CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Investment Planning

1. CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning Module 6Features of Fixed-Income Securities

2. Learning Objectives 6-1: Explain terminology, characteristics, and sources of risk of debt securities and preferred stock, including convertible issues of both. 6-2: Explain terminology and characteristics of preferred stocks. 6-3: Evaluate the implications of yield curves.

3. Questions to Get Us Warmed Up

4. Learning Objectives 6-1: Explain terminology, characteristics, and sources of risk of debt securities and preferred stock, including convertible issues of both. 6-2: Explain terminology and characteristics of preferred stocks. 6-3: Evaluate the implications of yield curves.

5. Basic Terminology of Bonds • Indenture (governing document) • Principal (face amount, maturity value, par value) • Coupon (or nominal rate) • Maturity date • Secured bonds • Debentures (unsecured) • Subordinated (junior) debentures

6. Basic Terminology of Bonds • Income bonds • Serial obligation bonds • Floating-rate bonds • Pay-in-kind (PIK) bonds • Put bonds • Bond ratings • Bond quotes • Basis points (1% = 100 b.p.)

7. Bond Ratings Four major agencies • Standard & Poor’s • Moody’s • Duff & Phelps • Fitch Investment grade: top four ratings • Standard & Poor’s: AAA, AA, A, and BBB • Moody’s: Aaa, Aa, A, Baa

8. Embedded Options & Sinking Funds • Callable bonds • Putable bonds • Convertible bonds • Bond with warrants • Sinking fund provisions

9. Bond Risks Primary risks when investing in bonds • Default risk (credit risk) • Reinvestment risk • Interest rate risk • Purchasing power risk Potential additional risks • Call risk • Liquidity risk • Event risk • Financial risk • Exchange rate risk

10. Major Bond Issuers • U.S. government and its agencies • Municipal government • Corporations • Foreign governments and corporations

11. Bond Maturity Classifications • Short term • one- to three-year maturities • Intermediate term • three- to ten-year maturities • Long term • more than ten-year maturities

12. Video Play Video • Relationship between bond prices and interest rates • 7 minutes • Play video from Video Layout Text chat or other questions

13. U. S. Treasury Obligations

14. U.S. Treasury Obligations: TIPS Treasury Inflation-Protection Securities • Minimum face amount of $100 • Fixed interest rate • Principal adjusted semiannually for inflation • Index used is CPI-U • Principal adjustment subject to federal income tax even though not received until maturity

15. U.S. Savings Bonds • Series EE and Series I Savings Bonds • $25 or more • $10,000 annual purchase limit per Social Security # for each; as of 1/1/12, paper bonds no longer sold at financial institutions • Series EE • fixed rate announced by the Treasury • Series I • earns a fixed rate plus a semiannual inflation rate based on CPI-U

16. U.S. Government Agency Issues Pass-Through Securities • GNMA: Ginnie Mae • Direct obligation of U.S. government • FHLMC: Freddie Mac • FNMA: Fannie Mae • CMO: collateralized mortgage obligations • Divided into classes (tranches) • “A” tranche pays off first, then “B”, etc.

17. Municipal Bonds General Obligations (GO) • full faith and credit of issuer backing Revenue (Private Activity) • backed by a specific project • “riskier” since only backed by project • interest subject to AMT (some private activity bonds issued in 2009 and 2010 are not subject to AMT)

18. Taxable Equivalent Yield (TEY) Calculated by: Example: The tax-free yield is 4.5%, what is the TEY if an investor is in the 35% MTB? 4.5/(1 - .35) = 6.92% TEY To calculate the tax-exempt yield: 6.92 x (1 - .35) = 4.5%

19. Other Bond Types • Equipment trust certificates • Asset-backed securities (ABS) • Collateralized debt obligations (CDOs) • CARS – Certificates for automobile receivables • Zero coupon bonds • Original issue discount bond (OID) • Credit default swaps (CDSs) • High-yield bonds (junk) • Fallen angels • International bonds • Eurobonds • Yankee bonds • Eurodollar bonds

20. Learning Objectives 6-1: Explain terminology, characteristics, and sources of risk of debt securities and preferred stock, including convertible issues of both. 6-2: Explain terminology and characteristics of preferred stocks. 6-3: Evaluate the implications of yield curves.

21. Preferred Stock • Fixed dividend (not tax deductible by corporation) • Dividend paid from earnings, generally cumulative • Qualified dividends eligible for capital gains tax rates (2012) • Dividend exclusion for a corporation holding preferred stock (70% or more depending upon percentage of ownership)

22. Preferred Stock • In event of bankruptcy, bond holders come first, then preferred shareholders, then common stock shareholders. • Preferred stock is riskier than debt (no maturity date). • Some issues are convertible into common stock. • Do not confuse with “trust preferreds” which are structured as debt and pay “interest” not “dividends.”

23. Preferred Stock: Valuation Use the zero-growth model Example: $1.50 dividend and interest rates currently at 6% $1.50/.06 = $25 What if interest rates change to 7%? $1.50/.07 = $21.43 (decline of $3.57 or 14.28%)

24. Learning Objectives 6-1: Explain terminology, characteristics, and sources of risk of debt securities and preferred stock, including convertible issues of both. 6-2: Explain terminology and characteristics of preferred stocks. 6-3: Evaluate the implications of yield curves.

25. Yield Curves Hypothetical Yield Curve Return Rf 0 Years until maturity 30

26. Positive (Normal) Yield Curve Return Rf 0 Years until maturity 30

27. Negative (Inverted) Yield Curve Return Rf 0 Years until maturity 30

28. Term Structure of Interest Rates

29. Changes in Yield Curve Discuss change over time from YC1 to YC2 % Yield YC1 YC2 Years to maturity

30. Question 1 Which of the following are characteristics of mortgage-backed securities? • stable cash flow • ordinary income • tax-sheltered income • capital gains and losses • I and II only • II and IV only • I, II, and III only • II, III, and IV only

31. Question 2 Which of the following is an advantage of investing in convertible bonds? • There is minimal financial and business risk. • The yield-to-maturity tends to be lower than that of similar nonconvertible bonds. • The potential for capital gains is greater than that for the underlying stock. • Its value as a bond, assuming it did not have the convertible feature, provides downside protection.

32. Question 3 Kathleen is risk-averse, and is considering the purchase of some short-term fixed income investments. Which of the following are reasons why Kathleen should consider U.S. Treasury bills? • They may sell at a premium over face value. • The longest maturity available is 52 weeks. • They can be purchased for as little as $1,000. • The interest income is exempt from state income taxes. • I and III only • II and IV only • III and IV only • I, III, and IV only • II, III, and IV only

33. Question 4 Which of the following features distinguish GNMA mortgage-backed securities from corporate bonds? • Distributions of GNMA mortgage-backed securities are made semi-annually, reducing reinvestment risk. • GNMA mortgage-backed securities are free of default risk. • Distributions from GNMA mortgage-backed securities are comprised of both interest and principal. • Because GNMA mortgage-backed securities are government guaranteed, investors cannot lose money on them. • I and II only • II and III only • III and IV only • I, II, and III only • II, III, and IV only

34. Question 5 Ken Kannopolis has come to you for advice about investing in municipal bonds. Which of the following statements is (are) correct? • A revenue bond relies on the general taxing ability of the issuing municipality for repayment of the debt. • Municipal securities have a relatively thin market, with only moderate activity in the secondary market. • Municipal bonds are free from default risk. • The interest from general obligation bonds may be subject to the alternative minimum tax (AMT). • II only • I and II only • II and III only • II and IV only • III and IV only

35. Question 6 Which of the following are similarities between long-term corporate bonds and preferred stock? • Both offer favorable tax treatment to the corporation on the dividends and interest paid out. • Both have a maximum maturity of 30 years or less. • Both are subject to interest rate risk and purchasing power risk. • Both bond interest and preferred stock dividends must be paid before common stock dividends may be paid. • I only • I and II only • III and IV only • I, II, and III only • II, III, and IV only

36. Question 7 You are considering the purchase of XYZ preferred for your client. XYZ pays an annual dividend of $2.50, and the yield on current comparable preferred is 8.2%. The current risk-free rate is 4%. Which of the following is closest to the intrinsic value of XYZ Preferred? • $25.00 • $30.49 • $59.25 • $62.50

37. Question 8 Your client has noticed that short-term interest rates are currently lower than long-term interest rates. You explain to her that one of the reasons that this may be the case is because of one of the following theories which attempts to explain the term structure of interest rates. Which answer correctly matches a theory with its appropriate definition? • The market expectations theory states that investors expect long-term rates to be higher than short-term rates. • The liquidity preference theory states that the longer the maturity, the less liquidity; so long-term rates are higher to compensate for the reduced liquidity. • The market segmentation theory states that the long-term portion of the bond market is not influenced at all by the short-term portion of the market. • the positive yield curve theory states positive yields are considered normal.

38. CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning Module 6End of Slides