Unit
5
Fixed-Income Investing
1. List
the characteristics of “loanership,” or
fixed-income, investments? (See page
5-1)
Common characteristics of fixed income investments include:
· A loan of money is made to a government, corporation, or financial institution in exchange for periodic interest payments.
· The interest rate paid can be fixed or variable in response to interest fluctuations in the economy.
· The full amount loaned, or principal, is returned at some future date. Should the investment be redeemed or sold prior to the maturity date, the value of the principal will be determined by changes in market interest rates.
· Interest rate risk affects the value of fixed-income investments if sold before maturity. Generally, the price and current interest rates available in the economy for similar investments work in an inverse relationship. Thus, if rates rise and the investment must be sold early, the sales prices would be less than the initial loan amount, or principal.
2. List
the primary reasons for purchasing fixed-income investments. (See pages 5-1 and
5-2)
Fixed-income investments are popular because they:
· Diversify a portfolio, thus reducing the overall risk.
· Can be a good, safe option for conservative or elderly investors who fear the volatility of ownership assets.
· Can provide a predictable stream of investment income.
· May provide tax advantages, such as state or federal income tax exemption or tax deferral.
· May allow for reinvestment of earnings (e.g., bond funds).
· Usually provide a higher return than typical bank time deposits that also offer the benefit of FDIC insurance.
· May have capital gain (or loss) potential if sold on the secondary market prior to maturity.
· Are generally affordable in that the minimum purchase amounts are low and sales commissions are low or avoidable.
3. Aside
from market and economic conditions, what two factors consistently affect the
rate of interest paid on a fixed-income investment? (See page 5-2)
Safety of the issuer and the term of the loan affect the interest rate paid to an investor. Bond ratings and interest rates are inversely related. As the safety rating, or evaluation, of the borrower goes down as provided by Moody’s or Standard & Poor’s, the required interest rate goes up. Similarly, the longer a borrower has the use of the money, or the longer time to maturity, the greater the interest rate required in compensation. Term until maturity and interest rates also are inversely related.
4. Why is accurate timing on the need for funds invested in a certificate of deposit (CD) so important? (See page 5-3)
Aside from making sure the money is available to meet your goal(s), there are two important reasons to match the goal(s) and the maturity on a CD.
· As the term of the CD increases, so does the rate of return. Thus, you could earn more on a longer term CD as opposed to buying a shorter term CD that is subsequently reinvested. However, be sure to consider the future of interest rates and if they are expected to go up or down over the time period in question. But, in general, as the term increases so does the rate of return.
· Interest reductions and penalties apply when a CD is withdrawn prior to maturity, and if necessary can be deducted from the principal. In other words, you could leave the financial institution with less than you initially deposited.
5. Describe
brokered CDs. (See page 5-3)
Investment representatives employed with financial institutions (banks, credit unions, etc.) as well as traditional brokers offer high yield CDs purchased in large blocks from financial institutions around the country. The brokered CDs are then sold in smaller denominations to investment clients who benefit from a higher interest rate than would be available locally with traditional bank CDs. Should the CD need to be redeemed early, the principle of interest rate risk would determine if the value of the CD would be higher or lower than the initial purchase price.
For example, you walk in XYZ National Bank to purchase a CD. The investment representative with XYZ National Bank could sell you a brokered CD earning more than the typical XYZ National Bank CD of the same maturity sold by a customer service representative or teller. Both CDs would be FDIC insured. It can pay to know the right questions to ask!!
6. Why do most financial advisors suggest that you avoid equity-indexed CDs? (See page 5-3)
While the principle of tying the return on a CD to an equity index (e.g., Standard and Poor’s 500) sounds good, particularly in an up market, restrictions on the product often limit the benefits. Higher initial investments may be required and caps on growth rates and other restrictions further limit the potential return. Consequently, financial experts typically recommend the two traditional investment products to meet your income and capital growth needs—a CD and a stock index mutual fund.
7. List
the characteristics of Series EE and I bonds that contribute to their
long-standing popularity with investors.
(See pages 5-3 and 5-4)
Characteristics that contribute to the popularity of Series EE and I bonds include:
· Tax advantages. Earnings are exempt from state and local taxes. Federal taxes can be deferred for 30 years or until the bond is cashed. When income guidelines and other restrictions are met, earnings can be federally tax-exempt when the funds are used to pay qualified higher education expenses.
· Cheap, easy purchase. Bonds can be purchased from most banks and credit unions, through employee payroll deduction plans, through automatic bank account debits with the U.S. Savings Bonds EasySaver™ plan, or on the Web with a credit card. No fees or commissions apply.
· Ease of redemption. Bonds are easy to redeem at most financial institutions after the initial 12 months of ownership with the values easily determined by financial institutions or the Treasury Department Web site. A 3-month interest penalty applies if the bonds are held for less than five years.
· Small investment amounts. Bonds can be purchased in small denominations starting with $25 for a $50 face value EE bond or $50 for a $50 face value I bonds. (Note: EE Bonds are sold at half of their face value; I bonds are sold at face value in the same denominations as Series EE.)
· Generally competitive rates. Series EE rates are based on 90% of the average market yield of five-year Treasury securities. Rates are adjusted twice annually. I Bonds offer the additional benefit of paying a fixed rate with an inflation adjustment based on changes in the Consumer Price Index.
8. How do the earnings on Series EE, I, and HH bonds differ? (See pages 5-3 and 5-4)
Earnings on Series EE and I bonds are available when the bonds are cashed; they pay no periodic interest. Series HH bonds pay semi-annual interest directly to the bondholder. Series HH bonds, which can only be purchased through the exchange of Series EE bonds, defer federal income tax on EE bond earnings for up to 20 more years. Note: New sales of EE bonds were discontinued by the U.S. Treasury, effective September 1, 2004.
9. Define interest rate risk and call risk. What risks do they represent for the bond investor? (See page 5-5)
Interest rate risk refers to the risk of the price of a bond falling in response to newly issued bonds that are paying a higher rate of return. In other words, the bondholder would be forced to sell the bond at a discount, or lower than face amount, to compensate a new purchaser for buying a bond paying a lower than currently available rate. (The inverse relationship would also increase the market price of a bond, should rates in the market be lower than the rate paid on the bond available for sale.) Keep in mind that this “risk” only affects bonds sold to a subsequent purchaser prior to maturity. Interest rate risk does not affect the face value of a bond held until maturity.
Call risk applies only to bonds with a callable feature. The bondholder risks the bond being called and paid off early. The issuer might choose to do this in response to a reduction in the interest rate currently paid on bonds in the marketplace. By calling the bonds paying a higher rate of interest, the issuer could save money by issuing new bonds at the lower rate. The bondholder would lose the higher payment rate for the years remaining until maturity.
Both interest rate risk and call risk affect the return expected by the bond investor.
10. ABC Mutual Fund is offering a “high yield” bond fund. What might this tell you about the bonds in the portfolio? (See page 5-5)
The terms “high yield” or “junk” refer to bonds that are
rated substandard and thus carry a higher level of risk to the purchaser. Investment grade bonds, as rated by Moody’s
and Standard and Poor’s, carry a lower level of risk and reflect a stronger
capacity of the bond issuer to repay the debt.
11. Define “reciprocal immunity.” How does this affect fixed income investors? (See pages 5-6 and 5-7)
Reciprocal immunity refers to the relationship between the taxing authority of state or local and federal governments on debt issued by the other party. State and local governments do not tax the earnings on federal debt, or Treasury securities; conversely, the federal government does not tax earnings on state or local government debt securities, or what are typically called municipal bonds. Investors benefit from the tax savings. Municipal bonds are particularly attractive to investors in higher tax brackets.
12. Summarize the characteristics of Treasury bills and Treasury notes. (See page 5-6)
Key characteristics of Treasury bills include:
· 3- and 6-month maturity terms.
· Sold at a discount equal to the interest rate, with the full face value paid at maturity.
Key characteristics of Treasury notes include:
· 2-, 5-, and 10-year maturity terms.
· Semi-annual, fixed rate of interest paid until maturity when the face amount is returned.
· Rate of return slightly higher than Treasury bills due to the longer maturity.
True of both Treasury bills and notes:
· Sold in $1,000 increments.
· Can be purchased from a bank, brokerage firm, or other financial professional for about $50 or less.
· Can be purchased from the Federal Reserve Bank using the “Treasury Direct” program.
13. What are the unique characteristics of municipal bonds? (See pages 5-6 and 5-7)
Municipal bonds are categorized as general obligation or revenue bonds. The former generate income to repay the debt and interest through the taxing authority of the issuer; the latter generate income from user fees. Revenue bonds tend to carry more risk and more return. Common characteristics of municipal bonds include:
· Earnings are federally tax-exempt, and may be state tax-exempt if (1) the bonds are not “private purpose” and (2) the investor buys bonds from his/her state of residence.
· Interest is paid semi-annually.
· Investments can be made in $5,000 increments or in “minibonds” (smaller increments) through a brokerage firm. Municipal bond mutual funds offer another alternative for investing smaller amounts.
14. Why is a mortgage bond considered safer than a debenture? (See page 5-7)
Should the company declare bankruptcy and default on the bonds, mortgage bonds are backed by the value of the company’s land and buildings. Mortgage bonds are considered the least risky of corporate bonds, while debentures, which are backed only by the company’s promise to pay, are considered the most risky.
15. What are the primary advantages and disadvantages of convertible bonds? (See page 5-7)
Convertible bonds offer the advantage of conversion to shares of common stock, thus allowing an investor to participate in company earnings or stock price appreciation. However, as stock prices go up, so does the value of convertible bonds. Disadvantages include the callable feature and interest rate risk. Also, convertible bonds typically convert to fewer shares of common stock than could be purchased with the bond value.
16. List the unique characteristics of zero-coupon bonds. How can an investor avoid the annual taxation on the increase in the bond value? (See page 5-8)
Bondholders many years ago submitted a “coupon” for their periodic interest payment. As the name implies, zero-coupon bonds pay zero periodic interest. Instead, the bonds are bought at a deep discount and the interest is paid when the bond reaches maturity, or the full face value of $1,000. Advantages of these bonds include low initial costs and the predictability of the return and future value at a given point in time. Disadvantages include interest rate risk that contributes to extreme volatility in the bond values and the requirement that the annual “phantom” interest be treated as taxable income.
17. Characterize bond unit investment trusts (UITs), noting advantages and disadvantages of this fixed-income investment. (See page 5-8)
As a “buy and hold” investment, bond UITs pay periodic interest payments and a return of principal at maturity. Principal could be returned early if any of the bonds comprising the UIT are sold or called prior to maturity. Units of the bond portfolio are usually sold for $1,000. Interest is taxable, unless it is a portfolio of tax-exempt bonds.
Advantages of a bond UIT include:
· Broad diversification for a relatively low initial purchase.
· Locked in rate of return for the life of the UIT.
Disadvantages of a bond UIT include:
· High upfront commissions to purchase.
· Because of interest rate risk, units can sell at a loss, if sold prior to maturity.
· Liquidity can be limited due to a small secondary market for selling units prior to maturity.
18. What key factors are important when selecting a bond mutual fund? What advantages might a bond index fund offer? (See pages 5-8 and 5-9)
Historical performance and the expense ratio are key factors when comparing bond funds. Look for bond mutual funds that have an expense ratio equal to or less than the category average of 1%. Because index funds mirror the securities represented by a benchmark market index, trading costs are minimal and fund management expenses are low.
19. What advice should conservative investors follow when choosing a bond fund? (See pages 5-8 and 5-9)
Conservative investors are advised to stick with short-term, investment grade bond funds to avoid the volatility associated with longer-term bond prices.
20. Why are mortgage-backed securities called “pass through” securities? What potential problems might investors encounter with these securities? (See page 5-9)
Mortgage-backed securities “pass-through” principal and interest payments to investors. Although this practice contributes to the name, it also contributes to the potential problem with these securities. Because consumers move and refinance, some mortgages in the portfolio are repaid early. Consequently, the security may have an uncertain maturity or pay an irregular monthly payment. In addition, investors must not spend the principal as it is “passed through” if they want to continue to re-invest for the future. Furthermore, the amounts and timing of the pass-through amounts may limit the investment options and the returns when re-investing these dollars.
21. What are the similarities and differences in Ginnie Mae, Freddie Mac, and Fannie Mae mortgage-backed securities? (See pages 5-9 and 5-10)
All three require a $25,000 minimum purchase, unless purchased indirectly in a UIT or mutual fund. Ginnie Maes carry the “full faith and credit” guarantee of the federal government, although Freddie Macs and Fannie Maes do not. However, to compensate for the lack of government insurance, the latter two securities typically pay a higher rate of return than the Ginnie Mae securities. All pay slightly more than the Treasury bonds, which have a similar maturity term. Unlike Treasury bonds, earnings are not state or local income tax exempt.
22. How do collateralized mortgage securities (CMOs) compare to other mortgage-backed securities? (See page 5-10)
Like other mortgage-backed securities, CMOs pay principal and interest periodically, although the portfolio of mortgages is divided into classes, or tranches, corresponding to estimated maturity dates. Designed to overcome the unpredictable returns associated with other mortgage-backed securities, CMOs offer more stability of payment, although principal prepayment can occur sooner or later than expected. The complexity of this investment and irregular repayments are problems. CMOs are purchased in $1,000 increments from brokerage firms and pay a higher return than comparable mortgage-backed securities. Investors must remember that the return includes both principal and interest, creating similar problems to those associated with traditional mortgage-backed securities.
23. Characterize variable and fixed annuities. What should investors remember when purchasing an annuity? (See page 5-10)
Variable and fixed annuities are similar in that they represent a contract with an insurance company to pay the annuitant and/or a survivor a regular income for a specified period in exchange for a lump-sum payment or periodic deposits that grow tax-deferred until withdrawn. The income repayment may start immediately or at some time in the future. A minimum initial investment of $5,000 is usually required.
Variable and fixed annuities differ in the types of investments “purchased” through the annuity. Variable annuities offer the investor a choice of growth-oriented and income-oriented investments in mutual fund subaccounts. In contrast, fixed annuities offer a fixed rate of return for a period of 1 to 5 years that subsequently adjusts annually in response to market conditions. As noted in this unit, fixed annuities can be thought of as a “tax-deferred CD.”
When purchasing an annuity, be sure to compare surrender charges for cashing the annuity out early, rates of return, and the financial health of the insurance company offering the product. Be sure to check with one of the rating services listed in Unit 5 and buy only from top-rated companies.
24. Preferred stock is sometimes referred to as a “hybrid” investment. Why? (See page 5-11)
Preferred stock is sometimes referred to as a “hybrid” investment because it combines features of both stocks and bonds. Preferred stock offers investors the benefits of a fixed dividend that is paid prior to the payment of common stockholders. Similarly, should a company go into bankruptcy, preferred stock holders share in the company assets after bondholders, but before any distribution is made to common stockholders. Like bonds, prices of preferred stocks fluctuate inversely to interest rates. Like stocks, preferred stock has no fixed maturity date but can earn dividends indefinitely. Dividends are paid as a fixed percentage of par value, which for most preferred stock is around $25 per share.
25. Although GICs, or “stable value funds”
offer several benefits, most notably a slightly higher return than CDs and
other cash investments, experts often discourage their use for long-term
financial goals like retirement.
Why? (See page 5-11)
GICs offer a tax-deferred, fixed interest rate for specified time period, often 3 to 5 years. Because of the risk associated with an insurance company, as opposed to the federal government or FDIC insurance, rates tend to be slightly higher than CDs or other cash investments. Long-term financial goals, like retirement, can better be met through stocks, based on the historical returns of various investments. (See Unit 2 for a review of these returns.) For this reason, GICs are not recommended as a primary tool for meeting long-term financial goals.