SHORT TERM INVESTMENTS -INVESTMENT IN MARKETABLE SECURITIES

Companies and other organizations sometimes havea surplus of cash and become cash rich.

A cash surplus is likely to be temporary, but while it exists the company

should seek to obtain a good RETURN by investing or depositing

the cash, without the risk of a capital loss (or at least, without the risk of

an excessive capital loss).

 

Three (3) possible reasons for cash surplus are:

  Profitability from the trading operations. Low capital expenditure, perhaps because of an absence of profitable

new investment opportunities Receipts from selling parts of the business.

Reasons for keeping surplus funds

The board of directors might keep the surplus in liquid form:

a)  To benefit from high interest rates that might be available from bank deposits, when returns from re-investment in the company appear to be lower.

b) To have cash available should a strategic opportunity arise, perhaps for the take over of another company for which a cash consideration might be needed.

c) To buy back shares from share holders in the near future.

d) To pay increased dividends to share holders.

Temporary cash surpluses are likely to be:

a) Deposited with a bank or similar financial institutions (With bank deposit the risk of capital loss is minimal.

b) Invested in short term debt instruments. Debt instruments are debt securities, which can be traded (Any capital loss should not be large because of the short term of the maturity).

c) Invested in longer term debt instruments, which can be sold on the stock market when company eventually needs cash. ( Risk of Capital loss)

d) Invested in shares of listed companies which can be sold on the stock market when the company eventually needs cash (Risk of Capital loss

Marketable Securities

Marketable Securities are investments (or

are derived from such investments) in

companies, government entities and/or

market indices. Marketable securities are

generally "liquid" in that they can usually

be sold (converted to cash) with relative

ease on a securities exchange or market

YIELD OF MARKETABLE SECURITIES

Default Risk(Credit Risk) When a borrower does not fulfills the contractual obligations regarding the Principal & Interest payments.Marketability. It means the ability of the owner to convert a marketable security into cash (Price and Time required). The lower the marketability of the security the greater yield is required to attract the investor.Maturity: The longer the maturity the greater the risk of fluctuation in market value of the security (Risk premium demands increases)Coupon Rate: Besides maturity the price fluctuation of security also depends upon the level of the coupon rate. For fixed income security the lower the coupon rate, the greater the price change with the shift in interest rate. Volatility of security depends upon both maturity and Coupon rate.Taxability: It also affects the market yield of the security. Income from certain Government securities are tax exempt therefore they sell in market at lower yields to maturity than Corporate securities of the same maturity.

COMMON TYPES OF MKTBLE SECURITIES

The most common types of Marketable Securities

are:

1. Equity Securities

2. Bonds – Fixed Income Securities

3. Option Securities

4. Mutual Funds

5. Unit Investment Trusts

6. Commodities

7. Derivatives

EQUITY SECURITIES

Equity Securities

Equity securities – or stock – represent an ownership interest in a

company. The owner of an equity security, the shareholder, is a

pro-rata owner of the issuing company.

Equity securities generally pay shareholders periodic dividends.

Dividends are pro-rata payments to the shareholders, paid from the

company’s earnings. Essentially, dividends help the company

distribute its earnings to its owners.

Dividend payments must be declared by the company’s Board of

Directors

KEY FEATURES OF EQUITY SECURITIES

• Par Value :For accounting purposes, equity securities are assigned a Par Value at the time of issuance. The Par Value of a security, which is expressed as an amount per share, has no impact on the issue price or market value of the stock.

• Traded on an Exchange or Market :Equity securities are generally traded on either one of the listed stock exchanges or on the Over-the-Counter market. The market value of equity shares is influence by prevailing economic conditions such as the company’s performance (ie. earnings) supply and demand and interest rates.

• Limited Liability:Shareholders of equity securities enjoy limited liability from the consequences of the actions or deeds of the corporation and/or its corporate officials and employees. The shareholder’s liability is generally limited to the original amount of the investment plus the Par Value of the shares owned.

• Therefore, in the event of a liquidation or lawsuit, the personal assets of a firm’s equity investors are not available to the firm’s creditors and cannot be claimed as part of a legal settlement.

• In addition to the original investment amount, shareholders are liable for the Par Value of the shares owned. Therefore, it is in the best interest of the equity investor that the Par Value be set as low as possible at the time that the shares are issued.

Classes of Equity Securities Different classes of equity securities exist:• Common Stock • Preferred Stock

The primary differences between Preferred Shares and Common Shares are:

1. The dividend rate on Preferred Shares is usually fixed

2. Owners of Preferred Shares receive dividends ahead of common shareholders

3. In the event of a liquidation, Preferred Shareholders have a prior claim to assets over common stock owners

The dividend rate on Preferred shares is usually fixed. This rate is generally expressed as either: 1. an annual dollar amount per share - $2.50 per share 2. an annual percentage of the Par Value of the stock – 5% per

shareVoting vs. Non-Voting StockBecause equity securities represent an ownership stake in the company, shareholders generally have a voice in certain corporate decisions. Shareholders are often permitted to vote on important corporate matters at the annual shareholder’s meeting. Generally, shareholders are entitled to one vote for each share of stock owned.

In some cases, however, equity securities are issued solely to raise capital – and it is not the intention of the Board of Directors to convey voting rights to the shareholders. In this case, Non-Voting stock is issued. Shareholders of Non-Voting stock are still entitled to dividend payments from earnings, but are not empowered to vote on corporate affairs at the annual meeting

Restricted Stock

• In certain cases, shareholders receive their shares as part of a special distribution or incentive plan. Often, the terms of these distributions or plans prohibit the sale of these securities for a set period of time. To prevent the holder from selling these securities prior to the proscribed date, Restricted Securities are issued.

• Restricted securities contain a printed legend on the face of the stock certificate that prohibits the sale of the shares until the restriction period is ended. The legend is generally printed in red so that it stands out, and prevents the Stock Transfer Agent from transferring the shares out of the customer’s name, thereby preventing the securities from being sold before the end of the restriction period.

• Once the restriction period is ended and the restriction is lifted, it is permissible for the shareholder to sell the shares

Convertible Bonds

• Convertible Bonds are fixed income securities that are readily convertible into shares of the issuing company’s stock on or after a pre-determined date. This means that holders of Convertible Bonds will eventually receive equity securities as a result of their investment.

• As such, Convertible Bonds are treated as equity securities for accounting and tax purposes and are therefore mentioned in this section.

American Depository Receipt’s – ADR’s

• An American Depository Receipt is an investment security created by a US Bank or custodian. The US Bank holds the stock certificates of a foreign entity – which are traded on a foreign exchange or market – in its vault. The bank or custodian issues a domestic ADR equity security that is collateralized by the foreign securities held, and is traded on a US exchange or market.

• ADR securities are created to alleviate the difficulties involved in transferring securities from one country to another and in converting currencies in the buy and sell process, making it easier for US investors to invest in foreign securities.

• To the investor, an ADR represents a ‘receipt of ownership’ of the foreign securities that are held on deposit at the American Depository. The ADR securities are traded in US currency and are readily transferable from one investor to the next.

ADR EXAMPLE

• For example, assume that MAJOR US BANK acts as custodian for INTL Co., a foreign security which trades on a foreign exchange. MAJOR BANK holds 300,000 shares of INTL Co. common stock in its vault. MAJOR issues 300,000 shares of INTL ADR – a domestic security that trades on a US stock exchange. Each domestic ADR represents one share of the foreign stock – INTL Co.

• The one-for-one relationship in the preceding example between the foreign securities held and the ADR’s issued is not a requirement. ADR securities are often issued to represent multiple shares of the foreign security.

• For example, MAJOR might have instead issued only 30,000 shares of INTL ADR, each ADR share representing 100 shares of the foreign INTL stock

Bonds – Fixed Income Securities • To raise required funding, Corporations and Government entities

borrow money from individual and institutional investors by issuing bonds or debt securities. Issuers of debt securities offer to pay a certain rate of interest for the use of the investor’s money over a specified period of time.

• Holders of debt securities are creditors of the issuing entity. Debt holders do not have an ownership interest in the issuing entity and do not receive dividends from earnings.

• Because the rate of interest is determined or ‘Fixed’ at the time the debt securities are issued, debt securities are also referred to as Fixed Income securities.

• Similar to equity investments, fixed income securities are generally traded on established exchanges or markets, and many enjoy strong liquidity. In addition, bond holders also benefit from limited liability. An investor in debt securities has only the original amount invested at risk

Key Fixed Income Terms • Par Value :The Par Value of a debt security is the Principal

amount that will be paid back to the investor when the bond matures – or the maturity value. The Par Value is also referred to as the Principal or Face Amount.

• The price of fixed income securities is expressed as a percentage of its Par Value. The price of a bond trading at Par Value is $100.

• Maturity Date :The Maturity Date is the date upon which the issuer of debt securities agrees to repay the loan from the debt investor. The amount paid is the Principal or Face Amount.

• Coupon Interest :The annual rate of interest the issuer agrees to pay its debt security investors is called the coupon rate or coupon. The bond coupon rate is expressed as a percentage of the bond’s Par Value and is fixed for the life of the bond.

• For example, a bond with a $1,000 Par Value and a 7% annual coupon rate will pay a total of $70 in annual interest

• It is interesting to note that the annual interest rate acquired the name ‘Coupon Rate’ due to the fact that most fixed income securities were originally issued with detachable interest coupons. When the interest payment came due, investors were required to ‘clip’ the coupon off the bond and present it to the issuer for payment. Although the vast majority of modern fixed income securities are no longer issued with detachable coupons, the term ‘Coupon Bond’ is still widely used.

• Discount :Bonds trading at prices below Par Value – less than $100.

• Premium :Bonds trading at prices above Par Value – greater than $100.

• Yield-to-Maturity – YTM :The Yield-to-Maturity is the actual rate of return a debt security investor will earn if that investor holds the securities until it matures. The YTM is a factor of the bond’s actual coupon payment – which is fixed – and the market price of the bond.

• Because the coupon rate is fixed, each interest payment received by the investor is the same percentage of the bond’s Par Value – regardless of how much the investor actually paid for the bonds. When bonds trade at Par – the YTM and the Coupon Rate are the same. For bonds trading at a discount the YTM is higher than the coupon rate. Finally, the YTM is less than the coupon rate for bonds trading at a premium.

• For example, assume a 5% coupon bond with a Par Value of $1,000. The investor receives a fixed amount of $50 (5% of $1,000) each year. If the investor paid $1,000 for the bond (Par Value) and receives interest payments of $50 (5% of $1,000) each year, the rate of return is equal to the coupon rate - 5%.

• Investors that pay Par Value for the bond earn a rate of 5% until maturity. Investors who pay only $900 for the same bond also receive $50 (5% of $1,000). Because 5% of $900 is only $45 and the investor receives $50 each year, the investor earns more than 5% on the $900 investment and therefore has a higher yield to maturity.

• Conversely, investors who pay $1,100 for the same bond earn a lower rate of return because the $50 per year received by the investor is less than $55, which is 5% of $1,100.

Bond Pricing :The market value of debt securities fluctuates as interest

rates rise and fall. As prevailing interest rates increase, bond prices decline. Similarly, as interest rates fall, bond prices rise.Fixed Income securities trade at Par, at a discount or at a premium. Bonds trade at Par - $100 – when the prevailing general interest rate in the economy is the same as the coupon rate of the bond. Bonds trade at a discount, or below Par, when general interest rates are above the fixed coupon rate. Bonds trade at a premium, or above Par, when general interest rates are below the stated coupon.For example, the value of a 5% coupon bond is Par or $100 when the prevailing general interest rate is also 5%. If interest rates rise to 6% - that is, debt issuers are willing to pay a 6% coupon on new bond issues of similar risk – a bond paying only 5% becomes less attractive to investors. Because the prevailing interest rate for new debt is 6% - investors will only buy existing bonds that have a yield to maturity of 6%. To increase the YTM of a 5% bond the price must be adjusted below Par. If general interest rates instead fall to 4%, the 5% coupon bond becomes more attractive to investors. The market price of the bond will adjust until the Yield-to-Maturity is equal to the 4% general interest rate. To decrease the YTM of a 5% bond the price must be adjusted above Par

Bond Rating Agencies

• Bond Rating Agencies assist bond investors in the analysis of risk. The two most influential bond rating agencies are:

• Standard and Poor’s • Moody’s• These agencies perform financial analysis of debt issuers. The bond

issues are then rated as to the issuer’s ability to make the obligated interest and principal payments. The greater the issuer’s risk of default the lower the bond rating.

• Based on the bond’s rating, the issue is classified as either Investment Grade or High Yield. Investment Grade debt securities are rated AAA, AA, A or BBB. Because issuers of Investment Grade debt securities are less likely to default, the coupon rate is generally lower – less risk equals less reward.

• High Yield or Junk Bonds are rated BB or lower. ‘High Yield’ implies a higher coupon rate. This higher rate compensates the bond investor for accepting a higher risk of default.

Common Fixed Income Securities include

Corporate Bonds

Municipal Bonds

US Treasury Securities

Mortgage-Back Securities

Zero-Coupon Bonds

Commercial Paper

Certificates of Deposit

Corporate Bonds

• A Corporate Bond is a Fixed Income debt security issued by a corporation to raise capital. Corporate Bond investors assume the risk that the company might not be able to satisfy its obligations to pay interest and ultimately to repay the debt. The degree of risk depends on the strength of the particular company and the length of time before the bonds mature. The longer the time until maturity, the greater the risk of default.

Municipal Bonds • Municipal Bonds (Muni’s) are debt securities issued by local, city and

state governments to raise capital for special projects and operations. Municipal Bonds are generally less risky because they are backed by the taxing authority of the issuing municipality.

• The Municipal Securities Rulemaking Board – MSRB – oversees both the issuance and trading of Municipal Bond securities.

• The investment advantage of Municipal Bonds is that the interest payments received are exempt from federal income tax. Further, if the investor lives in the same city or state as the bond issuer, the interest payments are exempt from state and/or local taxes as well.

• Because Municipal Bonds are subject to less risk – coupon rates are generally lower than those of other debt securities.

GOVT TREASURY SECURITIES

• Treasury Securities are debt securities issued by the Government .Treasury Securities offer investors substantially less risk because the scheduled interest and principal payments are guaranteed by the Government. As such, the interest rates paid on Treasury Securities are low relative to the rates on debt securities of other issuers.

• There are three general classes of Treasury Securities:

1. Treasury Bonds

2. Treasury Notes

3. Treasury Bills• Treasury Bonds are Treasury debt securities with a maturity of

10 – 30 years from the date of issuance.• Treasury Notes are US Treasury debt securities with a maturity of

1 – 10 years from the date of issuance.• Treasury Bills or T-Bills are US Treasury debt securities with a

maturity of less than 1 year from the date of issuance

Treasury Auctions Treasury Securities are issued to the public in periodic auctions.

Only brokerage firms that are designated as ‘Primary Dealers’ of

Treasuries are eligible to participate in the periodic auctions. This

designation is obtained from the State Bank of Pakistan.

During the auction, Primary Dealers submit bids to the Treasury for

both the Principal or Rupee amount of Treasury Securities they wish

to acquire in the auction, and the coupon rate or ‘level’ that is

desired.

Prior to the auction, the Treasury establishes an optimal level or

coupon for the issue. This level is not disclosed to the Primary

Dealers participating in the auction. Dealers submitting bids that are

better than (below) the pre-determined level are allotted securities

first. Any remaining bonds in the auction are assigned to the

remaining dealers on a pro-rated basis at the level pre-determined

by the Treasury

Zero Coupon Bonds

• Zero Coupon Bonds are stripped of coupons. Therefore, Zero Coupon Bonds do not make regular interest payments. Instead, Zero Coupon Bonds are issued at a ‘Deep Discount’. At maturity, the Par or Principal value is paid to the investor. The difference between the discounted amount paid by the investor at the time of the investment and the Par Value received by the investor upon maturity represents the interest paid

• Zero Coupon Bonds are issued by the Treasury, Municipalities and Corporations alike, and most enjoy relatively liquid secondary markets.

Commercial Paper (CP )

• Commercial Paper is a very short-term debt instrument issued by banks, corporations and other borrowers. Commercial Paper enables issuers to obtain short term financing at below market interest rates.

• Typical maturities for Commercial Paper range from 2 – 270 days. Most CP is issued at a discount – although some are interest bearing

Certificates of Deposit (CD)

• A Certificate of Deposit is an interest paying debt instrument issued by banks. CD maturities range from a few weeks to several years. Interest rates on CD’s are determined by prevailing market rates and competitive forces.