Bonds (L5) Flashcards
US Treasury Securities
All US Treasuries are NON-TAXABLE at the state and local level
Nonmarketable US Treasury Issues
- Series EE/Series E Bonds
○ Sold at Face Value, $25 Minimum purchase
($10,000 annual maximum) available only through
TreasuryDirect (online)
○ Offered at one-half of Face Value
○ NON-MARKETABLE
○ NON-TRANSFERABLE
○ DO NOT pay interest periodically
§ Bond slowly increases in value over 20 years
based on fixed rate at time of purchase
○ Redeemable after one year with 3 months interest
penalty if redeemed in less than 5 years
○ Interest is NOT subject to federal income taxes
until bond is REDEEMED.
§ May qualify for tax free treatment if redeemed
for education purposes
○ Interest is NOT taxed at the state and local level - Series HH/Series H Bonds
○ Pay interest SEMIANNUALLY (different from EE
Bonds)
○ Not been issued since August 2004 - Series I Bonds
○ Inflation-Indexed Bonds issued by the US
government
○ I bonds are sold at face value and have no
guaranteed rate of return
○ The interest portion consists of the following 2
components:
§ Fixed Rate of Return
§ Inflation Component that is adjusted every 6
months
Marketable US Treasury Issues
- All Sold in denominations of $100 or more
- Treasury Securities are sold on an “auction” basis with the lowest yield winning the auction
- US T-Bills
○ Maturities LESS than 1 year
○ Sold on a DISCOUNTED yield basis, which simply
means they do not pay interest
§ Bonds mature at PAR Value - US T-Notes
○ Maturities between 2-10 years
○ Interest is paid SEMI-ANNUALLY - US T-Bonds
○ Maturities GREATER than 10 years
○ Interest is paid SEMI-ANNUALLY
Original Issue Discount (OID)
- OID bond is issued at a DISCOUNT from PAR Value
- EXAMPLE = ZERO COUPON BOND that is sold at a deep discount to PAR value.
○ Bond holder must recognize income each year,
even though no interest is received (imputed OR
“phantom” income)
Treasury Inflation Protected Securities (TIPS)
- Provide inflation and purchasing power protection
- The PRINCIPAL/PAR VALUE adjusts for inflation and, then, the coupon rate is applied to the new principal amount
- Coupon Rate DOES NOT change
Separate Trading of Registered Interest and Principal Securities (STRIPS)
○ The periodic coupon PMTs are separated from the bond and each coupon PMT, including PAR value, trade separately
○ Essentially treasury STRIPS create zero-coupon bonds
○ STRIPS are highly liquid and appropriate for investors looking for a low risk, highly liquid investment, and with a specific time horizon
Federal Agency Securities
- Agency bonds are MORAL OBLIGATIONS of the US Government but are NOT backed by the “full faith and credit” of the US government.
○ ONE EXCEPTION ==> GNMA are a direct obligation of the government and backed by the full faith and credit of the US government
On-Budget Debt
- Government National Mortgage Association (GNMA - Ginnie Mae)
○ division of Department of Housing and Urban
Development - Farmers Home Administration (FHA)
Off-Budget Debt of Agencies
○ Federal National Mortgage Association (FNMA - Fannie Mae)
○ Federal Home Loan Mortgage Corporation (FHLMC - Freddie Mac)
○ Student Loan Marketing Association (SLMA - Sallie Mae)
○ Federal Farm Credit Banks (FFCB)
○ Federal Intermediate Credit Banks (FICB)
○ Federal Home Loan Bank (FHLB)
Mortgage-Backed Securities
- GNMA or Ginnie Mae
○ Consists of pool of FHA/VA guaranteed mortgages
○ Each month GNMA distributes interest and
principal PMTs to investors
§ Interest component is subject to both state
and federal income tax, component that is
return of principal is NOT TAXABLE - FNMA or Fannie Mae / FHLMC or Freddie Mac
○ Historically NOT backed by the US government - BIGGEST RISK
○ Interest Rate FALLING
§ Mortgage and Bonds get repaid EARLY, leaving
the investor with a REINVESTMENT problem
Corporate Bonds
Secured Bonds
○ Mortgage-Backed Securities (MBS)
○ Collateral Trust Bonds
Collateralized Mortgage Obligations (CMOs)
Unsecured Corporate Bonds
○ Debentures
○ Subordinate Debentures
○ Income Bonds
Mortgage-Backed Securities (MBS)
- Backed by a pool of mortgages
- PMTs consist of both INTEREST and PRINCIPAL
- Biggest Risk to bond holder is PREPAYMENT RISK
Collateral Trust Bonds
- Backed by an asset owned by the company issuing the bonds
- Asset is held in trust by a 3rd party
- In the event of default on the debt payment, the bond holders are entitled to the asset being held in trust
Collateralized Mortgage Obligations (CMOs)
- Investors in CMOs are divided into “TRANCHES”, which determines which investors will receive principal repayments
- Investors are divided into tranches A - Z, which represent short, intermediate, and long-term tranches
- Interest from pool of mortgages is distributed pro-rata and the principal repayments are used to retire tranches sequentially
- Investors in the Short-Term Tranche receive principal repayment before the intermediate and Long-Term Tranche
- CMOs are meant to mitigate prepayment risk associated with mortgage-backed securities
Unsecured Corporate Bonds
- Debentures
○ UNSECURED DEBT (Not backed by an asset)
○ Backed on the belief of the creditworthiness that
the issuing company (or government) will repay the
debt - Subordinate Debentures
○ Lower claim on assets than other unsecured debt
○ More RISK because of the lower claim on assets if
the company defaults on the bond repayments - Income Bonds
○ Stipulate that interest is ONLY paid when a specific
level of income is attained
Tax-Equivalent & Tax-Exempt Yields (TEY)
- TEY ==> the yield a taxable corporate bond would need to pay for the yield on a Tax-Exempt Muni to be equivalent to a taxable corporate bond
○ It is the AFTER-TAX RoR a taxable corporate bond
pays - If a bond is double or triple-tax free, simply combine the federal, state, and local income tax rate. This is then used for the marginal tax rate in the formula below:
○ To be DOUBLE tax free ==> the bond holder must
live in the state that issued the Muni-bond
○ To be TRIPLE tax free ==> the bond holder must
live in the local municipality that issued the bond - We can RESTATE the formula:
○ TEY = (Corporate Rate) x (1- Marginal Tax Rate) - If a Muni-Bond is exempt from federal and state taxes, the effective state tax rate must be considered
○ The EFFECTIVE TAX RATE ==> takes into
consideration that state income taxes are
DEDUCTIBLE at the federal level - The formula to determine the TEY for a double-tax-free bond is:
○ TEY for both Federal and State Taxes
= Tax-Exempt Yield / 1 - [ Federal Rate + State
Rate (1- Federal Rate)]
NOTE: only use the above formula if the client itemizes deductions on his tax return. OTHERWISE, just add the federal and state tax rates and use the TEY formula.
