Types and Characteristics of Underlying Securities

Every mutual fund, closed-end fund, Unit Investment Trust (UIT), Exchange-Traded Fund (ETF), and variable contract separate account is made from the same raw ingredients: equity, debt, and occasionally options. Series 6 representatives do not recommend these securities directly (that scope belongs to Series 7); they recommend the wrapper that holds them. You still need to know the ingredients because prospectuses, risk disclosures, and suitability reviews all reference them.

What equity securities sit inside Series 6 products?

Equity securities sit at the bottom of the capital structure. If a company liquidates, creditors get paid first and shareholders get whatever is left.

• Common stock: ownership claim on the corporation; residual (last-paid) position in liquidation; voting rights; dividends are discretionary and not guaranteed
• Preferred stock: fixed stated dividend rate; ahead of common in liquidation and dividend priority; typically no voting rights; interest-rate sensitive because the fixed dividend behaves like a bond coupon
• Rights: short-dated equity warrants issued to existing shareholders during a follow-on offering; let shareholders maintain their ownership percentage
• Warrants: long-dated equity options attached to bonds or preferred shares as a "sweetener" to make the senior security more attractive

Exam Tip: Gotchas

• Equity products appear on Series 6 as portfolio holdings inside a fund or separate account, not as standalone recommendations. A direct stock recommendation requires Series 7.
• Preferred stock is interest-rate sensitive, not "safer than common." When rates rise, preferred prices fall the same way bond prices fall.
• Rights are short-dated, warrants are long-dated. Rights give existing shareholders a limited-time option to buy more shares; warrants can have lives of several years.

What debt securities are held in Series 6 products?

Debt securities pay interest and return principal at maturity. Investment companies hold debt in bond funds, money market funds, and the fixed-income sub-accounts of variable annuities.

Corporate bonds:

• Debt obligations of a corporation; fixed or floating coupon
• Senior to equity in liquidation but junior to secured creditors
• Interest taxable at all levels (federal, state, local)

Treasury securities (direct obligations of the U.S. Treasury, backed by full faith and credit):

U.S. government agency securities:

• Issued by government-sponsored enterprises
• Ginnie Mae (Government National Mortgage Association, GNMA): backed by the full faith and credit of the U.S. government; interest is fully taxable (federal, state, local)
• Fannie Mae (Federal National Mortgage Association, FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation, FHLMC): implicit (not explicit) guarantee

Other debt instruments listed in Function 3.2:

• Corporate commercial paper: short-term unsecured corporate debt; maturities up to 270 days; issued at a discount
• Brokered certificates of deposit (CDs): CDs issued by banks and sold through broker-dealers; Federal Deposit Insurance Corporation (FDIC) insured up to applicable limits; longer maturities and/or higher yields than branch CDs; may trade on a secondary market
• Banker's acceptances (BAs): short-term time drafts guaranteed by a bank; used to finance international trade

Exam Tip: Gotchas

• Treasury interest is exempt from state and local tax but taxable federally. Municipal interest is the mirror image: exempt from federal tax, often exempt from state tax for in-state residents.
• Ginnie Mae interest is fully taxable at all three levels despite the federal guarantee. Agency debt is not the same as Treasury debt for tax purposes.
• Commercial paper maturity is capped at 270 days. Longer than 270 days and the issuer loses the Securities Act Section 3(a)(3) exemption from registration.

How do options appear in Series 6 products?

Options appear in the Function 3.2 outline as a category of underlying security, but Series 6 representatives do not recommend options directly.

• Call option: right to buy the underlying at the strike price
• Put option: right to sell the underlying at the strike price
• Options show up in Series 6 contexts as:
  • Portfolio holdings inside certain fund strategies (option-writing income funds, covered-call ETFs)
  • Hedging instruments inside variable annuity separate-account sub-accounts

Exam Tip: Gotchas

• A direct options recommendation requires Series 7, not Series 6. A Series 6 question that asks "can you recommend a covered-call strategy?" is testing scope, not options mechanics.
• Recognize the terms, do not trade them. Series 6 candidates should know call = buy, put = sell, but are not tested on multi-leg strategies, Greeks, or settlement mechanics.

How does the tax character of underlying securities flow through to fund shareholders?

The tax character of the interest and dividends flowing out of a fund depends on what the fund holds. This is the first link in the conduit-theory chain covered in the next section.

Exam Tip: Gotchas

• Funds cannot change the tax character of what they hold. A fund full of Treasuries passes through state-tax-exempt interest; a fund full of corporates passes through fully taxable interest. This is the foundation of conduit theory covered next.