SELECTING INVESTMENTS IN A GLOBAL MARKET

Discuss the characteristics of fixed-income securities available to investors,   including    U.S.   Treasury   securities,   corporate   bonds,   and Eurobonds.

Investors who acquire fixed-income securities (except for preferred stock) are really lenders to the issuers. Characteristics of fixed income investments:

The payment schedule of fixed income securities is contractually mandated. Fixed income securities promise specific payments at predetermined times.

By purchasing fixed income securities, investors loan money (called the principal) to the borrower.

In return, the borrower promises to make periodic interest payments, and pay back the principal at maturity.

Savings Accounts

They are convenient, liquid and low-risk because almost all are insured. The rates of return are generally low too. Several versions are:

Pass book savings account: no minimum account balance; funds can be withdrawn at any time with little loss of interest; high flexibility and thus low interest rate. certificate of deposit (CDs): require minimum deposits and have fixed durations; Interest rates increase with the size and the duration of the deposit; cashing in a CD before maturity will result in a heavy penalty.

Money market certificates: minimum investment of $10,000 and minimum maturity of

6 months; interest rates are higher than that of 6-month T-bills; heavy penalty if withdrawn before maturity.

Capital Market Instruments

They are fixed-income obligations that trade in the secondary market.

US Treasury securities

The US government borrows funds in large part by selling Treasury securities. They are essentially free of credit risk. The income earned on T-securities is exempt from all state and local taxes.

o  T-bills mature in one year or less. Investors buy the bills at a discount from the stated maturity value, and the difference between the purchase price and ultimate maturity value constitutes the investor's earnings. They are highly liquid: they are easily converted to cash and sold at low transaction cost and with not much price risk.

o  T-notes maturities range up to 10 years. T-bonds are issued with maturities ranging from 10 to 30 years. Both are issued in denomination of $1,000 or more. Both  make semiannual coupon payments that are  set at an  initial level that enables the government to sell the securities at or near par value. Aside from their differing maturities at issuance, the only major distinction between the two is that T-bonds may be callable during a given period, usually the last five years of the bond's life.

US government agency securities

Some government agencies issue their own securities to finance their activities. These agencies usually are formed to channel credit to a particular sector of the economy that Congress believes might not receive adequate credit through normal private sources. The majority of the debt is issued in support of farm credit and home mortgages. The major agencies are Fannie Mae, Ginnie Mae, Freddie Mac, etc. Although the debt of federal agencies is not explicitly insured by the federal government, it is widely assumed that the government would step in with assistance if an agency neared default. Thus, these securities are considered extremely safe assets, and their yield spread above Treasury securities is quite small.

Municipal bonds

They are issued by state and local governments.

o  Taxation: This is the key feature. Their interest income is exempt from federal income taxation. The interest income also is exempt from state and local taxation in the issuing state. Capital gains taxes, however, must be paid on "munis", when the bonds mature or if they are sold for more than the investor's purchase price. Because investors need not pay federal (and possibly state) taxes on the interest proceeds, they are willing to accept lower yields on these securities. These lower yields represent huge savings to state and local governments. An investor choosing between taxable and tax-exempt bonds must compare after-tax returns on each bond, and high tax-bracket investors tend to hold municipals.

o  Two types: General obligation bonds are backed by the full faith and credit of the issuer, and revenue bonds are issued to finance  particular projects and  are backed by the revenues from that project or by the particular municipal agency operating the project. Typical issuers of revenue bonds are airports, hospitals and turnpike or port authorities.

o Maturity: they vary widely in maturity.

Corporate bonds

They enable private firms to borrow money directly from the public. They are similar in structure to Treasury issues - they typically pay semi-annual coupons over their lives and return the face value to the bondholder at maturity. However, they differ most importantly from Treasury bonds in degrees of risk. They can be categorized by the credit quality of the issuer,  maturity,  components of  the  indenture  (sinking fund  or  call feature); or  type  of security offered by the issuer.

Preferred Stock

Preferred stock has features similar to both equity and bond.

1.        It promises to pay to its holder fixed dividends each year. In this sense it is similar to an infinite-maturity bond (a perpetuity).

2.        It also resembles a bond in that it does not convey voting power.

3.        However, the dividends are not legally binding, as are the interest payments on a bond. It is sometimes considered an equity investment in the sense that failure to pay the dividend does not precipitate corporate bankruptcy.

4.        It is cumulative: firms can decide not to pay preferred dividends even if the firm earns

enough money to make the payment. However, unpaid dividends cumulate and must be paid in full before any dividends may be paid to holders of common stock. In practice, preferred dividends are binding because  of the  credit implications of a missed dividend.

5.        It also differs from bonds in terms of its tax treatment for the firm: because preferred

stock payments  are  treated as dividends  rather  than  interest,  they  are  not tax- deductible expenses for the firm. This disadvantage is somewhat offset by the fact that corporations may exclude 80 percent of intercompany dividends from taxable income. They therefore make desirable fixed-income investments for some corporations. Due to  this  tax benefit, the  yield on  high-grade  preferred  stock  is typically lower than that on high-grade bonds.

International bond

1.        Eurobond: it is an international bond denominated in a currency not native to the country where it is issued. Examples are: Eurodollar bonds, Euroyen bonds, and Eurosterling bonds. A Eurodollar bond is denominated in US dollars and sold outside the US to non-US investors. A Euroyen bond is denominated in yen but sold outside Japan. A US corporation can issue Euroyen bond in London.

2.        Yankee bond: it is sold in the US, denominated in US dollars, but issued by foreign corporations or government. This allows a US citizen to buy the bond of a foreign firm or government but receive payments in US dollars, eliminating exchange rate risk. In the UK this kind of bond is called Bulldog, and in Japan it is called Samurai.

3.        International domestic bond: it is sold by an issuer within its own country in that country's currency. For example, a bond (denominated in yen) sold in Japan by Sony. A US investor acquiring such a bond would receive maximum diversification, but would incur exchange rate risk.