Lesson 5 of Investments: Bonds Flashcards
US Treasury Securities
- ALL US Treasury Securities are nontaxable at the state and local level.
Subsections:
- Nonmarketable US Treasury Issues
- Marketable US Treasury Issues
- Original Issue Discount (OID)
- Treasury Inflation Protected Securities (TIPS)
- Seperate Trading Of Registered Interest and Principal Securities (STRIPS)
Nonmarketable US Treasury Issues
Nonmarketable securities are NOT easily bought or sold.
- Series EE/Series E Bonds
- Series HH/Series H Bonds
- Series I Bonds
Series EE/Series E Bonds
- Sold at face value, $25 minimum purchase ($10,000 annual maximum) available only through Treasury Direct (online).
- Offered at one-half of face value.
- Nonmarketable, nontransferable.
- 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 month 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 expenses.
- Interest is not taxed at the state or local level.
Series HH/Series H Bonds
- They pay interest semiannually - different than EE bonds.
- Series HH bonds have not been issued since August 2004.
Series I Bonds
-
Inflation-indexed bonds issued by the U.S government.
- Protected by variable rate too.
- I bonds are sold at face value and have no guaranteed rate or return.
- Does not pay interest periodically.
- The interest portion consists of the following two components:
- Fixed rate of return.
- Inflation component that is adjusted every six months.
Exam Tip:
- With I Bonds, the inflation changes in the Rates.
- TIPS interest changes in the principal.
I bonds the rate changes. TIPS change the principal.
Exam Tip of EE Bonds
- They are NOT marketable securities.
Marketable US Treasury Issues
All
- bills,
- notes and
- bonds are sold in denominations of $100 or more.
Treasury securities are sold on a “auction” basis with the lowest yield winning the auction.
- US Treasury Bills
- US Treasury Notes
- US Treasury Bonds
US Treasury Bills
T-bills have maturities less than 1 year.
- T-bills are sold on a discounted yield basis,
- which simply means they do not pay interest,
- the bonds just mature at par value
US Treasury Notes
Notes have maturities between 2 and 10 years.
- Interest is paid semi-annually.
US Treasury Bonds
Bonds have maturities greater than 10 years.
- Interest is paid semi-annually.
Original Issue Discount (OID)
An OID bond is issued at a discount from par value.
- An example of an OID is a zero-coupon bond
- that is sold at a deep discount to par value.
- For example, a $1,000 par value zero-coupon bond may sell for $600.
- The bond will then increase in value over the term of the bond until it matures at par value.
- For zero-coupon bonds,
- the bond holder must recognize income each year, even though no interest is received.
- This is known as imputed or “phantom income” because
- the bond holder doesn’t receive interest, but
- still must pay taxes on the increase in value of the zero-coupon bond.
Exam Tip
- There are taxes on increase every year.
Example of OID
- Shayla purchased a thirty -year zero coupon $1,000 bond at initial issue to yield 7% per year.
- Shayla pays $126.93, calculated by FV=$1,000, i=7/2, n=30x2, solve for PV.
- At the end of the first year she will have taxable interest of $8.89, calculated by 126.93 × 7% = $8.89
- Year two: 135.82 (derived from 126.93 + 8.89) × 7% = $9.50
- SEMIANNUAL if INCLUDED
Treasury Inflation Protected Securities (TIPS)
-
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.
- The coupon rate does not change as is the case with I Bonds.
Exam Tip:
- Only the principal amount will change.
Example of TIPS
A TIPS has a par value of $1,000 and a coupon rate of 4%. The initial coupon payment is calculated as follows:
- $1,000 x 0.04 = $40.
The par value is subsequently adjusted to reflect an inflation rate of 3%; therefore, the new coupon payment will be:
- $1,000 x 1.03 = $1,030 (To adjust the par value for inflation)
- $1,030 x 0.04 = $41.20 (Subsequent coupon payment)
Seperate Trading Of Registered Interest and Principal Securities (STRIPS)
-
The periodic coupon payments are seperated
- from the bond and
- each coupon payment and
- principal/including the par value, trade seperately.
- 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.
Exam Question
Which of the following bonds mitigate against purchasing power risk?
A) TIPS and STRIPS
b) STRIPS and EE Bonds
c) TIPS and EE Bonds
d) I Bonds and TIPS
e) I Bonds and EE bonds
Answer D
I bonds adjust the interest paid for inflation, and TIPS adjust the par value for inflation. All other bonds provide no purchasing power risk protection.
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:
- GNMAs are a direct obligation of the government and backed by the full faith and credit of the US government.
Subtopics:
- On-Budget Debt
- Off-Budget Debt of the Agencies
- Mortgage-Backed Securities
On-Budget Debt
- Government National Mortgage Association (GNMA-Ginnie Mae), division of the Department of Housing and Urban Development.
- Farmers Home Administration (FHA).
Off-Budget Debt of the Agencies
- Federal National Mortgage Association (FNMA - Fannie Mae).
- Federal Home Loan Mortgage Corporation (FHILMC - 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
Government National Mortgage Association (GNMA or Ginnie Mac).
- Consists of a pool of FHA/VA guaranteed mortgages.
- Each month GNMA distributes interest and principal payments to investors.
- Interest component is subject to both state and federal income tax, component that is return of principal is not taxable.
Federal National Mortgage Association (FNMA or Fannie Mae) and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).
- Historically not backed by the US Government. FHFA did help bail them out in 2008. (Federal Housing Finance Agency).
The biggest risk with mortgage-backed securities is falling interest rates.
- Mortgages could get repaid early, the bond get retired early, which leaves investors with a reinvestment problem
Exam TIp
- Know that agency bonds are not backed by the full faith and credit of the US government.
- Also, know that the exception to the rule - GNMA bonds are backed by full faith and credit of the US government.
Corporate Bonds!
- Secured Bonds
- Collateralized Mortgage Obligations (CMOs)
- Unsecured Corporate Bonds
Secured Bonds
- Mortgage-backed Securities (MBS)
Mortgage-backed Securities (MBS)
- Mortgage-backed securities are backed by a pool of mortgages.
- Payments consist of
- both interest and principal.
-
The biggest risk to bond holders is
- prepayment risk and default.
Collateral Trust Bonds
- A collateral trust bond is backed by an asset owned by the company issuing the bonds.
- The asset is held in trust by a third 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 repayment.
- Investors are divided into tranches A - Z,
- which represent short, intermediate, and long-term tranches.
- Interest from the pool of mortgages is distributed pro-rata and
- the principal repayments are used to retire tranches sequentially.
-
Investors in the short-term tranche (A).
- Receive principal repayment before the intermediate and long-term tranch (Z).
CMOs are meant to mitigate against prepayment risk associated with mortgage-backed securities
Unsecured Corporate Bonds
- Debentures
- Subordinated Debentures
- Income Bonds
They have more risk then secured so in return they have more risk.
Do not need to know specifics.
Have more yield then secured because more risk.
Debentures
Debentures are simply unsecured debt that is not backed by any asset.
- Debentures are backed on the belief of the creditworthiness
- that the issuing company (or government) will repay the debt.
Subordinated Debentures
- Subordinated debentures have a lower claim on assets
- than other unsecured debt.
-
Subordinated debentures have more risk
- because of the lower claim on assets
- if the company defaults on the bond repayments.
Income Bonds
- Income bonds stipulate that interest is
- only paid when a specific level of income is attained.
Bond Rating Agencies!
Moody’s and Standard and Poor’s both rate bonds on the company’s
- default risk and investment quality.
The higher the bond rating,
- the lower the yield.
The bond rating agencies analyze a firm’s:
- Liquidity.
- Total amount of debt.
- Earnings and stability of those earnings.
Moody’s ratings are:
Aaa - C
- AAa - Baa are investment quality bonds.
- Ba and below are junk bonds.
Standard and Poor’s ratings are:
AAA - D
- AAA - BBB are investment quality bonds.
- BB and below are junk bonds.
Guaranteed Investment Contract (GIC)!
Issued by insurance companies with a
- guaranteed rate of return.
The insurance company agrees to
- repay the principal and guaranteed rate of return for a period of time.
Yield is higher than treasury securities.
Municipal Bonds!
Municipal bonds are nontaxable at the federal, state, and local level if you live in the issuing state.
Bonds issued by territories of the US (Puerto Rico) are not subject to taxes at federal, state, and local levels.
There are three types of municipal bonds:
1. General Obligation Bonds.
2. Revenue Bonds.
3. Private Activity Bonds.
- There is Also Insured Municipal Bonds
General Obligation Bonds
- General obligation bonds are backed by the
- full faith,
- credit, and
- taxing authority of the municipality that issued the bond.
- Safest type of Municipal bond
Revenue Bonds
- Revenue bonds are backed by the revenue of a specific project.
- Revenue bonds are NOT backed by the full faith, credit, and taxing authority of the entity that issued the bond
Toll road is an example.
Private Activity Bonds
- Private activity bonds are used to finance construction of stadiums.
Insured Municipal Bonds
The following companies insure municipal bonds:
- American Municipal Bond Assurance Corp. (AMBAC)
- Municipal Bond Insurance Association Corp. (MBIA)
If an insured municipal bond is in default,
- the insurance company will pay the interest and principal amounts.
Exam Tip
know the three types of municipal bonds and the insurance companies.
- Know that a general obligation muni is backed by the taxing authority of the issuing municipality.
Fixed Income Risks!
EXAM TIP:
- The primary difference between the Corporate and US Government Bonds risks is that the US government are NOT subject to default risk.
- Municipal bonds can be considered to have default risk unless they are insured.
Subtopics:
- Corporate Risk
- US Government Bond Risk
Corporate Bond Risk
- Default Risk
- Reinvestment Rate Risk
- Interest Rate Risk
- Purchasing Power Risk
US Government Bond Risk
- Reinvestment rate Risk
- Interest Rate Risk
- Purchasing Power Risk
Municipal Securities!
- Tax Equivalent & Tax-Exempt Yield
Tax Equivalent & Tax-Exempt Yield
- The “Tax-Equivalent Yield” (T.E.Y.) is the yield a taxable corporate bond would
- need to pay/earn for the yield on a tax-exempt muni
- to be equivalent to a taxable corporate bond.
-
The “Tax-Exempt Yield” is the
- after-tax rate of return 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 municipal bond.
- To be triple-tax-free, the bond holder must live in the local municipality that issued the bond.
Exam Tip:
- Use the amount that is exempt in the equation, denominator. Amount of money you save.
- You are subtracting the tax out.
TEY Formula
Provided on the Exam
TEY = r ÷ (1-t)
r = tax exempt yield.
t = marginal tax rate.
How can you restate the formula?
Not provided on exam
Tax-Exempt Yield =
(Corporate rate) x (1-Marginal Tax rate)
Example
Which of the following bonds would you recommend if the investor wants to maximize his after-tax rate of return, assuming a tax rate of 3.5%?
Corporate:
After Tax-Yield = 0.085 x (1-.035) = 5.52% vs Mini paying 5.25%
Municipal:
After Tax-Yield = 0.0525 ÷ (1-0.35) = 8.07% vs corporate paying 8.5%
- Either formula will give you the same answer.
- An investor would prefer to invest in the corporation bond because it provides a higher after-tax rate of return.
More Municipal Information
- If a municipal bond is exempt from federal and state taxes,
- the effective state tax must be considered.
- The effective tax rate take into consideration that
- state income taxes are deductible at the federal level.
T.E.Y. Both Federal and State Taxes
Formula is used to determine the taxable equivalent yield for a double-tax free bond:
Tax-Exempt Yield
÷
1- [Federal Tax Rate + State Tax Rate (1-Federal Tax rate)]
- Only use the formula if the client itemizes deductions on his tax return.
- Otherwise, just add the federal and state tax rates and use the taxable equivalent yield formula.
Exam Question
William lives in a state with a 5% state income tax and itemizes deductions on his federal tax return. His marginal federal tax rate is 35%. His local municipality issues a 4.5% municipal bond. What is the taxable equivalent yield based on this information?
a) 6.9%
b) 8.3%
c) 7.3%
d) 45%
e) 9.7%
What if he does not idemize deductions?
Answer: C
TEY =
0.045
÷
1 - [0.35 + 0.05 ( 1 - 0.35 )]
=0.045 ÷ (1-0.3825)
=0.0729 or 7.3%
What if he does not idemize deductions?
TEY =
0.045
÷
1 - (0.35 + 0.05)
=0.075 or 7.5%
Exam Question:
What is the taxable equivalent yield on a treasury security paying 3.5% if the marginal federal tax rate is 35% and the state income tax rate is 5%?
a) 5.8%
b) 3.7%
c) 5.1%
d) 4.8%
Answer: B
0.035
÷
(1-0.05)
=3.68%
US Treasuries are exempt from state and local taxes only. Use the taxes you save in the equation.
0.05 because 0.05 is not taxed.
Explanation:
- Because you do not pay taxes on the state tax rate for treasury securities, you subtract the 0.05 out of the equation.
Taxable and Tax Free returns
If the yield ratio is Rtf (tax-free) ÷ Rt (taxable), how does a higher ratio affect the attractivneness of municipal bonds?
a) The higher the ratio, the more appealing?
b) The lower the ratio, the more appealing?
c) Both A and B
d) Neither A and B
e) Investors are indfferent to the ratio.
Answer: A
As the tax-free return increases, the ratio becomes bigger. If investors are able to earn a tax-free return that is very close to a taxable return, investors will always choose the tax-free return.
