Bonds. from V.Kirubanandan

Transcription

1 Bonds from V.Kirubanandan October, 2003

2 What is a bond? A bond is debt issued by either a federal, state or local government agency or a private company. When you buy a bond, you re effectively loaning the bond issuer your money. With a bond, the issuer promises to repay your principal with interest. What s the difference between a bond and a note? Nothing really, only the term to maturity. Both are debt instruments usually paying interest every six months but a note generally matures in 2 to 7 years (sometimes 10 years is the upper boundary). Bonds are of longer maturity, from 7 (or 10) to 30 or more years. Why are bonds considered less risky than stocks? Bonds overall are more reliable than stocks due to their fixed interest payments and the prior rights of bondholders over stockholders if a company declares bankruptcy. According to "The Truth About Money" (Georgetown University Press, Washington, D.C.), "All investments are designed to produce income or grow in value (sometimes both). Of the two, income is much more reliable than growth. After all, a company s management cannot make its stock price rise, but it can pay interest to its bondholders and declare stock dividends for shareholders. Therefore, income-producing investments are considered safer (in this case, safety is defined as reliability) than growth-oriented investments because investors can expect to receive their income more reliably than they can expect an investment to grow in value." The greater certainty in bond cash flows over stocks has a price; historically bonds have underperformed stocks with respect to investment yields. What are the historical rates of return for cash, bonds and stocks? How should these returns affect how my assets are allocated? To create a successful long-term investment plan for a lump sum of money, it s important to strike a balance between the three major financial asset classes. 1. Cash and cash equivalents provide a stable investment value and current investment income. This group includes money market funds, T-bills, and bank CDs. 2. Bonds are interest-bearing obligations issued by corporations, the federal government and its agencies, and state and local governments. The yields offered by these securities are generally higher than those of cash reserves, but their value fluctuates with interest rates and bond market conditions. 3. Common stocks represent ownership rights in a corporation. They offer potential for capital growth and often pay dividends. Stock market risk can be substantial, however, as any one who invested in 2000 or later can tell you. Your investment returns depend to a great extent on how you allocate your money among these three asset classes. Common stocks have historically delivered the highest returns. Since 1926, according to Ibbotson Associates, the average annual return on stocks has exceeded 10%. The return on bonds has been 5% and on cash reserves less than 4%. Although stocks and bonds offer the potential for higher returns than cash reserves, they also expose you to more risk, particularly in the short term. Also, remember that these historical returns are averages, which means that to get a 10% average return, annual

3 returns greater than 10% must be offset along the way by annual returns of less than 10%. Finally, historical average returns do not assure future returns. What s the difference between a bearer bond and a book-entry bond? For decades, all bond investors received a bond certificate that detailed the terms on which the bond would be repaid. The certificates had coupons attached that the investor, or "bearer," would pull off and redeem when an interest payment was due. Since the investor actually held the bond, these were called bearer bonds. Starting in the early 1980s, technological advances allowed new bond issues to be registered and stored electronically. These are called book-entry bonds and have eliminated the need for cumbersome bearer bonds What is a callable bond? A callable bond is a bond that can be retired, or "called in," by the issuer before the bond matures. The power to call a bond gives a company the ability to respond to falling interest rates. Say XYZ Corp. issued bonds with a 12% coupon several years ago, when interest rates were high. If bond rates subsequently dropped to 7%, XYZ Corp. could call the bonds, issue new bonds at 7% and pay off the investors -- saving millions in interest charges. The investors would come out on the short end, because they would have to reinvest the cash at much lower rates. Callable bonds often pay higher rates than noncallable bonds to compensate investors for this uncertainty. If you decide to buy a callable bond, just remember that the bond might be called in if interest rates drop. Often, there is a grace period before the bond can be called. When buying callable bonds, it is important to know when the first call date is How do I know if a bond is callable? Callable bonds often pay higher rates than noncallable bonds to compensate investors for this uncertainty. Issuers must state if the bond is callable or noncallable and the call date in the offering prospectus. If you buy your bonds through a broker, the broker should advise you whether a bond is callable. In bond dealer s guides, corporate bonds that have NC next to their names are noncallable How will I know if my bond is called in? If you own a callable bond and the issuer decides to call the bond in, you will be notified by mail. Issuers also take out advertisements, usually in publications such as The Wall Street Journal. Should your bond be called, you have no choice but to accept. That s because the bond will stop paying interest on the date specified by the company. What are taxable bonds? Taxable bonds include all long-term debt instruments other than those issued by cities, states, counties, or other local-government entities. (Those are called municipal bonds). Taxable bonds are issued by corporations, the U.S. government and its agencies, and foreign governments. U.S. government (Treasury) bonds are exempt from state taxes. Municipal bonds are not subject to federal taxes and state taxes of the home state of issuance.

4 How am I charged for buying or selling a bond? Securities brokers use either of two methods to charge you for buying or selling bonds, notes and bills. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), "The first way is to charge you a commission or fee. Called a net trade, the second way is to include the sales charge in the price. All municipal bonds and most government and corporate bonds are traded net. Any bonds traded on the exchanges are executed with a commission." How does accrued interest affect the sale or purchase of a bond? Accrued interest is interest that has been earned but not yet paid. It usually comes into play when you buy bonds on the secondary market. Bonds typically pay interest every six months, but the interest actually accrues every month. So, if you buy a bond between interest-payment dates, you must pay the seller for the months of interest that have already accrued. You ll get the full six months interest on the next interest-payment date What are at-the-market trades? Most stocks and bonds are bought and sold on an at-the-market basis. If you call your broker and tell him to buy bonds of XYZ Corp. "at the market," the broker will execute your trade at the current asking price. Trades that aren t at-the-market involve a buyer or seller specifying a certain price known as a limit order. What is buying a bond at discount? Bonds are traded at discounts or premiums in order to bring their stated (coupon) rates in line with market rates. Bonds sell at a discount to their par value when market interest rates are higher than the stated coupon rate (interest payment). If a bond has a coupon rate of 8% and market interest rates rise to 10%, then the bond would sell at a discount. Why? You wouldn t buy a bond at par value that pays $80 a year when you can buy a comparable one that pays $100 at year. The discount makes up for the lower income received from the 8% bond. Bond prices move inversely to market interest rates since the interest payment is fixed and any adjustments must be made to the market price of the bond What is selling a bond at a premium? Bonds sell at premium to their par value when market interest rates are less than the stated coupon rate (interest payment). If a bond has a coupon rate of 10% and market interest rates fall to 8%, the bond would sell at a premium. Why? You wouldn t sell a bond you currently own at par if it was paying $100 a year when the best comparable bond you could reinvest the proceeds in pays only $80 a year. The premium paid makes up for the lower reinvestment yield you would receive if you sold the bond. What factors are used to determine a bond s rating? Rating agencies rate bonds based on factors including the issuer s financial strength and how well it is prepared to cover future interest and principal payments. As a general rule, the higher the rating, the lower the interest the bond pays. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), "When you buy a bond, its credit rating should be one of your main considerations. Most bonds are rated by Moody s

5 Investors Service (Moody s) and Standard & Poor s (S&P) based on the issuer s ability to pay interest and principal at maturity. U.S. Treasury and government agencies securities are not rated; most corporate and municipal debt securities are rated. Bonds rated as being investment grade have one of the four highest ratings. Bonds rated below this level are considered low quality and are sometimes referred to as junk bonds, which means that they carry more risk and more potential for volatility and even default. Some municipal bonds and notes are insured by an insurance company, which generally earns them an Aaa or AAA rating by Moody s or S&P, respectively. U.S. treasury bonds are backed by the full faith and credit of the U.S. government. The chance of default is basically nil. So, the bonds are considered risk-free What is the Lehman Brothers Aggregate Bond Index? The Lehman Brothers Aggregate Bond Index includes government bonds, corporate bonds, mortgage-backed bonds, and Yankee bonds (Yankee bonds are foreign bonds issued in the U.S. and denominated in dollars) with maturities greater than one year. The Lehman Brothers Aggregate Bond Index may be used as a performance benchmark for bond funds and bond portfolios. The index represents a market portfolio of bonds and represents the market s average annual rate of return and duration. What is bond duration? Duration is a risk measure of the price volatility of a bond to changes in interest rates. The greater the duration, the greater the price volatility. The greater the price volatility, the greater the risk. If an investor anticipates a rise in interest rates, he or she would buy bonds with lower durations (bond prices move opposite to changes in interest rates). Likewise, an anticipation of declining interest rates may result in a strategy of buying bonds with greater durations. Do not confuse duration with a bond s maturity. For bonds paying coupons, the duration is less than the maturity. The exception is with zero-coupon bonds. The duration of a zero-coupon bond is the same as its maturity. Duration is a complicated calculation, but the percentage price change of a bond using its duration is quite simple: % change in price = -duration x change in interest rates. For example if a bond has a duration of 7.5 and market interest rates rise 2%, the percentage price change in the bond is -15% (-7.5 x 2%). The negative sign before the duration indicates the inverse relation between bond prices and interest rates. What is a bond s par value? The par value of a bond is its face value upon maturity -- the lump sum you will get when it matures. For example, if you purchase a $1,000 zero-coupon bond today, its par value would be $1,000 (the amount of principal you will receive upon maturity) -- even though you may have paid only $500 for it What is the yield curve of a bond? A graph of the bond yields available at a given moment in time, with yield-to-maturity rising along the vertical line and bond maturities moving outward along the horizontal line. A normal yield curve rises upward to the right, because bonds of a longer maturity generally pay higher returns. The steeper the slope of the yield curve, the less additional

6 maturity you need for a higher yield. An inverted yield curve slopes downward to the right because short-term rates are higher than long-term rates. There may be several reasons for an inverted yield curve such as higher anticipated inflation in the short run versus the long run or possibly a recession in the offing; high short-term rates will work their way through the economy, putting the brakes on longer-term growth. If short and long-term rates are the same, the yield curve is flat. The yield curve is typically constructed using Treasury securities What is yield to maturity for a bond? Yield to maturity is the promised rate of return if the bond is held to maturity. It takes into account the bond s market price, its par value (principal paid on maturity), its coupon rate (interest payments) and the years remaining until the bond matures. Calculating the yield to maturity is difficult without a financial calculator because the formula is extremely complicated. Brokers and investment advisers should be able to provide the yield to maturity for you. What are the advantages of laddering bonds or CDs when I buy them? Laddering fixed-rate investments lets you manage your exposure to inflation and interestrate risk.say you want to invest in certificates of deposit. You could buy one CD that matures a year from now, another that matures in two years, a third that matures in three years and so on until all of the money is invested. Every year, one of your CDs is going to mature. If interest rates rise, you can re-invest the proceeds of the CD at an even higher rate. If rates fall, you ll still be getting high interest income from your longer-term CDs. This strategy can work for bond investors as well. How does immunization protect a bond portfolio? Immunization is a bond portfolio risk management strategy that protects (immunizes) the portfolio from interest rate changes by matching the duration of the bond portfolio to the duration of the liability (or when the funds from the portfolio are needed). For example, if you are planning to pay college expenses in 5 years for your child and want to invest in bonds during the interim, you should structure the bond portfolio to also have a duration of 5. This protects the bond portfolio from losing value should interest rates rise or overallocating resources for college funding. Immunization works on the following premise: If interest rates fall, the coupon payments are reinvested at a lower rate than initially but the value of the bond portfolio rises. Conversely, if interest rates rise, the value of the bond portfolio declines but the coupon payments can be reinvested at a higher rate. In essence, immunization offsets interest rate risk against reinvestment rate risk. Unfortunately, the duration of the liability and the duration of a portfolio of coupon bonds do not decline at the same rate and periodic rebalancing of the portfolio is required (at least once a year). Rebalancing can be avoided if the bond portfolio is constructed with zero-coupon bonds How does a sinking fund protect bondholders? A sinking fund is a special reserve account created by a bond issuer. The issuer promises to put money into the account at regular intervals and to use the cash that accumulates to redeem the bonds. A sinking fund gives bondholders an extra layer of protection against

7 default. But the sinking fund may also result in the bond being retired prior to its maturity. So a bond with a sinking fund is similar to a bond that can be called. What types of bonds do unit investment trusts (UITs) purchase? A unit investment trust, or UIT, is a variation of a closed-end mutual fund but has a definite termination date, which may be rolled over into a subsequent new UIT to maintain continuity. Most invest in a fixed portfolio of bonds that are held until they mature. This sets UITs apart from bond mutual funds, which can buy and sell bonds daily. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), most UITs buy primarily debt securities issued by entities in the United States. Each trust typically purchases bonds or notes that fall into a particular category of maturities -- that is, short term, intermediate term or long term. Within each category, the trust can be classified as high quality, medium quality or low quality. Bond trusts established in the United States also can be classified as either taxable or tax-exempt. Taxable bond UITs invest in bonds that pay taxable interest income; these include corporate and U.S. government bonds. Tax-exempt bond UITs invest in bonds that pay tax-exempt interest income, such as municipal bonds. Some UITs invest only in municipal bonds issued by one particular state to obtain state income tax benefits. Each bond UIT s prospectus explains in detail the ratings of the bonds in the portfolio. Other unit investment trusts invest primarily in bonds issued by entities outside of the United States. These UITs operate the same way as trusts that invest in U.S. bonds, but also present currency risk. You purchase shares in the trust, not the individual bonds held in the trust. You also pay trust management fees. How does a unit investment trust that invests in bonds handle principal payments? A unit investment trust, or UIT, is a variation of a closed-end mutual fund. The trusts don t actively buy or sell the securities they hold, which sets them apart from conventional bond mutual funds. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), when a security held in the trust is sold or redeemed, the trust generally pays the proceeds to you based on the number of units you hold on a pro-rated basis. Bond UITs, especially, have bonds called or redeemed. These provide you you with payments that are considered a return of principal. Return of principal is not subject to income taxes. When you receive a distribution check, be sure what portion of the payment is principal rather than income. Should I invest in bond funds? Many investors have found that a smart way to buy bonds is through the convenience of bond mutual funds, available through stockbrokers, financial consultants, banks and often directly from fund companies. Investors are attracted to bond funds for two primary reasons. The first is income: Bond funds generally provide a monthly income that is higher and steadier than cash reserve investments such as money market funds or bank passbook accounts. Unlike stable cash reserves, however, bond fund shares will fluctuate in value as interest rates change. The second reason investors like bond funds is diversification: Though sometimes volatile, bond funds are usually considered less risky than stock funds and can serve to balance a portfolio heavy in stocks or stock funds. A

8 bond fund is a professionally managed portfolio consisting of a group of fixed-income securities, with the primary objectives of providing high current income and and investing for total return. By combining the assets of many individual and institutional investors, the fund is supposed to invest and manage those assets more effectively than investors can do on their own. Where individual bonds have a maturity date, bond fund shares have no maturity. Thus, they re unable to provide a promised rate of return. How do changes in interest rates generally affect bond mutual funds? If you purchase a Treasury bond during a period of high interest rates and hold it to maturity, your yield is unaffected by any subsequent drop in rates. It s a different story with bond funds, because they rarely buy and hold their bonds to maturity. Purchasing a bond fund is more like making an investment in the overall debt market. For instance, the American Century Government Bond fund (formerly the Benham Treasury Note Fund), which holds a portfolio of U.S. Treasury bonds, had an annual yield from income distributions in excess of 9% in the early 1980s. This gradually declined over the years to its current yield of slightly more than 5%. But the TOTAL return on a bond fund includes gains or losses in value as well as from income distributions. During years of falling interest rates, the value of existing high-rate bonds goes up. In 1982, for instance, the total return on the old Benham Fund was 17.5%, a combination of income and the increase in value of the high-rate bonds in the fund s portfolio. During 1983, however, rising interest rates caused bond prices to fall. In that year the Benham Fund had a total return of just 5.1%. What is a corporate bond fund? A corporate bond fund is a mutual fund that primarily invests in bonds issued by corporations. Investors in corporate bond funds usually are looking for high levels of income rather than the chance to make big, long-term profits when they sell. Many corporate bond funds also purchase U.S. Treasury bonds and bills or bonds issued by other federal agencies. What is a multisector bond fund? A multisector bond fund primarily invests to generate current income, with a chance to produce long-term capital gains. To do so, multisector bond funds invest in a variety of fixed-income securities, including corporate bonds, government bonds and international bonds. Sometimes, they will also purchase stocks. MSN Money s fund research area offers a current list of the top-performing multisector bond funds What are U.S. bond funds? U.S. bond funds mainly hold -- you guessed it -- bonds issued in the United States. According to "The Investing Kit" (Dearborn Financial Publishing, Inc., Chicago), a fund will buy buys bonds or notes of a particular range of maturities-that is, short term, intermediate term or long term. Within each of these three categories, the fund can be classified as high quality, medium quality or low quality. U.S. bond funds also can be classified as being either taxable or tax-exempt. Taxable bond funds invest in bonds that pay taxable interest income, such as corporate and U.S. government bonds. Tax-exempt bond funds invest in bonds that pay tax-exempt interest income, such as municipal bonds.

9 Some funds invest only in municipal bonds issued by one particular state to obtain the tax benefits of that state. All funds, regardless of name, have provisions to invest in securities outside the predominant class, even derivatives.. What are U.S. Treasury bond funds? U.S. Treasury bond funds are mutual funds that invest in Treasury securities. The securities are backed by the full faith and credit of the federal government, which means their safety is guaranteed. However, investors purchase shares in the fund, not the Treasury securities held in the fund. Fund shares are NOT backed by the full faith and credit of the federal government. Some fund managers add top-rated corporate bonds or other securities to their portfolio to boost a fund s return. U.S. Treasury bond funds primarily attract investors looking for safety, steady income through interest payments and a chance of reaping long-term gains if interest rates fall and the value of the bonds in the portfolio rises. What is a basis point for bond funds? A basis point is one one-hundredth of a percentage point (100 basis points equal one percent). Thus, if a bond s yield drops from 6.56% to 6.51%, it is said to have fallen by 5 basis points, which is 0.05% or in decimal form. Should I invest in a mutual fund that specializes in foreign bonds? Several mutual fund companies specialize in bonds issued by foreign governments and corporations. Foreign bonds may pay higher interest rates than bonds from U.S. issuers, but that should be only one factor in your decision to invest. You can usually find several countries with interest rates higher than those in the United States. But there are downsides: language barriers, differing regulations, and illiquid markets. Fluctuating currency values, although a potential advantage, can work against you if the currency of your foreign investment loses value relative to the U.S. dollar. Investing in a foreign bond mutual fund probably makes more sense than buying foreign bonds directly. It gives you diversification, professional management and a fund s ability to hedge against currency fluctuations by using sophisticated investment techniques. MSN Money s funds research area offers a current list of top-performing international bond funds. What is a convertible bond? A convertible bond gives you the right to trade in or convert a corporate bond into company stock (generally the stock of the same company issuing the bond). The terms of the conversion are set when the bond is first issued. Terms include the date that the conversion can be made and how much stock will be exchanged for each bond. Corporations issue convertible bonds because they usually don t have to pay as much interest as they would on traditional bonds. Investors are willing to buy convertibles despite the lower yields because they hope to trade the bonds for the company s common stock. If the stock rises sharply, they could make a lot more money than they could on a bond. On the other hand, if conversion doesn t pay, investors can hold on and collect bond interest.

10 What is a callable convertible bond? A callable convertible bond is a bond with two embedded options. One option is the right of the owner of the bond to exchange the bond for a specified number of shares of the issuer s stock. The other option is the right of the bond issuer to call or buy back the bond if interest rates drop sufficiently to warrant refunding the bond issue. You can appreciate the skill necessary to accurately value these bonds. What tips do the pros offer about buying convertible bonds? Convertible bonds, or CVs, are bonds with an embedded conversion option on common stock. If you buy a convertible bond, you collect interest payments just as you would with any other bond. But if the company s common shares rise to a certain price, you can convert the bond into stock and make even larger profits. Some convertible bonds are more attractive than others. According to the Dun & Bradstreet Guide to Your Investments (HarperCollins Publishers Inc., New York), "Buy a CV only if you like the common stock. Avoid CVs of potential takeover companies or CVs that are also callable; you may be forced to convert early. Buy only high-rated issues BB or above as rated by Standard & Poor s or Ba by Moody s. Know the call provisions; if a CV is called too early, you may not recover your premium." Finally, stick to convertible bonds whose common stock is expected to rise sharply in value. If the stock doesn t rise, you won t get to convert Under what circumstances should I convert my convertible bond to stock? A convertible bond should be exchanged for the issuer s stock when the conversion value of the bond exceeds the bond value (there is no conversion premium). If the convertible bond has a conversion ratio of 25 shares of stock for each bond exchanged, the market value of the stock is $40 per share, and the bond value is $950; the conversion value of the bond is $1,000 ($40 per share x 25 shares per bond exchanged). Since $1,000 is greater than $950, you are better off exchanging the bond for the stock. What is the conversion premium of a convertible bond? Convertible bonds have two values, the value as a bond and the value if converted into stock. The conversion premium is the excess of the bond value over the stock value. For example, if the value of the bond is $950 and the value of the stock is $850. The conversion premium is $100. The conversion premium is usually expressed as a percentage of the stock value, in this example $100/$850 or 11.76%. What does this imply? You would not convert the bond into stock because you would be paying an 11.76% premium over the market value of the stock. If you want the stock, you would be better off purchasing the stock directly in the market. What is the conversion value of a convertible bond? The conversion value is the market stock value of a convertible bond if that bond is exchanged for the issuer s stock. For example, if the convertible bond can be exchanged for 25 shares of the issuer s stock and the market value of the stock is $35 per share, the conversion value is $875 ($35 per share x 25 shares per bond exchanged). The value of the convertible bond is the GREATER of the market of the bond or its conversion value.

11 What is the conversion ratio of a convertible bond? Convertible bonds have an embedded stock option that provides the owner of the convertible bond to exchange bond debt for stock equity. The conversion ratio specifies the number of shares exchangeable for each bond. For example, a convertible bond may have a conversion ratio of 25. This means that the bond can be exchanged for 25 shares of the issuer s stock. What are corporate bonds and what are their tax advantages? Corporate bonds are issued by companies rather than by governments. Most corporates pay somewhat higher interest than bonds backed by the full faith and credit of the U.S. or by local government taxing powers, but government bonds usually carry tax advantages. Jane Bryant Quinn, writing in "Making the Most of Your Money," says you might want to buy a corporate bond if: (1) You re investing with tax-deferred money in your retirement plan and want more interest than Treasuries pay. Corporates are fully taxable by federal, state and local governments. (2) You re in the 15% federal tax bracket. At that level, you will net more, after tax, from taxable corporate bonds than from tax-exempts. Quinn says one of the best ways to invest in corporate bonds is via a good, diversified mutual fund. "Always remember, however, that to buy a long-term bond fund is to bet that interest rates won t rise over the period that you expect to hold the investment." What is common stock and how does it differ from a corporate bond? Common stock is a security that represents ownership in a corporation. A bond, by contrast, is debt issued by the company, basically an IOU. Bondholders are lenders; stockholders are owners. In the event of trouble, bondholders have a superior claim, but they don t share in the company s success the way stockholders do. Common stock is also to be distinguished from preferred stock. Dividends paid to common stock holders can vary. Dividends paid to holders of preferred stock, on the other hand, are fixed, and do not rise or fall based on the company s profits. Also, preferred stockholders do not have an ownership interest in the company. Preferred stock is like common stock in that there is no defined maturity (although some preferred stock issues have associated sinking funds). Preferred stock, other than having no maturity, resembles debt in most other features. Preferred stock is known as a hybrid security since it has characteristics of both debt and equity. Are corporate bonds any safer than stocks? Bonds overall are less risky due to their fixed interest payments and the prior rights of bondholders over stockholders if a company declares bankruptcy. However, over the long term, bond investments that pay a fixed rate of interest run the risk of lagging behind inflation, causing an erosion of the purchasing power of those payments. Bond prices and yields at issue are tied to prevailing interest rates in the economy. As interest rates fall, bond prices rise because the value of bonds with relatively higher rates increases. When rates rise, the prices of existing bonds fall. This price relationship holds for all bonds, corporate, Treasury, and municipals. The extent of a bond s rise or fall depends on its maturity; the longer the maturity of a bond, the greater its sensitivity to interest rates. The ups and downs of bond prices in the market are largely irrelevant if you plan to hold the

12 bond to maturity. You get the same steady stream of income throughout the life of the bond. Corporate bonds have lower but steadier returns (the combination of income and change in value) than stocks, and represent a reliable source of income. In addition, when added to a portfolio of stocks, bonds act as a stabilizer because they reduce volatility. The real advantage of stock/bond diversification, however, is that it lowers your risk more than it lowers your potential return. Bondholders have a prior residual claim to corporate assets over stockholders in the event of bankruptcy How does a debenture differ from a secured bond? A debenture is a type of bond, but unlike secured bonds, debentures are not secured by the company s equipment, real estate or other assets. Basically, investors in debentures loan their money to the company based on its overall credit worthiness, reputation and its perceived ability to repay. When a company that has issued debentures goes bankrupt -- which has occurred from time to time -- the debentures cannot be paid off until all of the investors who bought the company s secured bonds have been paid. Since debentures are riskier propositions, they usually pay more interest than secured bonds Why are the yields on corporate bonds higher than those for money market accounts? Corporate bonds tend to provide better overall yields than money market accounts do, primarily because bond investors must pledge their money for a longer length of time. Corporate bonds generally take several years to mature. An investor could sell his bond early, but might lose money if interest rates have gone up and the resale value of the bond has fallen. A deposit in a money market account, on the other hand, can be withdrawn at any time and there is virtually no risk that the initial investment will ever be diminished. Money market depositors pay for this flexibility and safety by accepting lower returns on their money. Also, bonds are not federally insured as are bank money market accounts. What is a corporate bond fund? A corporate bond fund is a mutual fund that primarily invests in bonds issued by corporations. Investors in corporate bond funds usually are looking for high levels of income rather than the chance to make big, long-term profits when they sell. Many corporate bond funds also purchase U.S. Treasury bonds and bills or bonds issued by other federal agencies. What are "junk" bonds? So-called junk bonds are high-yield, speculative grade bonds. The bonds offer unusually high yields because there s a greater risk of default. Junk bond mutual funds can help reduce the risk of junk bonds through diversification and professional management. Junk bonds have non-investment grade classifications from rating agencies. Check with a bond broker concerning the investment grade status before investing in the bond. What is a municipal bond? A municipal bond is a debt obligation of a state or local entity, such as a state highway agency or a local school district. Interest on these bonds is exempt from federal income tax and, if the bonds are issued in your state of residence, from state and local income

13 taxes as well. For this reason, municipal bonds are often called "double tax-free" bonds, or simply "munis." Because of their tax-exempt status, municipal bonds pay a lower interest rate than taxable corporate bonds. Municipal bonds may be classified as general obligation (GO) bonds, which are backed by the taxing authority of the issuing entity, or revenue bonds, which only have recourse to the project revenues for which the proceeds are used. Industrial bonds are revenue bonds. What are U.S. Treasury Bills? Buying a Treasury Bill is one of the safest investments you can make because the bills are backed by the full faith and credit of the U.S. government, and T-bill maturities are so short that there is little risk from rising interest rates. Treasury bills mature in three months, six months or one year. The minimum investment is $10,000. New Treasury bills are sold at a discount from their par value and, when they mature, can be redeemed at full face value. Treasury bills are essentially zero-coupon securities. Interest on T-bills is exempt from state and local taxes. How does the Treasury Direct system for purchasing Treasury issues work? When you buy a U.S. Treasury issue -- whether it s a bill, bond or note -- you can purchase it through a stockbroker and pay a commission, or save the commission by purchasing directly from the Federal Reserve Bank. To buy through the Federal Reserve, you must first establish a Treasury Direct account. Interest and principal (if held to maturity) will be paid directly into a designated institutional account. You can now also use Treasury Direct to sell before the security matures at a substantial saving over commissions typically charged by stockbrokers. What is a noncompetitive bid at a Treasury auction? A bid submitted at a Treasury auction for a specific amount of securities but at an unspecified price. The buyer agrees to pay the average price of accepted competitive bids. Competitive bids are usually tendered by primary government bond dealers. Retail investors generally purchase new-issue Treasury securities on a noncompetitive bid basis. What is a Treasury note? A Treasury note is a debt security issued by the federal government that matures in two to 10 years. The notes are backed by the full faith and credit of the U.S. government, which makes them extremely safe. Treasury notes are issued in $1,000 and $5,000 denominations. The $1,000 minimum is usually available only on notes of four to 10 years. Notes that mature in two to three years are usually issued only in $5,000 denominations. Treasury notes pay a fixed rate of interest, and income from the notes is exempt from state and local taxes. How does the Treasury Direct system for purchasing Treasury issues work? When you buy a U.S. Treasury issue -- whether it s a bill, bond or note -- you can purchase it through a stockbroker and pay a commission, or save the commission by purchasing directly from the Federal Reserve Bank. To buy through the Federal Reserve, you must first establish a Treasury Direct account. Interest and principal (if held to maturity) will be paid directly into a designated institutional account. You can now also

14 use Treasury Direct to sell before the security matures at a substantial saving over commissions typically charged by stockbrokers. What are CPI-Indexed Treasury Notes (TIPS)? A series of inflation-adjusted 10-year notes were first issued by the U.S. Treasury in The Treasury hopes that these securities will save taxpayers money by attracting more demand for treasuries through a better mix of offerings. The 10-year notes attempt to protect investors from inflation by linking the principal payment to the consumer price index. The interest payment is constant over the 10 years. What changes is the principal. Each year, the principal is increased by the same percentage that the CPI increases during the prior year. The interest payment, not the rate, increases as well, since the interest is calculated on a higher principal balance commensurate with the CPI increase. Of course, investors will not see any of the greater principal amount until the maturity of the note. Herein lies one of the drawbacks of the new notes. The IRS requires that you pay taxes each year on the interest payment and on the increase in principal. You can t touch the inflation adjustment on the principal until the maturity of the notes, but you will pay taxes on it now. What is a noncompetitive bid at a Treasury auction? A bid submitted at a Treasury auction for a specific amount of securities but at an unspecified price. The buyer agrees to pay the average price of accepted competitive bids. Competitive bids are usually tendered by primary government bond dealers. Retail investors generally purchase new-issue Treasury securities on a noncompetitive bid basis. What are savings bonds? Savings bonds are like Treasury securities for small investors. They come in denominations as small as $50, are absolutely safe with respect to payment of interest and principal, and involve no transaction costs. The government issued Series E bonds from 1941 until In 1980, it began issuing Series EE and Series HH bonds. Now there are the new Series I bonds, which offer buyers a measure of protection against inflation. Interest earned from savings bonds is exempt from state and local taxes. You must pay federal tax on the earnings, but you have the option of deferring these taxes until the bond matures. Bond proceeds used for qualified educational expenses may be tax exempt. What is the long bond? The long bond is a nickname traders use for a Treasury bond that matures in 30 years -- the longest maturity that the Treasury offers. What are stripped U.S. Treasury bonds and their tax advantages and disadvantages? Stripped bonds have no current "coupon" or interest payment. Instead, the coupons are stripped and the principal portion and coupon portion are repackaged into zero-coupon bonds and issued at deep discounts. The interest is accumulated and compounded, and at maturity the full face amount is paid. STRIPS (Separate Trading of Registered Interest and Principal of Securities) is the acronym for Treasury zero-coupon securities. These Treasury bonds are issued in the traditional way (with coupons) but separated into

15 interest and principal components at the discretion of the bondholders using book entry accounts at Federal Reserve banks. Because they are issued by the U.S. Government, the implied interest on STRIPS is not subject to state income taxes. An important disadvantage of STRIPS, however, is that federal income taxes are payable each year as interest accrues. Since no current income is derived from the zeros, money for the taxes must come from your pocket. How can I avoid paying commissions on U.S. Treasury bonds? There really is no reason to use a broker to buy Treasury bonds. You can avoid paying a commission, which can approach $100 per security, by buying Treasuries through the federal Treasury Direct program. It s fast and easy. You can use the phone or Internet to make your purchase and perform many of the functions needed to maintain your account. Treasury Sell Direct will even sell your securities prior to maturity at rates less than a conventional brokerage. You ll need to establish an account with the government for this purpose, which can be done at one of more than three dozen servicing offices nationwide. What are U.S. Treasury bond funds? U.S. Treasury bond funds are mutual funds that invest in Treasury securities. The securities are backed by the full faith and credit of the federal government, which means their safety is guaranteed. However, investors purchase shares in the fund, not the Treasury securities held in the fund. Fund shares are NOT backed by the full faith and credit of the federal government. Some fund managers add top-rated corporate bonds or other securities to their portfolio to boost a fund s return. U.S. Treasury bond funds primarily attract investors looking for safety, steady income through interest payments and a chance of reaping long-term gains if interest rates fall and the value of the bonds in the portfolio rises. What is a zero-coupon bond? Zero-coupon bonds can be issued by corporations, municipalities and the U.S. government. They are sold at a deep discount and generate no interest payments. Instead, you redeem the bond for its full face value, usually $1,000, when it matures. Your yield is the difference between the discounted price you paid and its face value at maturity. To illustrate, say you purchase a zero-coupon bond with a par value of $1,000 and an implied yield of 10% that matures 10 years from now. The bond would cost you $377 today and pay you $1,000 in 10 years. What are stripped U.S. Treasury bonds and their tax advantages and disadvantages? Stripped bonds have no current "coupon" or interest payment. Instead, the coupons are stripped and the principal portion and coupon portion are repackaged into zero-coupon bonds and issued at deep discounts. The interest is accumulated and compounded, and at maturity the full face amount is paid. STRIPS (Separate Trading of Registered Interest and Principal of Securities) is the acronym for Treasury zero-coupon securities. These Treasury bonds are issued in the traditional way (with coupons) but separated into interest and principal components at the discretion of the bondholders using book entry accounts at Federal Reserve banks. Because they are issued by the U.S. Government, the

16 implied interest on STRIPS is not subject to state income taxes. An important disadvantage of STRIPS, however, is that federal income taxes are payable each year as interest accrues. Since no current income is derived from the zeros, money for the taxes must come from your pocket Are zero-coupon bonds a good way to finance my child s college education? Zero-coupon bonds can be a good investment if you know that you will need a lump sum on a specified date in the future, such as when your child is ready to enter college. "Zeros" are sold at a deep discount to their face value generate no ongoing interest payments, and have no reinvestment risk. Instead, you get to redeem the bond for its full face value when it matures. The difference between the discounted price you paid and the bond s face value when it matures represents your return. Because of the way they work, zeros can be an excellent way to finance a child s future educational expenses. For example, assume you purchase a zero with a $10,000 par value for your child s college education in 10 years. If the zero has an implied yield of 6%, you would pay $5,537 today and receive $10,000 when he or she enters college. The higher the implied yield, the greater the discount and lower initial price you must pay. You can buy even more zeros if you expect college to cost more, or buy different zeros that mature at different dates (a strategy known as laddering bonds) to fund the child s sophomore, junior and senior years as well. One drawback to zeros is that you have to pay tax on the "implied interest" each year even though you don t collect anything until the bond matures. Check into tax-advantage education IRAs to shelter such income from taxes.