Basic securities

Introduction to fundamental facts about types of securities

This section should hopefully be primarily a review, but we need to make sure we understand how the basics works, as that is a lot of what we are likely to be supervising.

Equity and debt

In simplest terms, stocks and bonds. Equity is ownership. The owner of an equity security, has some form of ownership claim on the issuer of the security. The specific claim can get a little complicated. Common stock and Preferred stock are the most used forms of equity, with common stock being the most common (no pun intended).

Debt is loaning the company money, and they are now a debtor to you, the creditor, and they, the company, will pay interest on the loan to you and eventually replay the loaned principal, if able. Bonds and debentures are the most used forms of debt, with bonds and debentures basically being identical, except debentures are backed by faith and credit specifically, and bonds could be secured by some collateral.

Derivatives

We will be going into far more detail in their own sections on options, but derivatives are a type of investment category we need to understand. The term derivative is used, because these are securities that derive their value, from the underlying security. In many cases, we can think of these types of securities as a “bet”, betting if the price will go up, betting if the price will go down, betting the price will stay the same, or far more complicated bets are possible. In practice, they are a contract between 2 parties.

Rights and warrants

Rights and warrants are issued by the issuing company, when certain events happen.

Rights are issued when a currently listed company, one that has already had an IPO, and has common stock outstanding, issues additional shares. This could be in an additional public offering (APO), subsequent public offering (SPO), or follow-up/follow-on offering. When an issuer issues additional shares, they have to give their current common stock shareholders rights to maintain proportional ownership. They do this through issuing preemptive rights, or just rights. These allow the holder of them to buy the shares, to keep their proportional ownership, at a discount from the current market price. They would be able to sell them on the secondary markets if they choose. Rights though, are short term, 30-45 days is usual, 60 days is basically the maximum expiration.

Warrants are issued as a sweetener, to make a deal more attractive. Typically warrants are issued with a bond, but they could also be issued with preferred stock. The idea is that the issuing company, doesn’t want to pay as high an interest rate, so they have to offer something else to “sweaten the deal”, if they want to pay a lower rate than their company otherwise should based on the risks. The idea is that a warrant allows the owner, to buy the stock of the issuer, at a price higher than it currently is at the issue of the warrant, but unlike rights, warrants have a very long expiration period. Warrants usually are 3-5 years at least, with some warrants being perpetual or forever warrants. The summary use being, if you think the company is a good company, and you like their bonds, would you be willing to accept a slightly lower interest rate when you loan them money, in exchange for the ability to buy their stock at a stated price for 5 years? If you think the company will go up, then that capital gain potential, would be worth a lot more than that extra income would be.

Options: puts and calls

Usually, everyone’s favorite topic. We will go into more details in their own section, especially on the supervision as that is what is most often tested.

For now, think of them as a bet, they are contracts, but they function as a bet, someone is betting that the underlying investment is going to go up (buying a call), the other person therefore is “taking the bet”, and saying “it’s not going to go up”. The other situation has someone betting that the underlying investment is going to **go down **(buying a put), and the person “taking the bet”, is saying “it is not going to go down”.

An options quote would look something like “2 ABC Jan 40 call at 5”. That is stating there are 2 call contracts being discussed, these are call contracts that will expire the third Friday of January. They have a strike price of 40, meaning the person buying this believes it will go above 40, and the person selling it believe it will not go above 40, all by the third friday in January. The option costs $5 per share, and each contract is for 100 shares, so each contract costs $500, 2 contracts, $1,000 for buying this quote.

Options may not be bought or sold on margin, and may not be used as collateral in margin accounts.

Almost all options questions will be tested on the Series 9, but there could be some questions, especially about the non-marginal nature, that could be seen on the Series 10.

Variable annuities

Again, most of this should likely be review. These are an insurance product, most suitable for investors wanting a stream of income for life, likely for a long life, and have a reasonably long period of time to grow the money, or a lump sum to invest in them. If a client withdrawals any money, from any annuity, prior to 59.5 years old, they will have the 10% retirement penalty.

Annuity earning grow tax deferred, meaning you are not paying taxes each year on growth in the account.

Representatives must have an understanding of the client’s investment objectives, time horizon, liquid net worth, and similar information before recommending these products. There is severe liquidity issues, with potentially very high surrender charges for the first few years. Remember as well, this like all FINRA exams, will focus on the vanilla annuities, not the riders we know and love. Do not assume there are annual step-up or lock-ins, no guaranteed minimum income benefit, or any other riders.

When replacing annuities, the surrender charge of the old annuity needs to be taken into consideration. It doesn’t really matter the benefits of the new annuity over the old annuity, if the client is going to lose 5-6% or more of their money due to surrender charges or other contractual limitations. If the old annuity is out of surrender charges, then it might be useful to consider, and the 1035 exchange means it would be tax-free, the deferral of the taxes would remain and carry over. There certainly are times when the annuity can be exchanged during a surrender period, but the key must still be that the new annuity is clearly better than the old product, with the additional benefits outweighing the fees/costs associated with terminating the old product. If there are no fees/costs with the old, it is even easier to justify.

Registered reps must be insurance and securities licensed in each state they wish to sell these, and supervisors must be registered in both securities and insurance, in each state they supervise reps in these products.

One of the trickier things to never forget about annuities is that regardless of the type of annuity, if taxes are owed, they are always ordinary income. If the annuity has been annuitized, the proportion of each payment that is excluded from taxes is the same proportion of the annuitized value that the client had already paid taxes on. Ex. If the client invested $50k into an annuity that grew to $150k, that means 1/3 of the money has already been taxed, 2/3s owes taxes, so on each annuity payment, 1/3rd is excluded from taxes. Again, if any taxes are owed, they are always ordinary income.

Qualified vs non-qualified

Like in all areas with these words, it comes down to qualified means tax deductible and tax deferred, non-qualified means not those, not deductible, and not deferred. When it comes to annuities, all of which are deferred, the only difference than means qualified has not been taxed yet, tax deductible, and nonqualified means it has been taxed, investors have already paid the tax on their investment, it creates a cost basis, and is non-deductible.

Qualified annuities are only available through employers offering 403b plans. Those would be schools, hospitals, churches, 501c3 organizations. The employee specifies an amount to be withheld, the employer may also contribute. It has not been taxed yet, so 100% of the withdrawals, will be taxable as ordinary income.

Nonqualified annuities are available through insurance/brokerage companies. They are after-tax meaning only the gain is taxable, as you won’t be double taxed. Annuities must use LIFO accounting, meaning the withdrawals are 100% taxable as ordinary income, until all growth has been removed.

To be clear, whenever taxes are owed on annuities, regardless of what the annuity is invested in, all taxes owed on annuities is ordinary income. Never anything other than ordinary income tax.