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.