INNOVATIVE INVESTMENT AVENUES

Abstract:

The purpose of holding a portfolio is to diversify the risk involved in investments. The assets

in the portfolio could include bank accounts, stocks, bonds, options, warrants, gold

certificates, real estate, futures contracts etc. This is a conceptual study which discusses

about some of the emerging investment avenues like Treasury Strips, REITs, Green

Investment and Structured Notes. It stresses on working mechanism of these Investment

avenues.

Introduction

Before we begin the study, it imperative for us to know about certain key terms like Portfolio

and Portfolio Management in order to ascertain the impact of this paper.

A portfolio refers to collection of investment held by an investor or an institution. The

purpose of holding a portfolio is to diversify the risk involved in investments. The assets in

the portfolio could include bank accounts, stocks, bonds, options, warrants, gold certificates,

real estate, futures contracts etc.

From the perspective of Management, the portfolio management can be defined as “The art

and science of making decisions about investment mix and policy, matching investments to

objectives, asset allocation for individuals and institutions, and balancing risk against

performance”

Aims

To understand the new avenues of investment arising in the financial sector.

To explore the four new avenues of investment.

To portray the financial Picture of an entity’s activities

To understand the understand the risk-return relationship in an Investment

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1) TREASURY STRIPS

Origin of stripped securities:

It began in the US, when the Federal Reserve or the Treasury stopped issuing

zero-coupon bonds and notes. Obviously any security issued by the US government would

have a great demand as it is a gilt-edged security and free from credit risk. There was a lot of

demand for these zero-coupon bonds and notes because they had a maturity period more than

one year. Such securities are in great demand for investors with long time horizon. So, the

private investment bankers (Ginnie Mae, Fannie Mae, and Freddie Mac) wanted to utilize this

opportunity and make business. These bankers tried and created these kind of securities. Here

the aim of these bankers was to convert a security with explicit coupon payment into a zero

coupon note or a bond which has no explicit interest payment periodically.

Process of conversion:

It is easier to understand this concept with an example, in terms of Indian rupee.

Suppose Rs.100000 of a treasury note is purchased with a 10-year maturity and a coupon rate

of 10%, having semiannual coupon payments, is purchased to create a zero coupon Treasury

securities.

The cash flows from the Treasury note are 20 semiannual coupon payments of Rs.5000 each

(100000*0.10\2) and the repayment of principal of Rs.100000, 10 years from now.

Now there are 21 different payments inclusive of coupon as well as the principal repayment

Each of these payments is discounted and issued at the discounted prices by the banker. Thus,

creating 21 zero-coupon instruments.

The amount of the maturity value of the zero-coupon instrument depends upon, whether

coupon or principal, the amount of payment to be made by the Treasury on the underlying

Treasury security.

In our example, 20 coupon receipts each have a maturity value of Rs.5000, and one receipt,

the principal, has a maturity value of Rs.100000.

The maturity dates for the receipts coincide with the corresponding payment dates for the

Treasury security.

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Features This practice of stripped securities is more prevalent in the US. Zero coupon

instruments are issued through the US Treasury’s Separate Trading of Registered Interest and

Principal Securities (STRIPS) program, it is a program designed to facilitate the stripping of

the Treasury securities. The zero-coupon Treasury securities created under STRIPS program

are direct obligations of the US government.

Stripped treasury securities are simply referred to as treasury strips. The strips that are created

from coupon payments are called coupon strips and those created from principal payment are

called principal strips. The reason for distinction between the two is because of tax treatment

by non-US entities as discussed below.

A disadvantage of a taxable entity that is investing in Treasury coupon strips is that the

accrued interest is taxed every year even though interest is not paid until maturity. Thus these

instruments lead to negative cash flows because tax payments are to be made and no cash

inflow is recognized.

One reason for distinguishing coupon strips and principal strips is that some foreign buyers of

this security have preference for the strips created from the principal payment (i.e., principal

strips). This preference is due to tax treatment of the interest in their home country. Some

countries’ tax laws treat the interest as a capital gain if the principal strip is purchased. The

capital gain receives a preferential tax treatment (i.e., lower tax rate) compared to the income

received otherwise ordinarily.

Coupon stripping: Creating Zero-coupon treasury securities

Security

…… ……

…...

Creating Zero-coupon treasury

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Par: Rs 100000 Coupon: 10%, semiannual

Principal: Rs100000

Receipt in 10 years

Coupon: Rs5000

Receipt in 10 years

Coupon: Rs5000

Receipt in 1year

Coupon: Rs5000

Receipt in 6 months

Maturity value: Rs100000

Maturity: 10 years

Maturity value: Rs5000

Maturity: 6months

Maturity value: Rs5000

Maturity: 10 years

Maturity value: Rs5000

Maturity: 1 year

2) REITs

Last year towards the end of 2010 there was a fall in the real estate segment which

throughout the year had seen a gradual rise. However there is no question that there is

demand for urban housing in India. The fall that was seen towards the end of 2010 was

generally seen due to the economic crisis that had romped the global economy. Moreover

funding, both for developers and buyers was a major issues. But investors are speculating a

rise in this sector in the near future, therefore it is considered as a source of income for real

estate investors. To facilitate this there are some aggregation vehicles.

Aggregation vehicles aggregate investors and serve the purpose of giving investors collective

access to real estate investments. Real Estate Investment Trusts (REIT) are a type of close

end-investment company. They issue shares that are issued in a stock market, and they invest

in various types of real estate. Thus, they aggregate individual investors and provide them

easy access to real estate which also leads to diversification within real estate. Of course they

come with their own risk and returns depending on the type of investment they make. This

type of aggregation vehicle is yet to make an impact in the Indian investment field. There are

basically two types of REIT’S:

Mortgage REIT’S, they invest mainly in mortgages and they are similar to bond

investment. Equity REIT’S, they invest in commercial or residential properties using debt or

leverage and it is similar to an investment in a leveraged equity real estate.

The shares of REIT’S trade freely in the stock market and they may be traded at a discount or

premium to the NAV of the properties in their portfolio.

Valuation Approaches:

The Cost Approach:

In this method it deals as to what it would cost to replace the building in its present

form. Of course, an estimate of the land value must be added to the building replacement cost

estimate. This technique is based on current construction costs but comes with certain

limitations. First, it is the appraisal of the land value cost and second is that the market value

of the asset might differ from that of the cost of construction.

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The Sales Comparison Approach:

In here the market value is estimated relative to a benchmark value. It may be the

market value of a similar property or the median value of the market prices of similar

properties. The benchmark has to change from time to time as the market value itself might

change quite often and has to be revalued. One formal variation of the sales comparison

approach is the method of hedonic price estimation. In this method the major characteristics

of a property that are relevant and that which affects its value are identified. It can be the age

of the building, its size, its location, its vacancy rate, its amenities, and so on. For example,

location could be ranked from 1(very bad) to 10(very good). The sales price for all recent

transaction of the properties in the bench mark are then regressed on their characteristics

ratings. This is a regression in which there is one observation for each transaction. The

dependent variable is the transaction price, and the independent variable is the ratings for

each of the characteristics. The estimated slope co-efficient are the valuation of each

characteristic is the transaction price. The result is a bench monetary value associated with

each characteristic’s rating. It is then possible to estimate the selling price of a specific

property b y taking into account its rating on each feature. This technique has also been

applied to income reducing property.

The Income Approach:

This approach values property using a perpetuity discount type model. The perpetuity

is the annual net operating income (NOI). This perpetual stream is discounted at a market

required rate of return. NOI is the gross potential income minus the expenses, which includes

estimated vacancies and collection losses, insurance, taxes, utilities, and repairs and

maintenance. For a constant and continuous stream of annual NOI, we have

Appraisal price = NOI/ market cap rate

And the market rate is calculated on the benchmark transactions as

Market cap rate = Benchmark NOI/ Benchmark transaction price

This approach makes the simplifying assumption of a constant and perpetual amount of

annual income. It can also be adjusted according to the constant growth rate in rentals

coupled with long- term leases. In this approach all calculations are performed before tax.

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The Discounted After-Tax Cash Flow Approach:

The discounted after tax cash flow approach is a check on investment

valuation. If the investor deducts any depreciation and any interest payments from NOI, then

the investors after tax cash flow depends on the investor’s marginal tax rate. Hence the value

of the property depends on the investor’s marginal tax rate. Once these cash flows and after-

tax proceeds from future property dispositions are estimated, the net present value of the

property to an equity investor is obtained as the present value of the cash flows, discounted at

the investor’s required rate of return on equity, minus the amount of equity required to make

the investment. For an equity investment to be worthwhile the expected net present value has

to be positive.

3) Green Investments

Climate change affects all of us. But it is expected to hit developing countries the

hardest. Its potential effects on temperatures, precipitation patterns, sea levels, and frequency

of weather-related disasters pose risks for agriculture, food, and water supplies. At stake are

recent gains in the fight against poverty, hunger and disease, and the lives and livelihoods of

people in developing countries. Tackling this immense challenge must involve both

mitigation to avoid the unmanageable and adaptation to manage the unavoidable all while

maintaining a focus on its social dimensions. Addressing climate change requires

unprecedented global cooperation across borders.

Green Investing: Mainly focused on investing in companies that are deemed to

be good for the environment. These companies have a track record of reducing their

operational impacts on environment and offer alternative technologies such as wind and solar

power. A Green fund can come in the form of a focused investment vehicle for companies

engaged in environmentally supportive businesses, such as alternative energy, green

transport, water and waste management, and sustainable living. Pure play green investments

are those that derive all or most of their revenues and profits from green activities. Green

investments can also be made in companies that have other lines of business but are focusing

on green based initiatives or product lines.

Green bonds are used to invest in emission reduction projects in developing countries,

including solar and wind energy projects, upgrades to existing power plants, and forestry

protection initiatives. The philosophy behind the environmental Green credit cards is that

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cardholders can contribute to environmental research and green projects while also earning

reward points redeemable for cash and green products.

GREEN FUNDS

A green fund's strategy can be based on avoiding negative company criteria (businesses such

as guns, alcohol, gambling, pornography, animal testing, etc.), choosing positive company

criteria (environmental programs, energy conservation, fair trade, etc.), or a combination of

both strategies. Investment activities that focus on companies or projects that are committed

to the conservation of natural resources, the production and discovery of alternative energy

sources, the implementation of clean air and water projects, and/or other environmentally

conscious business practices.

Green investing can be accomplished through individual securities or through pooled

investment vehicles such as mutual funds or exchange-traded funds. This style of investing is

an offshoot of socially conscious investing, but neither type of investing implies investments

that are safer than a market index such as the S&P 500.

The London Green Fund is a £100 million fund that will invest in climate change projects

across Greater London such as waste, energy efficiency and decentralized energy. The fund is

part of the European Investment Bank and European Commission's Joint European Support

for Sustainable Investment in City Areas (JESSICA) initiative and has the broad remit of

providing debt, equity and guarantee investment to support climate change infrastructure

projects through urban development funds. The call for expressions of interest will seek

applicants to manage the Energy Efficiency Urban Development Fund. The focus of the fund

will be to invest in urban projects that involve:

The adaptation and/or refurbishment of existing public and/or voluntary sector

buildings to make them more energy efficient, sustainable and environmentally friendly;

and/or,

Improvements to existing social housing properties to make them more energy efficient.

It is anticipated that the urban development fund will invest primarily through debt (senior,

junior or mezzanine) although the use of equity-type instruments has not been specifically

excluded.

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GREEN BONDS

These are tax-exempt bond which is issued by federally qualified organizations and/or

municipalities for the development of Brownfield sites. Brownfield sites are areas of land that

are underutilized, have abandoned buildings, or are under developed. They often contain low

levels of industrial pollution. Green Bonds are otherwise called Qualified Green Building and

Sustainable Design Project Bonds.

These bonds are created to encourage sustainability and the development of Brownfield sites.

The tax-exempt status makes purchasing a green bond a more attractive investment when

compared to a comparable taxable bond. To qualify for green bond status the development

must take the form of any of the following.

At least 75% of the building is registered for LEED certification.

The development project will receive at least $5 million from the municipality or State, and

The building is at least one million square feet in size, or 20 acres in size.

The World Bank Green Bond raises funds from fixed income investors to support the World

Bank lending for eligible projects that seek to mitigate climate change or help affected people

adapt to it. Since 2008, the World Bank has issued an equivalent of approximately USD 1.6

billion in Green Bonds. Eligible projects are selected by World Bank environment specialists

and meet specific criteria for low-carbon development. Examples of the types of eligible

mitigation projects are the following:

Solar and wind installations;

Funding for new technologies that result in significant reductions in greenhouse gas

emissions (GHG).

Rehabilitation of power plants and transmission facilities to reduce GHG emissions.

Greater efficiency in transportation, including fuel switching and mass transport.

Waste (methane emission) management and construction of energy efficient buildings.

Carbon reduction through reforestation and avoided deforestation.

For investors, these bonds are an opportunity to invest in climate solutions through a triple-A

rated fixed income product. The credit quality of the Green Bonds is the same as for any

other World Bank bonds. Repayment of the bond is not linked to the credit or performance of

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the projects, and investors do not assume the specific project risk. Investors benefit from the

AAA/Aaa credit of the World Bank, as well as from the due diligence process of the World

Bank for its activities.

GREEN CREDIT CARDS

One of the latest trends in the green movement is the advent of eco-friendly credit cards. The

philosophy behind environmental credit cards is that cardholders can contribute to

environmental research and green projects while also earning rewards points redeemable for

cash and green products.

4) STRUCTURED NOTES

Medium-Term Note (MTN)

A Medium Term note (MTN) is a kind of debt instrument, which usually has a maturity

period ranging from 5 years to 10 years; however the term (maturity) may be less one year

like nine months or may have up to 50 years. They can be issued at a Fixed or floating

interest basis denominated under U.S. dollars or a foreign currency. It is mandatory that the

Medium Term Notes are to be registered with Securities and Exchange Commission under

415 (A regulation that a company can call forth to comply with U.S. Securities and Exchange

Commission (SEC) registration requirements for a new stock offering up to three years

before doing the actual public offering. However, the company must still file the required

annual and quarterly reports with the SEC) which gives a borrower (company, agency,

sovereign or supernatural) the maximum flexibility for issuing securities on a continuous

basis.

The Primary Market

MTS are differentiated from the bonds on the basis of their distribution pattern to the

investors when they are initially sold. In addition, MTNs are sold in relatively smaller

amounts on perennial basis as compared to bonds which are sold in large and irregular basis.

It may be said that some Corporate Bonds are sold on a “best-efforts basis” i.e., Intense

marketing (here the underwriter does not purchase the securities from the issuer but only

agrees to sell them, to reduce the risk), typically corporate bonds are underwritten by

investment bankers. In case of an “underwritten” security, they are purchased by the

investment banker or other broker / dealers acting as agents from the issuer with an

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agreement on price and yield and then they attempt to sell these instruments to investors

through the application on best effort basis which has been followed traditionally.

It is imperative for a company that wants to start a MTN Program has to file a shelf

registration with SEC with regard to the offering of securities to the Investors. Once

particular batch of MTNs are sold, the company can approach SEC for issuing a new batch of

MTNs to the investors. In the matter of registration, the borrower is usually represented group

of investment banking firms, usually ranging two to four, to act as agents to distribute MTNs.

The agents / broker who are the representative of the borrower will make the interest rate

schedule available to their potential investor base, who will be interested purchase of MTNs.

When an investor who is interested in the offering, contacts the agent for the purchase of

MTNs, the agent / broker gets in touch with the borrower to confirm the terms of the

transaction. Here the investor may be allowed to choose a maturity date, since there is the

absence of specific maturity date, subject to the approval by the issuer.

The issuer of a MTN can change Interest rate offering schedule at any point of time due to

changing market conditions or because the issuer has raised the desired amount of funds at a

given maturity for which the issuer may need not post the interest rate for that maturity range

or offer lower interest rate.

Structured MTNs

Earlier, a MTN was a fixed interest rate debenture that was non-callable in nature. However

in the present scenario, the issuers of MTNs to combine their offerings with a derivative

component (options, futures/forwards, swaps, caps and floors) in order to balance/ adjust the

risk-return profile of the instrument in the corporate bond market. Under specific situation, a

MTN issue can have a floating- interest rate over all or part of the life of the securities and

the interest formula can be based on base interest rate, equity index, individual stock price,

foreign exchange rate or commodity index. These are MTNs with inverse floating coupon

rates, and they can include various embedded options (Put and Call Option).

MTNs created when the issuer simultaneously transacts in the derivative markets called

structured notes. The structured notes are hybrid financial products projected to fixed

income instruments but contain embedded option. These notes have interest payments

determined by some type of formula tied to the movement of an interest rate, stock, stock

index, commodity, or currency. By offering this instrument which pays the interest in

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association with the derivative feature, the borrower will be able to create a potent investment

vehicle that are more customized to the requirements of the institutional investors to satisfy

their investment objectives, but who are forbidden from using swaps for hedging or

speculating. Moreover the structured notes are called as “rule busters” because it gives an

opportunity for the institutional investors, who are restricted to investing in investment grade

debt issues to participate in other asset classes such as equity market.

Common structured notes include: step-up notes, inverse floaters, deleveraged floaters, dual-

indexed floaters, range notes and Index amortizing notes.

Inverse Floater: An inverse floater is a floating rate instrument whose interest rate moves

inversely with market interest rates

Deleveraged Floaters: A fixed-income investment with a floating rate tied to a specific

index with less than a one for one payback ratio, where the coupon rate is computed as a

fraction of the reference rate plus a quoted margin.

Dual Indexed floaters: A debt instrument with coupon rates associated with the spread

between two market indexes. For example, the Federal Home Loan Bank System issued a

floater whose coupon rate (reset quarterly) as follows:

(10-year Constant Maturity Treasury Rate) – (3 Month LIBOR) + 160 Basis points

Range Notes: Range notes are securities whose coupon rate is equal to the reference rate as

long as the reference rate is within a contractually specified range. If the reference rate is

outside the range, the coupon rate is zero for that period. The coupon rate for the year is the

Treasury rate as long as the Treasury rate at the coupon reset date falls within the range as

specified below:

Year 1 (%) Year 2 (%) Year 3 (%)

Lower limit of Range 4.5 5.25 6.00

Upper limit of Range 6.5 7.25 8.00

If the 1-year Treasury rate is outside of the range, the coupon rate is zero. For example, if in

year the 1-year Treasury is 5% at the coupon reset date, the coupon rate for the year is 5%.

However, if the 1-year Treasury rate is 9%, the coupon rate for year is zero since the 1-year

Treasury rate is greater than the upper limit for year 1 of 6.5%.

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Index Amortizing Notes: An Index Amortizing Note (IAN) is a structured note with a fixed

coupon rate where the principal is repaid based on an amortization schedule linked to a

specific Index, usually LIBOR. The maturity of an index amortizing note extends when

interest rates rise and shortens when interest rates decline.

From the perspective of an Investor, there is visibility of reinvestment risks associated with

investing in an IAN. It is known that in an IAN that the coupon rate is fixed. Hence, when the

interest rate increases, the investor expects a faster repayment of the principal, but in this

case, the rate of principal repayment is decreased. On the contrary, when the interest rate

decreases, the investor does not prefer a speedy repayment of principal, as he may be forced

to reinvest the amount received at prevailing lower interest rates.

Conclusion

When we talk of the term “investment”, we are required to think from both the borrower’s

perspective as well as investor’s perspective in terms of risks involved and returns expected.

From analysis conducted for the purpose of documenting this paper, we were able to get a

thorough insight on these four new investment avenues arising in the financial market. In

addition, we were able to portray a bird’s eye view of these investment avenues.

With the emergence of these four new investment avenues, an investor would be able to

assess the risk-return relationship, accordingly take an appropriate investment decision.

Hence, it is important for have such innovations in the financial market which would be

mutually beneficial for the borrowers as well the investor.

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BIBLIOGRAPHY

CFA level 1 material on “Equity and Fixed income securities”

CFA level 1 material on “Derivatives and Alternative investments”

http://www.investopedia.com/terms/r/reit.asp

http://www.mysmp.com/bonds/treasury-strips.html

http://www.treasurydirect.gov/instit/marketables/strips/strips.htm

http://www.bondtrac.com/professional/information/education/TreasuryStrips.xml

http://lastbull.com/what-aretreasury-strips/

http://treasury.worldbank.org/cmd/pdf/WorldBank_GreenBondFactsheet.pdf

http://www.investopedia.com/articles/bonds/07/green-bonds.asp

http://www.investopedia.com/terms/g/green_fund.asp

http://www.investopedia.com/ask/answers/07/green-investments.asp

http://en.wikipedia.org/wiki/Medium_term_note

http://www.investopedia.com/terms/m/mtn.asp

http://www.investopedia.com/terms/s/structurednote.asp

http://en.wikipedia.org/wiki/Structured_note

http://en.wikipedia.org/wiki/Derivative_%28finance%29

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