only thing bond funds will invest in.
Some will look for less risky investments and for that reason invest in government issues.
On the other hand, some bond funds will target the best current income possible by looking at higher yields provided by lower-rated bonds, or junk bonds.
Let’s look at some bond fund types.
We start with corporate bond funds.
When compared to government-issued bonds, corporate bonds generally do have a higher credit risk.
However, they can be classified in two ways:
- Investment-grade which are considered a safer investment option
- Noninvestment-grade which are considered a riskier investment option
As always, with greater risk, comes greater reward.
This is typical of high-yield bond funds.
Their increased risk, however, sees them classified as speculative investments.
Next up are tax-free bond funds and UITs.
These target a specific type of bond for their investment, those that are exempt from federal income tax.
The investment vehicles are investment bonds and notes that will return dividends and are often ideal for those investors seeking income but who are in high marginal tax brackets.
US government funds deal with specific securities that are either issued by an agency of the US government or the Treasury.
This type of investment is perfect for investors who want investment safety coupled with a current income.
Note that security funds belonging to government agencies are as safe from risk when compared to government funds but their yields are higher.
When it comes to agency funds, there are two types:
- Those guaranteed or issued by U.S. federal government agencies
- Government-sponsored enterprises (GSE) bonds
GSEs are specific corporations that are specifically created by Congress for a certain public purpose, for example, the creation of affordable housing.
Like Treasuries, any bonds issued/guaranteed by some federal agencies receive backing from the U.S. government.
So when the debt security reaches maturity, investors can be guaranteed that the security they have invested in has a commitment to pay interest payments and return the principal investment.
Note that those bonds issued by the FHLMC, FNHM, and other GESE do not offer this same guarantee as that provided by federal government agencies.
Another bond fund example is that of principal-protected funds.
This fund provides a guaranteed principal at the maturity date of the fund.
This principal, however, will be adjusted because of distributions and dividends.
But it also provides higher investment returns through certain higher risk and higher expected return asset classes.
These include equities, for example.
There is a guarantee with these funds and that is that the return an investor can expect will never be less than what they originally invested.
Because of these guarantees, these funds have become extremely popular in recent years.
That said, there are factors that limited the usefulness of these funds:
- Guaranteed principal: The initial investment is guaranteed but minus front-end sales charges.
- Lock-up period: Should investors sell shares in the fund before the guarantee period is over (normally between 5 to 10 years), that guarantee no longer counts. This means that should share prices fall, money could be lost on their initial investment.
- A mixture of bonds and stocks held: During the guarantee period, most of these funds will invest in debt securities such as zero coupon bonds and equity investments such as stocks. When markets are volatile and interest rates are low, the fund might invest only in zero coupon bonds to ensure they can support the guarantee. This can reduce gains significantly. Rising interest rates too can then cause bond prices to fall.
For risk-averse investors who don’t want to lose the principal of the investment, a principal-protected fund makes the most sense.
When it comes to no-load, open-ended investment mutual funds, look no further than a money market fund.
Here, the portfolio is made up of various money market securities which provide excellent liquidity over everything else.
Investors who want liquidity, as well as regular income from dividends, tend to prefer this type of fund.
This is because each day dividends – which are taxed as interest – are worked out and once a month, they will be paid to investors’ accounts.
Note that even though interest rates may change, the price of money market shares doesn’t fluctuate.
That’s because most have a fixed NAV of $1 per share.
This isn’t guaranteed, however, but even though markets may change, funds are managed to “break the buck” so to speak.
Note that while retail money market funds can keep a $1 per share NAV, institutional funds have a floating NAV.
That means that depending on market factors, the NAV can change from day to day.
There is one other money market fund type with a stable NAV.
Those are known as institutional money market funds.
They are almost entirely made up of government securities.
Note, for the exam, understand that money market fund investments are not guaranteed by any government agency and while these funds aim to maintain a NAV of $1 per share, it still is possible to lose money when investing in them.
Packaged products – Exchange-traded funds (ETFs)
There are two types of exchange-traded funds (ETFs) that can be registered with the SEC as required by the Investment Company Act of 1940.
ETFs can be registered as:
- Unit investment trust (UIT ETF)
- Open-ended management company (open-ended ETF).
For the most part, a specific index, like the Dow Jones, for example, is where ETFs will look to invest.
But as long as there is a published index around any class of asset and it is liquid, it can be made into an ETF.
That means you will find them for all kinds of things including stocks, bonds, commodities, and real estate.
Because of that, ETFs and index mutual funds are actually pretty similar although one difference is that ETFs are like closed-ended investment companies and trade like a stock on the Nasdaq, for example.
In other words, price changes due on the market instead of just a stock’s underlying value is something that an investor has in their favor.
While many ETFs are passive, there has been a step towards more actively managed ones over the last number of years.
These work slightly differently in that individual assets are selected by managers as a result of their expected performance instead of mirroring an index.
Because of this, some ETFs might only look to purchase equities or income securities.
Others could look to both of those while some still delve into commodities and other non-securities assets.
Like other listed stocks, ETFs can be purchased on margin and then sold short by the investor which makes them different from mutual funds.
As for expenses, ETFs generally are lower than mutual funds and they can also provide investors with some tax advantages.
In terms of brokerage commissions, ETFs will charge on each trade, both in and out.
This means that when small investors who make periodic investments regularly compare them to a no-load index (like a dollar-cost averaging plan), they generally are a little more expensive.
While many ETFs are open-end companies, because shares are not redeemable by the issuer, they may not be called mutual funds.
Delivery of a prospectus isn’t required for ETFs either.
That’s because the secondary market is where all their trading takes place.
Don’t confuse them with CEFs either, although they trade on exchanges too.
That’s because CEFs have full-time, active portfolio managers while ETFs are not actively managed at all.
They differ in terms of pricing too.
With a CEF, trading prices are independent of NAV, and in general, the trade a distance from it as well.
Because the price is determined by supply and demand, it could be a discount or premium.
ETFs as we know, trade very close to their NAV and sometimes even right at it.
On the Series 7 exam, you may be asked about ETFs and their uses.
Here are some to remember:
- ETFs can be used for asset allocation
- ETFs can be used for hedging
- ETFs can be used for speculative trading
- ETFs can be used to help balance an investment portfolio
- ETFs can be used to follow industry trends
Leveraged ETFs are different from the regular type that we have just covered.
That main difference comes in the returns they try to deliver.
In fact, based on the benchmark index they follow, the object of a leveraged ETF is when it comes to returns and that’s to deliver multiples of them.
So if an ETF was 3x leveraged, the return it aims for is three times what the tracked index delivers.
When it comes to the amount of leverage that these funds can be applied to a portfolio, well there is no limit at all.
Most leveraged funds operate in the 2x or 3x range.
Of course, while returns are going to be greater than a regular ETF, there is a downside.
That’s because just as returns are magnified, so is the overall volatility associated with a leveraged ETF.
In other words, just as an investor can make two or three times the returns of a normal ETF for example, should the benchmark index fall in a volatile market, the leveraged EFTs losses are amplified.
That’s one reason why they might not be suitable for all investors, but there are others too.
For example, derivatives products including options, futures, and swaps help leverage funds towards their investment goals.
Not all investors are suited to these.
That’s why the suitability of an investor is always critical when it comes to recommending an investment vehicle like a leveraged ETF.
Also called reverse or short funds, these track a benchmark index but instead of trying to deliver what it does, the idea is that it must return must be opposite to it.
So should a benchmark fund be down 3%, an inverse fund attempts to be the opposite of that, or in other words, up 3%.
Sometimes, these might actually be leveraged funds and aim to be two to three times opposite of what the benchmark index is doing.
These funds are considered to have a bearish outlook.
Should the benchmark index rise and improve, the inverse fund would lose value.
This will be amplified greatly if it is leveraged as well.
Another thing to know about inverse funds is that each day, they will reset.
This means that their stated objective is something they try to achieve daily.
When you compare their performance to the benchmark index they are tracking, the two will differ a lot.
In other words, buy-and-hold investors aren’t suitable for inverse funds while those with a short time investment horizon are.
Investment company benefits and risks
We’ve covered a vast range of investment companies in the sections above.
And while we’ve looked at some of the risks and benefits they offer, let’s expand on that even further.
Understand that by including investment company securities in the portfolio of a client, two very critical characteristics should be noted
- They allow for diversification
- They are professionally managed
Let’s look at the types of investment companies and the overall benefits they offer.
The benefits offered by mutual funds
Here are the benefits that mutual funds bring.
These are some of the best investment vehicles to match whatever choice of objectives an investor might have.
For example, growth funds offer a range of ways to provide income for investors, from more conservative approaches to those that are highly aggressive, but riskier.
There are investors for both those situations, that’s for sure.
Income funds generate income from government bonds to high-yield bonds, again with varying degrees of risk, while for investors who want capital preservation, look no further than a money market fund
They also offer convenience.
In the modern investment world, all the information an investor needs from their mutual fund can be found on the fund’s website.
Here, investors can even alter reinvestment options, buy and liquidate shares, and more.
Another plus is the fact that mutual funds offer liquidity.
It’s a requirement set out in the Investment Company Act (1940).
They must always allow for shares to be redeemed at the next calculated NAV per share.
Following any redemption requests made, payment must be processed in the next seven days.
Liquidity is always assured with open-end investment companies.
In terms of how easy it is to invest in these funds, well thanks to their minimum initial investment, anyone can.
It doesn’t take a lot of cash to get started and once an investor has bought their initial shares, the large majority of mutual funds allow for further investments to be made for as little as $100 and in some cases, even less.
Adding to shares or claiming money out of the fund are made easy too thanks to mutual funds having automated investing and withdrawal systems in place.
Should investors choose, they can have automated amounts invested in mutual funds, for example, quarterly or even once every month.
The opposite is true as well, with investors able to set up automated withdrawals as well, perhaps once per annum, for example.
Mutual funds provide investors with combination privilege.
This is because often, there isn’t only one fund but a selection run by a mutual fund company.
This is known in the world of securities as a family of funds.
One major benefit of this is reduced sales charges, specifically when an investor combines different investments to reach a breakpoint in more than one of the family of funds.
This also allows for exchanges within a fund family.
These exchanges or conversion privileges as they are known allow the conversion of an investment found in one fund into an equal investment in another fund in the family.
This happens at NAV and no additional sales charges are involved.
How does this work in a practical sense?
Well, someone investing in the 20s and 30s might want a more aggressive approach and choose a fund with high potential returns.
As they approach retirement age, they will want to change their investment to a more conservative fund that’s less risky.
That’s easily done in a family of funds.
Mutual funds also offer simplified tax return options thanks to their convenient tax information.
The taxability of these funds will be explained as investors receive Form 1099s each year.
These provide all the information an investor needs to help complete their tax return information regarding their investments easily enough.
The final benefit of mutual funds comes in the form of inverse and leveraged funds.
These provide the potential for far higher gains but obviously are riskier.
The benefits offered by UITs
UITs have numerous benefits, so let’s look at those that draw investors towards them.
To start, the income that UITs provide is usually higher than mutual funds that have a similar portfolio.
Part of that is the fact that, unlike mutual funds, a UIT doesn’t have a management fee applied to it.
That’s because UITs do not have portfolio managers.
And that can significantly increase the overall income they provide.
Another advantage of that income is its overall stability.
Income generated by UITs does not alter much at all and that’s because of their fixed portfolios.
UITs offer excellent liquidity.
UITs tendered by investors must be tendered by trustees at their NAV which helps in that regard, even though they aren’t traded on secondary markets.
They provide rolling over proceeds too.
All UITs, whether a debt or an equity, have a date on which they terminate.
When this happens, investors are given the option of putting the proceeds generated and rolling them over.
This means that with no extra fees charged, they can be placed into another trust for the process to start all over again.
The benefits offered by CEFs
When compared to mutual funds, here are some of the benefits that investors can expect from their CEFs.
First up, they are exchange-traded.
As we know, that means they receive all the benefits of trading on secondary markets.
Two of the most critical are that shares can be bought on margin and when they are sold, they can be sold short.
There’s intraday trading too as well as excellent liquidity.
And there is no seven-day redemption rule that mutual funds must adhere to.
Instead, your CEF sale proceeds will be made available two business days after the transaction was approved.
There are pricing advantages too as CEFs are subject to supply and demand.
This means at times, they can sell at a discount from their NAV and other times at a premium.
Buying CEFs at a discount from their NAV is something that can never happen with mutual funds.
Because CEFs can issue debt securities, the money that’s borrowed in these situations helps create financial leverage.
That can be a major advantage as it can help generate multiple gains.
The benefits offered by ETFs
If you study ETFs closely, there is a wide range of advantages for investors.
Let’s first look at taxation.
With mutual funds, capital gains distributions are taxed each year when they are paid out.
With ETFs, it’s different as it’s only upon the sale that an investor realizes a capital gain or loss and that’s when they are taxed.
ETFs tracking an index have low expense ratios too as management fees aren’t as high as with mutual funds.
Investors looking for niche areas to sink their money in also turn to ETFs thanks to the portfolio specificity they offer.
As for ETFs that are exchange-traded, the benefits are much the same as for CEFs as we covered above.
They do have one major advantage, however.
That’s the fact that, unlike CEFs, the price of investing in ETFs is never far from the NAV.
Finally, ETFs also offer inverse as well as leveraged funds for investors to consider.
Before we move on, the Series 7 exam often tests overall knowledge on the difference between an index ETF and an index mutual fund.
There are three main points to remember here:
- Intraday trading: Because they are priced all through the day, ETFs can purchase or sell shares at any time. So if the market does change, it’s far easier for an investor to react to it.
- Margin eligibility: Subject to common stock terms, investors can purchase index ETF shares on margin.
- Short selling: At any point during trading hours, index ETFs can be short sold.
Well, that’s all the benefits covered, let’s get onto the risks.
As we know, all investments, even the most stable will have some form of risk.
When dealing with investors, finding the best investment option from a risk perspective is all about matching it with the risk tolerance of each individual.
Let’s look at various investment company securities and see what type of risks they have.
The risks to be aware of when dealing with mutual funds
The first risk when it comes to mutual funds is related to the market.
Market prices aren’t stable, we know that to be true.
Therefore, market risk is a concern when it comes to mutual funds.
Some of these, like changes in economic conditions that severely affect stock prices are beyond anyone’s control as well.
There’s interest rate risk as well.
This especially affects bonds as well as other income-orientated funds.
Bond prices are linked to interest rates.
When they rise, the price of bonds will fall.
With bond funds not having a final date on which they mature, it doesn’t repay the principal at maturity.
There are far less risky mutual funds that can be considered, for instance, a money market fund.
But as always, there is a trade-off and that’s the fact that while the prices do not fluctuate as with other mutual funds, income from a money market fund is low and growth is slow.
The next risk to consider for mutual funds is unique just to them and that’s net redemptions.
But what are they?
Well, they appear when markets are declining mostly, and when compared to new share purchases, you will find far more shareholder redemptions.
In this situation, those managing the portfolio have a very difficult decision to make.
That decision revolves around choosing which assets to liquidate.
At the end of the day, if a fund is struggling with net redemptions, its overall performance is going to be poor which will affect overall performance.
Should a fund manager not want to sell assets in a portfolio to meet the redemptions, there is the option of short-term borrowing.
That money can come from banks but there will be limits as to the amounts that they will lend.
Moving on, we next look at expense risks that can affect mutual funds.
Fees can be added and even reduced from time to time.
Often, however, investors fail to pay attention when receiving notifications about extra fees.
Fees that should always be understood when it comes to mutual funds include:
- 12b-1 fees
- Redemption fees
- Management fees
- Overall tax efficiency
The last risk to consider for mutual funds deals with tenure risk.
Fund managers come and go so investors and registered representatives mustn’t look to invest in a mutual fund just because of who is in control of it.
Sadly, this is often the case and sometimes, investors can be left unhappy if a fund manager moves on.
The risks to be aware of when dealing with UITs
There are two main risks that you should be aware of when it comes to UITs.
The first is market risk.
Just like other equity securities, UITs are not free from this but they do have a bit more of a unique situation in this regard.
That comes in the fact that the portfolio is not managed at all.
In fact, the portfolio in UITs is fixed.
So if some of the stocks in the portfolio start to perform badly and lose money, there’s no active management to make a change.
That might be ok with one or two stocks, but if the whole portfolio is struggling, there’s not much that can be done other than wait for an upturn, which hopefully comes.
UITs are also subject to interest-rate risk with bond and equity UITs both having the same problem.
When these interest rates start to go up, investors are placed in a difficult position because of the fixed nature of UIT portfolios.
For example, if you compare it with a bond mutual fund, new money coming that’s flowing in can be utilized by fund managers.
They do so by using it to buy into higher-yield bonds.
With UITs, however, this simply cannot be done.
The risks to be aware of when dealing with CEFs
Next up, let’s look at the risks associated with CEFs.
To start, there is pricing risk.
It’s supply and demand that will determine closed-end share pricing.
Often, even with these shares at a price that’s premium and above the NAV, investors will still buy into them.
Later, however, when the investor looks to sell the shares, they might be selling at a discount and that could result in a loss.
With mutual funds or UTS, this would never happen.
That’s because they are always sold at NAV.
EFTs too, because they trade close to the NAV, this scenario is unlikely but it remains a risk for CEFs.
Leverage risk is something to consider too.
As CEFs can issue bonds and returns can be increased on borrowed money.
But that’s about the manager understanding where the market may go.
Getting it wrong will result in losses when the market moves the wrong way.
The risks to be aware of when dealing with ETFs
Index risk is similar to that associated with a UIT fixed portfolio.
Should a security in the index underperform, until it’s removed from the ETF, there is nothing that can be done about it.
When it comes to passive investing, this will always be one of the greatest risks.
Tracking risks too should be a consideration.
Having a performance that’s the same or even better than the tracked index is just not something that’s going to happen.
That’s because, unlike the ETF, the tracked index won’t have expenses such as trade commissions, filings with regulatory agencies, or legal and other expenses.
At the end of the day, finding the ETF with the highest reliability when it comes to tracking is the aim.
Packaged products – Variable Insurance
In this section, we are looking at the many different products offered by life insurance companies.
These are not securities, but it’s something that many people look towards, either in their own capacity, together with their employer who provides cover, or in some cases, both.
While these aren’t securities, some of them are defined in that manner and that’s what the Series 7 exam focuses on.
In particular, this section will cover:
- Variable annuities
- Variable life insurance
These are generally purchased to help generate retirement income.
In most cases, an annuity is a contract drawn up between a life insurance company and an individual.
But how does it work?
Well, the premium can be paid in a lump sum but more often than not it’s done through periodic payments by the investor who is called an annuitant.
The policy will include a future date on which the annuitant will receive the money in it.
This can be done as a lump sum payout or as regular distributions, every month, for example.
All earnings on variable annuities are tax-deferred.
That makes them an effective tool in accumulating additional funds for retirement and there is no legal limit placed on the annuitant as to how much funds they can contribute towards it.
Sometimes, however, a limit might be placed by the insurance company running the annuity.
Depending on the guarantees that they offer, there are two types of annuity contracts:
- Fixed annuities
- Variable annuities
Let’s look at fixed annuities first up.
The most important thing to remember first with fixed annuities is that they are not securities.
That’s because there is no risk for the annuitant as the insurance company guarantees a specific return.
It’s critical to understand them and how they work because the Series 7 exam will often compare them against variable annuities which are a security.
So the word fixed is going to give you a clue about their rate of return.
Yes, that’s guaranteed.
At a point when the individual holding the annuity decides to start receiving the income from it, the payout is calculated.
Two factors help determine that calculation.
The most critical is the value of the annuity, which makes complete sense.
The second deals with the life expectancy of the annuitant who owns the annuity.
These are calculated using mortality tables.
As a result of inflation fixed annuities do risk the loss of purchasing power but the principal, as well as the interest, is never at risk.
Those selling these products do need life insurance licenses to do so but don’t have to hold securities licenses.
Here’s a quick recap on fixed annuities:
- After-tax dollars are used for payments
- These are then invested in a general account
- The portfolio of a fixed annuity includes real estate/fixed income annuities
- Investment risk is taken on by the insurer
- Fixed annuities are not considered as a security
- Fixed annuities will provide a rate of return that is guaranteed
- Administrative expenses are fixed
- Income is guaranteed
- Payments each month will never be lower than the guaranteed minimum
- Fixed annuities have purchasing power risk
- Fixed annuities are governed by insurance regulations
What about variable annuities?
Well, these work a little differently.
To start, money is not paid into the general account of the insurance company as would be the case with fixed annuities.
Instead, it goes into various sub accounts connected to a separate account for variable annuities.
There are numerous of these subaccounts and each works differently.
For example, some would be for investors that want more returns with higher risks while others would be more conservative.
Each of these subaccounts acts in much the same way as mutual funds do, but obviously, they aren’t mutual funds and cannot be called that.
They are similar in the fact that they have various investment objectives.
For example, these could include income, growth, or a combination of the two.
A loss of principal can happen when investors pay money into these sub-accounts because the returns for them simply cannot be guaranteed.
As required by the Securities Act (1933) each of these separate accounts will be registered as an investment company.
Before any sale is made, potential investors must be given a prospectus regarding the objectives of each separate account.
More often than not, purchase payments on these accounts are invested into stock portfolios.
That’s because they are more geared towards keeping up with changes in inflation.
They can also be bonds and money market securities, however.
Because variable annuities offer more potential gain, it’s riskier when compared to fixed annuity options.
That’s because unlike accepting an insurance company’s guarantees like a fixed annuity would, it rather invests in securities as we’ve covered.
Because the unit worth of an annuity can fluctuate, payouts for variable annuities will vary.
A guaranteed monthly income for life is an option that can be chosen by annuitants who have opted for a variable annuity.
It is still dependent on how the account performs, however.
For example, should it perform extremely well, the next month’s payment may be higher.
If it performs badly the following month, the payment will drop accordingly.
Almost all variable annuities do include a guaranteed death benefit option.
Here, should the investor pass away, their beneficiary will receive the amount invited or the current value of the account.
This differs depending on the variable annuity that has been chosen.
Here’s a quick recap on variable annuities:
- After-tax dollars are used for payments
- These are then invested in a separate account
- The portfolio of a variable annuity includes mutual, equity, and debt funds
- Investment risk is taken on by the annuitant
- Variable annuities are considered as a security
- Fixed annuities will provide a rate of return that depends on the performance of each separate account
- Administrative expenses are fixed
- Income is guaranteed
- Payments each month can fluctuate
- Variable annuities protect against purchasing power risk
- Fixed annuities are governed by the SEC regulations and must be registered with the state insurance commission
For exam purposes, to sell variable annuities, two licenses are required.
These are a securities license as well as an insurance license.
Investor suitability must be carried out on potential annuitants and before or on the solicitation of the sale, they must receive a prospectus.
Upon the death of the person insured, a life insurance policy will pay out a death benefit to a named beneficiary.
These policies have many variations, however, but for the Series 7 exam, only one is considered a security and that will be our focus.
No matter the insurance type, premiums for a life assurance policy are calculated according to a few factors.
- The overall health profile of the person insured
- Their age
- Their sex
- The face value of the policy when issued
In particular, let’s highlight two types of life insurance: whole life and term life.
Whole life will last until someone either passes away or reaches the age of 100.
Those holding the policy may borrow from it to help themselves with living needs.
Whole life policies are not considered to be securities, and only an insurance license is required to sell them.
Term life provides policyholders with insurance protection for a specific term as highlighted in the policy.
These are the least expensive of all life policies but it does not build cash values, unlike a whole life policy.
If a policy is not renewed or surrendered before the death of the policyholder, it becomes nothing but an expired policy.
Now let’s move on to variable life insurance.
This is different from whole life insurance in the fact that while it also has a fixed premium that’s scheduled, this is split.
That means that some of it goes into the insurance company’s general assets.
This is done so that a minimum death benefit is guaranteed.
But what happens to the other part of the premium?
Well, that will represent the cash value of the policy for each individual holder and it’s placed in a separate account.
Note that this cash value cannot be guaranteed.
This is because the value will move up and down in the separate account where it is placed.
As long as premiums are paid by the holder, the death benefit of the policy can never drop below the minimum value.
It can increase well above the guaranteed minimum amount, however, if investment results are favorable of course.
Subaccounts where part of the premium can have various objectives, much like variable annuities.
These can include:
- Money market or
- Index objectives
Variable life insurance policy death benefits are adjusted each year.
They can either increase or decrease.
This is based on the separate accounts’ performance up against an assumed interest rate (AIR).
This describes the minimum rate of return the policy tries to generate according to the death benefit stipulated in it.
This is not a projection, however, but a target.
Note that an advantage of a variable life insurance policy is that it can keep up with a rise in inflation if the death benefit is raised.
Should the separate account generate returns higher than the AIR, the death benefit and the cash value of the policy will increase.
When the returns and AIR are equal, the death benefit will have no change.
If the returns are lower than the AIR, there will be a decrease in the death benefit of the policy but never below the amount stipulated when the policy was issued.
Purchasing annuities and settlement options
In this section of the guide, let’s cover annuities and the various purchase and settlement options available.
We start with purchasing annuities.
Annuities have various purchase arrangements to consider.
For example, if you look at aggregate fees charged, these might not only be on the front end as sales charges but when the policy is surrendered too as a conditional deferred sales load.
For most annuities, however, purchasing often has no load at all.
There usually are significant charges, however, when the policy is surrendered early, for example.
FINRA Rule 2320 stipulates that variable annuities sold by its members aren’t governed by a maximum sales charge minimum.
Having said that, FINRA also recommends that sales charges are “reasonable”.
When purchasing an annuity, an investor must specify their preferences.
For example, the payments they make to the insurance company they bought the policy from can either be made in a single lump sum should they be able to afford it or periodically.
This can be monthly, each quarter, or annually, if they’d prefer.
There are different options, however, depending on the type of annuity purchased.
A lump sum is needed to purchase a single premium deferred annuity.
The payments, however, will be delayed until the date as stipulated by the annuitant.
A periodic payment deferred annuity doesn’t need a lump sum payment but instead, will allow investments over a period of time.
The annuitant must also select a date on which the benefits are to be paid out.
And then there is the immediate annuity.
Benefits for this will pay out to the annuitant normally within 60 days but can vary and the policy itself can only be bought with a lump sum payment.
Note, for exam purposes, a period payment immediate annuity does not exist.
Some variable annuities also offer extra bonus options which are over and above what the investor has initially contributed.
Normally, a bonus annuity has surrender charges that are for a far longer length of time than those without one.
When suggesting these types of annuities to a potential investor, not only should the benefits of the bonus be disclosed but also that these additional costs will come into play as well.
Annuity settlement options
The Series 7 exam looks at settlement options for those investors who opt to annuitize although there are others available.
These settlement options below are the four we need to consider.
They are ranked in order of the largest to smallest monthly payout.
- Life annuity (sometimes called a life only or straight life annuity)
- Life annuity with period certain
- Joint life with last survivor annuity
- Unit refund option
Once annuitized, there is no going back.
The decision is considered final because the annuitants have entered into a contractual obligation with the company holding the life insurance policy.
To begin, let’s look at the life annuity in more detail.
An annuitant will be paid by the insurance company for life when they select the life income option.
Should they pass away, however, these payments will stop and if there is any money left in the life annuity, it returns to the insurer.
This will provide the biggest monthly payment option for the annuitant.
That’s because the risk of passing away early is placed on them and there is no further obligation for the insurance company should they pass away.
Then there is the life annuity with period certain.
Because it allows for payments to a beneficiary, this is considered less risky.
That is because it guarantees that a minimum number of payments will be made.
Periods for these payments will differ but are usually between 10 to 20 years and the annuitant must decide on this length when selecting a payout option.
While the annuitant will receive payouts for life thanks to this policy, should they die, these will continue for the remainder of the annuity but instead, they will go to a named beneficiary.
This named beneficiary, however, means that payments made are smaller than they would be with a straight life option.
Now let’s look at the next settlement option, joint life with last survivor annuity.
This will provide a guarantee of payments but for two lives, not one so this makes it an ideal option for an annuitant that also wants to cover their spouse.
Because there are two lifetimes covered here, the payment received is smaller than those received from a life annuity with period certain option.
Last is the unit refund option.
This will result in a minimum number of payments to the annuitant upon their retirement.
A beneficiary is named as well.
That’s because money still in the account will be paid to them should the annuitant die and the policy still be active.
Note that this option is slightly different from the other three.
That’s due to the fact it can be selected as a rider and added to them should the annuitant want to.
It’s also the only option that allows for all the life insurance contracts money to be distributed.
Variable annuities valuations
There are two phases that variable annuities move through for each annuitant.
There is the growth or accumulation phase and then the payout or annuity phase.
Depending on the contract, the interest generated – which is placed in a separate account – is known as annuity/accumulation units.
Let’s look at these two phases a little closer.
First, it’s critical to note that the accumulation stage is the period where money is paid into the annuity.
This is true for deferred annuities only and not immediate annuities.
That’s because they do not have a period of accumulation.
An annuities accumulation phase offers flexible contract terms and this means that an annuitant isn’t in danger of forfeiting any early contributions should they miss a periodic payment.
During this stage, the annuitant is allowed to terminate the contract at any point.
There are going to be surrender charges involved on the amounts they withdraw once they have done so, particularly in the first five or 10 years after it was initially signed.
Let’s quickly talk about accumulation units.
These are a representation of the share of the ownership of the contract that is kept in a separate account.
The overall value of an accumulation unit is worked out in the same way as mutual fund share value.
That value will change as the value of the securities in the separate account change.
Accumulation units all have a NAV as well.
Of course, things will change significantly during the payout phase.
In fact, there are three different taxable scenarios that we will look into.
Any amounts exceeding the investor’s cost basis on withdrawal are always taxed as ordinary income.
Let’s start with random withdrawals first.
When random withdrawals are made on annuity contracts, the last in, first out (LIFO) method is used.
In this situation, earnings are what the IRS considers to be drawn first out of the annuity.
These earnings are viewed as ordinary income and taxed in that manner.
Once all earnings have been withdrawn, cost basis contributions can be taken out of the account with no tax implications.
Only earnings are taxed when it comes to nonqualified annuities.
But what about lump-sum withdrawals?
The LIFO method is also used when it comes to lump-sum withdrawals so earnings are first removed before contributions.
Should a lump-sum withdrawal take place before 59.5 years old, the portions of earnings taken out are not only taxed as ordinary income but will also incur a 10% tax penalty in most cases.
This penalty falls away if a withdrawal takes place over the age of 59.5 for disability, death or if the policyholder has a life income plan with fixed payouts and decides to withdraw from it.
For Series 7 exam purposes, always assume annuities are nonqualified unless stated otherwise.
Also, distributions from annuities are only subject to income tax.
There is never capital gains tax applied to them, so any answer mentioning that can be ruled out.
Last, when it comes to withdrawals, we look at annuitization.
These payments which are made up of principal plus earnings, are taxed using an exclusion ratio as they are normally made every month.
A return of the cost basis defines the principal’s portion.
Because the policyholder is getting their original investment back, this isn’t subject to taxation.
Deferred earnings, however, which make up the balance of the payment left, will be taxed.
The percentage of each monthly payment that will be taxed is known as the exclusion ratio.
When a tax-free exchange happens between contracts, this is called a 1035 exchange.
It’s something that the IRS will allow without tax current liability for annuity and life insurance policyholders.
So should a life insurance or annuity policyholder even move their policy from one company to another, this can be carried out without any tax implications.
This is different from a mutual fund, for example.
While there is no sales charge, any move like this would be considered a new purchase and sale.
1035 exchanges allow for cash value transfers between:
- Annuity to annuity
- Life to life
- Life to annuity
It does not allow for a transfer from an annuity to a life insurance policy.
Variable insurance product regulation
Let’s start by looking at some FINRA rules for variable insurance products.
Variable contracts of an insurance company – FINRA Rule 2320
This highlights a major difference between funds and variable annuities as the latter does not have a maximum sales charge placed on it.
FINRA wants to ensure that the suitability of variable life insurance products is always a consideration and their sale is not misrepresented.
Remember, these are legally defined as a security.
They may never be sold solely on that premise, however.
When it comes to the overall suitability of a variable life production always remember:
- There must be a need for life insurance
- Applicants must understand how separate accounts work and be comfortable with that
- Applicants must understand that there is no guarantee of cash value
- The variable death benefit feature must be explained to the applicant and they must understand it fully
Member’s responsibilities regarding deferred available annuities – FINRA Rule 2230
Due to unethical behavior as well as failure to supervise variable annuities by those selling them, FINRA instituted this rule.
Note, however, that it only applies to deferred variable and not immediate annuities and covers recommended exchanges and purchases as well as first subaccount allocations.
It is never applied to reallocations between subaccounts, deferred variable annuity exchanges, or funds paid after purchase.
That means that investments that are made after the purchase of the variable annuity and any decision regarding subaccounts made later will not fall under this rule.
Rule 2230 also says that no deferred variable annuity or exchange should be recommended to the customer unless the member or person associated with them thinks that it is indeed a suitable product for their needs.
Let’s talk about some of the specific suitability requirements as covered by this rule.
Other than the general suitability rules that need to be applied, this rule adds that a customer is considered suitable when:
- They have been properly informed of deferred variable annuities and their features, including the potential surrender period and the charges applied to a surrender of the annuity. These fees include tax penalties on redeemed annuities before the age of 59.5, expense and mortality fees, investment advisory fees, charges for riders as well as market risk.
- The features of the deferred variable annuity would benefit the customer
- On the whole, the deferred variable annuity would benefit the customer
What about the suitability of 1035 exchanges?
Regulators have specifically cited sales personnel of variable annuities telling investors to switch from a contract they already have to a new one that they suggest.
While these are exchanged under IRS Section 103 and are tax-free when carried out properly, it is expected that the overall suitability of the investor is checked according to:
- Their financial condition
- Their financial objectives
- The overall pros and cons of switching (and the pros should be far more than the cons)
Negative factors that should flash as a warning sign that the exchange shouldn’t take place include:
- The insurance company imposing surrender charges on the variable annuity
- The start of a new surrender period
- If there is a reduction in the death benefit
- The expenses associated with the new contract compared to the old one
- Whether the benefits in the new contract are needed by the purchaser
Another consideration is known as the 36-month rule.
This too will help determine whether there already has been a deferred variable annuity exchange within the last 36 months for the customer.
This could have been made through another broker-dealer and regulations require that a reasonable effort is made.
This reasonable effort includes asking the customer.
This request to the customer as well as their answer must be documented according to the regulations.
Rules for variable life insurance as set out by the Investment Company Act (1940)
Under federal law, several specific rules apply to variable life insurance contracts.
We begin with policy loans.
Variable life insurance contracts are like traditional whole life insurance in the fact that both will allow those insured through them to borrow against the policy.
The amount they can borrow is determined by the cash value of the contract with 75% as the minimum that is made available.
Again, this is only allowed once the policy has been in operation for three years or more and a 100% loan of the cash value is never required from the insurer.
Should the policyholder pass away during the outstanding loan period, the amount they loaned from the policy is taken from the death benefit amount.
If the policy is surrendered during the outstanding loan period, the cash value that still needs to be prepared will be taken from the cash value of the policy.
Also, it’s important to understand variable life insurance contract exchange.
Once an insured person has signed a variable life insurance policy, they do have the right to exchange the contract for permanent insurance, like a whole life product.
The exchange can only be made to a whole life product that has similar benefits to the variable life insurance policy they initially signed.
So what’s the time frame allowed for this exchange to take place?
Well, this will vary, depending on the company selling the products.
Federal law, however, says it must be available for at least two years.
Should products be exchanged, the new policy will:
- Have the same contract date as the variable life insurance contract
- Have the death benefit as the variable life insurance contract’s guaranteed minimum
- Have equal premiums as the variable life insurance contract
Another rule to consider is refund provisions.
With variable life insurance products, policy owners have a free look period in which to change their minds.
This is either 10 days from the time the policy is received or 45 days from the application’s execution, whichever is the longer period.
Should they choose to terminate the policy during this period, they have every right to do so.
Any payments made will be paid back to them as well.
Note that refund provisions remain in place for the first two years of the policy although if not made during the first 45 days, the cash value of the contract and a percentage of the deducted sales charges can be refunded.
The redemption notice received by the insurer will help calculate the contract’s cash value.
Following the passing of the two-year period, all sales charges are retained by the insurer and then only the cash value will have to be refunded.
Packaged products – Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts (REITs) are another form of packaged product that the Series 7 exam will cover.
But how do they work?
Well, the portfolio managed by a REIT contains real estate investments and operates as a pooled investment vehicle with diversification options too.
Shareholders buy into this to earn income through the profits it makes and the portfolio is professionally managed at all times.
REITs act as a long-term financing vehicle for real estate projects and are similar to an investment company in the way that it pools capital.
There are three basic REITs that you should know about:
- Equity REITs: These own commercial property and receive rental income. Future sales of the property owned can result in capital gains.
- Mortgage REITs: These own commercial property mortgages and provide real estate loans. Earnings for these REITs are generated on the interest payments the loans generate.
- Hybrid REITs: This is a combination of the equity and mortgage REITs and owns both commercial property and mortgages.
As for investing in REITs, that’s possible as they are organized as a trust, the shares of which are bought and sold.
These are available for potential investors not only on stock exchanges but also on the OTC market.
While REITs offer the liquidity of listed stocks, they are in no way redeemable in the way that UITs or mutual funds are.
While they do have a NAV per unit, this is only an approximation.
That’s because when compared to the price of publicly traded stock, real estate evaluation is not an exact science.
As for pricing, well that’s determined by supply and demand because they cannot be redeemed by the issuer.
So investors can pay the same as the NAV, more than the NAV, and sometimes, less than the NAV, as is the case with CEFs.
Unless the questions on the Series 7 exam regarding REITs say differently, you can assume that they are publicly traded although nontraded REITs with limited liquidity are available too.
Why are REITs popular, and what benefits are there to including them in a diverse client portfolio?
Here are some of the benefits of REITs:
- Offer real estate investment without any real liquidity risk as they trade on the OTC and exchanges
- The properties selected for REITs are picked out by professionals
- Because the stock market and real estate prices often move opposite to each other, they have a negative correlation
- REITs offer potential capital appreciation as well as reasonable income
Of course, any investment has risks, and here are some associated with REITs:
- There is no direct control for investors over the REITs in their portfolios.
- When compared to direct ownership of real estate, REITs are for the most part more price volatile because of the influence of various conditions on the stock market.
- Liquidity is limited should the REITs not be publicly traded.
- Income and capital can decrease in a portfolio that includes problem loans
Packaged products – Direct Participation Programs (DPPs)
These investments have limited partners which are past any income, gains, or losses that the DDP might generate.
Limited partners will also receive tax benefits in the form of depreciation, depletion, and tax credits.
While limited partnerships are the DPPs you will find most often, they can occur as S corporations or limited liability companies (LLCs).
For the purpose of the Series 7 exam, the focus will only be on limited partnerships.
Limited partnership structure
For what’s covered here, the idea behind a partnership is derived from tax law.
When it comes to federal tax purposes, two or more members make up an incorporated organization should the members take part in:
- Financial operations
- Divide profits earned
A partnership is not when expenses are shared by a joint undertaking, however.
As an example, unless services are provided to tenants by co-owners of a maintained, entered, or leased property, it is not considered a partnership.
The structure of a limited partnership sees one member acting as the limited partner (LP) and the other as the general partner (GP).
Their particular roles will be expanded on later in this guide.
For federal tax purposes, an organization can be classified as a partnership should it have two or more members.
It cannot, however:
- Be referred to as a corporation or see itself as incorporated
- Be an insurance company
- Be a REIT
- A trust or other organization that receives the IRCs special treatment
Also, a business entity must not have elements such as continuity of life or other corporate characteristics to be considered a partnership.
Note that corporate characteristics might come up as a test question.
The most difficult of these to avoid is centralized management while we’ve already established that continuity of life is the easiest.
As for a DDP, the easiest to avoid are continuity of life and freely transferable interests.
Limited partnerships: Issuing of interests
It’s through public offerings or private placements that limited partnerships can be sold.
A private placement memorandum for disclosure is what investors will receive when the limited partnership is sold privately.
With these, a large sum of money is contributed by a relatively small group of accredited investors and not members of the general public.
Remember, to be considered accredited, an investor will have to meet income and net worth targets.
Public offerings, on the other hand, include partnerships that will need to be sold with a prospectus.
Here, small capital contributions generally between $1,000 and $5,000 are received from a large group of investors.
Both the selling of and partnership promotion are in the hands of an indicator as well as any tasks that need to be carried out to see that the partnership is registered.
Of course, there is remuneration that must be paid to the syndicator but this can never be more than 10% of the securities sold (their gross dollar amount).
For a limited partnership to exist, three critical documents are required.
- Limited partnership certificate
- Partnership agreement
- Subscription agreement
Let’s look at all three of these a little closer.
We start with the limited partnership certificate which must be filed in the partnership’s home state.
It will include the following:
- The name of the partnership
- The business the partnership is involved in
- The place of business of the partnership
- How long the partnership will be in business for (an estimate)
- The conditions that must be reached for the partnership to dissolve
- Current and future sizes of LP investments
- If set, the contribution return date
- Compensation or share of the profits afforded to each LP
- LP assignment of ownership interest conditions
- If other LPs may be added to the limited partnership
- If at death or incapacity of a GP, the remaining GPs are allowed to continue with the business
The partnership agreement is a document drawn up and given to all partners.
The role of the GPs and LPs in the partnership, as well as the operation guidelines, are the main aim of this document.
Lastly, the subscription agreement is a document that must be completed by investors who want to become LPs.
With this agreement, a GP – and in some cases more than one – will act on the behalf of other investors.
The subscription agreement must – along with the subscribers’ money – include:
- The net worth of the investor signing it
- Their annual income
- A risk statement in which the investor conveys that they understand the risk involved
- A power of attorney which makes the GP the partnership agent.
Responsibility will need to be assumed too by subscribers.
This is for the portion of the loan – called a recourse loan – that was made to the partnership.
That’s not the only way partnerships use loans, however.
Another way is via a nonrecourse loan.
The difference with these, however, is that they need to be repaid by the GPs of the limited partnership and not the LPs.
Dissolving a limited partnership
The partnership is normally liquidated on a specific date.
This will be outlined in the partnership agreement.
That doesn’t mean that it cannot be shut down earlier.
This can happen if the assets are sold or if a decision is taken to dissolve the partnership earlier.
This can only be made by those LPs who have a majority interest in the partnership.
Should a partnership be dissolved, the first thing that happens is that the limited partnership certificate is canceled.
From that point, accounts must be settled.
There is an order for that, however:
- Secured lenders
- All other creditors
- LPs: A claim to the shares of profits as well as claims for contributed capital to be returned
- GPs: They are paid claims and other fees that aren’t profits first followed by a share of profits and finally, capital return.
Limited partnership investors
We know that in a limited partnership, there are two investor types: GPs and LPs.
Let’s look at both of these in greater detail starting with GPs.
Here’s a breakdown of what you need to know about them:
- GPs have unlimited liability but personal liability for any debts or losses incurred by the partnership
- GPs have management responsibility. That means that the operation of the partnership is handled by them
- GPs have a fiduciary responsibility. That means they must ensure that the best interests of investors are taken into account with all decisions made regarding invested capital. In fact, they are morally and legally bound to do so.
Now let’s look at a breakdown of what you need to know about LPs:
- LPs have limited liability. If the limited partnership is liquidated, for example, LPs cannot lose more than what they’ve invested.
- LPs have no management responsibility. They are passive investors that cannot participate in the management of the company but do provide capital for it.
- LPs and their limited liability states is put at risk should they try to engage in a management role
- LPs have the power to act against GPs if they consider them to have used assets in an improper manner or if they feel they are not acting in the best interests of the limited partnership.
Now let’s look at the activities that are allowed for LPs and GPs.
An LP in a limited partnership can:
- Vote: For example, should a new GP be added to the limited partnership, LPs get to vote on that first. They can also vote when it comes to partnership investment objectives. They can also vote on other issues, for example, the sale of property belonging to the partnership.
- Get paid: LPs receive capital gains, cash distributions as well as tax deductions
- Inspect: LPs are able to look at all records regarding the partnership as well as their financial records and books.
- Exercise their right to special votes: Sometimes special circumstance votes must be made by the LPs, for example, allowing GPs to act in a manner that’s contradictory to the limited partnership agreement.
A GP in a limited partnership can:
- Make decisions: The overall running of the partnership will see GPs given the power to make legally binding decisions that affect it
- Buy/sell: Property acquisition or the refinancing thereof, for example, is a task that GPs are tasked with
- Hold a financial interest in the partnership: This has to be a 1% minimum
- Be compensated: The partnership agreement will specify how GPs will receive compensation due to them
What about those activities that aren’t allowed for both LPs and GPs?
Well, an LP in a limited partnership cannot:
- Take part in the management thereof or act on its behalf
- Sign certificates they know includes untrue information
- Include their names in the partnership’s name
As for a GP in a limited partnership, they cannot:
- Make any personal gains by competing against the partnership
- Use the partnership to borrow money from
- Place personal assets or assets from other partnerships together with partnership funds
- Admit other GPs or LPs that are new to the partnership unless the partnership agreement says they can
Types of DPPs
While there are various types of DPPs, there is one thing they have in common.
That’s the fact that they are a business that is raising capital via a limited partnership structure.
Here are some examples of the types of DPPs you might be questioned on in the Series 7 exam.
Real estate partnerships
Without a doubt, this type of DPPs is the one that you will come across most often.
There are five distinct kinds of real estate partnerships, each with its own particular focus, for example, those that offer income, those that offer growth potential, and those that offer a little bit of both.
There are five in particular that we cover:
- Raw land
- New construction
- Existing property
- Government-assisted housing programs
- Historic rehabilitation
Let’s break these down even further, starting with raw land.
- Objective of the partnership: Buy underdeveloped land that has significant potential for appreciation
- Advantages: The major advantage of the DDP comes in the property and its appreciation potential
- Disadvantages: A DPP like this has no income distributions or tax deductions
- Tax features: It is not considered a tax shelter, while there are no depreciation or income deductions
- Degree of risk: This real estate partnership is considered to be the most speculative
Next is new construction.
- Objective: New property construction with potential appreciation in mind once constructed
- Advantages: Minimal maintenance cost for the first few years, property and structure has appreciation potential
- Disadvantages: Building costs going over budget, during construction the current expenses cannot be deducted, permanent financing is difficult to find
- Tax features: After construction depreciation and expense deductions are possible. Income is generated as well
- Degree of risk: While it’s riskier than investing in an existing property, it is less risky than buying new land
The third option we look at is existing property.
- Objective: Purchase an existing property to create an income stream
- Advantages: All income and expenses history is known. There is an immediate cash flow for investors
- Disadvantages: Repair and maintenance expenses are higher than they would be when compared to new construction. There are also rental agreements that may be less favorable and the chance that leases that expire are renewed.
- Tax features: Depreciation and mortgage interest deductions
- Degree of risk: Very low
Then we have government-assisted housing programs.
- Objective: Retirement and low-income housing development
- Advantages: Rent subsidies as well as tax credits
- Disadvantages: Maintenance costs are high, appreciation potential is low, risk of changes in government programs
- Tax features: Offers both tax losses and credits
- Degree of risk: Very low
Lastly, it is historic rehabilitation.
- Objectives: Historic sites developed for commercial use
- Advantages: Historic structure preservation tax credits
- Disadvantages: Building costs going over budget, during construction the current expenses cannot be deducted, permanent financing is difficult to find
- Tax features: Both tax deductions and credit for depreciation and expenses
- Degree of risk: Risk is on the same level as new construction
Oil and gas partnerships
These DPPs not only invest in oil-producing wells but also in speculative programs that drill for oil and gas.
There are three types of these DPPs:
First up is exploratory which is also known as wildcatting.
- Objective: Look for oil or gas reserves that haven’t been discovered yet
- Advantages: New reserves discovered mean high rewards
- Disadvantages: New discoveries might not be that expansive and produce little
- Tax features: Immediate tax sheltering for high intangible drilling costs
- Degree of risk: This is the riskiest of all oil and gas DPPs
The second is developmental.
- Objective: Discover new oil and gas reserves by drilling near existing fields
- Advantages: Far less chance of discovery risk when compared to the exploratory option covered above
- Disadvantages: New wells might produce little
- Tax features: Immediate tax sheltering, medium intangible drilling costs
- Degree of risk: Medium to high risk
The last option we look at is income.
- Objective: Existing oil sales will generate income immediately
- Advantages: Cash flow begins immediately
- Disadvantages: Fluctuating oil prices and wells don’t produce forever
- Degree of risk: Risk is low
Equipment and leasing programs
The final DPP we look at is those that are equipment and leasing programs.
This takes the form of equipment purchased by the DPP which is then leased out to other businesses.
The lease payments then generate income for the investors.
They will also receive income for a proportional income share.
This relates to interest expenses, write-offs from operating expenses, depreciation, and more.
With equipment and leasing programs, a tax-sheltered investment is the primary objective.
Partnership investments and issuing them
There are two ways that DPPs are offered:
- Private placement
- Publicly registered
As a private placement, under state and federal law, they qualify for exemption from registration.
Publicly registered DPPs are either registered with the SEC, the state in which they operate, and in some situations, with both.
Private placements are where you will find most sold, however, and if a private sale does take place, it’s normally only an accredited investor that may make the purchase.
DPPs differ from other securities in the fact that subscribers have to accept sales made.
In other words, an investor might be interested in buying into the DDP as a GP, but that doesn’t mean they will be accepted.
Often wholesalers handle the sales of the offerings too.
These are firms (but sometimes individuals) that are the go-between between the broker-dealer and the issuer.
What are the tax ramifications for investors who look to DPPs?
Well, that’s what we intend to get into in this section.
To start, always remember, buying into a DPP is investing but it just doesn’t involve the purchasing of stock.
The partnership structure of DPPs has tax advantages too.
For example, the flow-through of income or loss immediately stands out.
Here are some DPP tax concepts that are considered important:
- In the past, DPPs were known as tax shelters. This is because losses were used by investors to shelter or reduce ordinary income. This was carried out by taking ordinary income and writing off passive losses against it.
- Income and loss from DPP investments are now classified as passive income and loss under revisions to tax laws. These laws now only allow passive income sheltered by passive losses and not all ordinary income. This change caused many DPPs to lose their overall investing appeal.
- Note that passive income is not seen to be earned income when it comes to IRA contributions
- Abusive tax shelters are programs the IRS considers to have no economic viability. This can result in severe penalties for those promoting them.
The biggest tax advantage of a DPP is flow-through.
This sees all the businesses’ economic consequences move straight through to those who have invested in the DPP.
Because they take a passive role in the DPP, all losses and income generated will be passive.
Remember, a DPP is not like a corporation that will pay investors dividends.
There is none of that here.
Income, losses, gains, deductions, and credits are passed straight on to investors.
Now let’s look at taxation as per the different types of DPPs.
First up, we look at taxation for real estate programs.
DPPs that incur a loss, can be used to save on taxes but also to offset any passive income.
When it comes to a real estate program, there can be several expenses that will contribute to the tax losses.
- Interest expenses on mortgage
- Depreciation allowances
- Property improvement expenses
Real estate programs have two unique benefits as well:
- Nonrecourse debt. This is affixed to the investor’s cost basis.
- Tax credits: These form part of historic rehabilitation and government-assisted housing projects. This lowers dollar-for-dollar tax liability.
What about taxation for oil and gas programs?
There are a few tax advantages that are unique to these DPPs.
These include those related to drilling costs as well as depletion allowances.
Intangible drilling costs (IDCs) are those that have no salvage value once they have been incurred.
Write-offs during the first year of operation are normally 100% deductible.
This covers a wide range too, including fuel costs, supplies, wages as well as insurance.
Tangible drilling costs are those that have salvage value once they are incurred.
An excellent example of this is equipment such as storage tanks or drills.
These costs cannot be deducted immediately but will depreciate over time and are then taken off over a period of several years.
There is also a depletion allowance.
This is related to the oil or gas source with the IRS allowing these allowances as they are depleted.
This allowance takes the form of tax deductions as a way of compensation and can only be taken once oil or gas is sold.
Depletion allowances come in two types, cost and percentage.
You wouldn’t have to know how they work for the exam, however, just their names.
A depletion allowance is found in other natural resource-based DPPs as well, like those for timber and mining.
Last in this section, we look at arrangements for oil and gas sharing.
There are many ways that the costs for these programs can be shared including:
- Overriding royalty interest: While there is no partnership risk associated with this, the holder will receive royalties. An excellent example of this is someone who has sold a partnership mineral rights to a piece of land that they own
- Reversionary working interest: With this, LPs will be responsible for deductible and non-deductible costs. Until LPs have recovered any capital invested, GPs will receive no revenue. They won’t have to worry about program costs either.
- Net operating profits interest: Only available in private placements. With this, LPs will be responsible for deductible and non-deductible costs. GPs can receive a percentage of net profits but don’t have to worry about sharing in any program costs.
- Disproportionate sharing: Here GPs will bear a small part of expenses. For that, however, a large part of the revenues are reserved for them too.
- Carried interest: While they don’t receive IDCs, tangible drilling costs are shared by the GP and the LPs. While immediate deductions are received by the LPs, GPs get depreciation write-offs.
- Functional allocation: Of all the sharing arrangements we’ve covered above, this is the most common. Here, IDCs are received by the limited partnership. This means that immediate deductions are allowed. As for revenues, well they are shared and tangible drilling costs go to the GP.
Tax characteristics pertinent to all DPPs
Limited partnerships are allowed to apply tax credits and deductions which we will cover below, starting with business deductions.
The current year’s deductions that are taken off the income of the business include the likes of partnership expenses, interest payments, management fees, and salaries but not principal payments made on property.
Note that cost recovery systems are put in place that, using defined IRS schedules, will offer write-offs covering a certain period, which is usually a number of years.
Those that apply to cost recovery of real estate (not land) and expenditures for equipment are known as depreciation write-offs.
As we mentioned earlier, should the limited partnership be involved with natural resources, a depreciation allowance covers the natural reduction that occurs of that resource over the years.
When income is produced by the partnership, that’s the only time it can claim depreciation and depletion allowances.
Renewable assets cannot be depleted or depreciated.
That’s because they return – think of farm crops, for example.
Next, we look into what is known as tax basis.
This relates to the deductibility of losses and represents the upper limits thereof.
Tax basis must be tracked by LPs which effectively is their amount at risk.
That’s because it’s used upon the sale of their partnership interest to determine gain or loss.
Cash distributions and other additional investments will mean that, from time to time, the investor’s basis will be subject to adjustments.
When it comes to LPs, their basis will be made up of:
- Cash contributions they have made to the partnership
- Property contributions they have made to the partnership
- Partnership recourse debt
- Nonrecourse debt (only in real estate partnerships)
But how do you compute tax basis?
Well, there is a formula to follow:
Tax basis = investment in partnership + share of recourse debt (plus non recourse debt for real estate DPPs) – cash or distributions.
The beginning basis will not be affected by an investor’s incurred upfront costs (like broker-dealer commission, for example).
What happens, however, when a partnership interest is sold?
Well, the difference between the adjusted basis at the time the sale is made and the sales proceeds would be the gain or loss made.
Should the customer have unused losses at the time of sale, the cost basis will see these losses added.
Let’s move on to tax filing requirements for DPPs.
As everything flows through to investors, limited partnerships do not file a formal tax return.
They do, however, use Form 1065 to file an information return.
This also sees partners receiving a Schedule K-1 that indicates their amount of income or loss.
At no point will the business entity pay tax.
Evaluating the DPP
Before suggesting a DPP to an investor, it has to be evaluated thoroughly.
As a start, answer these two questions.
Does the partnership that you are suggesting match up with the investor’s investment objectives?
Does the DPP offer economic viability?
In other words, is there a potential for returns either from capital gains or cash distributions?
Tax benefits are also something to consider, but that’s lower down the ladder when it comes to the overall evaluation of the DPP.
Determining the overall economic soundness of a DPP
The economic soundness of a DPP is one of the most critical parts of the process of evaluation.
To measure it, two methods can be used:
- Comparing revenues (income) to expenses through a cash flow analysis
- Finding the present value of revenues generated in the future as well as sales proceeds through an internal rate of return. This can then be compared against other DPPs.
We will begin with cash flow.
This is a pretty easy-to-understand concept in the world of finance.
It’s simply the net income or loss of a company with non cash charges (depreciation, for example) added.
When working out cash flow, a company (or DPP) will either show a net profit or loss.
Depreciation does make a difference when added back in, however.
So what might look like a negative cash flow through a net loss could turn out to be positive when depreciation is added back in, so bear that in mind.
Let’s move on to the internal rate of return.
Also known as the IRR, this is classified as a discount rate.
It will make the investment’s future value equal to its value presently.
The exam won’t expect you to know any IRR calculations.
Just know that this is often a method favored to evaluate DPPs and is considered the time value of money in doing so.
Other factors to consider in evaluating DPPs
Let’s look at other factors that should be considered once you carried out the two mentioned above:
- GPs experience in running DPPs similar to the one being evaluated
- The overall management ability of the GP
- Is it a blind pool or a specific program? A blind pool allows less than 75% of assets to be used while a non-specific program it’s at least 75%
- The overall timeframe of the partnership
- Startup costs and revenue projections when compared to other similar DPP ventures
- Interest liquidity
Because of how they operate, not all investors are going to be interested in DPPs.
That’s why it’s always critical that the fact that they don’t offer liquidity could be a determining factor as to whether they are the right kind of investment.
There are many advantages that DPPs bring to those that invest in them including:
- It’s others that manage the investment
- Flow-through income
- Limited liability
As for disadvantages, the Series 7 exam might focus on a few including:
- The liquidity risk of DPPs. When it comes to a secondary market for DPPs, well that’s limited. If investors want to sell their interest in the DPP, locating a buyer might take a fair amount of time. That lack of overall liquidity is often a reason why some investors look elsewhere.
- The legislative risk of DPPs. Tax laws change and that can (and has had) an effect on limited partnerships.
- The leverage risk of DPPs. Many DPPs make use of borrowed funds. While this may boost returns, when a loss occurs, it can boost them too. Should a partnership choose to make use of recourse debt, then the risk grows even more.
- The risk of audit. DPPs are often audited by the IRS
- Depreciation recapture. We’ve seen that DPPs allow for the accelerated depreciation of most fixed assets. In fact, it’s one of the major tax benefits that they offer. The overall tax basis of the asset is lowered by a depreciation deduction. But when the asset is sold and the money earned is more than the basis, the excess earned is subject to tax as it is recaptured.
The sale of DPPs are subject to certain rules and regulations.
We begin by taking a look at those from FINRA.
FINRA DPP rules
The main FINRA rule that covers DPPs is Rule 2310.
The overall suitability of the DPP is the basis for this rule and it says that they all need a prospectus with the stated standards of suitability as part of it.
When recommending a DPP, a member firm must evaluate the program so that it meets the investment objectives of the customer.
They need to evaluate the customer too and see that:
- Their position will take advantage of DPP-generated tax benefits (if any).
- Their net worth can handle an investment loss and other DPP risks
Documents need to be maintained should the member firm pass the investor as suitable for the DPP and how they came to this reasoning must be kept on file.
The rule also states that any transactions from a discretionary account can only take place if the customer of the member firm has given written consent.
Rule 2310 also covers compensation restrictions for DPPs.
In doing so, it looks at overall expenses as well as the broker-dealer compensation amount that’s considered to be fair and reasonable and places limits on them.
Offering expenses cannot exceed 15% of the gross proceeds as anything higher than that is what FINRA wants.
As for compensation for the member firm, that must be 10% or below the gross process of the DPP and it includes compensation to wholesalers as well.
There are DPP roll-ups as well that Rule 2310 provides guidelines.
These are transactions where a limited partnership (or partnerships) are reorganized or combined into securities of the successor corporation.
This could be attractive to investors as illiquid DPPs are turned into a security that offers more liquidity.
The proposed roll-up transaction will need disclosure documents that:
- List all possible risk factors
- Show the GP believes the transaction to be fair
- Include options, reports, and appraisals that the GP has received regarding the transaction
It’s considered to be fraud if adequate disclosure of negative opinions regarding the transaction are not provided by the financial adviser or investment banker handling the roll-up.
FINRA rules also state that votes cannot be solicited from LPs by member firms related to the proposed roll-up unless:
- Member compensation received would be equal notwithstanding LPs vote yes or no to the rollover
- Member compensative received is not more than 2% of the value of the securities received when the exchange happens
Packaged products – Options
Understanding options can be one of the more difficult parts of your preparation for the Series 7 exam.
It will cover questions on equity options (options on stock) for the most part but some will delve into nonequity options too.
These will include foreign currency contracts, interest rates, and indexes, for example.
But what is an option?
It’s critical that candidates have an understanding of what this term means.
Well, like the way it would be used in the English language, in finance, options provide a choice.
That choice is twofold: buy stock or sell stock.
It’s an option contract that will provide the details behind that choice, for example, who are you buying stock from or selling it to at what cost.
It’s a simplified way of looking at things, but it’s a great way to remember what options are all about.
The basic characteristics of an option contract
There are two parties involved in any option – a buyer and a seller.
In fact, an option is a contract between the two.
This contract will convey an obligation to the seller and a right to the buyer.
These contracts are standardized.
This is according to the terms as laid out by the Options Clearing Corporation (OCC).
Because of this standardization, all options can be traded with relative ease.
As we know, they are traded on exchanges, an example of which is the Chicago Board Options Exchange (CBOE).
A number of underlying securities from which these contracts originate include the following:
- Stock market index
- Foreign currency
- Interest rate
- Government bond
Because their value is derived from the value of the stock, index, foreign currency, or any other underlying instrument, options are also known as derivative securities.
Option contacts that are the most frequent are equity options.
Here each contract accounts for 100 shares of the underlying stock.
Note that the CBOE is by far the biggest exchange for options and the first to offer them.
While most options contracts will represent 100 shares as mentioned above, the CBOE does offer mini-option contracts.
Instead of having 100 shares per contract, these have 10.
Let’s look at some information about the two parties in an option contract: the buyer and the seller.
First, we have the buyer.
Well, in the world of option securities, these are also known as the holder, owner, or long.
Obviously, the buyer will pay the cost of the contract to the seller of the option.
This is also known as paying the premium and when this happens, their account is debited.
With that debit to their account, a buyer is said to have opened their position.
The buyer is also said to have the right to exercise.
This means they can not only sell stock but buy it too.
Second, we have the seller, also known as the writer or short.
When purchasing an options contract, they are said to be receiving the premium from the buyer.
When this happens, there is a credit that appears in their account and a seller is said to open their position.
When a contract is exercised, a seller is said to have obligation.
As for options contracts, there are three specifications that will be found in all of them.
- Underlying instrument: This is anything with a value that changes (or fluctuates). Common stock is the main focus as an underlying instrument for this section of the guide.
- Price: The sale of the underlying security as specified in the options contract will take place at the strike price, also called the exercise price.
- Expiration: All contracts will expire on a specified date and have a life cycle. It can only be bought or sold during the time of that life cycle. For example, standard contracts last for nine months while long-term equity anticipation securities (or LEAPS) will expire after 39 months.
There are three things by which options are categorized:
- Type: Options come in two types – calls and puts
- Class: Options on the same underlying security and of the same type are therefore classified in the same class.
- Series: Options are in the same series when they are of the same class, have the same exercise price and expiration month.
What we need to focus on now, in particular, are the two types of options – calls and puts.
Let’s start with calls.
The terminology is important when dealing with calls.
Investors can “go long” and buy calls or “go short” when they sell (write) them.
- Long call: The buyer of a call has the right to purchase 100 shares of a specific stock before the expiration date and at the strike (exercise) price. The option owner can also sell it if they prefer.
- Short call: The seller or call writer can sell 100 shares of stock at the strike price as soon as the buyer exercises on the contract.
What about puts?
Investors can “go long” when they buy puts or “go short” when they sell them.
- Long put: The buyer of a put has the right to sell 100 shares of a specific stock before the expiration date and at the strike (exercise) price. The option owner can also sell it if they prefer.
- Short put: The seller or put writer is obligated to buy 100 shares of stock at the strike price as soon as the buyer exercises on contract.
When it comes to options, it’s the buyers that are in control.
That’s because they can choose whether to exercise on an option or not to exercise on it and it’s the main reason as to why premiums are paid by buyers.
When the buyer makes a decision, options are then exercised against the writer.
At no point can a writer choose to exercise.
- An exercised contract is what a buyer is aiming for. When this happens, the seller loses at the exercise and the buyer wins.
- An expired contract is what the seller wants because in this way, the premium is kept and no purchase of stock is required.
The Series 7 exam will include plenty of questions that cover the rights of buyers and obligations of sellers.
Opening and closing positions
Both the order ticket and confirmation are marked either with Opening Purchase or Opening Sale when an investor establishes the option position by buying (writing) puts or calls.
The first step – to open – is the key here.
If a customer buys an option, he can then choose to sell it at any point before the expiry date.
If the customer does choose to do that, this is known as the closing sale.
This leads to the confirmation and ticket memorandum to have the Closing Sale mark added to it.
An option can be bought back by a customer too.
If they sold as an opening transaction, before the option expires, they choose to buy it back.
When this happens, the ticket and confirmation will be marked as a Closing Purchase.
That’s the name of this transaction type as well.
Often, the price of the closing transaction is not the same as the opening transaction for an investor.
That’s because the underlying stock’s price will change during the life of the option.
This means that the difference between paid premiums and those received on closing transactions will show gains or losses.
Should options be bought and sold, the next day is when settlement must take place.
In the securities industry, this is known as T+1.
Settlements for options are quick because there are no certificates for them, unlike you will find with stocks and bonds.
So should an investor purchase an option on a Wednesday, that option will have to be paid for by the end of the business day on Thursday.
As for the investor selling the option, they would receive the funds for doing so at the end of business on Thursday as well.
When it comes to proof of ownership, it’s possible without a certificate.
That’s because the investor can prove ownership of an option thanks to the trade confirmation.
Role of the OCC
We’ve already spoken briefly about the OCC but let’s expand a little on the role they play as the issuer of listed options contracts.
Owned by the exchanges on which options are traded, the main aim of the OCC is threefold:
- It standardizes option contracts
- It helps to undertake to ensure the performance of options contracts
- It deals with the issuing of options contracts
It has other functions too.
For example, it will:
- Decide when the market will be offered new options contracts
- Take new contacts issued within market standards and place strike prices and expiration dates on them. This helps to ensure uniformity but also helps to maintain liquidity.
What the OCC won’t do is determine what the option premiums are.
In a traditional market, that’s established by supply and demand.
The exercise of option contracts is one of the most important undertakings of the OCC.
In other words, the OCC will perform should a seller not be able to for any reason.
A broker-dealer will notify the OCC when the holder of an option wishes to exercise on it.
The exercise notice is then assigned by the OCC against the broker-dealer of the customer with the written option.
That exercise is assigned as a short position by the broker-dealer.
Let’s talk a little more about the assignment of exercise notices.
Investors who are the holder or owner of an options contract and who are said to be long on it have the choice of where they will exercise that option.
Should it be a call, they instead can exercise the right to buy it.
If they do, that purchase is at the strike price.
The OCC will select a firm that holds a short position in the option when they are notified by a broker-dealer that one of their customers wants to exercise.
The randomly selected firm is then assigned the exercise and chooses from its clients as to who will be obligated.
So how do customer notifications and allocations work?
Exercise assignments are allocated in three ways by broker-dealers.
- First in, first out (FIFO) method
- Other methods deemed to be fair and reasonable
Options customers have to be notified of the way that the broker-dealer allocates exercise notices.
This is known as the notification of allocation method.
Often tried but not considered to be a fair and reasonable way in which exercise assignments are allocated is by choosing a writer because of the size of their position.
The client with the largest short position can’t deliberately be chosen even though they may have written hundreds of contracts before.
That said, even with random selection in place, they do stand a higher chance than a client who is short one contract, for example.
Finally, for this section, let’s talk about delivery after exercise.
Settlement must be made between the two parties following the exercise of an option.
From notification of the exercise, the writer (or assigned party) must:
- Within two business days deliver the stock (for a call), or
- Buy the stock (for a put)
As with any stock trade, this uses the same T+2 settlement.
But earlier, we mentioned T+1, so what’s going on here.
Well, when it comes to settlement dates, the Series 7 exam will try to confuse you.
For equity options that are bought or sold it is the next day or T+1.
When an equity option is exercised, however, it’s regarded just like any other transactions with equities and that sees a T+2 settlement date.
So remember T+1 when equity options are bought or sold and T+2 when it is exercised.
Knowing that an option is fairly priced is something that’s important to investors.
So what factors that investors evaluate that play a role in the price of options contracts?
Well, let’s take a look.
For most, this is the most critical aspect of valuing options.
There are several terms related to intrinsic value that make it possible to understand what it is all about
We start with the term, in the money.
When the underlying asset exceeds the strike price of the option, the call is said to be in the money. This is something a buyer but not a seller, wants.
Note that this doesn’t refer to the investor but the option.
With a put option that’s in the money, the underlying assets market price is less than the option’s strike price.
In general, the benefit of contracts that are in the money goes to buyers, not sellers.
What about a call or put that is at the money?
In this situation, the underlying assets market price and the strike price are equal.
The next term is out of the money.
When the underlying asset’s market price is less than the option’s strike price, it is said to be out of the money.
Calls that are out of the money at expiration will not be exercised by buyers.
Sellers like this situation because they keep the premium when the options expire.
Should it expire, they have no obligations to perform either.
When the underlying asset’s market price is more than the option’s strike price, it is also out of the money.
As with calls, puts that are out of the money will not have buyers exercise them.
Any contracts that are out of the money are a major benefit to sellers.
What you would have noticed when we looked at both of these terms is the fact that puts and calls act in opposite ways to each other.
A call in the money sees the stock’s price increase.
In that situation, by the exact same amount, a put will be out of the money.
So when the stock price rises, a call is beneficial to the owner.
When the stock price goes down, a put is then beneficial to the owner.
Let’s revisit the term intrinsic value again.
When a contract is in the money, its intrinsic value is the same amount.
When the market price of the stock is higher than a call’s strike price, then it has intrinsic value.
Options on the other hand see their intrinsic value as either zero or a positive amount.
It can never be a negative value.
When at the money or out of the money, the intrinsic value of an option is zero.
While sellers don’t want calls to have intrinsic value, buyers do.
Should an option have intrinsic value come expiration, the buyer is likely to exercise or sell it.
If not, the most likely scenario is that it will expire.
In summary, the lifetime of an options contract sees a buyer wanting it to stay in the money while a seller wants it to be out of the money.
Our second component that helps to value options is time value.
Simply put this is the time that’s left before the option will expire.
A time value of zero is therefore reached when the option gets to its expiration date.
The longer an options contract has to its expiration date, the more time value it is said to have.
On the Series 7 exam, you might be asked how to compute the time value.
Well, when an option’s premium is more than its intrinsic value, it has time value.
What the seller will accept and what the option buyer will pay over its intrinsic value is time value.
So the further it is away from the expiration date, the underlying stock has more time for price changes.
Buyers will therefore pay more for option contracts that are far away from their expiration dates than those that are close to expiring.
Below are three simple points to remember for the Series 7 exam:
- The amount that an option is in the money is its intrinsic value
- The time remaining to expiration and the market’s perceived worth thereof is time value
- Premium – intrinsic value = time value (PIT)
There’s another term that you should understand as it may appear in the exams and that is time decay.
This signifies the diminishing of time value as the expiration date of the option approaches.
When the last day of trading before expirations gets underway, time value for the option is no longer present.
When this happens, in most cases, the intrinsic value equals the premium.
Trading at parity
When the premium of an option is equal to the intrinsic value of the contract, it is said to be trading at parity.
Usually, this will occur before the expiration date of the option.
Basic single option strategies
There are several basic strategies – the reasons why investors will buy or sell options – that will appear in the Series 7 exam.
In this section, we are going to identify those that you will need to understand.
Options investors have four basic strategies available to them:
- Buying calls
- Writing calls
- Buying puts
- Writing puts
Those who buy calls are wanting the underlying stock’s market price to go up.
Should it reach the strike price, the investor who owns the call can buy it back at that price.
This holds true even when the market price climbs higher.
Those who sell calls are wanting the underlying stock’s price to either stay the same or fall.
Should the market price not rise above the strike price, the contract is not exercised at expiration
The seller (writer) will hold onto the premium with no obligation.
Take note that the buyer, who wants the market to rise, is considered to be the bullish investor.
The writer (seller) who wants the market to fall is considered to be the bearish investor.
As always, only one side can win.
So if the buyer makes a certain amount when the stock price rises, that’s the same amount the seller is losing and vice versa.
Long option call strategies
When an investor buys calls, they will make money if there is an increase in the stock’s price.
You don’t need to invest vast amounts of money to do so either.
There are other reasons why investors look to buy calls.
Let’s look at speculation as it’s the main reason why investors buy calls.
By only paying the premium, an investor can then speculate on the stock price moving upwards.
It’s a far bigger investment to buy the actual stock.
This is considered leverage.
There’s the option of deferring a decision too.
For example, investors can lock in the purchase price when they’ve bought a call on a particular stock.
That purchase price is locked in until the option expires.
That means no financial commitment has to be made until that happens.
All the investor has to pay is the premium.
This is an option for investors that know that in the future (before the expiration date of the option they are locked into) they will have funds available to them to make the purchase.
Another reason why investors buy calls is that they can diversify their holdings.
It doesn’t take too many funds to do so either.
For example, an investor can find various stocks, buy calls on them, and should there be a rise in the options premium, they could make a profit on them.
And then there is short stock position protection.
This can be achieved through the use of calls.
In this way, the option will act as an insurance policy against price rises in stocks.
When investors short stock, they will lose as soon as stock prices go up and as there is no limit to how high these prices can go, theoretically, there is no limit on losses as well.
But investors can protect (hedge) against these potential losses by buying a call on the stock.
This gives short sellers knowledge of how to cover their short stock position in terms of how much they would have to pay to do so.
Short call strategy options
When it comes to the price of underlying stock, call writers are said to be bearish.
When investors think the price of a stock will stay the same or decline, they will write calls for the following reasons.
First, it’s covered versus uncovered call writers.
Let’s first confirm that covered and uncovered call options can only be linked to short calls.
But what does it mean when a call option is covered?
Well, simply put, when you look at the options contract, the investor owns the number of shares covered by it.
So if the writer is selling two contracts, the writer’s account will have 200 shares of stock.
The option therefore can be covered at no cost by a security convertible into the right number of shares instead of having the stock itself.
Convertible debenture and preferred stock can be included in this.
Uncovered call options occur when they are written by an investor who does not own the underlying stock or related assets that, should the option be exercised, would need to be delivered.
This is sometimes called a naked write.
Options sellers have an obligation and it’s something that the OCC wants to ensure.
So if an option is exercised, the OCC wants writers to be able to perform.
The obligation with a call is simple – deliver the stock.
That’s easily met if the writer has the stock.
But with an uncovered option, there is no form of protection.
Should that happen, the seller must make a specified cash deposit so funds are available to buy and deliver the stock should the need arise.
There is the chance of unlimited potential risk for naked call writers.
Selling uncovered call options as well as selling stock short are two investment strategies that cover the most risk.
Both are important to know for the Series 7 exam.
Next, let’s look at increasing returns.
Whether they are naked or covered, there’s no doubt that a major income strategy takes the form of writing options.
With covered options, any dividend on the underlying stock is added by the premium which means a portfolio can create even more income.
Investors can then keep the premiums if there is an expiration of the calls and that’s something that they hope does happen.
There is speculation too.
If a stock’s price stays the same as the strike price or drops below it, investors who write calls can make a profit.
That’s because, if this happens, a premium will be earned.
This is the main strategy used by those who opt for uncovered writing.
The next strategy is locking in a sale price.
This is about trying to lock in a profit.
This is possible if the investor’s stock has unrealized gains and they are willing to sell it.
If that’s the case, a call written at the exercised price is the best way to attempt this.
Our second last short call strategy option is the protection of a long position.
Limited downside protection is achieved from the premium gained from writing a call.
That protection is only to the extent of the premium realized.
Lastly, we have ratio call writing.
This encompasses looking at what the long stock position covers and then selling more calls than that.
Because of short uncovered calls, this entails unlimited risk but it can also lead to extra income through premiums for investors.
Long put option strategies
When it comes to underlying stock, put buyers are said to be bearish.
When purchasing puts, a decrease in the price of the stock means an investor can profit.
That profit can come with a small amount of money invested as well.
Below, we look at some of the reasons as to why puts are purchased by investors.
We start with speculation.
By paying the premium only, an investor can speculate on prices moving downwards on the stock.
When the stock’s market price moves lower than the strike price, a profit may be in store for the buyer as the option is now in the money.
When compared to selling a stock short, this is a low-risk alternative.
There’s also deferring a decision.
Here investors can lock in a sale price when they’ve bought a put on a particular stock.
This means that they can wait until the expiration date of the option before making a selling decision.
This strategy not only protects the appreciation potential of a stock until its expiration date but also locks in acceptable sale prices for the stock an investor owns.
There are tax benefits to using this approach as well.
Last, we cover protecting a long stock position.
Puts can be used by investors to do this and options are an insurance policy against declining stock prices.
When it comes to a long stock position, this is an excellent hedge.
That’s because, it doesn’t matter how far the market price of a stock falls, for the premium’s cost the investor who holds the stock can sell his position at the strike price.
Short put options strategies
To start, we first need to understand what a covered and uncovered put option is.
With covered puts, there is a similarity to covered calls.
One difference, however, is the fact a short stock position and a long one is the covering equity position.
Puts can be covered in two ways:
- First, with the stock underlying the short put and taking a short position in it
- Second, with a cash covered put
The put writer’s obligation is to pay the exercise price to the holder and this can only be achieved with money.
Should that money be needed, a deposit of the cash to cover the exercise price can be made into the account of the writer.
When it comes to the price of underlying stock, put writers are considered to be bullish.
Should an investor see a stock price and believe that it will stay the same or go up, they might write puts for the following reasons.
The first reason is speculation.
Should the stock’s price stay the same or go higher than the strike price, by writing puts an investor can make a profit.
That profit is made by earning the premium.
There are also increasing returns.
The premium is a place of income for put writers, which is similar to call writers.
A portfolio can make even more income when writing puts.
The main aim here for investors is that expiration of the puts leads to them getting to keep the premium.
The last reason to cover is buying stock at below its current price.
The cost of stock when the put is exercised can be offset against the premium received for writing them.
So the actual cost to the writer is the strike price with the premium received subtracted from it.
If an investor believes the current stock price is too high, this is a technique they often use.
A put-call ratio is one of the tools often used to help determine a strategy.
This uses put and calls and open interest found in them.
When we look at an option, the number of contracts outstanding is said to be the open interest, and the more liquid the option, the higher the open interest is going to be.
It will decline, however, as soon as the expiration of the option approaches.
That’s because investors either choose to exercise their existing position or close out.
Let’s look at the put-call ratio a little more.
In the trading of put options to call options, this reflects the current open interest.
It’s a great way to find out if investors are bullish or bearish (or investor sentiment).
Across a wide range of indexes and underlying securities, it can be used to calculate various sectors of the market.
It can be focused on one underlying security too as a way to gauge overall investor sentiment towards it.
So how is the put-call ratio calculated?
Well, it is simple.
Just divide the number of traded put options by the number of traded call options.
If the ratio is higher, it shows that up to that point in time, investors have been more bearish.
So as the ratio goes up, it shows that investors were buying more puts because they felt that the underlying security, or the market sector would drop lower.
Or it also could indicate that, in anticipation of a downward move, they wanted to hedge long portfolios.
Traders use this ratio as a contrarian indicator as well.
For example, they might want to close or cover short positions for long positions the higher the ratio climbs.
So as the bearish sentiment begins to drop, the ratio could climb extremely high as a reversal might be on the horizon.
Advanced option strategies
In this section, we will cover advanced strategies that options investors use to improve on their overall portfolio results.
We will first look at spreads.
To start, let’s understand the concept that the word spreading covers.
When you see the word spread, you should immediately think of a difference, because that’s what it refers to.
For example, the spread is the difference between the bid and the ask price when quoting securities.
That’s the main thing to remember when dealing with a spread related to options.
It’s always going to involve some difference but particularly in:
- Exercise prices
- Expiration dates
- Both exercise prices and expiration dates.
Purchasing one option and the sale of another option of the same class simultaneously is a spread too.
- A long call and a short call is a call spread
- A long put and a short put is a put spread
Now let’s look at the various types of spreads that you need to know about.
We start with price or vertical spreads.
This is a spread that has the same expiration date but two strike prices that differ.
Because option report strike prices are reported vertically, it’s sometimes called a vertical spread.
Note that this is the most common of the spread types and the most likely to appear on the exam.
The second type we are going to look at is the time or calendar spread.
Sometimes also known as the horizontal spread, these are options contracts that have the same strike prices but different expiration dates.
These are generally established when no great stock price changes (volatility) is expected by investors.
Instead, the time values of the two options premiums will erode at a different rate and through this, the investors hope to turn a profit.
They are sometimes called a horizontal spread because on option reports, expiration months areas are shown horizontally.
A diagonal spread is a little different.
Here both in time and price the options differ.
The two positions will be connected by a diagonal line on an options report, hence the name.
Bull and bear spreads
We’ve learned what spreads are – an investor buying one option but offloading another in the same class
On the Series 7 exam, you’ll deal with the majority of questions about spreads that cover those that are considered bullish and bearish.
So a bullish spread sees a low strike price on options bought and a high strike price when they are sold.
When talking about bullish or bearish spread, it’s never based on the premium, only on the strike price, or sometimes called the exercise price.
Debit and credit spreads
We’ve got to mention debit and credit spreads too.
- Debit spread: When comparing long and short options, the long option will have a higher premium
- Credit spread: When comparing long and short options, the short option will have a higher premium
For a more practical way of looking at it, an investor will pay a difference when they pay more for the options they buy compared to those that they sell and they will be charged for the overall net cost, and a debit spread has occurred.
Should it be the other way around, their account will receive a credit which results in a credit spread.
T-charts are the most effective way to determine credits and debits.
While on the subject of debit and credit spreads, let’s look into debit call spreads.
These can reduce the cost of a long option position and are often used by bullish investors.
The thing about these types of spreads is that they offer limited potential rewards for investors.
A profitable debit spread occurs when two premiums see the difference between them increase or the options are exercised.
A profitable credit spread occurs when two premiums see the difference between them decrease or the options expire.
We need to also discuss credit call spreads.
Bearish investors who take a short option position use credit call spreads to help reduce the risk of that position.
It’s not only call spreads that can be debit or credit either.
So we have to cover puts as well starting with debit put spreads.
To reduce the cost of a long put position, debut put spreads are used by investors.
When they look to make use of these, investors are considered to be bearish.
It’s the opposite for credit put spreads.
This reduces the risk of a short put position for bullish investors.
Working out a spread investor’s market attitude
Are they a bull or a bear?
Well, the more costly option of the two will help determine the market attitude of a spread investor.
And the more costly of the two would be the one with the higher premium.
In call spreads, that’s the lower strike price option contract.
And whether the investor purchased or sold the lower strike price option determines whether it is a debit or credit spread.
A debit occurs when the lower strike price option (with the higher premium) is purchased.
A credit occurs when the lowest strike price option (with the higher premium) is sold.
Investment strategies combining puts and calls
In the Series 7 exam, you will find three different strategies covered when it comes to put and call investments.
We will begin with straddles which are made up of a call and a put.
The most critical thing here is that for it to be a staddle, both of these must not only have the same expiration month but the same strike (exercise) price as well.
A method used by investors to speculate on the price movement of stock, straddles can be both long and short.
So those who purchase a straddle are expecting the stock price to move significantly in the future.
With long straddles, an investor will expect much volatility in the price of a stock but they are sure if that price movement will be up or down.
To cover that, both a put and a call will be purchased by the investor with the same strike price as well as the same expiration date.
The call will be profitable should the market price of the stock rise enough and the put will be left to expire.
In the opposite scenario, when the market price of the stock falls significantly, the put will provide the profits and the call will be left to expire.
An investor will make money with this type of strategy as long as the market price of the stock moves significantly either up or down.
Short straddles are another investment strategy, however.
These are used when an investor feels that the price of s stock will not change that much and in this way, two premiums can be collected.
A short straddle comes about when a call and put are sold.
Both of these must have the same strike price and expiration date, however.
So if the market price of the selected stock doesn’t change much, the call and that put will expire on the signified date.
That allows the investor to profit off the two premiums collected.
Of course, the price of the stock may become volatile.
Should it move either up or down, an investor will see the put or call exercised against them.
That can lead to losses.
Because of the short naked call, the maximum losses an investor can expect in this type of scenario are unlimited.
The next strategy we are going to look at involves combinations that are similar to straddles with a few small differences.
When investors use this strategy, a call and a put are used once again, but in this scenario, they can have either different strike prices or expirations months.
In some cases, both the strike price and expiration month may be different between the call and the put.
Why are combinations a strategy that investors choose?
Well, when compared to long straddles, they tend to be cheaper when both the call and put are out of the money.
The last investment strategy we are going to cover are collars.
When an investor wants to protect a long stock position’s unrealized gain, they can use a collar.
For example, they could purchase an out of money call as well as an out of money put on a stock that they bought for $20 that is now $30.
This helps them to collar the gain.
Should the stock rise by a significant amount, the call would be exercised, and should it drop by a significant amount, the puts can be exercised.
While they have limited the upside potential of the stock, they have at least protected their profit.
There is a cashless collar that’s often used by investors as well.
This sees the premium taken in on a short call either be the same, or higher than a long put premium that they have paid out.
We need to look at nonequity options as well as this is something that might come up on the Series 7 exam, although most of the questions deal with equity options.
The three important nonequity options that you should know about are:
- Interest rate
- Foreign currency
Profits can be made on the movements of markets or market segments by investors who use index options.
Hedging against market swings too is a way to use index options to turn an investment profit.
Indexes that investors look to are those with a particular focus or broad or narrow-based indexes.
Broad-based indexes include the likes of the S&P 100, S&P 500 as well as the Major Market Index.
The movement of the entire market is reflected by these indexes.
Narrow-based indexes look specifically at certain market segments in a certain industry.
When dealing with index options, we need to look at the Volatility Market Index (VIX).
This is an index that has a very specific focus
In particular, it’s a measure as to the S&P 500 Index and the implied volatility of its options traded on the CBOE.
VIX options are also traded on the CBOE.
Sometimes called the fear gauge, their purpose is to mirror market volatility in terms of the expectations of investors for an upcoming period of 30 days.
Should a reading be high for this index, it doesn’t indicate a bull or bear market, but only that the overall fear of the market becoming more volatile.
Usually, this will result in options contracts having higher premiums.
When the purchase of put options is on the increase, the VIX will usually rise.
It falls when more call options are purchased over puts.
That’s because the buying of puts is seen to be a more bearish behavior and market participants get a little anxious as it could indicate that bears are more active in the market.
That anxiousness amongst market participants decreases when more calls are bought, as that is seen as more bullish behavior, indicating that bulls are active in the market.
Next, we look at index option features.
Many of the features exhibited by index options are similar to what you find with equity options.
Let’s breakdown some of them:
- Premium multiplier: $100 is the multiplier used by index options. To work out the option’s cost, you would take the premium amount and multiply it by $100. To work out the index’s total dollar value, you would multiply the strike price by $100.
- Trading: If an index option is broad-based, it stops trading at 4:15 pm ET. Those that are narrow-based will stop trading at 4:00 pm ET. Just like equity options, the sales and purchase of all index options will be settled the next business day.
- Exercise: When an index option is exercised, it is settled in cash and not the delivery of a security as would be the case of an equity option. Delivery of the cash must be the next business day (T+1) and it must equal to the intrinsic value of the option.
- Settlement price: On the day they are exercised, an index options settlement price will be based on their closing value only.
- Expiration dates: When it comes to their expiration month, index options will expire on the third Friday.
For the Series 7 exam, it’s important to understand the major difference between equity options and index options when it comes to settlement.
For index options, the next business day is when settlement will occur when the exercise of an index option takes place.
The exercise of an equity option will for the most part be two business days.
Buying and selling (trading) of both index and equity options see settlement for both as the next business day.
The last section to cover is index options strategy.
Often, they are used as a way to speculate on overall market movement.
So an investor will purchase index calls or write index puts if they think the market is going to rise.
On the other hand, they will purchase index puts or write index calls if they think that the market is going to fall.
One of the most important uses of index options is to hedge portfolios.
For example, when a diverse portfolio of equities is overseen by a portfolio manager, he might look to purchase puts as a way to offset any losses should the market value of the stocks in the portfolio drop.
This is commonly known as portfolio insurance.
Interest rate options
Because they are directly influenced by movements in interest rates, they are also known as yield-based options and are based on T-bonds and T-bill yields.
As for the strategy used, it’s similar to the up and down when related to calls and puts that we covered earlier instead it’s now applied to interest rates.
So a portfolio manager will either write calls or buy puts when they think that interest rates will fall.
Should they think that the opposite is true and that interest rates will rise, they will buy calls and write puts.
Yield-based options don’t factor in market prices but instead, allow investors to try to make a profit based on the movement of interest rates.
There are a few characteristics that index options and interest rate options share in common.
- $100 contract size multiplier
- Cash settlements
Foreign currency options
Foreign currency options or FCOs allow for speculation on the overall performance of a chosen currency.
They also, however, can be used as a form of protection against currency exchange rates that fluctuate against the U.S. dollar.
U.S. listed exchanges offer currency options trading on various foreign currencies including:
- British pound
- Swiss franc
- Japanese yen
- Canadian dollar
- Australian dollar
As a way to hedge currency risk, importers and exporters often turn to currency options.
Let’s look at some of the features that FCOs have.
- Contract sizes: Retail investors can be accommodated by currency options because their contract sizes are small enough. Each currency will have a specific contract size that relates to them. For example, the option contract size for all of the currencies mentioned above is 10,000 except for the Japanese Yen. That’s 1 million. This is a fact worth knowing for the Series 7 exam.
- Strike prices: For most FCOs, the strike price quoted will be in U.S. cents. Again, the exception is the Japanese yen. That’s quoted at 0.01 of a cent.
- Premiums: Cents per unit is also how currency options are quoted. As for premium, well one point of premium equals $100. To find out the total premium contract, simply take the number of units and multiply it by the premium.
- Trading: Trading of listed currency options takes place between 9.30 am and 4:00 pm ET and they are mostly traded on the Nasdaq OMX PHLX.
- Expiration date: As with equity options, these expire on the third Friday of their set expiration month
- Settlement: Settlement takes place on the next business day, just like equity options. If a currency option is exercised, it is settled on the next business day as well. U.S dollars are the currency used for delivery.
Let’s look at strategies involving currency options.
It involves the purchase or selling of puts and calls.
For example, if it’s the belief of an investor that a currency will go up, they can either sell puts on that currency or buy calls.
And they will sell calls or buy puts on the currency should they think it is going to fall.
When currency options are measured, it’s always against the U.S. dollar.
Should it rise, then the foreign currency will fall and vice versa in this inverse relationship.
It’s important to note the EPIC rule when it comes to currency options.
What this means is those that export will buy puts to hedge while importers, on the other hand, hedge by purchasing foreign currencies.
The math behind options
You can expect several exam options questions on the exam including those about breakeven points, maximum loss, and maximum gain, for example.
We’ve looked at the unique terms that are used to describe options contracts in the marketplace including in the money, at the money, out of the money, breakeven, and intrinsic value.
When an investor is not losing or making money, they are at the breakeven point.
But let’s look at breakeven when it comes to more specific investment vehicles.
To start, we will look at breakeven when it comes to call options.
The strike price with the premium added is the breakeven point when it comes to calls.
Those investors who are call buyers will see a profitable contract above this breakeven point.
The call seller, on the other hand, starts to make a profit below the breakeven point.
It’s important to note, however, if an option is said to be in the money, this doesn’t mean that it is at breakeven point.
Also, when an option is in the money, it doesn’t always mean it’s profitable.
What about breakeven when it comes to put options?
Here the strike price is the option’s strike price minus the premium.
The put buyer will see a profitable contract below the breakeven point.
The put seller, on the other hand, starts to make a profit above the breakeven point.
Both breakevens for put and call options are relevant when contracts are both long or short.
What about breakeven when it comes to spreads?
The trick with this relates to choosing the correct strike price if two calls or two puts are involved.
The net credit/debit must always be added to the strike price which is the lowest in the case of a call spread.
As for a put spread, the net debt/credit is taken away from the highest strike price.
We have to investigate breakeven for straddles and combinations as well.
Because there are two options here, there are two breakeven points as well.
For a call, the breakeven point is the strike price plus both of the premiums.
The breakeven point for a put is the opposite, in other words, the strike price minus both of the premiums.
Maximum gains and losses
When an investor opens an option position, there are a few critical scenarios that they need to wrap their heads around.
- The biggest amount they can make
- The biggest amount they could lose
- The breakeven point of the investment
As we’ve covered the breakeven point already, it’s maximum gains and losses that we will look into next.
We start with long calls maximum gain.
This occurs when the breakeven point sees the price of stock move above it.
On a call option, the potential gain will, for the most part, increase along with the stock value at a point for point ratio.
In theory, call owners can receive unlimited potential gains.
That’s because the rise in a stock price has no limit.
What about long calls maximum loss?
100% of the premium paid can be lost by investors when it comes to a long call.
This happens at the options expiration as a result of a stock market price that is at or below the exercise price which in effect makes it totally worthless.
The most an investor can lose, however, is ultimately what they paid for it, just like any other securities available.
Let’s look at short calls maximum gain.
Anticipating that a stock price will drop is something that bearish call writers want to happen.
The call becomes worthless to a buyer, however, should it drop lower than the exercise price on the expiration date.
This will lead to it expiring unexercised and the entire premium is kept by the writer.
Even if the stock price drops to zero, a writer can only gain the amount of the originally received premium.
As for short calls maximum loss?
Call writers will take on the greatest risk if they do not have stock to deliver should the call they wrote be assigned.
This loss can be unlimited if the option is a naked or an uncovered option.
Should this situation arise, the stock that has to be bought could be priced far higher than the exercise price of the option and the potential loss to the call seller will go up as the stock prices head upwards.
An increase in losses, however, can be curtailed should the call writer enter a closing purchase.
On covered calls, the premium received as well as the cost of the underlying stock to the writer will limit losses.
Now that we’ve covered maximum loss and gain for short and long calls, we have to do the same with short and long puts.
Let’s begin with long puts maximum gain.
Typically, those who buy puts are more on the bearish side of investor behavior.
The maximum gain on puts happens when the underlying stock price goes as low as it possibly can which in theory is zero.
Should an investor buy stock for that amount, they could then exercise the option on it and sell it at the strike price.
The gain they make however is reduced by the opening transaction and the premium that has to be paid when it occurs.
As for long puts maximum loss, well that’s related to the premium paid by the put buyer.
As with all long options, this has to be paid by the investor.
A worst-case scenario for put buyers is that before it’s worth exercising, the option expires.
This can happen at any market price that is either at or higher than the strike price.
Next, let’s look at short puts maximum gain.
An opening transaction leads to the writer of a put receiving the premium for it.
This premium is the highest maximum gain that the writer can receive.
The put will have no value, however, should the stock price be level with or higher than the exercise price.
Should this occur, the writer will keep the premium of the put as it will expire.
And short puts maximum loss?
Should a stock price drop to zero, a put seller will experience maximum loss and when this happens, the option will be exercised by the put owner.
Delivery of the stock, which has no value, will also be taken by the put seller which leaves them out of the exercise price with the premium taken from the opening transaction subtracted as well.
For our next section on gains and losses, we look at spreads.
This is important for the exam and you will find questions covering this topic.
Let’s look at a few key points before we jump into them, however.
- Investors want the difference between premiums on a debit spread to widen. Should they get far enough apart, the investor will profit as the options will be exercised.
- Investors want the difference between premiums on a credit spread to narrow. Should they get close enough together, the investor will profit when the options expire.
- Somewhere between the two strike prices, you will find the breakeven point.
- An investor will start to profit if the price of the underlying asset moves beyond the breakeven point.
- To find the breakeven point on call spreads you take the lower SP and add the net premium to it
- To find the breakeven point on put spreads you take the highest SP and subtract the net premium from it.
Now that we have that insight, let’s start with the maximum gain on debit call spreads.
Bullish is the way to describe an investor that has established a debit call spread.
This description is accurate as the option sold would have been done so at a high strike price while the option bought would have been done so at a low strike price (a typical bullish strategy).
Should the underlying assets’ market price reach the level of the strike price or go above it, the gain for that investor will be maximized.
What about maximum loss on debit call spreads?
The debit is the maximum loss that you will find on debit spreads.
Now we move to debit put spreads.
These are generally the domain of an investor who is considered bearish.
They will buy the put with a higher strike price and sells the put at a lower striker price.
More money will come into the account from the put purchased than will leave the account from the put sold.
That’s because the higher strike price put will have a higher premium and be worth more to the investors than the lower strike price of the put.
Should a bearish investor expect the price of a stock to fall, they will buy a put or put spread on that stock.
Should it fall, the investor will then take the put with the higher strike price (the long put of the spread) and exercise it.
This sees the investor sell their stock at a higher price than the current market price.
If they exercise the lower strike price put (the short put), stock will need to be purchased.
The strike price less the net debit, however, is kept by the investor as they have exercised the option they own.
Similar to single option strategies, the options position of the investor can also be closed out.
This means they take the profit (or loss) instead of opting to exercise.
With that insight, let’s look at maximum gain on debit put spreads.
Should the market price of a stock be at or below the strike price of the lower option, maximum gain is realized for debit put spreaders.
When this happens, the stock must be bought at the lower strike price, however, stock can then be sold at the higher strike price.
The difference between the two prices with the net premium or net debit subtracted can be kept.
Then there is maximum loss on debit put spreads.
In this scenario, both puts will expire and be worthless should the price of the stock be equal to or rise above the highest options strike price.
If the stock can be sold for more than the options strike price, no investor will look to exercise a put.
They will have a maximum loss, however, at any price above the higher strike price.
This is as a result of both expiring and being worthless.
On a debit spread, it’s accepted that the maximum loss is the net premium or net debit.
The difference in strike prices minus the net debit is the maximum gain.
The next section to look at involves credit call spreads.
These are established by investors that are considered to be bearish.
To establish credit call spreads, investors will buy calls that have higher strike prices.
They then will sell the calls with a lower strike price
The sale sees the investor taking in more money than they are paying out for the purchase because the higher strike price call’s premium is lower than that of the one with the lower strike price.
A net credit then occurs as more money comes into the investors’ account than that which flows out of it.
When they think the underlying stock’s price will drop, bearish investors will sell calls and call spreads.
Should this happen, the options bought will be worthless when they expire.
This allows the investor to keep the net premium (net credit).
Should the stock price rise, however, the investor can buy stock by exercising the long option.
This is then delivered against the short option and the difference between the two strike prices minute the net credit will be lost by the investor.
Or instead, the investor can take losses or keep profits by closing out their position instead of taking the option to exercise.
The net premium (net credit) is the maximum gain available on a credit call spread.
This occurs if the stock price is below or at the lower strike price.
The difference between strike prices minus the net premium is the maximum loss that can occur on a credit call spread and happens if the price of the stock is the same or above the higher strike price.
Lastly, the lower strike price with the net premium added is the breakeven point for a credit call spread.
Now, let’s look a little deeper into credit put spreads.
When bullish investors purchase a put with a lower strike price and then sell one with a higher strike price, they have established a credit put spread.
They spend less money on options with a low strike price compared to that taken on the sale of the highest strike price option.
The reason for this is that a lower premium is associated with the put with the lower strike price than that with the higher strike price.
When this scenario plays out, the difference between the strike prices with the net credit subtracted from it is what the investor will lose.
They do have the option, however, to take losses/keep profits by closing out the positions and not exercise.
The net premium (net credit) is the maximum gain available on a credit put spread.
This happens when stock prices are equal to or move higher than the higher strike price.
The difference between strike prices minus the net premium is the maximum loss that can occur on a credit put spread and happens if the price of the stock is the same or below the lower strike price.
The higher strike price with the net premium subtracted is the breakeven point for a credit put spread.
Our next section when it comes to gains and losses is related to closing positions.
Should they choose not to wait until after expiration has occurred, an investor could take the decision to close out their spread position.
This can be done at any time.
In other words, they can opt to sell their long position which is a closing sale.
Then they can buy back the short position which is the closing purchase.
Should it close out at a bigger credit than the initial debit, a debit spread will be profitable.
So the spread between the purchase price that covers the short and the sale price of the long will be wider or greater than the initial debt.
It’s for this reason debit spread investors want spreads between premiums to widen as much as possible.
When the difference between the closing purchase (the short position) and the closing sale (the closing sale) is a debit that is smaller than the initial credit when the position opened, credit spreads are profitable.
In other words, the spread must narrow for those using credit spreads as a form of investment.
What about straddles and combinations?
As there is unlimited potential gain on a long call, the maximum gain for any long straddle is, therefore, unlimited as well.
As for the loss on a long straddle, well the maximum here is both premiums paid.
Remember that because there are two options, that means that there are two breakeven points as well.
- Call breakeven: Strike price and both premiums paid added
- Put breakeven: Strike price and both premiums paid subtracted
When the market price is below the breakeven for the put, the investor will profit.
When the market price is above the breakeven for the call, the investor will profit.
The way options transactions are taxed depends on the type of option and that’s what we will cover in this section.
It’s important to have an excellent grasp of options taxation as this will be covered on the Series 7 exam.
While most of the taxation of options transactions is much like other securities, there are some changes here and there.
Tax rules for options
The first thing to remember about options is that because they are capital assets when it comes to taxation, tax rules regarding capital gains will apply.
Depending on what investors choose to do with the options position, different tax consequences will result.
So let’s look at a few examples, starting with expiration, close, and exercise.
When an option is in an open or existing position, it can be handled in three ways as we’ve mentioned above.
To start, let’s look at expiration.
When an options contract expires, the buyer will lose the premium while the seller of the contract will gain the premium as profit.
The premium amount can be reported as a capital loss by the buyer.
For the seller, however, it’s the opposite as the premium must be reported as a capital gain.
Long-term equity and anticipation securities (LEAPS) writers follow a unique tax treatment at expiration, however.
Even if the contract has been held for a period of more than 12 months, at expiration, LEAPS writers have to report short-term capital gains.
LEAPS buyers holding contracts for more than 12 months will report long-term gains and losses.
So just remember that while LEAP contracts for buyers are treated similarly to other securities when it comes to short-term gain and losses, for sellers, they are treated as a short-term sale.
What about taxation when it comes to closing out?
Well, whether it’s a purchase or a closing sale, either a capital gain or loss that’s equal to any price difference will be generated.
This is related to the date of the closing transaction for buyers and sellers and as always, what the writer makes the same as the buyer loses.
The last thing to look at is exercise.
A capital gain or loss is not generated by the exercise of options until the ensuing sale or purchase of the stock happens.
The option holder will buy the stock when a long call is exercised.
The strike price as well as the premium form the total cost basis for the stock as a result of the investor having paid its premium.
Let’s look at the various options strategies and the tax consequences thereof.
- Buy a call: If the option expires, it results in a capital loss. If the option is exercised, the cost basis equals the strike price plus the premium. If the position is closed, there is either a capital gain or loss.
- Sell a call: If the option expires, it results in a capital gain. If the option is exercised, the sale proceeds equals the strike price plus the premium. If the position is closed, there is either a capital gain or loss.
- Buy a put: If the option expires, it results in a capital loss. If the option is exercised, the sales proceeds equals the strike price minus the premium. If the position is closed, there is either a capital gain or loss.
- Sell a put: If the option expires, it results in a capital gain. If the option is exercised, the cost basis equals the strike price minus the premium. If the position is closed, there is either a capital gain or loss.
The second tax rule for options we will look into deals with stock holding periods.
The postponement of stock sales as a means to bring about long-term capital gains treatment is not permitted under IRS rules.
Investors can use long puts as their choice of options should they want to lock in a sale price.
Note that the gain will be seen as short-term if the holding period of the stock is 12 months or less before the put is purchased.
Under this section, we have to cover married puts.
Should a customer buy stock and on the same day buy a put option as a hedge on it, the put is married to the stock.
For tax purposes, the stock’s cost basis will move upwards by the premium paid and whatever happens to the put will have no impact.
There won’t be a capital loss on the put either, should it expire but instead, the premium paid shows in the cost basis of the stock.
This is then the long stock/long put breakeven point, in other words, the cost of the stock bought plus premium.
Candidates can expect numerous questions on the exam that will cover options taxation.
For most of these, you can use a T-chart to work out profit and loss.
Exercising options alone do not produce a taxable event.
Rules and regulations for the options market
Let’s look at some rules and regulations that the Series 7 exam tests on.
The rules governing the opening of an options account
We’ve covered some of this before, but note that this section does expand significantly on what’s been covered earlier.
The first step is completing a new account form.
The following information must also be secured from the client by the broker-dealer:
- What their investment objective is (for example, generate income)
- Their employment status
- Income generated annually from all potential sources
- Their estimated net worth (without factoring in residences)
- Their estimated liquid net worth (for example, cash-on-hand, and securities)
- Their marital status
- How many dependants they have
- If they are of legal age
Further records for clients should also include (where applicable):
- Their overall knowledge when it comes to investments as well as their experience
- Financial and background information
- When the customer was given an ODD (this cannot be later approved date for their options trading account)
- What transactions their account has been approved for
- If the account is for an institution or natural person
- Signatures of the account’s registered representative, as well as the registered options principal/general sales supervisor
Following that, there needs to be written approval for the account by the registered options principal.
This has to be completed before any trading can take place on a new account.
There are some considerations that need to be taken into account before this approval can be given, but most of it will come from the new account form of the investor or institution in whose name it will operate.
The types and nature of transactions permitted by the firm will also be indicated on this written approval.
Depending on the type of investment strategies, different levels of approval come into play as well.
For example, options strategies are speculative in nature.
As we know, this means they work in a way so as to take advantage of any price movements of the underlying asset.
In other situations, investors can limit their risks or look to improve potential returns using options.
Spreads, straddles, combinations, and other strategies see investors dealing with more than one option at a time.
This includes both purchasing and selling them.
The most basic level when it comes to option trading involves buying them.
Should a customer wish to take part in option writing, additional approval could be required.
This would include:
- Uncovered option writing
- Ratio writing
- Spreads and straddles
- And more
ROPs will use all the information gathered from new investors to decide on the appropriate levels of option trading for them as per suitability standards and then the account will be approved.
For the most part, the various levels of approval are similar between FINRA member firms and new investor accounts will be assigned a specific level that specifies how they can trade.
Here’s an example of the type of levels you might find:
- Level 1: Covered options
- Level 2: Long calls, puts, straddles, and combinations
- Level 3: Spreads
- Level 4: Uncovered options including naked calls and puts as well as ratio spreads, combinations, and short straddles
Should a new investor be approved at Level 4, all the levels below that are inclusive as well, so they can trade in those options too.
Should investors receive approval to write uncovered puts or calls, extra written procedures need to be put in place.
- The criteria used to approve the account as well as the minimum entry requirements for such an account
- Providing the customers with written documentation that highlights the risk of uncovered writing.
Verification is needed from customers as well.
This will happen within 15 days of the approval of the account and takes the form of a signed customer option agreement.
This also states that the account will abide by rules as set out by the OCC and CBOE.
Customers must also comply with the fact that position or exercise limits cannot be violated.
A customer signature on this document serves to verify that the information found on the new account is also accurate.
Should the option agreement not be returned signed by the customer within 15 days of the account being approved, only closing transactions can be permitted on the account.
This is often a question that appears in the Series 7 exam.
Also, it’s important to note that should the ODD be revised by the OCC, the revised ODD must be sent to all options account holders.
This must happen by no later than when the next option transaction confirmation is delivered to customers.
Options contracts adjustments
Adjusting options contracts for stock dividends, rights offerings, stock splits, and reverse stock splits are a requirement of FINRA rules.
On ordinary cash dividends, however, these adjustments do not take place.
When they do take place, the share number is always rounded down and only works in whole shares.
Listed option market functions
A range of U.S. exchanges and the OTC are where options are traded.
The options found on exchanges are called listed options.
All of these listed options will have exercise prices and expiration dates that are standardized.
Those options found on the OTC are called conventional options.
These options are not standardized.
This means that these kinds of options are rarely sold in secondary markets.
That’s because of the fact that buyers and sellers negotiate contract terms individually as no contracts are exactly the same.
Trading listed option locations that you should know about for the exam are:
- Nasdaq stock market
- Philadelphia stock exchange
It’s important to know that when a certain security is subjected to a trading halt, there is a stop in trading for the options on that security as well.
Standardization is critical for the listed options market, so let’s look into some standard features of options trading and settlement.
- Trading times: 9:30 am to 4:00 pm (ET) for listed stock options and up to 4:15 pm for broad-based index options trade
- Exercise: Exercise notices can be turned in until 5:30 pm ET.
- Expiration: On the third Friday of the month at 11:59 pm is when listed options expire. Options can be traded until 4:00 pm ET on their expiration day (the final day of trade).
- Settlement: This happens on the next business day for listed options transactions. Delivered stock, because of the exercise, is settled in two business days. This is known as a regular way basis.
- Automatic exercise: Unless other instructions are provided, contracts in the money by 0.01 and above are automatically exercised at expiration for both retail and institutional customers. Should a customer not want to have contracts exercised, they must give a do not exercise instruction. The OCC must receive these by 5.30 pm ET on the last day of trading (the third Friday of the expiration month).
With options contracts that are heavily traded, position limits are put in place.
This allows for only 250,000 contracts on the same side of the market for these contracts.
These position limits apply to:
- Registered representatives trading for discretionary accounts
- Individuals acting in concert
By splitting a large position to pass these limits, an investor group cannot bypass these position limit restrictions.
To see if there is a contravention of limits, the individuals acting together’s aggregate position applies.
With traditional options, LEAPS are added too.
Then they will be checked to see if any position limit rules have been broken.
To see if individuals are working together, the CBOE will look for control which is assumed when:
- Authority to act on behalf of a joint account is available to all parties
- An individual has authority to carry out transactions on an account
Unless proof can be provided that they are not, the following accounts are assumed to be acting in concert.
- Individual accounts (for one spouse, for example) or joint accounts (for married couples for example where the authority to act in a joint account while having control over their single account is carried out by a spouse. To see if a violation of position limits is taking place, the positions in both accounts would be aggregated.
- An individual who has discretion for and over an account. To see if a violation of position limits is taking place, the person who has a third-party trading authority’s account and the account that they have discretion over will be aggregated.
The number of contracts on the same side of the market is how position limits are measured.
Long calls and short puts will represent the bull side of the market while long puts and short calls represent the bear side.
Anything over the 250,000 limit when aggregating as mentioned above is a violation.
Remember, this aggregation sees long calls together with short puts and long puts with short calls.
When dealing with limits, let’s look at exercise limits as well.
Other than the 250,000 position limit which we’ve already discussed, the OCC also defines a specific period for exercise limits.
And that’s five consecutive business days.
So that means that only up to 250,000 contracts can be exercised on the same side of the market over a five business day period.
There are rules in place that are similar to position limits for exercise limits.
To work out if violations have occurred, bullish contracts (long calls and short puts) are aggregated together.
On the bearish side of the market, short calls and long puts are aggregated to check out if the contract numbers are over 250,000.
The other similarity between position limits and exercise limits is that they are applied to the same groups of investors, namely individuals, registered representatives for discretionary accounts, and individuals acting in concert.
Our last subject to cover in this section deals with American or European-style contracts.
Should a contract be American-style, this allows investors holding a long position the ability to exercise their contract at any point before the expiration date.
That’s not how European-style contacts work.
These can only be exercised on the last day of trading (the expiration date).
Note, however, that when it comes to equity options, the vast majority are American style.
ECOs on the other hand, can either be American-style or European-style.
The vast majority of index options, like weekly index contracts, for example, are European-style as well as yield-based options.
Always remember that American-style contracts can be exercised at any time while European-style contracts can only be exercised on the expiration date.
The Princeton Review CFA Study Material
When preparing for the Series 7 exam, you will need to understand these key options terms thoroughly.
- Call: A contract at a specified price and for a limited time to buy underlying instruments, assets, or stock
- Call buyer: Received the right to buy, during a specified time, an underlying asset at a specific price by paying a premium for an option contract
- Call writer: Receives a premium and then, for a specific period of time, has the obligation to sell an underlying asset at the call buyer’s discretion for a certain price.
- Option: This is a contact that provides a buyer with the privilege to buy or sell an asset (stock, for example). When the option buyer chooses to exercise the contract, the writer is required to sell or buy the underlying item.
- Covered: Options writers position with an offsetting position in the underlying instrument. This ensures the ability to perform if the option holder exercises on the option contract.
- Expiration date: The options will become worthless on this date. The rights specified in the contract are no longer held by the buyer.
- Naked (uncovered): Option writers position without an offsetting position in the underlying instrument that when the holder exercises the option, ensures the ability to perform.
- Parity: When the intrinsic value of the contract and the premium are equal.
- Premium: The option writer pays this cash price to the option writer
- Put: A put is the right to sell underlying instruments, assets, or stock for a limited time and at a specific price
- Put buyer: A put buyer will pay a premium for an options contract. This gives them the right to sell the underlying stock for a limited time at a specified price.
- Put writer: A put buyer will receive a premium. For a specified time, they take on the obligation to buy at a specified price and at the put buyer’s discretion, the underlying asset.
- Strike price: If the option buyer exercises their right in a contract, this is the price at which the underlying asset will be bought and sold.
- Underlying asset: The security that the option is based on
When we talk about debt securities, we are talking about a document that originates a debt obligation
The Series 7 exam will focus on the most common type of debt obligation.
This takes the form of a bond.
Note, however, there are many other types of debt securities, with money market instruments being one such example.
In this section, we will cover both of these.
To start, we must look at the various entities that issue debt securities of which the government of the United States is the largest.
But let’s first establish just what a debt security is and explain the different types we touched on briefly above.
Types of debt securities: Bonds
We start looking at debt securities by focusing on bonds.
Money loaned to issuers by investors buying the issuer’s bonds is called debt capital.
The issuer’s overall indebtedness is represented by a bond while the indenture (sometimes known as the deed of trust) is a document where the terms of the loans can be found.
The indenture will also include details of the obligation of the issuer paying back a set amount of money by a certain date.
Not only that but it declares the obligation of the issuer in paying a set rate of interest to the investor for the use of the funds as well as collateral acting as security on the loan.
Bonds purchased by investors will see them lend money to an issuer over a certain time period and an annual interest rate (sometimes called the coupon rate) that is fixed.
Note that on the exam, the term nominal yield is used to describe this rate.
During the lifetime of a bond, this rate will never change from what it was initially set at and it’s for this reason that bonds are considered a fixed-income investment.
Bonds and debt capital are associated with long-term debt financing.
This means that money is borrowed for an extended period of time and not sure term.
The shortest time that long-term debt financing allows to borrow money over is a period of five years.
In most cases, however, the length of time the money is borrowed is more likely to be between 20 and 30 years.
Types of debt securities: Money market instruments
If investors are looking to buy securities, loans, and other types of short-term loanable funds, they do so on the money market.
Note that because money and not cash is traded here, that’s how the money market received its name.
It’s the lender of the money that buys a money market instrument, while the seller thereof is borrowing the money.
For the most part, money market instruments are seen as high-quality investments with low risk attached to them.
That, however, also means that on the whole, their yields are fairly low too.
While there are many types of money market instruments, they hold several common factors amongst them.
- All money market instruments have a maturity date that is 365 days or less (most mature within six months)
- Most of them are issued at a discount and will not pay any interest
Let’s just touch on that second point for a moment.
At maturity, the principal amount of the loan will be repaid and as most of them will mature within six months, administrative costs that are linked to paying out interest are simply too much.
That’s why they are issued at a discount.
At maturity, an investor will still be getting back par.
Also, the difference between the value at maturity over the price paid can be considered interest.
While money markets are low risk as we have mentioned and seen as safe investments, that risk isn’t the same for all instruments you will find here, so that’s worth bearing in mind.
For example, a Treasury bill will carry more risk than a commercial paper.
So who buys money market securities?
Well, the primary purchasers are money market mutual funds, insurance companies, banks, and other institutions.
As for individual investors, most won’t deal in money market instruments as minimum denominations are extremely high.
The last thing to remember about the purchase of these securities is that it’s recommended that a DVP or delivery versus payment system is used when they are purchased.
Common characteristics of debt securities
Let’s look at some of the common characteristics shared by various debt securities.
We start with the interest rate and the price of debt securities and the inverse relationship shared between them.
We know that preferred stock market prices and current interest rates are inversely linked.
If interest rates go up, preferred stock market prices will go down.
Just keep hold of this for now, we will explore it a bit later on.
The next common characteristic shared by debt securities is structure.
Let’s look at some of the components that that overall structure comprises.
- Indenture: This is only found in bonds, but not other money market instruments. They will have a legal opinion. It’s not tested, however.
- Negotiability: Money market securities are easily transferable, just like bonds. That means that before they reach their maturity date, an investor can choose to sell them should they wish to. Shorter maturities of money market securities mean that they are not commonly seen in secondary market training.
- Specified maturity date: On a specified maturity date, debt securities are redeemed by the issuer. We already covered the fact that money market instruments usually mature within a year. In fact, it could even be one day. Bonds, on the other hand, have very long maturity periods as we discussed.
- Payment of interest: As mentioned above, money market instruments do not pay out interest but instead are issued with a discount. This is unlike bonds where interest is generally paid semi-annually.
- Accrued interest: If a bond is sold before the interest payment date, the buyer must pay the seller the amount of interest accrued since the previous payout. Any interest payments after this will go to the new owner of the bond.
- Paying agent: These are generally a bank’s trust department although sometimes, it’s the treasurer of the issuers. All payments of principals, as well as interest, are paid to investors by the paying agent. That’s the case for bonds but for money market instruments, because there are no interest payments, the paying agent will only repay the principal.
- Pricing: Bonds are generally quoted as a percentage of face value (par). From time to time, they can sell below or above par as well.
- Trustee: Investors are represented by trustees which usually are a trust company or other financial institution. Their responsibility is to make sure that the terms of the loans are followed by the borrower. In many cases, trustees can be paying agents as well.
- Secured or unsecured: Sometimes, specific assets can be used as collateral for the loan by the debt securities issuer. That makes it secure and adds a level of safety to the security. Otherwise, loans can be given based on the credit standing of the issuer with no asset acting as collateral.
- Callable or noncallable: The term callable and noncallable refers to bonds specifically. A callable bond can be redeemed by the issuer before maturity. This means they pay off the principal. This is useful when interest rates decline as they issue new bonds. From the proceeds generated, they can then call in the older bonds that have higher coupons. This is commonly known as refunding.
Let’s just expand on the dates on which semi-annual interest is paid.
If not specified, it’s assumed that this would be 1 January and 1 July, these types of bonds are known as J&J bonds.
But other bonds will pay on different dates and be named accordingly.
Here are the five other different types:
- F&A 15 bonds: Interest is paid on 15 February and 15 August
- M&S bonds: Interest is paid on 1 March and 1 September
- A&O bonds: Interest is paid on 1 April and 1 October
- M&N 15 bonds: Interest is paid on 15 May and 15 November
- J&D 15 bonds: Interest is paid on 15 June and 15 December
Types of money market instruments
Now that we have some more background about them, let’s look at the types of money market instruments that are to be found.
We begin with U.S. treasury bills.
T-bills, as they are known, are considered to be one of the safest money market securities available.
They are available in a range of maturities too from 4,8, 13, 26, and 52 weeks.
While these maturity ranges can change, they can never be longer than a year (52 weeks).
Of these, the 13-week (91) day T-bill is considered to be a risk-free investment and when issued, will include a discount compared to their overall face value.
Next, let’s discuss commercial paper (CP).
Issued by finance companies, in particular, a CP is a short-term unsecured paper that serves current and not long-term needs.
These are also called promissory notes and CP issues usually have outstanding credit ratings.
As far as maturities on a CP go, they can be anything from one up to 270 days.
Most CPs, however, will mature in around 90 days and when issued will include a discount when compared to their overall face value.
Our third money market instrument is negotiable certificates of deposit (CD).
In the Series 7 exam, these could be called jumbo CDs as $100,000 is their minimum size.
Interestingly with CDs, the most common size is $1 million but they can be higher than that as well.
And don’t confuse them with regular bank-issued CDs.
CDs do not have assets pledged as collateral making them unsecured time deposits as the money is loaned for a specified period to the bank.
As they are negotiable, CDs are readily transferable too.
This means that it can be sold before its maturity date on the open market with no prepayment penalty.
It’s interesting that as far as money market securities go, CDs are the only ones issued without a discount.
That means when they are issued, it is at face value.
It also pays periodic interest, usually on a semi-annual basis.
CDs can also be sold by broker-dealers and these are known as brokered CDs.
Compared to jumbo CDs, these, for the most part, will have a longer holding period.
It’s important to note these do not form part of the money market.
They are different from bank-issued CDs in the following ways:
- Their fees are far higher
- In some cases, FDIC insurance will not cover them. Don’t worry as to the reason why, just remember that this is the case for the exam.
For the most part, a brokered CD cannot be redeemed before it has reached maturity although the broker-dealer that offered it is allowed to buy it back.
There’s banker’s acceptance (BA) that’s a money market instrument that you need to know about.
This is used as a short-term time draft with a designated payment date usually by companies that operate in the import and export business.
In defining them, BAs operate as a line of credit or much like a postdated check.
Payment dates for BAs are never beyond 270 days but usually more likely to be between one and 180 days.
The bank on which the instrument is drawn will make payment when it matures.
To signify this, the word “accepted” is stamped on the face of the draft.
This payment happens even if a customer has repaid the bank for the acceptance that was initiated for them.
BAs are very marketable because of this bank liability.
BAs are used by U.S. corporations to help them finance trade internationally, for example, paying for services or goods in another country.
When used in this manner, they are often called a bill of exchange.
BAs, when issued, will include a discount compared to their overall face value.
Next up, we have repurchase agreements (Repo).
A repo agreement sees securities sold with an agreement in place.
This agreement specifies that on an agreed-upon future date they will be repurchased at a higher price.
There are even overnight repos and with these, the very next day is set as the purchase date.
Note that the interest earned by the investor is represented by the difference between the sale and repurchase price, so repos therefore, are always purchased at a discount.
The load advanced to the seller has the security enchanted serving as collateral of which Treasury securities are the most common.
There’s a reverse repo available as well.
As you’d probably guess, with this, the repurchase agreement is reversed and it’s not the seller, but the purchaser that will instigate the deal.
The attendant agreement says that securities purchased will at a future date be resold at a higher price.
The interest earned by the investor is then the difference between the purchase and resale price.
Usually, the Series 7 exam only includes questions about reverse repos being money market securities although it is good to understand how they differ from a regular repo.
Foreign debt securities
While the Series 7 exam will focus more on U.S. debt instruments, there might be questions on debt securities from foreign countries too
So let’s look into a few of the types of foreign debt securities that you get as well as their characteristics.
We begin with sovereign debt securities.
Who issues these?
Well, it’s the national governments of other countries, and the U.S equivalent, to give you an idea, would be U.S. Treasury securities.
Perhaps the best known of all sovereign debt securities are issued in the United Kingdom and these are known as gilts.
But what about those from other European countries?
Well in France, sovereign debt securities are called OATs and in Germany, they are known as bunds.
Don’t worry, you don’t have to memorize these for the exam, it’s just a bit of general knowledge.
What might come up on the exam about sovereign debt securities is how safe they are.
Well, ultimately, that depends on the issuing country and how its economy is performing.
That could lead to foreign governments defaulting on their bonds.
Next, we have foreign corporate debt securities.
In a manner similar to how U.S based corporations will, foreign companies too can issue debt securities.
For the most part, however, it’s not individual investors that will buy into these debt securities but institutions.
There are a few of these foreign corporate debt securities that might come up in the Series 7 exam, especially questions explaining the difference between the two below:
- Eurobond: These are long-term debt instruments. The currency in which they are denominated is not from the country they are sold in. For example, a French company might issue bonds that are denominated in British pounds.
- Eurodollar bond: With these debt instruments, the interest is paid in U.S. dollars although they are sold outside of the United States by non-American companies and even foreign governments. While they originated in Europe, they are not only limited to European issuers. The U.S. government, however, doesn’t issue Eurodollar bonds.
The easiest way to remember the difference between the two is the fact that Eurobonds will pay in foreign currency while Eurodollar bonds pay in U.S. dollars.
There are other bonds issued all over the world.
You won’t have to remember these but do understand that they can be popular as they have lower issuance costs because they don’t require registration with the SEC.
That said, their liquidity cannot compare with domestic issues from the United States but their yields can be higher due to influences such as political risks.
The next part of debt securities that we will cover relates to bond yields.
Most bond income will come from interest payments but of course, profits can be generated when securities are sold as well.
Let’s look at the various types of yields that you should know about.
We start with nominal yield.
The bond certificate will always show its interest rate as a percentage of the par value and this interest rate is called the nominal yield (or coupon rate).
It’s not difficult to work out the annual interest rate in dollars either.
Simply take the nominal yield and multiply it by the bond’s face amount.
Unless otherwise stated, the face amount is always $1,000.
For example, should a bond have an interest rate of 6%, it would pay out $60 per year.
Bonds are sometimes called fixed-income investments because each year the interest rate is the same.
Always assume that the interest is paid semi-annually on a bond (which means every six months) and that the par value for bonds is $1,000 unless the exam question says something different.
Also, note that if a bond pays 5% semi-annually, this isn’t two payments of $50 twice a year (every six months) but two payments of $25 each.
Next, we look at current yield.
The return on their investment is something that’s critical to all investors.
To work that out, simply take the current market price and divide it into the dollar amount for the annual interest for stock or the dividend in dollars.
This will provide you with the current yield, also known as the current return.
We’ve got to cover a few other things here as well.
A bond will sell at a premium should it be selling at a price that’s above face (or par).
It is selling at a discount when it sells below par.
In other words, investors get less when they pay more and get more when they pay less.
Par value will also affect payments at maturity, specifically the amount of the loan that the investor receives from the issuer in the form of repayment.
- A bond at maturity date purchased by an investor at a discount sees par value returned. This will be more than their purchase price for the bond which results in a gain over and above the interest.
- A bond at maturity date purchased by an investor at a premium sees a lower par value than the purchase price for the bond. The interest received will therefore be offset by a loss.
By looking at another yield, we can reflect the gain or loss at maturity of an investor.
This is known as true yield or yield to maturity.
For exam purposes, remember that if a bond’s yield (return) is above the coupon rate, it is selling at a discount from par.
And it’s a premium to par should the bond’s yield (return) be lower than the coupon rate.
We briefly touched on yield to maturity in the section above, but let’s look at it in a little more detail.
This acts as a measurement of the investors’ gain or loss for bonds when they reach maturity and are redeemed.
Again, there will be a profit in addition to interest when an investor has bought at a discount when compared to if they have bought at a premium (which will result in a loss if the bond is held to maturity).
These key facts play a part in all of this:
- Bonds are issued at par which is $1,000
- Interest will be fixed on the bond and is paid as a percentage of the par value
- No matter how much the market value of a bond fluctuates, interest values will always stay the same
- Supply and demand influences the current market price of any bond
- Bonds mature at par
- If purchase at par, the same as the original investment at maturity can be expected
- If purchased at discount, a profit can be expected on the original bond investment
- If purchase at par, the same as the original investment at maturity can be expected
- If purchased at discount, a loss can be expected on the original bond investment
The fourth bond yield we will cover is yield to call.
When a bond has a call feature, it can be redeemed at the issuer’s option before it reaches maturity with the call price either at premium or par but never at a discount.
The call date is in effect the maturity date when calling a bond.
Should this happen, the yield to call is linked to the rate of return the bond provides, much like yield to maturity.
However, it is from the purchased date to the call date.
It will produce a lower return than yield to maturity if the bond is selling at a premium which makes call protection important.
While many reasons contribute to why interest rates will go up and down, for the exam, all you need to know is how their fluctuations can affect bond prices.
And while we’ve mentioned it before, it’s worth reiterating – interest rates and bond prices move inversely to each other.
Interest rates going up mean older bond prices will go down and vice versa.
You must understand the impact of newly issued bonds as well.
That’s because, on these, a higher rate of interest is paid when compared to older bonds that are in the marketplace already.
These older bonds aren’t that attractive to investors as their interest rate returns won’t be as high.
Obviously, there are times when older bonds still have higher interest rates than new bonds, but generally, it will be the other way around.
For money market instruments, at maturity, the “interest” is paid when, at maturity, the investor receives the discount back.
This does not apply to CDs, however.
Note other than zero coupon bonds, all other bond types will pay interest every six months, or semi-annually.
Let’s just look at the term duration and how it is used in the financial industry.
It’s important first to understand what duration measures.
Well, when interest rates change, duration will measure the overall sensitivity of a particular debt security to those changes.
While the computation to work this out is pretty complex, we can make it easier to understand.
It relates to the invested principal and just how much time it takes for that to be repaid by cash flow, in this case, the interest payments.
In general, if interest rates are higher, the duration will be shorter than when interest rates are lower.
Market price movements come into effect when the duration is longer.
That’s because there is a greater interest rate risk on debt securities with a long duration over those that are shorter in length.
If we look at zero coupon bonds, they mature at par after being issued with a discount.
And the measured duration for them?
Well, that and the length of maturity are always equal.
What about an interest-paying bond?
Well, the measured duration for them is always shorter than the time to maturity.
Why is that?
Well, here the additional interest can be earned because interest payments can be reinvested.
The two crucial components in a duration calculation are the maturity date of the bond and the interest rate.
Should maturity rates be similar, the shortest duration is always the bond that pays the higher interest rate.
Those that have lower interest rates will have longer durations.
It’s important to remember these duration characteristics for the exam:
- Higher interest (coupon) rates mean shorter durations and vice versa
- A bond’s duration increases if the bond has a longer maturity
- Duration is always less than the maturity of a bond when it comes to coupon bonds
- Duration is always equal to the maturity of a bond when it comes to zero coupon bonds
A bond’s rating can play a major part in which bond investors end up choosing to invest in.
The overall strength of the borrower helps to show the relative safety of a debt security they might want to purchase.
If the loan has collateral, that strength can be further increased.
To see just how safe a debt security is for their clients, most investors will turn to rating services of which there are quite a few.
The SEC recognizes the following:
- DBRS, Ltd
- Fitch Ratings
- Moody’s Investors Service
- A.M. Best Co., Inc
- Standard and Poor’s (S&P) Rating Service
- Rating and Investment Information, Inc
For the exam, you should remember Moody’s and S&P.
They will indicate the debt’s safety of various debt securities using a letter rating system.
Let’s look at each of these rating systems for each of these companies.
Let’s start with Moody’s bond ratings.
- Aaa – Highest quality bonds
- Aa – High quality bonds
- A – While their security of principal and interest is adequate currently, Moody’s think that in the future, they may be impaired
- Baa – These bonds are considered to be neither poorly secured nor very well protected. They are medium grade bonds.
- Ba – The future of these bonds is not considered to be well assured by Moody’s. As far as quality goes, they are seen as speculative.
- B – These bonds are seen as having any characteristics that would make them a suitable investment target
- Caa – These bonds may be defaulted and are considered by Moody’s to be in poor standing
- Ca – These bonds are often in default and considered by Moody’s to be speculative
- C – These are the lowest rating bonds in the Moody’s system. They are not considered to offer any investment value at all.
Moody’s uses further categories for bonds from AA to B.
Here 1 is high, 2 is middle and 3 is low in terms of rating class.
Here’s the bond rating system used by Standard and Poor.
- AAA – Highest quality bonds
- AA – Debt obligations of high quality
- A – While they may be affected by other influences, these bonds are considered to be more than capable of paying both principal and high interest.
- BBB – The capacity to pay interest and principal on these bonds is considered by S&P to be adequate. Changing circumstances as well as unfavorable economic conditions can make them more vulnerable.
- BB – With limited positive investment characteristics, these bonds are of lower medium grade
- B – When exposed to unfavorable conditions, these speculative bonds are filled with major risk and uncertainty
- CCC – These bonds may be defaulted and are in poor standing
- C – No interest is being paid on these income bonds
- D – Bonds with this S&P rating are in default.
Within these bond ratings, S&P will also use + and – to show relative strength.
In other words, a bond of BBB+ is a better bet than BBB-.
Note that Fitch, another rating agency, uses the same system as S&P.
In the Series 7 exam itself, you may receive a question to rank the rating systems in order based on a particular rating agency.
The top four categories in bond ratings (BBB or Baa and higher) are also called investment grade.
When various institutions like insurance companies, banks, or fiduciaries want to purchase bonds, this is the quality that they look for.
The main reason for this is that these higher-rated bonds are far better in terms of their lower-grade counterparts because they offer greater liquidity.
But there’s risk and reward to consider as well.
That’s because the stability of the investment in higher rated bonds does mean that their yields are lower.
Junk bonds or those that are lower-grade are those that can offer higher yields.
They are also sometimes called high-yield bonds.
They have a rating lower than BB or Ba thanks to the fact that they have additional risks including that they may default.
During an economic downturn, these bonds might be subject to significant price erosion.
This can occur when the overall creditworthiness of the bond is questioned as well.
When compared to investment-grade bonds, these are far more volatile.
They are worthless, however, particularly for sophisticated investors.
That’s because speculative fixed-income investments can provide capital appreciation and high-grade returns.
With those potential higher returns, there is far more risk.
At the end of the day, all factors are considered when these agencies provide ratings for bonds, with collateral included too.
That said, not all bonds will receive ratings.
Either these bonds pay the agency to rate them, or they generate constant interest from investors, and therefore rating them is beneficial.
So if a bond isn’t rated, it doesn’t mean that it cannot offer some investment quality overall.
That’s why investors have to constantly be on the lookout for excellent opportunities that might not come from a rated bond.
Bonds and money market instrument ratings are very similar.
It’s the overall quality of the debt that is being measured by the rating agencies.
If the quality of a money market instrument is high, the financing cost is lower.
Moody’s, S&P, and Fitch are the three rating agencies that could come up in the Series 7 exam when it comes to money market ratings.
Moody’s ratings are as follows:
- MIG 1 (best quality overall) to MIG 4 (adequate quality). A speculative note will be listed with SG.
S&P ratings for notes are:
- SP-1 (best quality overall) moving down towards SP-3.
Fitch notes are rated as:
- F-1 (best overall quality) moving down towards F-3.
Investing in alternative debt securities
Let’s start this section by looking at the types of alternative debt financing that we should consider for the Series 7 exam.
Alternative investments, or Alts as they are known in the industry, became all the rage back in the 1990s when wealthy clients were introduced to them by financial advisers.
These Alts comprised financial derivatives that were highly sophisticated as well as other products such as ETFs and ETNs.
Their popularity stemmed from the fact that these structured products could be created in such a manner that a financial adviser could make them meet the specific investment needs of each individual.
Obviously, however, this made them extremely complex and super difficult to get to grips with, not only for the investor but the financial adviser recommending the investment as well.
Investment is pretty easy to understand on the whole.
Stocks will provide more returns but are riskier while the risk factor will drop with bonds, along with the lower returns.
These alternative debt securities are about trying to score excellent returns while not being saddled with a loss and while many do offer success, others can fail.
Case-by-case suitability should be the order of the day when suggesting these.
We’ve covered this before but it should always include the overall objectives of a customer, their circumstances, and their investment sophistication.
Even when recommending these investments to sophisticated customers, due diligence must be carried out by investment advisers.
Let’s look at a few of these products starting with equity-linked notes (ELNs).
With these a single stock, basket of stock, or equity index provides a return which is a final payment once they mature.
Should the note be index-based, it’s commonly called an index-linked note.
Some can be traded on exchanges but not many and these are called exchange-traded notes (ETNs).
Because of their risks, both ELNs or ETNs are not considered investment instruments for most investors.
But what risk do they have?
- Because they are unsecured debt obligations, ETNs and ELNs are a credit risk
- ETNs and ELNs have market risk
- ETNs and ELNS have liquidity risk
- ETNs can be recalled by issuers while both have acceleration and early redemption risks
- Trading activities of the issuer may not gel with note holders which creates conflicts of interest
Next, we look into private placement debt.
What is it?
Well, the name gives a clue.
This is when money is loaned out privately.
What that means is that these types of securities are not registered with any regulatory boards and their privacy also means that investors cannot be guided as to how good they might be, or how risky, because they simply are not rated.
Most companies that provide this type of investment opportunity are at a midpoint in their overall development, somewhere between the top and bottom floors, so to speak.
That’s why private placement debt is also known as mezzanine debt.
While potential rewards are greater with the kind of investments, so too are the risks.
Also, lenders can be repaid in stock instead of cash.
Investors can make excellent returns should the company go on to become a huge success.
The opposite is true should it fail, however.
In summing up alternative debt securities when compared to more traditional investments, we have to take some factors into account.
Perhaps the most critical is the fact that they do not have any form of regulation.
They also offer low liquidity, are particularly transparent, have high fees and because they are a relatively new way of investing, they don’t have any historical data to help make investment decisions.
So why would investors turn to these alternatives?
Well, for the most part, they are not afraid to take the risks associated with them to score the massive potential rewards.
Also, those that do invest in these alternatives are usually wealthy, highly sophisticated individuals or institutions.
By issuing securities, corporations can look to raise capital or finance debt.
For example, investors can loan money to a corporation through investors purchasing their issues.
This is known as debt security.
So when an investor purchases a bond, for whatever reason, they are effecting for a set time, lending a corporation money.
In return for that, they received returns at a fixed annual interest rate.
Bondholders have a number of advantages for becoming creditors too.
This includes taxation as well as their rights should the company be liquidated.
These are some of the things we will cover in this section.
To start, however, let’s look at the type of bonds that corporations issue.
We start with one of the most popular forms of investment available today and that’s mortgage bonds.
With these, backed by any real estate that they own including land, office buildings, and factories, for example, corporations will borrow money from investors.
It’s important to note that the real estate pledged in these situations is always going to be much more than the money borrowed under the issue of the specific bond.
Mortgage bondholders will receive payments of interest for loaning the money.
Should things go wrong financially for the corporation and that interest cannot be paid, the mortgage bondholders are paid off when the real estate assets that act as collateral are sold.
Sometimes, however, the sale of the collateral might come in lower than the mortgage balance outstanding.
Should this happen, they will become a general creditor for any balance that is still outstanding.
Equipment trust certificates
Many corporations need to finance expensive equipment, for example, airlines that need to purchase aircraft.
They do this through equipment trust certificates.
Because this equipment is so expensive, it’s never paid in full from the start.
Instead, a down payment is made and the balance owed will be paid back over a certain period, for example, 20 years.
Note that a portion of the loan is paid back each year.
The reason for this is the fact that the equipment is in use and will have general wear and tear and eventually, it will need to be replaced.
Theoretically, however, the value of the assets should not be less than the amount of the principal remaining on the loan.
Should the company default on its payments, the lenders can repossess the collateral.
It is then sold so that they can recoup their investment.
When the company has paid off the loan, the trustee will pass on the clear title for the equipment that was financed.
Think of how the finances work when someone purchases a car and you will easily understand how equipment trust certificates work.
Collateral trust bonds
A corporation might use a collateral trust bond to borrow money when they don’t have real estate or equipment as assets on which to loan against.
In this situation, the collateral for lenders is instead the securities owned by the corporation which are then deposited into a trust.
These can be securities linked to the corporation itself or any others that they may have purchased elsewhere.
The only real thing that these securities need is to be easy to liquidate which will make them marketable.
Bonds will receive higher quality ratings based on the overall quality of the securities used as collateral.
Backed by overall creditworthiness and its word, corporations can use debentures as a debt obligation.
These are effectively written promises by the corporation.
They confirm that on a specific due date, they will pay the principal of the debenture.
It also states, however, that they will pay interest to investors on a regular basis.
Debentures don’t include any pledge of property, for example, but are as binding as a promise for a mortgage bond.
So what does an investor base their decision on when buying into a debenture?
Well, ultimately, it’s on the company’s general credit.
Debenture quality depends on two things:
- The overall assets of the issuing company
- The earnings of the issuing company
Debentures are unsecured but some issuers have excellent credit ratings which can make them a safer option than the mortgage bonds issued by companies with less than stellar credit records.
Higher credit scores mean higher debenture limits as well as lower interest rates too.
When a corporation other than the issuer guarantees that interest or both principal and interest will be paid out to investors, you have a guaranteed bond.
The strength of the company making the guarantee, however, adds to the value thereof.
Income or adjustment bonds, as they are also known, have a particular role for companies that are coming out of bankruptcy and reorganizing.
Only when the board of directors for the company declares an interest payment and if there is enough income to meet that payment, will an income bond actually pay interest.
Note, if the company does not pay investors at certain points, any interest payments that are missed will not accumulate.
For this reason, customers who are looking for a stable income from their investment should not be advised to invest in income bonds.
Zero coupon bond
The bonds discussed so far will pay investors interest every six months (or semiannual interest) for the most part, unless it’s an income bond.
Zero coupon bonds, or zeroes as they are known, are different.
Instead of making interest payments, they are traded at a massive discount.
They also mature at par.
That difference between the value at maturity and the discounted price they were purchased at is the investor’s return (also called accretion).
When we talk about corporate bonds, we must look at claims and the sequence of priority should a corporation be forced to liquidate.
To start, the corporation will need to formally file for bankruptcy.
How this happens and the various bankruptcy filings on offer won’t form part of the Series 7 exam.
What you may be asked, however, is how the payment order works when it comes to priority.
In other words, who gets paid first and what order follows from there on in.
This is something we’ve touched on before, but it’s always useful to get a reminder, right?
Here’s the order of priority:
- Secured creditors
- Unsecured creditors
- Subordinated debt holders
- Preferred stockholders
- Common stockholders
Even for debt securities that find them low down the order of overall rankings, there is still a priority when it comes to payment.
So before any equity security is paid, it’s the principal and the payment of interest that must come first.
And remember, no matter what, equity securities will never come before a debt security.
That always has priority.
But what about the payment of items that aren’t considered to be securities.
Yes, when a company liquidates, these need to be paid too and will fit into the payment priority order.
This may come up in the Series 7 exam.
After secured creditors, the higher priority is wages, taxes, general creditors, and debentures.
Convertible debt securities
In the next section, we cover convertible debt securities, most of which are debentures.
These are considered long-term corporate debt securities.
But what are they exactly?
Well, it allows the investors (or lenders) to gain shares of common stock in the company by converting the debt.
Note that it’s only corporations that are able to issue convertible debt securities, while government or municipal bonds are not convertible.
Also, it’s at the discretion of the investor that the conversion privilege is exercised.
The indenture at the time the bonds were issued will include terms for the ratio of the conversion.
This will obviously differ from one corporation to the next that issued the convertible debt securities.
The indenture will also include the method for calculating the exact number of shares that can be converted.
When talking about convertible debt securities, we have to look into the conversion ratio.
To start, let’s look at what conversion price is.
That’s the price where a convertible bond is allowed to be exchanged for common stock shares.
The amount shares a bond may be converted into is the conversion ratio.
Sometimes this might also be called the conversion rate.
For example, the conversion ratio might be 40:1 or 40 shares for 1 bond.
A conversion ratio of 20:1 shows the bond can be converted into 20 shares.
For the most part, however, the indenture won’t mention the conversion ratio but instead, it will provide the conversion price.
We covered exactly what that is.
If you can’t work out the number of shares into which the bond is convertible, you can do so using a simple calculation.
All you need to do is take the par value (which is always $1,000) and then divide it by the known conversion price.
So, a bond that is convertible at $10 per share will convert into 100 shares as per the equation above – par value divided by conversion price: $1,000 / $10 = 100).
When it comes to convertible preferred stock, you can use the same concept.
What about convertible securities and their advantages to the issuer?
Well, to start, the option to make bond or preferred stock convertible means that corporations can make them more marketable.
And that’s often one of the main reasons as to why they do so.
There are other reasons too, however.
Let’s look at them:
- When compared to nonconvertible shares, those that are convertible are often sold with a lower coupon (interest) rate. That’s due to the conversion feature.
- Companies can reduce debt using convertible shares. That’s because by opting for this option, as the conversion takes place, fixed interest rate charges are eliminated.
- The stock price is not affected adversely by conversion because this process takes place over an extended time period. This is unlike a scenario with a subsequent primary offer where it may be affected.
- When compared to the market price of common stock, the conversion price is higher at issuance.
Of course, there are disadvantages of convertible securities to the issuer as well.
Let’s look at some of the disadvantages to both stockholders and the corporation.
- The equity of shareholders is diluted when bonds are converted. What does that mean? Well, with shares that are left outstanding, those that are not will represent a smaller portion of the overall ownership in the company.
- A large conversion of shares could mean a change in control of the corporation. That’s because common stockholders have a part to play in the management of the corporation.
- A loss of leverage results in using conversion to reduce corporate debt.
- The corporation’s taxable income will go up as a result of the lower deductible interest rate costs.
Now let’s look at convertible securities and their advantages to investors.
With the potential appreciation similar to the equity market as well as the safety of the fixed income market, it’s easy to see why convertible bonds are popular with investors.
Here are some other advantages as well:
- A convertible debenture, because it is a debt security, will pay interest at a fixed rate and it’s usually higher when compared to an underlying stock’s dividend income as well as that of common stock
- If the debenture has not been converted, it can be redeemed at maturity for its face value
- If a corporation is forced to liquidate, convertible stock when compared to common stockholders, convertible bondholders will have priority.
- When compared to underlying stock, the market price of a convertible debenture should be more stable in theory if the market starts to decline. When compared to other debt securities, the debenture price should reflect a competitive CY as there is a decline in stock price that will see it at a level far below the conversion price.
- As a result of common stock acquired through the conversion of convertibles, if stock prices move up, so does the market price of those convertibles.
- The potential upside experienced by common stockholders is something that the owner of a convertible debenture has too, but with less downside risk. When compared to most fixed-income securities, this is something that they do not offer.
- It’s not considered a purchase or a sale for tax purposes when a senior security is converted into a common stock. This means that a conversion transaction doesn’t have any tax liability.
Here are the disadvantages for investors of convertible securities.
- The biggest disadvantage when it comes to convertible securities is that they pay a lower interest rate. Should an investor’s primary goal be generating income, convertibles are what they should be investing in. This is something that may feature on the Series 7 exam.
- Compared to other debt securities, the investor’s priority is lower with convertibles. This is as a result of the fact that they are debentures.
- Investors may be forced to decide as to whether they should convert if the security is callable and the issuer decides to call it. If they do choose to convert it, the investor will lose the semi-annual interest payments and then all the risks of owning common stock come to the fore, for example, priority in the case of liquidation (right at the bottom of the list in the case of common stockholders).
Because dilution is important in the financial industry, let’s talk about convertible securities and any anti-dilutive protection they might have.
Dilution from a stock dividend or stock split is a real concern for holders of convertible securities and they’d certainly want some protection from that should it happen to their convertible bond or preferred stock.
Let’s say an investor-owned a bond that could be converted into 30 shares.
A 3:1 stock split is then declared by the issuer.
That means the investor would need to be able to convert into 90 shares if they wanted to have the same conversion benefit as before the stock split was declared.
But the new price would be half of the former if the conversion privilege was shown as the conversion price.
This would allow the investor to convert three times as many new shares.
Computing the parity price of a convertible bond
Parity is the concept behind all the details we’ve covered when it comes to convertible bonds and how they move in conjunction with the underlying common stock.
What does parity mean?
Well, if two things are considered to be in parity, they are equal.
But how does that work with convertible bonds then?
Well, if an investor holds a convertible bond, they have two actions that they can choose:
- Either they can continue to hold onto it, or;
- They can turn it into the common stock of the issuer by choosing to convert it.
Parity comes into the equation when the common stock available after the conversion and the convertible security beforehand are worth the same.
Series 7 exam questions that want the parity price will include the convertible securities (either preferred stock or debenture) conversion rate.
If the stock parity price is what the question is after, it will include the convertible’s current market price.
If the convertible’s parity price is what the question is after, it includes the stock’s current market price.
Remember this to make your life a little easier should these questions arise on the exam.
Having said all that, parity only occurs in theory.
In reality, the market price of the preferred stock or debenture is always going to be higher than the parity price.
As the underlying common stock’s value goes up when equity markets are strong and stock prices rise, so does the value of the convertible bond.
The opposite is true as well should equity prices decline, however, when the yield is competitive with that of the nonconvertible bond’s yield, it will level off, for the most part.
And that means that when it is compared to common stock, it won’t decline as far.
As for the premium at which they sell, convertible bonds are normally above parity in that regard.
Taxation of corporate debt securities
Corporate debt securities are no different from equity securities and they will be subjected to taxation.
That’s what we will cover under this section, particularly when it comes to the tax issues that investors in these securities face.
When the Series 7 exam talks about interest, it’s critical to understand that it is treated as ordinary income when corporations pay out interest on their debt securities.
Also, there is no reduced tax rate from a qualified interest category as you would find with dividends on stock.
Not only will it be at the federal level that income tax will be applied on interest but also at the local and state level too, if applicable.
We’ve talked about zero coupon bonds earlier and while they don’t pay interest income, investors in these bonds will have to pay income tax.
The amount is based on the accreted amount of the bonds.
And no matter what direction a market price moves, income tax will still be due.
Capital gains and capital losses
As we know, capital gains occur when bonds are sold for a higher price than what the investor initially paid for them.
On the opposite end of the spectrum, capital losses occur when they are sold for a lower price than what the investor initially paid for them.
So to determine the capital gain or loss, just look at the purchase price compared to the sale price.
Note, however, that the sale price is par when the bond is held until it matures.
Also remember, there are no gains or losses when a zero coupon bond is held to maturity but that’s not the same with interest-bearing bonds.
It’s important to distinguish between the two.
Tax rules are also governed by the length of time the bond is held.
For example, gains and losses are considered to be short-term should the bond holding period be 12 months or less.
Anything longer than 12 months for a holding period is considered to be long-term.
That’s the only thing the IRS worries about along with if it’s a gain or loss.
They most certainly aren’t concerned if the transaction is for a stock or a bond.
Municipal securities (bonds)
Municipal securities are those issued by:
- U.S. territories
- U.S. states
- Local government in the United States
When investors buy into these types of securities, they are effectively loaning money to those entities who issued them so that they can carry out various projects.
These include construction projects or public works, for example.
When it comes to risk, investors turn to municipal securities because of their relative safety.
In fact, they fall just under the U.S. government and their agency securities in terms of safety.
On the Series 7 exam, most of the questions around municipal securities will deal with municipal bonds, in particular, a form of long-term debt.
Let’s start by looking at municipal bonds and their general characteristics.
Basis quotations and municipal bond price
When priced and offered, for the most part, municipal bonds will be sold on a yield to maturity basis (YTM) over their dollar price in what is known as a basis quotation.
So if it’s quoted at a basis of 4.33, then the YTM is 4.33%.
It’s important to understand basis points in these scenarios too.
In our example above, should a bond see its yield fall to 4.25% it is said to have dropped by 8 basis points.
A change in price can also be reflected by using basis points.
Don’t forget about dollar bonds either.
This is when a bond is not quoted as basis or yield but instead as price.
For the exam, a question might give details like a 5% bond quoted on a 5.5 basis.
This means that the interest on the bond is 5% while 5.5% represents its yield to maturity.
It’s trading at a discount too, because the yield to maturity is higher than the interest (coupon) rate.
If the basis was 4.5 in that example, the bond would be trading at a premium.
Simply remember if the basis is above the bond percentage, it’s trading at a discount and if it is below the bond percentage it’s trading at a premium.
While we are on this subject, let’s look into quote rules for municipal bonds.
Before we get into that, let’s reconfirm a few facts about these bonds.
They won’t be found on any stock exchanges.
It’s on the OTC market where they are bought and sold.
The MSRB regulates all securities professionals that operate in this field and all major brokerages will have specific departments that only deal with municipal bonds.
Let’s look at some of the MSRB rules that deal with bonds.
Although you won’t need to know the rule numbers for the exam, it’s important to understand what these rules do.
- Firm (Bona Fide) Quotes
All quotes that are published, distributed, or given by a municipal dealer for a security according to regulations must be bona fide, or firm.
That means that the price of the security in the quote is the price at which the dealer will trade it as well as pertaining to any restrictions/conditions that go along with the quote.
The best judgment of the dealer must always be reflected in a bona fide quote and it must be close to the securities fair market value.
The quote, however, can also include the expectations that the firm has in terms of the direction the market can take and also reflect their inventory.
The fair market value and the quote’s relationship to that are more important in this situation than the quote representing the best price.
When other dealers are distributed by a brokerage, they must also do so believing that the quote is bona fide as well.
- Other quotations
Now that we’ve covered bona fide quotes, let’s look at a few others that dealers in municipal securities are likely to give.
First, we have a workable indication and this shows the price they are prepared to pay when buying securities but only from another dealer.
Second, we have a nominal quotation also known as a subject quotation.
These must always be clearly labeled as such and are only provided to serve as information.
They showed the estimate of the value of a security market from a dealer’s perspective.
Thirdly, let’s discuss holding a quote.
This sees dealers of municipal securities quoting on a bond price.
Nothing new here, except the fact that the price that is quoted is firm for a certain period of time only and it’s also known as an out-firm with recall quote.
But what’s the length of time involved for these quotes?
Well, generally that’s an hour (sometimes half-an-hour) with the quote having a five-minute recall period.
Dealers use out-firm quotes for bonds that they don’t own in an attempt to sell them.
Should they find a buyer in the specified time, the bonds can be purchased as per the out-firm quote from the firm providing them.
It’s often that municipal dealers won’t have certain municipal securities in their inventories but still be called upon to prove current quotations on them.
So they will solicit offers to sell from the marketplace when a customer of a municipal firm wants to purchase a certain bond.
They will also solicit bids from the marketplace should a customer approach them with bonds that they want to sell.
When compared to listed securities, you won’t find municipal bonds listed on an exchange as they are and therefore they do not have the same quote or price transparency.
- Multiple markets
More than one broker-dealer is often under the control of some massive financial organizations.
So if a municipal security quote is published, what must be made clear is that it’s not two independent quotes but only one quote.
If this is not carried out, it falsely shows that the bonds have far more liquidity than they actually do have.
Municipal bond maturities
Municipal debt issues have three types of maturity schedules and these all can appear on the exam.
Let’s start with term maturity.
On a single date in the future, all principals mature.
This includes dollar bonds or those that are quoted by price.
These are also called term bonds.
Both municipal and corporate issues may establish a sinking fund.
This is operated by the trustee of the bond and it’s put in place to help clear the way for the retirement of the bonds under the control of the municipal or corporate issuer.
Sinking funds can carry out numerous functions.
For example, when a bond reaches maturity, they are able to redeem them.
They can also call bonds or buy them back on the open market.
A trustee account is needed to establish a sinking fund and the issuer can then deposit cash into it.
Overall, the safety and marketability of a bond can be improved thanks to the fact that bonds can be paid off with money made available from a sinking fund.
We also have to consider serial maturity.
A predetermined schedule is used for bonds within an issue that will mature on different dates.
To show the difference in the issue when it comes to maturity dates, this schedule will quote serial bonds on their yield to maturity.
Should the price/yield column on the schedule for a bond entry show 100%, that will indicate the coupon rate and yield to maturity rate of that bond are equal which shows the bond is offered at par.
Also, the yields will be higher the longer the bond takes to mature.
The last type of maturity we are going to look at is balloon maturity.
This is when part of the bond’s maturity is paid by the issuer.
This payment takes place before the bond’s maturity date.
Note, however, that this portion that is paid off will be smaller than the final portion paid off at maturity.
Balloon maturity bonds are seen as a type of serial maturity.
Legal opinion on municipal bonds
On every bond certificate issued, you will see a legal opinion.
Signed by the bond counsel (attorneys who specialize in bond offerings that are tax-exempt), this is printed on the certificate itself unless the bond has a specific ex-legal stamp.
What purpose does the legal opinion serve?
It states that:
- The issue conforms to all the necessary laws
- The debt issuer is legally bound by the issue
- If the bond is tax-exempt
Legal opinions are issued in two ways:
- As a qualified opinion (which means purchasers must be informed if there are legal uncertainties)
- As an unqualified opinion (which means it is unconditionally issued by the bond counsel)
In some cases, issuers, as is the case with smaller municipalities, for example, may not obtain a legal opinion.
These bonds are then considered to be ex-legal and the bond certificate must clearly show this.
With these kinds of municipal bonds, good delivery requirements can be met but with no accompanying legal opinion.
Should another law firm be used as an underwriter’s counsel by the managing underwriter, they are employed to represent the interests of the underwriter only.
Legal opinion is not something that they will not be responsible for.
Types of municipal securities
It’s the maturity of municipal securities that helps define them.
For example, a municipal note will mature in less than five years.
Anything over a five year maturity period is known as a municipal bond of which there are two categories:
- GOs or general obligation bonds
- Reverse bonds
When capital is needed to be generated as a way to benefit a local community, municipal bonds in the form of GOs are issued.
The projects that they will help fund are generally not those that will create any revenue.
That means that taxes collected by the municipal issuer will be used towards paying out both principal and interest to investors.
For this reason, GOs are often called full faith and credit issues.
Let’s start by looking at the source of funds for GOs.
As mentioned before, it’s the taxing power of the municipality that helps back GOs in terms of paying investors both principal and interest.
The money needed for these bonds can be generated through:
- Sales tax
- Income tax
- License fees
- And in other ways
Should the bonds be issued not by municipalities but by counties, cities, or towns, they are backed by:
- Ad valorem (property) tax
- License fees
In most cases, GOs cannot just be issued, as they will require approval from local voters.
Now let’s look at statutory debt limits that relate to GOs.
As a way to protect taxpayers from paying too many taxes related to GOs, the amount of debt incurred by municipal governments might be limited by statutes, both from the state as well as locally.
These debt limits are also something investors look into as it helps make the bond a safer proposition for them.
That’s because, with lower debt limits, there is less risk of a municipality defaulting because there is less excessive borrowing.
A public referendum is required if municipalities want to issue GOs that are above the debt limit that’s imposed locally or by the state.
Voter approval will look at:
- Tax limits: Property taxes are limited in some states. They would only be allowed as a specific percentage of the value of the property assessed or a specific increase in percentage in any single year.
- Limited tax GOs: This type of GO is used as a specific kind of tax (for example, income tax) to secure it, or limits are put in place on tax amounts that may be assessed. This means when it comes to how much tax can be used to service any debt, the issuer of the bond is limited. A GO backed by the issuer’s full taxing authority is less risky than those with limited tax backing.
- Overlapping debt: This sees a range of taxing authorities that use the same taxpayer pool to issue debt. When the same taxpayer pool is tapped by bonds issued by different municipal authorities, it is known as conterminous debt. This only happens when property is taxed.
When a municipal facility generates sufficient income, revenue bonds are used to help finance projects related to them and for this reason, are seen as self-supporting debt.
These bonds won’t need voter approval and statutory debt limits do not apply to them either.
They may have to pass additional bonds tests if ensuing bond issues that have equal liens on the project’s revenue are to be issued.
That’s because it must be established that both the old and new debt can be paid by the revenue stream.
Revenue bonds will need to undergo a feasibility study before they are issued.
This will see issuers using a range of consultants to prepare various reports that cover:
- The overall economic feasibility for the specific project
- Estimates of generated revenues
- Operating aspects relating to the project
- Economic aspects relating to the project
- Engineering aspects relating to the project
Where do the sources of revenue for these bonds come from?
It’s the specific earnings as well as the net lease payments of facilities that produce revenue that is used to pay the principal and interest payments for these types of bonds.
- Utilities (sewer, power, water)
- Transportation (toll roads, airports)
- Education (student loan and accommodation)
- Industrial (pollution control and industrial development
These are just some of the examples.
Nor the municipality’s full faith or credit or real estate or general taxes will cover the debt service payments on bonds like this.
These bonds may have protective covenants in place.
A trust indenture or bond resolution may be referred to on the face of a revenue bond certificate.
This means that a trustee can act on bondholders’ behalf.
Through the trust indenture, certain protective covenants (promises) are meant to provide protection for the bondholder and this is something the municipality will agree to.
An indenture-appointed trustee will help supervise the compliance with these covenants.
We’ve mentioned it, but let’s shed a little more light on trust indentures.
These can vary but on most bonds, the provision of a trust indenture will include the following:
- Rate covenant: A pledge that expenses and debt service will be maintained through the maintenance of sufficient rates
- Maintenance covenant: This is a pledge that all facilities and equipment will be maintained
- Insurance covenant: This is a pledge that facilities will be insured. That means that should it become inoperable or even be destroyed, bondholders will be paid off.
- Additional bonds test: This will show if the indenture is open or close-ended. If it is open-ended, then further bonds may be issued. However, they must have the same status. They must also provide equal claims on revenues and assets. If it is closed-ended, no further bonds can be issued that have equivalent assets or revenue lien. Should additional bonds be issued, they will be ranked lower than the original issue.
- Sinking fund: Principal obligations and interest is paid off with money from this fund as we’ve mentioned previously
- Catastrophe clause: This is an obligation that should the facility be destroyed, the insurance proceeds will be used to repay bondholders and to call bonds. This is sometimes called an extraordinary mandatory call or calamity call.
- Flow of funds: This shows how revenues that the fund makes will be disbursed to investors as well as the priority order
- Book and records covenant: This shows that the fund will employ auditors from outside companies to deal with financial reports and auditing of records.
- Call features: This shows both the call price as well as the call date of the fund.
You won’t see trust indentures for all municipal bonds.
That’s because they aren’t actually a pre-requisite.
That said, they do offer some perks to those bonds that use them and certainly make them far more marketable.
Note that it’s revenue bonds that are likely to have trust indentures while GOs make use of a bond resolution mostly.
Revenue bond types
In this section, we are going to look at the various types of revenue bonds that you will find.
We start with industrial development revenue bonds.
Also known as IRDs or IDBs these bonds are used to either purchase equipment or in the construction of new facilities.
In the case of equipment, corporations will lease it for their use over a certain period of time.
The money generated from those lease payments is used by the municipality to pay investors their share of the interest on the bond as well as the principal.
Also, the debt rating of the bond is actually that of the corporation because they have the responsibility for the payment of interest and principal.
Alternative minimum tax (AMT) can be applied to certain industrial development revenue bonds.
The next type of revenue bond that we are going to look at is lease-rental bonds.
With these bond arrangements, office construction is financed for a municipality itself, the state, or the community by issuing these bonds.
Then there are double-barreled bonds.
These revenue bonds have similar attributes to GOs.
The earnings of a specified facility are used to pay both the interest as well as the principal.
But there’s another source of revenue too, hence the name of this revenue bond.
That source is the state/municipality’s overall tax power.
The similarity to GOs continues in the fact that they are rated and traded as such too.
Certificates of participation are what we are going to look at next.
With this type of release revenue bond, there is a stream of revenue that’s generated through a lease, installments, or loan payments associated with either the purchase of land, facilities, or expensive equipment.
And this is what the investor will benefit from.
There is no voter approval for certificates of participation, similar to other revenue issues.
A parent is tied to a year appropriation made by a government body, this form of bond is not seen as debt from a legal perspective.
While this happens rarely, one of the unique features of these certificates is the fact that in the event of a default, holders are allowed to foreclose on whatever the certificates financed themselves.
Another example of a type of revenue bond is special tax bonds sometimes called designated tax bonds.
It’s one or more designated taxes that will secure this type of bond although not for property (ad valorem) taxes.
So taxes that are raised by the sale of fuel, alcohol, or tobacco, as an example, could be used to fund bonds with a particular purpose in mind.
Note, however, that it’s not necessary for the tax used to fund the bond to be directly related to it.
Because other forms of income can be used to fund the bonds should the tax not generate enough, special tax bonds are not seen as a self-supporting debt.
Then we have special assessment bonds also known as special district bonds.
When finance needs to be raised for various public improvements, for example, building sidewalks or upgrading sewers, municipalities will use this type of revenue bond.
To pay the principal and interest on these bonds, issuers will assess a tax only on that which benefit from the intended improvements, for example, a municipal building.
When bonds are needed to fund new housing projects, it’s often new housing authority bonds (NHAs) that are used to generate the funds.
NHAs are generally used for low-income housing and they receive U.S. government backing in terms of credit and full faith.
For investors looking for the most secure of all municipal bonds, they will find them in NHAs.
That’s because any shortfall in income will be made up by the federal government.
That doesn’t mean they are a double-barrelled bond, however.
That’s because if the federal government does step in to make up shortfalls, it’s not another revenue stream like you will find with a double-barrelled bond.
They are also known as public housing authority bonds (PHAs) and sometimes Section 8 bonds.
Note for the exam that the full backing of the U.S. government is given to this type of municipal issue and it’s the only one that can lay claim to that fact.
Our last type of revenue bond is a moral obligation bond.
This can be issued locally or by the state or by a local or state agency.
The state legislature can make funds available should the tax collections or other revenues not be sufficient to pay the debt service of these bonds.
While this isn’t enforced by legislation (it’s a moral obligation only), the backup provided by the state in paying the debt service adds to the overall marketability of this type of revenue bond.
A legislative apportionment is needed, however, should the bond go into default.
That’s the only way that the bondholders will be prepared although the issuer’s legislator is not legally obligated to apportion money to pay off the debt.
When municipalities expect to generate other revenues soon, they can use municipal notes as a means to generate funds.
These are short-term securities that often will mature in 12 months or less but can be anything from three months to three years.
It’s only when they mature, however, that interest on municipal notes is paid out to investors although because of this, they will be discounted on issue.
There are a few categories for municipal notes:
- Municipal anticipation notes or TANs are issued by municipalities in anticipation of future tax receipts and to finance current operations. Between tax collection periods, they are used as a way to even out cash flow.
- Revenue anticipation notes or RANs are issued by municipalities in anticipation of future tax receipts provided by facilities or other revenue-producing projects and are a periodical offer that will help to finance current operations.
- Tax and revenue anticipation notes have a combination of the characteristics of both TANs and RANs.
- Bond anticipation notes or BANs act as a way to generate interim financing and are sold as such. Through the sale of bonds, they will be converted into long-term funding.
- Construction loan notes or CLNs act as a way to generate interim financing for housing project construction.
- Grant anticipation notes will see the government paying grant money for their issue.
Variable rate municipal securities
The interest rates for these municipal debt securities fluctuate.
That fluctuation is aligned to the current market interest rate changes.
Called reset securities by the MSRB, at certain intervals, the interest rate is reset.
There are two types of variable rate municipal securities that might appear in the Series 7 exam.
First are variable rate demand obligations (VRDOs).
A floating rate obligation, as defined by the MSRB, these securities will have an extended maturity period which is generally between 20 to 30 years.
From time to time, however, the interest rate will be reset.
The price of VRDOs is kept stable by keeping the interest rate in line with current market conditions.
A key point to remember about this type of security is the fact that issuers can be demanded to buy back the bonds at par value from the investor and this can occur on any of the reset dates that take place throughout the bond’s lifespan.
Essentially, this acts similar to a put option.
That’s because the investor will receive any accrued interest plus the face amount should they opt to take this action.
VDROs are seen sometimes as money market instruments because of this unique feature which makes them popular securities to add to an investment portfolio.
The second variable rate municipal security that we cover is auction rate securities (ARS).
Through Dutch auctions, these debt securities have their interest rates reset periodically.
This typically happens every 7, 14, 28, or 35 days.
These bonds have long-term maturities too and are usually structured as 20-30 year investments.
They first started out in the 1980s as a way for institutional borrowers, student loan providers, public authorities, and municipalities to generate funds.
While they didn’t have the same liquidity as money market funds or certificates of deposit, ARS were marketed as an investment vehicle that would provide a higher yield to retail investors than those mentioned above.
However, in 2007 following the worldwide financial market turmoil, the ARS interest rate auctions failed as too few bidders were interested in them.
This means that investors struggled to sell their ARS investments and eventually the market for these securities collapsed a year later.
They became illiquid investments with long-term maturities for those holding them and now new ARS has been issued since 2007.
Outstanding issues, however, still run into billions of dollars.
Mutual debt security analysis
When studying the advantages of GOs and revenue bonds, there are various criteria that need to be looked at.
For example, with GOs, one of the main things for investors to assess is whether the municipality will generate enough tax revenue so that the debt can be paid off and investors receive a return on their investment.
For a revenue bond, it’s whether the revenue-making instrument attached to the bond is going to be able to make enough money to not only pay the debt back to investors but also for the cost to operate it.
Let’s look into both of these a little deeper.
Analysis of GOs bonds
When it comes to analyzing GOs bonds, there are a number of factors that we need to consider.
It all starts, however, with the income of the municipality that issues the bond.
There are a few primary sources of income for municipalities:
- Sales taxes and other income are the primary providers of state income
- For county income, real property taxes are a principal income source
- For city income, the largest source comes from school districts but can also include license fees, fines, assessments, sales tax, utility taxes, personal property tax, income tax, and hotel taxes
The next thing to consider is the general wealth of the community.
This is important because it’s tax revenues that are mainly used to back GOs.
Their overall safety as a tool for investment can be gauged by looking at communities and certain demographic data that relates to them.
This data includes:
- The value of property
- Per capita retail sales
- Bank deposits
- Tax base diversity (based on different industries in the area)
- Population (is it growing or declining in the area)
Unless there are unusual economic conditions, the ability of a GO issuer to make principal and interest payments is enabled through its overall taxing power.
The third thing investors will look at is the characteristics of the issuer.
The municipality’s population, per capita income and property values can provide objective information for issuers and can be determined by carrying out a quantitative analysis.
It will also take on board other subjective factors that could affect securities issued by a municipality, for example.
- The way the community feels about debt and taxation
- Trends in population
- Trends in property value
- Other plans and projects undertaken by the municipality
Then there are debt limits.
Statutory debt limits might be in place for certain municipalities.
This will determine the overall amount of debt they are allowed to have.
It’s put in place to stop excessive taxation and is often used to protect taxpayers.
Let’s look at a scenario as to how it’s calculated.
Debt that a city can enter into might be limited to 10% of the estimated market value of all property that can be taxed there.
The statutory debt limit is therefore the value of those properties multiplied by 10%.
How close the total outstanding debt on a bond (which includes debt newly issued) comes to the statutory debt limit can be seen on the official statement of any bond issued by a municipality.
City charters or in some cases, state constitutions can also control when a city is allowed to issue a bond.
For example, only if bonds mature within the expected lifetime of the capital improvement they are financing are they issued.
Later, when the facility is past its workable lifespan, by following this route, the city has ensured that no money will be owed on it at that point.
Last, there are ad valorem taxes.
The assets valuation (a percentage of the estimated market value) of a property will determine the property tax on it.
That percentage as mentioned above will vary depending on the state or county the property is found in and it’s the county assessor who determines the market value of each piece of property.
They do this by looking at recent sales of similar property, streams of income, and replacement costs amongst other information.
The property tax is said to be ad valorem, or per tax value as it is based on the value of the property.
Should it not be paid, the property can be seized as the tax acts as a lien on it.
GOs are considered a safer investment than revenue bonds when they include the power to tax as well as seize property.
This means they can be issued with a lower interest rate.
The last thing to talk about in this section is the millage rate on which property taxes are based.
To find the amount of tax, you would take the assessed value of the property and multiply it by the millage rate.
$0.001 (a tenth of a percent) is the value of one mill.
Analysis of the Official Statement (OS)
A prospectus or official statement will be provided by municipal bonds to investors that want to know more about them.
These can be studied as a way to look into the financial condition the issuer currently finds themselves in but also at where they might be in the future.
Let’s look at the kinds of things that analysts will look at in terms of the information that official statements can provide.
We begin with any financial needs for the future.
The most critical thing here is looking for any future debt requirements that may come into play.
This might be necessary if:
- Short-term (floating) debt payments will struggle to be made as annual income is not sufficient
- Repayments of principal are going to happen at periods that are too close together
- There are inadequate sinking funds for outstanding bond terms
- Unfunded pension liabilities
- Capital improvements are in the pipeline in the near future
The credit rating of an issuer could be impacted negatively should they look to issue more future debt.
It has an impact on any current issues as well as they would then trade at a lower price.
Next, the debt statement.
When analyzing GO debt, this plays a large role.
In the debt settlement, you will find a number of critical pieces of information including:
- An estimation of the full valuation of the taxable property
- An estimation of the assessed value of the property
- The assessment percentage
The equation to calculate the debt structure of a municipality helps too.
To work this out, an analyst will take the total debt by adding all bonds issued by the municipality and then subtract the self-supporting debt.
Revenue bond debt, while not a burden on taxpayers of the municipality because it’s backed by revenues from the facility financed, will still be included in the total debt of a municipality.
Once this equation has been calculated, you are left with the net direct debt of a municipality.
The debt statement will also show any overlapping debt.
This shows a city’s proportionate share of county, school district, park district, and sanitary district debt.
Therefore to work out the city’s net total debt, you would add the net direct debt and the overlapping debt together.
The net total debt is also sometimes called net overall debt.
For the Series 7 exam, you may be asked as to what will be or won’t be included on a debt statement.
Well, you’d notice that most of the things we’ve covered so far start with the word “net”.
That means things like self-supporting debt or any accumulations from sinking funds are not something that you will find on a debt statement.
Analysis of revenue bonds
The potential of a facility to generate money that covers both principal and interest payments as well as covering operating expenses is how revenue bonds are rated.
As we’ve established already, these bonds are under any statutory debt limits because the investors are not paid from tax collected.
Note that while they are meant to be self-supporting, it is the bondholders, not taxpayers that bear the risk should the facility that the bond financed not be able to make enough money to repay any debts.
The following factors should be considered when looking at revenue bond quality:
- Economic justification: Can the facility that the bond will help finance generate enough revenue?
- Competing facilities: Are there better placed competing facilities that could overshadow the one covered by the bond?
- Source of revenue: Are they dependable?
- Call provisions: Higher call premiums on callable bonds are more attractive to investors, so this is something to look out for.
- Flow of funds: Not only must funds generated by the facility meet debt service obligations but they must also be able to pay all the operating expenses for the facility.
Let’s look a little more in-depth into this analysis as we start with the application of revenues.
We know that when it comes to revenue bonds, the principal and interest will be only paid from the money generated.
But expenses are paid in a specific order commonly known as the flow of funds.
According to the net revenue pledge (which is often used to determine how things are paid), the expenses to be paid first are operating and maintenance expenses.
The net revenues (funds) that remain after that then can meet further obligations, starting with servicing debt.
Let’s investigate the net revenue pledge in the flow of funds.
A revenue fund is opened in this situation and all the receipts from the facilities’ operations are then deposited in the fund.
They are then paid out as follows:
- Operations and maintenance: The first thing paid are all operating and maintenance expenses that are current. Any remaining funds after this are termed net revenues.
- Debt service account: The next in line for payment are the current year’s interest and the principal that could mature.
- Debt service reserve fund: The money to cover one year’s debt service is held here.
- Reserve maintenance fund: While there is a general maintenance fund, this is used as a way to supplement it should the need arise
- Renewal and replacement fund: When equipment needs replacing or there are large renewal projects on the go, money can be taken out of this fund.
- Surplus fund or sinking fund: A fund that can be used in many scenarios, for example, redeeming bonds.
When operating and maintenance expenses are not paid first by the issuer, the priority expense will be the debt service account.
When this happens, a gross revenue pledge describes how the flow of funds will take place.
When operating costs fall well below revenues generated, a surplus fund is usually opened where excess money can be kept.
Finally, to work out the debt coverage ratio, use this equation:
- Coverage = available revenues/debt service requirements
The marketability of municipal bonds
When we define marketability when it comes to municipal bonds, we can follow the MSRB.
They say it’s “the ease or difficulty with which securities can be sold on the market”.
In fact, their definition goes on even longer, but the essence is summed up in the above sentence.
When it comes to the marketability of municipal bonds, numerous factors can make one attractive to investors.
- Coupon of the bond
- Yield of the bond
- Dollar price of the bond
- If it offers any security provisions
- When it matures
- Overall credit quality
- Bond rating
Let’s break down some of these further.
Let’s start with the bond rating.
Bonds that are rated higher are more marketable, it’s that simple.
Higher rated bonds are targeted by institutional investors like insurance companies or banks because it’s only investment-grade debt that they are limited to according to their practices.
The marketability of a bond will also increase as the number of potential investors likely to buy into it rises.
What about maturity?
Well, a bond that’s going to only mature in 30 years (and is relatively new) is not as marketable as one that’s been around for 20 years and will mature in 10 years.
In other words, bonds are far more marketable if they have a shorter time to maturity.
That marketability increases as the time to maturity shortens.
When it comes to the coupon, in bonds where this is higher than others, their marketability is higher too.
Block size too, will see those bonds that trade in bigger amounts as more marketable.
Most municipal bonds have a block size of $100,000 and if the trades are for smaller amounts, the marketability of the bond will drop.
When it comes to call features, the most marketable bonds are those that are noncallable.
Bonds that offer longer call protection, in other words, the issuer cannot call the bond back before it reaches maturity are more enticing to investors than those that offer little or no call protection.
Another factor is dollar price.
For bonds to be more marketable than others when this is the decisive factor, their dollar price should be lower than the competition.
So the lower the dollar price, the more investor interest a municipal bond should generate.
Lastly, let’s look at refunding.
Similar to refinancing a mortgage loan, refunding occurs when interest rates fall.
When this happens, the municipality, for example, may offer a new bond that offers lower rates.
The higher interest debt of the old bond is then paid off with the proceeds generated from the new bond.
There are, in fact, two different types of refunds.
The first is advanced refunding, also known as pre-refunding.
In this scenario, before it reaches maturity, the existing municipal bond is refunded.
To do this, money generated by the sale of a new bond issued is used.
There are IRS restrictions that have to be taken into account using this method.
Pre-refunding proceeds must be placed in an escrow account which will be used for state and local government securities investment specifically issued to municipal issuers by the Treasury.
They are known as SLGS or “slugs”.
The original bond issued is then paid off at the first call date by the municipality using these funds.
The other method is current refunding.
With this, from the date of the issuance of the refunding bond, all old bonds will be redeemed in 90 days (or less).
In both of these examples, the quality of the resulting bond will increase and that means it’s more marketable.
The next thing that improves marketability is municipal bond insurance.
Often, a securities principal, as well as the interest payments for bonds, are insured with outsider insurance companies by municipal issuers.
When bonds are insured, for the most part, they will have a lower coupon rate.
That’s because thanks to the added safety of the insurance, investors are prepared to get a slightly lower rate of return than they would on a bond that didn’t have the backing of insurance.
Note also that the yield that’s paid out by the issuer might drop slightly as well.
When it comes to smaller issues of bonds, these are often not rated.
In that case, the insurer will be tasked with providing cover for the principal or the interest or sometimes both.
If they are insured, all certificates issued must include proof that this is the case as per MSRB rules.
Rule G-30 Fair Prices and Commissions
Let’s take a quick look at this MSRB rule.
Remember that no FINRA rules are put on municipal securities, they are exempt from them.
It’s only MSRB rules that they have to follow.
Note, this is a popular question on the Series 7 exam.
The MSRB rules that govern municipal securities are very similar to FINRA rules, however.
For example, a markup (or markdown) and a commission may not be charged on the same transaction by a broker-dealer.
Dealing with this here might seem a little out of place but fair pricing, as well as commissions, play a role when it comes to the overall marketability of a bond.
When a broker-dealer charges a markup, markdown, or commission, the MSRB requires that it is reasonable and fair.
It should also be shown on the customer confirmation.
Trade characteristics must be taken into account when determining these markup, markdowns, and commissions.
- At the time of trading, the FMV of the securities traded
- Transactions total dollar amount
- Any special trade difficulties must be noted (if any)
- That the dealer may make a profit
Note that fair pricing and reasonable compensation for the dealer are two different things.
Rules could be violated should a dealer not consider market value.
That’s even if they have limited their profit to a reasonable level when the transaction takes place.
So even if they didn’t make much profit, if the broker-dealer made a misjudgment on market value, for example, they’ve violated their fair-pricing responsibilities.
A broker for broker’s
In the securities industry, you will find some firms that work differently from most.
They don’t actually keep an inventory of bonds to sell and don’t purchase any either.
Instead, other brokers will use them to help find investors looking to buy municipal bonds.
In other words, they are considered agents of municipal securities firms and will never deal with public customers at all.
Are they necessary?
Well, the answer to that is yes and that’s because there isn’t a lot of trading that actually goes on in the municipal bond market and it’s actually pretty thin in that regard.
Of course, they will be paid a commission for their services.
Also, anonymity is key.
The customer’s identity is never given to the broker’s broker while they won’t disclose their customer buying up the bonds either.
Note that the Series 7 exam might include a question about anonymity as portrayed above.
Maths pertaining to municipal bonds
As with corporate bonds, there are many bond calculations for municipal bonds that are similar.
- Nominal (coupon) yield
- Current yield (CY)
- Yield to maturity (YTM)
- Yield to call
- Accrued interest
Let’s look a little more at how to compute accrued interest as this is something that will often appear in the Series 7 exam.
The buyer’s bond cost and the seller’s proceeds will include accrued interest.
Well, that’s in most cases unless the bond is considered to be trading flat, something we will discuss a little later.
How is it calculated?
Well, there’s a certain time frame to look at and that’s from when the last interest payment was made up to the settlement date.
But it won’t include the settlement date at all and remember, the settlement date occurs two days after the trade date).
It’s only on the settlement date that the buyer of the bonds will now own them.
In other words, the interest that begins then now belongs to the buyer.
Credited to the seller, however, is the interest from the previous six months.
When calculating accrued interest, all months are assumed to have 30 days and the year will contain 360 days.
We also have to look at something known as the dated date when it comes to the accrued interest which applies to new bond issues only.
The dated date is the beginning of interest accrual.
While bonds may be issued at a later date, it’s on their dated date that the interest on them will be accrued from.
Let’s say a bond’s dated date is May 1.
Interest is paid out on the bond semiannually, on June 1 and December 1.
The first interest payout is on December 1 but that will include seven months of interest.
This includes the six months between June and December as well as the month of May because May 1 is the dated date of the bond.
Earlier, we mentioned debt securities that are trading flat so let’s look into what exactly that means.
When this happens, the transaction will not include any accrued interest.
When does this happen?
Well, for the most part, this scenario will play out when there is a default on interest payments by the issuer.
But there is another time that this will happen.
Because there is no interest paid out for zero coupon bonds, they trade flat as well.
When bonds pay semiannually, there are two occasions each year where they will trade flat as well and that’s when a trade settles on those interest payment dates.
That’s because there will be no accrued interest as the issuer will send the seller a check for the interest.
Cost basis adjustments for municipal bonds
The cost basis must be known to determine whether a capital gain (or loss) has occurred when a municipal bond is sold, called, or redeemed at maturity.
If a bond was purchased at a premium or a discount will affect how the cost basis is adjusted.
Let’s first look at municipal bonds purchased at a premium.
When a municipal bond is at a premium, the purchaser must write that off (amortize) on the bond’s remaining life and on a straight-line basis whether it was bought on the secondary market or was a new issue when purchased.
This means that while the bond is held, each year, an identical amount of the premium is amortized.
There are two things that amortization will reduce:
- Cost basis
- Reported interest income
Note that the annual amortization will have no tax effect on municipal bond interest income.
That’s as a result of the fact that this income is not taxed.
The difference between the sales price and the adjusted cost basis is the gain made or loss incurred should the bond be sold before it has matured.
Next up, let’s look at municipal bonds purchased at a discount.
When this happens, the discount is accreted, a process in which the cost basis is amended back up to par.
When compared to amortization, it’s a reverse calculation.
When it comes to the tax treatment, however, it’s a little more involved.
Accretion’s tax effect first depends on how the bond was purchased.
In other words, was it bought as an original issue document (OID) which is basically a new issue that was offered at a discount, or was it bought on the secondary market at a discount.
There are two things that accretion will increase:
- Cost basis
- Reported interest income
Municipal bond tax calculations
In this section, we take a look at the various types of tax treatments applied to municipal securities.
Specifically, we will look at those that can appear in the Series 7 exam.
For the most part, any interest that a municipal security generates is free from federal income tax hence the fact that they are known as tax-exempt investments.
This favorable tax treatment has another advantage, however.
And that’s the cost of borrowing for municipal issuers as it’s at a lower interest cost, in most cases even below that of a U.S. government bond.
There was a change to how federal taxing on municipal bonds works thanks to 1986’s Tax Reform Act.
This placed restrictions on the tax exemption of interest for this type of bond.
It’s only public-purpose bonds or those that will finance projects that benefit citizens, that are tax exempt.
If private parties receive more than 10% of the proceeds of a bond, it’s not considered to be a public-purpose bond but a private activity bond instead.
Any private activity bond will not get granted the tax exemption as we have described above automatically.
On the Series 7 exam, it’s safe to assume that any municipal bonds mentioned in a question are of public purpose unless otherwise stated in the question.
So how do you go about calculating tax benefits?
As we have discovered, when investors receive interest generated by municipal bonds, for the most part, they won’t be charged federal income tax.
It’s also generally free state income tax if one criterion is met.
And that’s if the investor and the issuer of the municipal bond are from the same state.
Let’s look at a scenario.
If an investor has $1,000 and chooses to invest in a $1,000 par value municipal bond with a 7.5% nominal yield, they can expect a return of $75 each year.
This will be broken down into two six-month or semi-annual payments of $37.50.
Let’s compare that with the same investor who bought into a 10% coupon yield bond with $1,000.
Well, the return would be $100 which would translate as two six-month (semi-annual) checks of $50.
But we’ve got to factor in the federal income tax.
Let’s assume the investor is in the 32% bracket.
Any additional income the investor earns is taxed at 32% and that means the $100 earned is actually $68.
So the municipal bond will provide a bigger return than the coupon yield bond.
In other words, it’s always worth comparing at the end of the day.
For the exam, remember that a resident of a state in which the bond is issued will receive a double tax exemption.
This means that the tax-equivalent yield to that resident is higher.
Also, the exam might ask who municipal bonds should be recommended to.
Well, it should only really be investors that are in higher tax brackets that could benefit from their tax-exempt nature.
To work out tax-equivalent yield, you can use the following formula:
- Municipal bond coupon / (100% – investor’s tax bracket)
Following tax benefits, let’s look at original issue discount (OID) bonds.
Often, when it comes to their initial public offering, municipal bonds are offered at a discount.
We won’t go into the reasons as to why this happens because it’s not something that will be covered on the exam.
There are tax consequences, however, and that’s something we must look into.
We’ve already learned that discount is accreted on a straight-line basis to discounted municipal bonds bought on the secondary market but that accretion is regarded as taxable income.
The coupon interest, however, is exempt from taxation.
For OID bonds, the accretion is tax-free.
That’s because the discount is seen as part of the payment of interest made by the issuer by the IRS.
The investor’s cost basis will also be increased by the annual accretion which is exactly the same as when a bond is bought at a discount on the secondary market.
Capital gains and losses on municipal bonds
There’s no difference in the way municipal bonds are treated in terms of capital gains and losses when compared to other types of investments.
In other words, a capital gain will occur when the bond is sold for more than the investor paid for it.
A capital loss, on the other hand, occurs when a bond is sold for less than the investor paid for it.
This includes those bonds that have an amortized premium.
And just like other securities, the gains and losses are either short-term (less than 12 months) or long-term (more than 12 months).
That’s something we all know and understand, right?
For Series 7 exam purposes, it’s critical to remember that while income from municipal bonds is tax-free (in other words, the interest paid), capital gains (or losses) aren’t.
It’s to benefit a corporation that industry revenue bonds are generally issued.
When these private (nonpublic) purpose bonds generate interest, are they taxable?
Well, according to the 1986 Tax Reform Act, they can be.
Interest income generated can be subjected to alternative minimum tax (AMT) when it’s for nonpublic purposes that these bonds types are used.
AMT first came about in the late 1960s.
It was introduced as a way to ensure that high-income taxpayers didn’t get away with paying taxes.
Some items, however, do receive a tax preference.
The taxable income for the AMT must have these items added back into it.
So what are these items that receive tax preference?
Well, they include:
- Interest (which is tax-exempt) generated by nonessential government service municipal bonds and private purpose bonds
- Some direct participation program (DDP) costs (for example, those paid out for research and development)
- State income and property (local) taxes
- Interest on non-income generating investments
- Investment property accelerated depreciation
For this section, the critical thing to remember is that private purpose municipal bonds are included as an item that receives a tax preference.
Also remember that for a taxpayer to determine their total tax liability, they need to add the AMT excess over their regular tax.
Taxable municipal bonds
Obviously, as their name suggests, these municipal bonds are not tax-exempt.
The most likely example of these types of bonds that will appear on the exam is Build America Bonds (BABs).
These are fairly new, having first come on the market in 2009 as part of the Economic Recovery and Reinvestment Act.
Their main aim is to help stimulate the American economy but also to help issuing municipalities reduce costs.
They differ from other bonds that fund municipal projects because they are taxable
If a bondholder does receive interest from BABs they hold, they will pay tax on that.
It’s critical to note, however, that in lieu of other municipal securities and the tax-exempt status afforded to them, tax credits are provided on BABs.
So who buys into these bonds?
Well, it’s aimed at investors who aren’t really interested in buying municipal bonds that are tax-exempt.
However, its other aim is to expand the investor pool.
BABs do this by attracting:
- Those in lower-tax brackets
- Those funding retirement accounts (normally tax-free securities would be suitable for this type of investor)
- Public pension funds
- Investors from foreign countries
BABs are available in two formats.
First, there are tax credit BABs.
There’s a federal income tax credit available for investors who choose these.
That credit is 35% of each tax year’s interest paid.
Also, the tax credit can be carried forward as well.
This scenario will play out during a tax year when the bondholder doesn’t have sufficient tax liability to use up the full tax on offer.
Secondly, we have direct payment BABs.
There’s no tax credit for investors when it comes to these bonds.
Instead, municipal issuers will receive U.S. Treasury payments.
These are based on the interest paid by the issuer and are equal to up to 35% of those payments.
So the last thing to mention about BABs is that the program for them expired back in 2010.
But obviously, they are still in play on the securities market.
Municipal fund securities
In this section, we are going to look at various municipal fund securities which are considered as being a type of municipal security.
Section 529 plans
Aimed at those who are saving towards future education costs, Section 529 plans provide investors with tax advantages and are generally run by either state or state agencies.
Earnings for these plans will grow tax-deferred while it’s after-tax dollars that will fund them.
And for the most part, a withdrawal is taken from tax-free should it be used for proven education expenses.
If that’s not the case, taxation will occur.
That taxation is taken on the earnings portion of the distribution.
These are federal taxes but state taxes could apply as well.
The earnings portion of the distribution will receive a 10% tax penalty as well (with some exceptions).
Should the beneficiary have passed away or been disabled, the penalty will then fall away if the account is closed.
When funds are withdrawn from the account because the beneficiary has received a scholarship, the penalty won’t be paid either.
529 plans are available to anyone to open.
There is no need for the beneficiary of the plan and the donor to be related in some manner either.
When we talk about 529 plans there are two basic types.
These are prepaid tuition plans and college savings plans.
With a prepaid tuition plan, inflation protection is the main advantage.
That’s because future tuition fees can be locked in at current prices.
It’s easy to see why these are popular then, right?
With college savings plans, investors have two ways in which they can invest.
They can start with a lump sum but not everyone has a huge batch of money floating around, however, to take this route.
So there is an alternative.
That allows the investor to make periodic payments into the college savings plan.
When it comes to where the money for both these options is invested, generally it’s target-date funds that are used.
The investment strategy will get more conservative as that target date arrives.
Here are a few things to consider about these types of investments:
- They can be an investment risk and lose money
- When it comes to college savings plans, they can be opened in more than one state
- Prepaid tuition plans cannot be opened in more than one state
- Presently, allowable contributions are between $235,000 and $529,000.
- When it comes to contributions and distributions, there are no age limits
- When making income contributions to these plans there are no income limitations
- Contributions are subject to the tax rules that govern gifts. If an investor doesn’t want to pay a gift tax, an index maximum contribution of $15,000 per donor, per year must be adhered to.
- When opening a 529 plan, there is no real restriction on the beneficiary. Should the beneficiary change, however, only a close member of the original one can be nominated.
- An OS must be handed to all prospective investors showing an interest in a 529 plan.
Note that even when the beneficiary reaches legal age, the donor still owns any assets in a 529 plan.
If used in any other way than to fund education, fines may be imposed on the account by the IRS.
This starts with the account not only getting taxed at normal income rates but a 10% penalty is added too.
Also, when it comes to estate tax, 529 plan assets are not included.
For the Series 7 exam, you will need to know how 529 plans work from a general perspective even though these are state-based investment opportunities and each has its own version.
Achieving a Better Life Experience (ABLE) accounts
Aimed at individuals with disabilities, ABLE accounts are a type of savings account with various tax advantages.
They were introduced as part of 2014’s ABLE act.
Income generated by these accounts is not taxed in any way, while the owner of the account is the beneficiary of any income generated by this investment.
There are rules in place as to who can start an ABLE account.
As long as the onset of the disability started before the age of 26, applicants can establish one.
Individuals are automatically eligible if they meet the above criteria as well as receive benefits.
These benefits can either be from Social Security disability insurance or regular Social Security insurance but only one ABLE account per individual may be opened.
When it comes to who can contribute to ABLE accounts, it’s not only the beneficiary themselves.
In fact, anyone can as long as they use after-tax dollars.
Contributions are not tax-deductible either, for the most part, although some states do allow for them.
A specified dollar amount per year is allowed for contributions by anyone who participates in an ABLE account.
To account for fluctuations in inflation, this can be adjusted from time to time.
Local Government Investment Pools (LGIPs)
These are short-term investment vehicles established by States.
Their aim is to provide a way for other governmental structures with a way to invest, for example, state agencies, counties, cities, and even school districts.
For the most part, an LGIP will take the form of a trust.
Shares or units from the LGIPs investment portfolio can then be bought by these government structures as an investment.
LGIPs work in a similar manner to a money market fund.
As an example of how similar they are, a fixed $1 net asset value can be maintained for an LGIP.
This helps to ensure minimum price volatility as well as encourages liquidity.
Like municipal securities, LGIPs have a governmental exemption.
This means not only do they not have to be SEC-registered but none of the regulations of that organization will apply to them either.
That does mean that when it comes to investment guidelines for LGIPs, it can differ between states.
While there is no prospectus attached to LGIPs they will have disclosure documents for potential investors to study.
This will include information as to how the LGIP operates, the investment policy, and information statements.
The management fees of the LGIP can be found in the information statement.
Other securities products – Hedge funds
Let’s move our attention to hedge funds
Hedge fund structures
This form of fund usually has no more than 100 investors and is organized as a limited partnership.
Because of this, the hedge fund need not be SEC-registered.
The lack of transparency because of this non-SEC registration is part of the reason why a hedge fund and a mutual fund are different.
For example, mutual funds have a prospectus.
This needs to be filed with the SEC.
Instead, a hedge fund doesn’t have a prospectus but what is known as a private placement memorandum.
While it serves a similar purpose, obviously because a hedge fund is not registered with the SEC, no copies need to be sent to it.
Also, a private placement memorandum contains far less information than a prospectus would.
Note also that in terms of the 1940 investment Company Act, hedge funds are not considered to be investment companies.
That’s because of the way they are structured and this allows them far more flexibility than is possible with an investment company.
For the Series 7 exam, remember that with most hedge funds set up as a limited partnership, along with the investors, portfolio managers can invest as well.
Their partnership is with the ownership units issuer.
Hedge fund characteristics
Let’s move on to some characteristics that are associated with hedge funds.
Let’s start off with hedge fund strategies.
The similarity between hedge funds and mutual funds is obvious.
In both, the investments are not only professionally managed but pooled.
The major difference is something that we’ve already touched upon briefly.
That’s the fact that hedge funds are far more flexible and that’s because they are regulated under U.S. securities laws.
In terms of advanced investment strategies, these are investment vehicles that are much more aggressively managed and generally, are those sophisticated investors that meet accredited investor standards.
In other words, they should have investment knowledge, have a certain net worth and have a minimum annual income as set out by the accredited investor model.
As for their primary objective?
Well, for the most part, hedge funds are all about generating high returns although hedging is a practice of trying to limit risk.
Here are some of the hedge fund strategies that you should know:
- Currency and commodity speculation
- Investing in international markets that are politically unstable
- Utilizing options, futures, and other derivative products
- Using short positions
- Portfolios that are highly leveraged
Hedge funds are almost always seen to be speculative investing because of the fact that they are not regulated like mutual funds would be.
There is a minimum period of time too that investors will have to keep their investment should they choose a hedge fund.
This is usually set at around a year and this is known as a lock-up provision.
Because of it, hedge funds are illiquid.
During this time, a withdrawal from the fund is not possible.
Why is a lock-up provision necessary?
Well, the main idea behind it is that it helps to ensure that capital is available for the hedge fund manager to use if they need them.
But it also adds to the unique risk that these funds have for those wanting to invest in them.
Note, that these lock-up provision periods do differ in their time frames and are dependent on the specific fund.
What will influence that time period?
There are generally two factors:
- The investment strategy used by the hedge fund and the length of time to implement it
- How long results will start to be seen as a result of the strategy chosen
What about hedge fund management fees?
When compared to other investments, such as mutual funds, the management fees for hedge funds are considerably higher.
How are these fees charged?
Well, most hedge funds use a performance-based fee system.
In the securities world, many will use a 2&20 system.
This means that a 2% management feed is taken as well as 20% of any profits generated for an investor.
While that might seem excessive, it does mean that those managing hedge funds are focused on seeing them generate as high returns as possible.
But of course, that could lead to greater risk for investors as well because that’s just the nature of investment with higher potential returns.
The question we have to ask ourselves is how do non-accredited investors take part in hedge funds?
Well, that’s where funds of hedge funds come in.
For these types of investors, some registered mutual funds can provide the answer.
That’s because they will invest in unregistered hedge funds.
These are called funds of hedge funds.
Non-accredited investors can therefore gain access to hedge fund investments as these mutual funds will find and then diversify investments across other hedge funds.
One of the positives is that when compared to investing directly into a hedge, this option can be carried out with a far lower investment to start off with.
But there are negatives too, for example, secondary market trading of these shares is not allowed, like all mutual funds.
Also, shares aren’t liquid either.
It’s only when the mutual fund company redeems them that shares are eligible to be sold.
Should a registered representative recommend funds of hedge fund to an investor, they need to make sure that their client understands the risks associated with hedge funds, even though they are invested in using mutual funds in this case.
There’s another type we need to discuss as well and that’s the blind-pool or blank-check hedge fund.
These have a very specific target for investments which are black-check companies (also known as special purpose acquisition companies or SPACs).
As with anything in the investment world, there are very unique risks associated with an investment in SPACs which are companies that don’t have an operational side.
Instead, to raise money, they have their shares publicly traded through IPOs.
The sole purpose of that is so they can look for business or combinations thereof and when one is found, the holder of the shares are presented with proposals looking for their go-ahead.
In some cases, the target is blind-pool companies.
With these companies, investors are never told as to what the proceeds raised by selling securities will be used for but might indicate the type of industry.
Other securities products – Asset-backed securities
Let’s now look at asset-backed securities.
Types of asset-backed securities
When it comes to asset-backed securities (ABS), there are various types.
They are all similar in one regard, however.
That’s the fact that a particular pool of underlying assets is where their value and income payments are derived from
Expected payments for these pools of assets can be various loan types like auto loans, mortgages, and many others.
In certain situations, cash flow for ABS can also come from leases, royalty payments, and credit cards.
Because the assets are pooled into financial instruments, they are easier to sell to general investors than if they were sold individually.
In the securities world, this is known as securitization.
The advantage of this is that it allows risk to be diversified when investing in these underlying assets.
That’s because the total value of the pool of diverse underlying assets sees each security representing only a fraction thereof.
Note that with all ABS, debt is always paid as there is a contractual obligation to do so.
While this might not come up on the exam, it’s worthwhile knowing more about the securitization process.
When this takes place, a special purpose entity or SPE is created.
The SPE will then receive the title to the assets which are transferred to it.
From there, the ABS are issued with the collateral coming from the assets themselves.
Collateralized mortgage obligations (CMOs)
A pool of a number of mortgages on single-family residences mostly, makes up a CMO.
Backed by Ginnie Mae, Fannie Mae, or Freddie Mac pass-through securities more often than not, it’s private-sector financing corporations that will issue this type of ABS.
It’s for this reason that CMOs are highly rated, particularly those back by government agency securities.
Collateralized debt obligations (CDOs)
When it comes to the various types of ABS, CDOs are some of the most complex.
It’s nonmortgage loans or bonds that the portfolios of CDOs will mostly consist of.
Having said that, there is no particular single debt type that they will specialize in.
And the assets that back them?
Well, that can be anything from credit card debt, auto loans, pools of bonds, leases, company receivables, and more.
These assets are not very liquid and often are small.
Because they are pooled, however, they can be sold on the secondary market to individual investors.
In this section, we need to cover amortizing and nonamortizing CDOs as well.
As you know, a loan where payments against the principal are said to be an amortizing one.
When an investor receives their return from this, it’s made up of the interest earned as well as the principal.
That means that the principal would have been repaid at the end of the term of the loan.
For examples of an amortizing loan, look no further than a mortgage you take out on a house or a loan on a car.
In fact, the perfect example of an amortizing ABS is an auto loan CDO.
As for a nonamortizing loan CDO, the difference is that the debt obligations that back it won’t have a fixed ending date.
A credit card CDO is a perfect example of a nonamortizing ABS.
Characteristics of CMOs
As we mentioned above, it’s usually single-family residential mortgages in large numbers that are pooled together to make CMOs.
These are then structured into what is known as tranches which see them ordered into separate maturity classes.
Each month CMOs will pay both interest and principal from the mortgage pool.
Note that it’s only one tranche at a time, however, that principal is repaid.
In short-term tranches, before the next tranche starts receiving repayments of the principal, investors must be paid their full principal first.
This happens to bonds chosen randomly within a tranche with principal payments made in $1,000 increments.
Note that the changes in the interest rate will affect the rate of mortgage prepayments.
For the CMO investor, this will affect the principal repayment they receive as well as the interest payment.
The details above describe a regular type of CMO but there are many varieties.
Note that while interest payments are paid at the same time to tranches, the principal is not.
Until the point it is retired, this will only occur one tranche at a time.
Once a tranche is paid off, the next in line will receive payments until that is paid off and so the cycle goes on.
Either projections or historical data taken from the Public Securities Association (PSA) on mortgage repayment are used to estimate a CMOs yield and maturity.
The priority of an investor’s principal payment will come down to which tranche they own.
The following are never guaranteed: the principal amount that will be returned to the investor, the interest amount they will receive as well as the overall time to maturity.
The PSA model used, however, will allow for during the life of an obligation, prepayment assumptions, which affect the securities yield, will change.
We’ve discussed the standard type of CMO, but there are others. In this section, we are going to look into four types you should know about.
We start with principal only CMOs (POs).
Underlying mortgages used by CMOs produce an income flow.
This will then be divided into two streams, for principal only CMOs or POs and then interest-only CMOs or IOs.
The income stream for POs is linked to the underlying mortgages and the principal payments from them.
The full face value of the security is repaid to the investor.
When sold, POs will change hands at a discount from par.
In this case, the return for an investor comes from the difference between the principal value and the price, which is discounted as we know.
Changes in prepayment rates will affect a PO.
Should the interest rate drop, prepayments will accelerate and therefore the value of the PO will rise.
Should prepayments start to fall and interest rates increase, the opposite will happen and the value of the PO will drip.
We’ve already mentioned interest-only CMOs or IOs as they are known but let’s delve into these a little more.
How are they related to POs?
Well, they are actually their by-product.
We’ve already seen that the principal stream for a PO is from the underlying mortgage while the interest goes to the IOs.
As the interest rate proportion linked to a mortgage payment will decrease over time, the cash flow of an IO will do so too which means it will then sell at a discount.
When interest rates rise, so does the value of IOS, and should interest rates fall, their overall value will fall too.
That’s because of the fact that, as prepayment rates change, so does the number of interest rate changes.
This means that when it comes to interest-rate risks on a portfolio these can be used as a way to hedge that risk.
Owners of IOs could get fewer interest payments than they thought they would when prepayment rates are high.
Also, those who have invested in IOs have no idea as to how long the stream of interest payments will go on for.
That’s because of the fact that more principal is received beforehand for the full CMO series.
Our next CMO type is planned amortization class CMOs or PACs.
The TAC is structured so that when it comes to extension risk, there is no protection.
It’s only a companion tranche, however, that will have prepayment risk.
That said, this results in a higher interest rate, so TAC investors are prepared to accept the greater price risk as a result of the extension risk.
Then we have zero-tranche CMO or Z-Tranche.
These are the most volatile of all CMOs as it’s only when all preceding CMO tranches have been retired that this type will start receiving their payments.
When an investor is looking for funds in a certain time period, a Z-Tranche is not a suitable investment tool.
That’s because there is no certainty at all as to when payments will be received.
At the end of the day, CMOs are considered to be a relatively safe investment tool and that’s mainly due to the fact that they are backed by mortgages.
They aren’t without risks, however.
This is because they are influenced by the movement of interest rates which then change the mortgage repayment rate.
Here are just some of the risks that you can associate with CMOs:
- Varying rate of principal repayments
- Principal is received sooner (prepayment risk) if interest rates fall and there is an increase in homeowner refinancing
- CMO investments might need to be held for an extended period of time (extended maturity risk) if there is a rise in interest rates and refinancing declines as a result of that. This is also known as extension risk.
Other characteristics of CMOs
Let’s look at other characteristics that are associated with CMOs.
We start with the return on CMOs.
When compared to Treasury securities, the yield from CMOs is greater.
Remember too that investors of CMOs will usually receive principal and interest repayments each month.
When it comes to principal repayments, investors will receive these in increments of $1,000.
As we learned earlier, these repayments happen one tranche at a time.
As for taxation, well the interest that CMOS generates is taxed in three ways and that’s local, state, and federal tax.
As for the liquidity of CMOs, it’s boosted by the fact that there is a secondary market where they are traded and it’s pretty active in that regard, especially for simple CMOs.
A word of warning, however.
Those with characteristics that are more complex don’t offer much liquidity at all.
That’s because there simply isn’t much of a market for them.
Also, some CMOs are riskier when compared to others because of the tranches contained within them.
In some, investors may have to wait on the repayment of principal longer than they initially thought.
So it’s important to be aware of both sides of the story when it comes to CMO liquidity.
What about suitability?
Because of how complex they are and the investment risks they pose, some types of CMOs, for example, PAC companion tranches, are only for sophisticated investors.
For that reason, customers will be required to sign a suitability statement for complex CMOs that they want to invest in.
All investors should understand a few critical things about CMOs too.
For example, they can have a varying rate of return as a result of early payment, and other investment vehicles should not be compared to CMOs in terms of performance.
Here’s a summary of facts about CMOs that could be asked in the Series 7 exam:
- CMOs are corporate instruments and don’t receive backing from the U.S. government
- Interested generated by CMOs are taxed at all levels
- CMOs backing is provided by mortgage pools
- When compared to U.S. Treasuries, CMOs yield more
- Interest-rate risk is something CMOs are subjected to
- They are issued in denominations of $1,000
- They trade OTC
- Of all the CMOs, the ones with the lowest extension and prepayment risk are PACs
- For investors wanting prepayment risk protection, TACs are the best CMOs. They still have extension risk, however.
- PACs, due to their lower risk, produce far lower yields when compared to TACs.
The general characteristics of CDOs
While there are similarities in the way CDOs and CMOs are structured, when it comes to credit risk and the type of debt, CDOs are different.
CDOs operate debt and risk categories called tranches as well, and these have different types of risk associated with them as well as maturing at different times.
CDOs will pay out more when risk is higher but investors have the opportunity to find the right tranche within the CDO for their specific needs in terms of risk and return.
When investing using CDOs there are a few points of caution.
First, certain CDOs are extremely complex, and individual investors might find that complexity overwhelming which means that if they purchase them, they might not fully understand how they work.
While they can be purchased by an individual investor, broker-dealers should be encouraged to only present CDOs as an investment vehicle to sophisticated investors as well as institutional investors.
Second, originators of the loans can avoid collecting on the sale of individual assets when they are due because they can be sold to others who will repackage them.
In this scenario, the assets are owned by the issuer of the CDO.
Note, however, that this means that less disciplined and prudent behavior in terms of proper lending practices could arise from the originators of the loan when they are made.
Thirdly, it’s not only investors that find CDOs complex.
In fact, according to FINRA, many registered representatives don’t fully understand them either which led to the organization handing out fines and in some cases, even suspensions.
As always, any registered representative that sells any kind of investment product should know everything about it first.
Otherwise, they are simply doing their clients a massive disservice.
U.S. Treasury securities
There are many securities bought by investors that are issued by the U.S. Treasury from those for short-term investments, like money market instruments to those that serve as long-term investments, such as bonds.
To meet various federal budget needs, it is the U.S. Treasury Department that will not only determine the types of government securities that it must issue but the quantity as well.
As far as the interest rate that the securities pay to investors, well, it’s the market that will determine that.
Why are U.S. Treasury securities so popular?
Well, there are a few reasons but number one has to be the act that interest earned by investors for these securities is exempt from taxation.
That counts for both municipal, state, and federal taxes.
It’s not difficult to see why many investors turn to these securities, right?
Interest earned as well as principals on U.S. Treasury securities also have full faith and credit backing.
The nation’s largest borrower is the federal government.
In general, they are one of the least risky investments that can be made.
But that doesn’t mean that they are completely safe, however.
That’s because just like other debt securities, those offered by the government, like those from the Treasury are traded on the OTC or secondary market and there is always interest-rate risk found here.
It’s useful to know too that since the mid-1980s, the only way that Treasury securities have been made available to investors is in book entry form.
That means that it is on the books of the Treasury that a record is kept of the ownership of these various securities.
In the years before this change was made, when you owned a treasure you would receive its resulting physical certificate.
The different kinds of U.S. Treasuries
In this section, we are going to cover a range of U.S. Treasuries that you should know about.
We begin with Treasury Bills or T-Bills as they are most commonly known as money market instruments in the securities world.
Issued at discount from par, a T-Bill is an obligation for the short-term.
They will trade at a discount from par value instead of making consistent cash interest payments.
Note that the price is the difference between the par value at which the T-Bill matures and the price the investor paid will determine the return on that T-Bill.
In quantitative analysis, a 13-week T-Bill is seen as a risk-free investment.
Next, we have Treasury notes or T-notes.
These differ from T-Bill in the fact that at six-month increments, they will pay interest.
Investors are able to purchase T-notes every four weeks when they are sold at auction.
With maturities of 2,3,5,7 and 10 years, T-notes are seen as a security of intermediate maturity lengths.
Treasury bonds (T-bonds) are our next form of Treasury security.
These take anything from 10-30 years to mature and for that reason, are seen as a long-term security option for investors.
In the past, these could be called at par five years before they would mature.
That, however, is no longer the case as that variant of T-bond or callable bond hasn’t been available since the mid-1980s and there are none in circulation anymore.
That doesn’t mean that they won’t be made available at some point in the future, but for the time being, that seems highly unlikely, most securities experts believe.
Our fourth security type is known as Separate Trading of Registered Interest and Principal of Securities (STRIPS).
These have been around since 1984 and allowed the Treasury Department to have a security option for the zero-coupon bond market.
They did this by taking specified issues from the Treasury that were appropriate for stripping into two components: the principal as well interest.
These became known as STRIPS.
The separation and trading of STRIPs are carried out by dealers and banks but the underlying securities remain the direct obligation of the U.S. government.
These are considered to have minimal reinvestment risk because they are zero coupon bonds.
Next, we have an example of a treasury security that the U.S. Treasury doesn’t actually issue and that’s Treasury receipts.
These are created from U.S. Treasury notes and bonds by brokerage firms, for example and they are seen as a zero coupon bond.
So how does this all work then?
Well, Treasury receipts come about when Treasury securities are bought by broker-dealers.
These are then placed in a bank, for example, as a trust.
Now, separate receipts (the Treasury receipts in other words) are then sold against coupon payments as well as the principal.
The Treasury receipts are collateralized by the Treasury securities that are held in trust.
While other Treasury securities receive full faith and credit backing from the U.S. government, that’s not the case when it comes to Treasury receipts.
They are much like zero coupon bonds in the fact that they are priced at a discount from the payment account.
The next security we look at is Treasury Inflation Protection Securities (TIPS).
This Treasury issue offers investors specific protection.
That protection comes against inflation or purchasing power risk.
While the principal amount is adjusted every six months (or semi-annually), these bonds have a fixed interest rate.
Those adjustments to the principal amount are copied from the change in the Consumer Price Index (CPI).
As we know, CPI is used to measure inflation.
So how are the semi-annual interest amounts calculated?
Well, to determine that, take the fixed interest rate and multiply it by the new principal.
When inflation rises, so do the interest payments while they will fall when inflation falls.
When compared to regular fixed-rate Treasury notes, these are sold with interest rates that are lower due to their adjustable nature.
While they are not subjected to either local or state income tax, TIPS are not exempt from federal taxation.
Note, however, that if the inflation causes the principal to be adjusted, any increase is seen as reportable income for that specific year.
The increase, however, will not be received that year and only when the note reaches maturity.
Treasury bill pricing
When it comes to different types of denominations, Treasury bills are available in denominations of $100 right up to $5 million.
And anything from 52 weeks or less is the time frame for their original maturities.
In the case of 52-week bills, these are auctioned off each month.
Some are auctioned off weekly as well, for example, the 26-week bill as well as the 4-week bill.
While T-bill maturities can change, they will never be longer than a period of 52 weeks.
What about the pricing of T-bills (which are zero coupon securities).
Well, when quoted, it’s on a yield basis.
When sold, it’s at a discount from par.
Treasury note pricing
T-Notes have the same pricing structure as T-Bills, so that means they are available in denominations from $100 to $5 million.
Note, that when they reach maturity, they do so at par but they can also be refunded beforehand.
When this happens, the investor is offered a new security by the government.
This will not only have a new maturity date but a new interest rate as well.
These are provided as an option that can be taken instead of a cash payment for the T-Note that is maturing.
As for the pricing of T-Notes, if they are issued, quoted, and traded, it’s at a percentage of par in 1/32%.
Treasury bond pricing
Similar to T-Notes and T-Bill, T-Bonds are also available in denominations of $100 to $5million.
As for maturity, well that’s going to be no less than 10 years from the date upon which they were issued.
T-Bonds share the same pricing structure as that of T-Notes, so if they are issued, quoted, and traded, it’s at 1/32% of par.
For the exam, all these details regarding T-Bills, T-Notes, and T-Bonds are critical to understand.
Let’s break them down based on their maturity, pricing, and form.
First up is T-Bills:
- Maturity: 52-week maximum (short-term investment)
- Pricing: When issued, it is at a discount.
- Form: Book entry
Second, we have is T-Notes:
- Maturity: 2-10 years (intermediate-term investment)
- Pricing: Priced at a percentage of par
- Form: Book entry
Third, it’s T-Bonds:
- Maturity: Longer than 10 years (long-term investment)
- Pricing: Priced at percentage of par
- Form: Book entry
That’s a useful table to memorize so that you know the key differences between these three examples for the Series 7 exam.
U.S. Government agency securities
In this section, we look specifically at various U.S. Government Agency securities and what they entail.
Various agencies of the federal government can issue debt securities as authorized by Congress.
- Farm Credit Administration
- Government National Mortgage Association
There are others too.
These are operated by private corporations but are agency-like organizations and include:
- Federal Home Loan Mortgage Corporation (FHLMC)
- Federal National Mortgage Association (FNMA)
- Student Loan Marketing Association (SLMA)
Note that when we speak of an agency, not all of these are run by the government.
They do have ties with it, however, and in many cases, such as with the Federal National Mortgage Association, are sponsored by it.
Government National Mortgage Association (GNMA or Ginnie Mae)
The Government National Mortgage Association (GNMA) is commonly known as Ginnie Mae.
This corporation is owned by the government.
The primary role of the GNMA is as a support to the Department of Housing and Urban Development.
When it comes to full faith and credit federal government-backed securities, Ginnie Maes are the only type that can provide that backing.
So how do they work?
Well, neither does a Ginnie Mae issue, buy or sell securities.
It will, however, authorize the establishment of eligible loans through private lending institutions which have been approved to do so.
These loans are then pooled into securities.
These securities are commonly known as pass-through certificates.
Investors can then purchase these GNMA mortgage-backed (MBS).
When these securities are originated by the approved private lending institutions, they can include:
- Mortgage companies
- Thrift institutions
- Commercial banks
- State housing finance agencies
Only MBS backed by single and multifamily home loans are used as part of Ginny Maes.
These MBS are insured by the Federal Housing Association (FHB) and the Department of Veteran Affairs (VA) as well as other government agencies.
Note that as mortgages are paid, the principal on a GNMA certificate will constantly reduce which is the same as how a principal on a single mortgage operates.
Because of their government backing, there is a minimum risk for those who invest in Ginny Maes.
In fact, it’s practically zero.
Also, another advantage to investors is the fact that both interest and principal payments are guaranteed to be on time.
Those interest rates, too, are slightly above those of other comparable Treasury securities, while their rates are lower due to the fact that they are government-guaranteed.
What about price, yields, and maturities.
Well, these are affected by general interest-rate trends and therefore will fluctuate.
For example, the maturities of certificates will accelerate should interest rates fall.
That’s because homeowners will more than likely pay off their mortgages earlier in a scenario like that.
The opposite is true if interest rates rise and in that case, the maturity of certificates could take longer.
When it comes to MBS, there are two other risks that you should be aware of.
- Prepayment risk: This is when underlying mortgages get paid off quicker than what was originally expected. When this happens, homeowners are likely to use the lower interest rates to refinance their homes.
- Extended maturity risk: This sees mortgages extend over the original payment periods and therefore take longer to pay off. Refinancing won’t happen in situations like this either.
Here are the most critical things to know about Ginny Maes:
- They are the only government agency securities that are fully backed by the U.S. government
- They have a $1,000 minimum
- They provide monthly interest and principal payments
- They are taxed at all levels
- They have pass through certificate
- They are susceptible to reinvestment risk
Let’s touch on that last point.
Why are Ginny Maes susceptible to reinvestment risk?
Well, we’ve already discussed that homeowners look to refinance their mortgages when interest rates fall.
That’s to take advantage of the lower rates on offer.
By doing so, they will pay off their mortgages early.
This results in a principal prepayment to those holders of MBS.
What this means is that principal payment made earlier won’t get a comparable return if reinvested
Should the Series 7 exam ask for the best securities instrument that’s not going to suffer reinvestment risk, generally the answer would be zero coupon bonds should it appear as an option.
That’s because investors have no reinvestment risk as there is no current basis interest paid.
Farm Credit System (FCS)
This network of lending institutions is found all over the United States.
As you’d probably guess from the name, the FCS will provide agricultural-based credit and financing.
Note, however, that this privately owned enterprise is government-sponsored.
By selling Farm Credit securities to interested investors, the FCS is able to raise loanable funds.
While these obligations are backed by FCS banks, they are not guaranteed by any federal agency or the U.S. government.
Through a network of banks and Farm Credit lending institutions, funds are made available to farmers throughout the USA with the whole system overseen by a government agency, the Farm Credit Administration (FCA).
A range of banks are included in the overall system including Federal Land Banks, Federal Intermediate Credit Banks, and Banks for Cooperatives.
Here are the issues the FCS provides:
- Discount notes
- Floating rate bonds
- Fixed rate bonds
These have a differing range of maturities too, anything from one day up to 30 years, so are attractive to a range of investor types.
Real-estate loans, rural home mortgage loans, as well as crop insurance, are made available to farmers through the proceeds generated by the sale of these securities.
Federal Home Loan Mortgage Corporation (FHLMC)
In the securities industry, the Federal Home Loan Mortgage Corporation (FHLMC), which is a public corporation, is known as Freddie Mac.
The main aim of the FHLMC is to develop and promote a secondary market in mortgages available nationwide.
This is achieved through the purchase from financial institutions of residential mortgages.
They are then put up for sale to investors when they’ve been repackaged into MBS.
Two types of securities are sold by the FHLMC:
- Mortgage participation certificates (PCs): Principal and interest payments are made monthly
- Guaranteed mortgage certificates (GMCs): Interest payments are made semiannually (or every six months) while principal payments are made once a year.
Federal National Mortgage Association (FNMA)
The Federal National Mortgage Association (FNMA) is also known as Fannie Mae.
The primary aim of this publicly held corporation is all about supplying mortgage capital.
To do that, it creates securities that originate from convention and insured mortgages purchased by the FNMA.
These are bought from the FHA, VA, and other agencies.
Note that the securities that the FNMA makes available receive backing from the general credit of the FNMA.
Here’s a list of the issues the FNMA offer to investors:
- Short-term discount notes
As with all the agencies, records of ownership of these investment instruments are electronically kept and certificates for them are not delivered at all.
This is known as book-entry form, something we have covered already but well worth remembering.
Student Loan Marketing Association (SLMA)
Also known as Sallie Mae, these are issued as both short-term and long-term security offerings.
The sales of Sallie Mae securities generate proceeds that are then used for the provision of higher education student loans.
Currently, these are owned privately and will trade on the Nasdaq using the symbol SLM.
They were once an agency issue from the U.S. government and could be grouped as such in a Series 7 exam question.
Don’t let that catch you out.
Tennessee Valley Authority (TVA)
From time to time, the Tennessee Valley Authority (TVA) pops up in the Series 7 exam.
A corporation of the U.S. government, it is the biggest public power provider in the United States.
TVA bonds do not receive U.S. government backing, however.
There backing from agencies project revenues although most experts believe the government would guarantee them should the need arise.
What makes TVA bonds different from most others offered by government agencies?
Well, it’s their maturity period in the fact that they are often issued with that set at 50 years.
Characteristics of agency securities
Now let’s look at some of the characteristics agency securities have.
When groups of mortgages are pooled and certificates representing an interest in that pool are sold, a pass-through security is created.
But what does the term mean?
Well, it deals with homebuyers’ interest and principal payments, specifically how these are passed to investors from the mortgage holder.
Freddie Mac, Ginnie Mae, and Fannie Mae all make use of the pass-through mechanism.
Agency Securities Denominations
As per FINRA requirements, there are a variety of increments in which agency bonds are sold.
Usually, these increments are $5,000 with a minimum of $10,000.
Some agency bonds that we have covered above are different, however.
GNMA MBS, for example, will be issued with multiples of $1 for anything over $1,000.
When it comes to minimum denominations, well that’s $1,000.
Yield quotes are based on a 12-year prepayment.
This is an assumed period because not many mortgages go full term.
For the Farm Credit System (FCS), denominations are $1,000.
As for the increments, they are $1,000 as well.
Next, let’s look at FHLMC or Freddie Mac denominations.
These are different in the fact that they have a large spectrum of increments.
These increments all have different minimums as well.
Here are two examples.
First, a one-year or less to maturity discount note is available in denominations of $1,000 with $1,000 increments as well.
Second, there’s a reference note available to investors too.
This has a maturity range of two to 10 years and the minimum denomination is $2,000 while the increments are set at $1,000.
FNMAs, where interest is paid every six months have denominations of $1,000 with $1 increments.
Finally, SLMAs have $10,000 set as a minimum denomination as they are long-term issues.
Treasury securities taxation
When it comes to the taxation of treasury securities, we will focus on income generated by interest as well as capital gain or loss.
When it comes to interest income applied to treasury securities, it will have federal taxes applied to it but not state or local taxation.
Note, however, that TIPS bonds operate a little differently.
Here, based on inflation using CPI as a measurement, the principal value is adjusted every six months.
This increase will not be received by the investor when this occurs, however.
Instead, they only receive it at bond maturity.
However, the investor must report this each year as interest income.
As for capital gain and loss, they are treated in the same way as any other securities.
If an investor sells their treasury security at a higher price than what they paid for it, they have a capital gain and that will be taxed.
If they sell a treasury security for less than what they paid for it, they have suffered a capital loss and can claim against it when it comes to taxation.
Agency securities taxation
Now let’s look at how agency securities are taxed.
First, let’s look at interest income.
Like treasury securities, agency securities are taxed at the federal level.
When it comes to state income tax, however, well there are a few things to note.
Should GNMA, FHLMC, and FNMA certificates earn interest, they are not only taxed at federal but state and local levels too.
What isn’t taxable, however, is the portion of payments on MBS.
That’s because this is a return of principal.
This differs from the interest received from Farm Credit System and Federal Home Loan Bank securities.
These are only taxed at the federal level and not at the state and local level.
As for capital gains and loss, well that works exactly like with treasury and other securities as explained earlier.
Here’s a handy summary regarding tax treatment related to interest earned on securities:
- When corporate bonds earn interest, they are taxed on three levels: federal, state, and local
- When municipal securities earn interest, they are taxed at the municipal level but not the state level. This means that they are subject to state and local government tax
- When federal government issues (for example, bonds, notes, and treasury bills) earn interest, they are taxed at the federal level but not the state or local level
- When it comes to the interest earned by any mortgage-backed security, they are taxed on three levels: federal, state, and local
- U.S. territory issues, for example, those from Puerto Rico won’t pay federal, state, or local tax on interest