Fixed Income Tutorial

There is no such thing as a risk-free investment. Here are some of the more common types of risk to consider when choosing fixed-income securities.

• Credit Risk: The risk that the issuer will default on its payments of interest and principal on its debt. You can help manage this risk by choosing only investment-grade bonds (rated BBB or higher) or by diversifying among several issues of high-yield bonds. Or you can purchase bonds that are insured, a guarantee that interest and principal will be paid in the event of a default by the issuer. The insurance does not guarantee the original price if sold before maturity, or current market value.
  
  
• Reinvestment Risk: The possibility that interest rates may have fallen by the time your investment reaches maturity. If this occurs, you may be unable to reinvest your funds at the rate of return you were accustomed to receiving. When interest rates drop, bond prices generally rise because the market is willing to pay more for a higher coupon. When interest rates rise, bond prices generally fall because the market will pay less for a lower coupon.
  
  
• Inflation Risk: The possibility that the value of your investment may not grow enough to keep up with inflation, reducing your purchasing power as a result.
  
  
• Market Risk: Yields and market value of bonds will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost.

Fixed Income: Certificates of Deposit

• Certificates of deposit (CDs) are debt instruments that usually offer a fixed rate of return.
  
• Issued by banks and savings and loans and are generally insured by the Federal Deposit Insurance Corporation up to $100,000 per institution. This insurance covers the principal and accrued interest on the CD.
  
• Maturities range from 3 months to 7 years. Generally, CDs may not be withdrawn prior to maturity.
  
• Individual CDs start as low as $100, although they are generally sold in increments of $1,000, up to $100,000 maximum (including interest).
  
• CDs can be suitable for IRAs and Keogh plans, and can also be purchased by pension and other employee benefit plans.

Zero coupon CDs
Zero coupon CDs are purchased at a discount to their face value. They mature at par, eliminating concern over how to reinvest interest distributions.

• Interest income from zero coupon CDs is subject to taxation annually as ordinary income, even though the investor receives no income.
  
  
• The market value of zero coupon CDs fluctuates more than traditional CDs, and therefore may not be suitable for investors with liquidity needs.

Callable "step-up" CDs
These are CDs in which interest rates can increase over time on a predetermined schedule.

• After a noncallable period—typically one or two years—these CDs are callable by the issuer.
  
  
• In return for the high yields offered by CD "step-ups," you must accept the risk of your CD being called (redeemed) before maturity. This means you may have to reinvest principal at a lower interest rate.
  
  
• As with traditional CDs, if you sell your CD "step-ups" prior to maturity will also be subject to market risk. The market value of the CDs will fluctuate so that your CD, if sold prior to maturity, may be worth more or less than its original cost. Additionally, liquidity in the secondary market can be limited.
  
  
• If you invest in CD "step-ups" you should be prepared to hold the CD until maturity or call.

Fixed Income: Government Securities

Government securities are direct obligations of the U.S. Government. They are widely regarded as a safe and profitable investments if held to maturity. These securities are brought to the market on a schedule established by the U.S. Treasury, and the proceeds are used to finance the U.S. Government's operations. They are separated into three different maturity groups: Treasury bills, Treasury notes, and Treasury bonds.

Fixed Income Government Securities Investment Minimum Denominations Maturity Treasury bills $1,000 or more 3 months 6 months, or 1 year Treasury notes $1,000 to more than $1 million 1 to 10 years Treasury bonds $1,000 10 years or longer

Because of their short maturities, Treasury bills do not pay interest, but instead are sold at a discount to their face value and then pay the full face value (also called "par value") upon maturity. For example, a 3-month Treasury bill might sell for $800 and pay $1,000 at maturity.

Treasury notes and Treasury bonds both make semi-annual interest payments. Treasury issues are often used as benchmarks for other comparably maturing securities, because of their liquidity and safety features.

Fixed Income: Government Sponsored Agencies

Issued by federal government-sponsored corporations, these government-sponsored agency (GSA) securities are the direct obligations of the issuing agency. Although commonly referred to as "federal agencies," they are actually government-sponsored enterprises. GSA securities, while not fully backed by the U.S. Government, have implied AAA credit ratings and usually supply steady, dependable income.

Government-sponsored agency securities are a good investment choice if you're interested in dependable income and high credit quality. They are available in a wide range of issues and maturities to suit your particular needs, and often offer higher yields than U.S. Treasury securities of similar maturities.

Issuing agencies include:

Fixed Income Government sponsored Agencies Security Issuer Abbreviation Description Tax Treatment Federal Home Loan Banks These institutions provide liquidity for the housing industry through savings and loan institutions. Exempt from state and local taxation. Government National Mortgage Association GNMA "Ginnie Mae" This organization purchases mortgages and repackages them into securities, which are then resold to investors. This process helps to increase the amount of capital available for mortgage lending. Government backing makes default practically unheard of. Subject to state and local taxation. Federal National Mortgage Association FNMA "Fannie Mae" FNMA purchases mortgages, packages them into securities, and resells them to investors. Subject to state and local taxation. Federal Home Loan Mortgage Corporation FHLMC "Freddie Mac" Freddie Mac also assists in funding for the housing industry by purchasing and repackaging mortgages. Subject to state and local taxation. Federal Farm Credit Banks These institutions provide funds for farmers to purchase land and equipment and finance crops. Exempt from state and local taxation. Student Loan Marketing Association SLMA "Sallie Mae" This entity funds and services the Guaranteed Student Loan program. Exempt from state and local taxation. Separate Trading of Registered Interest and Principal of Securities STRIPS These are zero-coupon securities backed by the U.S. Government that have been separated into interest and principal components. Stripped interest components are sometimes called TINTS (Treasury Inflation-Indexed Securities). Exempt from state and local taxation. Resolution Funding Corporation REFCORPS This government agency was formed in 1989 to raise funds for both the Resolution Trust Corporation and for institutions formerly belonging to the Federal Savings and Loan Corporation. REFCORPS are no longer issued, but are available on the secondary market in maturities of 1- to 30-years. Exempt from state and local taxation. Financing Corporation FICOs This government agency assists the Federal Savings and Loan Insurance Corporation (FSLIC) by issuing bonds. FICOs are no longer issued, and not as liquid as REFCORPs; they do, however, offer higher yields as compensation. FICOs are available in the secondary market in 1- to 20-year maturities. Exempt from state and local taxation.

Other issuing agencies include TIGRs (Treasury Investors Growth Receipt), CATS (Certificates of Accrual on Treasury Securities), TRs, TVAs, ETRs, and COUGRs. The interest income derived from these investments may also be exempt from state and local taxation; consult your tax advisor for more information.

Many of the newer federal agency issues have call features that provide investors with higher yields to compensate for the possibility of the issues being called before their stated maturity. (Market value will fluctuate prior to maturity.)

Fixed Income: Zero Coupon Bonds

Unlike regular coupon bonds, most of which pay interest semi-annually, zero coupon bonds make no interest payments while the bond is outstanding. Instead, the interest accrues (builds up) and is paid all at once at maturity. Because zeros are offered at a deep discount to face value, they are subject to greater volatility than coupon bonds. As market conditions change, the market value of zero coupon bonds fluctuates more than regular coupon bonds and, therefore, may not be suitable for all investors.

• Zeros are issued by major corporations, municipalities, and the U.S. Government.
  
  
• U.S. Government zeroes are similar to U.S. Treasury bills in that they are sold at a discount to the face value of the bond; as the maturity date approaches, the price of the zero moves toward par. (For example, a bond with a yield of 8% and a par value of $1,000 with a maturity of ten years is priced a little over $450. Its value increases over time, until it eventually reaches par value on the maturity date.)
  
  
• The return is derived solely from the price increase between the time of purchase and the maturity date (or the sale date, if sold prior to maturity).
  
  
• Zero coupon bonds make no interest payments while the bond is outstanding; instead, the interest accrues and is paid all at once at maturity.
  

Zeros may be a good alternative if you have a specific time frame—such as a child's college tuition payments—and if you intend to hold the bonds until maturity. However, because of their volatility, they may not be suitable if you need immediate access to cash. Unless you hold them in a tax-deferred account, the interest that accrues on these bonds may be subject to income taxes annually, even though you don't receive any interest payments until maturity. (This generally does not hold true for interest payments on municipal zero coupon bonds, which generate tax-free income that is payable at maturity. Income for some investors may be subject to the federal Alternative Minimum Tax.) You should consult your tax advisor about the special tax consequences of zero coupon bonds.

Fixed Income: Preferred Securities

If you are searching for attractive yields in this low-interest-rate world but don't want to assume high levels of risk, preferred securities may be the solution. Like corporate bonds, preferred securities are issued by major banks, utilities, industrial corporations, and various foreign entities to raise capital. Most preferreds make fixed quarterly payments at a rate that is set when the securities are first issued. (Some newer types pay monthly.) Preferred securities have many other attractive features, including "preferred" status on payments; investment-grade ratings; affordability; and liquidity.

Why are preferred securities "preferred" by investors who are looking for relatively high yields, but who want to retain relative peace of mind?

• Payments made to owners of preferred securities have preference over, or are senior to, common stocks. In other words, payments must be made to preferred security holders before dividends can be paid to common stock owners.
  
  
• The payments of most preferred securities are "cumulative." If, for any reason, preferred payments are suspended, all missed payments must be made up before any common dividends are paid.
  
  
• Common stock dividends must be suspended before any preferred securities payments can be suspended. However, preferred securities are considered subordinate to a company's senior debt, meaning that interest payments must be made to bondholders before preferred shareholders.
  
  
• Preferred status extends beyond payments. If an unforeseen disaster occurs and a company is forced to liquidate, preferred shareholders' claims on the company's assets come before common stockholders' claims. Again, however, bondholders' claims are senior to those of preferred shareholders.
  
  
• Most preferred securities are rated by Standard & Poor's and Moody's Investors Service as investment-grade quality, meaning they exhibit the strongest capacity to make payments as scheduled.

Preferred securities share characteristics of both stocks and bonds:

Stock characteristics Affordable for many investors; a good number of preferred securities trade at $25 per share. Generally listed on major stock exchanges such as the NYSE. This makes it easy to follow their price and adds to their liquidity.

Bond characteristics Relatively high fixed-rate dividend payments. Interest-rate-sensitive; thus, Preferred securities perform more like a bond than a stock.

Preferred securities generally have a call feature that allows the issuer to redeem them by paying a stated price after a specified date. Like bonds, preferred securities are sensitive to interest rates.

• If interest rates decline, share prices on preferreds will generally rise. As a result, the preferreds' share price could be expected to rise - possibly reaching or exceeding the call price. In that case, the company may redeem the preferred security after the call protection period expires and possibly issue new ones at a lower rate to the issuer.
  
  
• If interest rates remain the same or rise, the company is not likely to call or retire the preferred security.
  
  
• If interest rates rise, the preferred share price may drop, as investors move to higher-yielding alternatives.

If you are concerned about rising interest rates, certain types of preferred securities, such as adjustable rate preferreds, may present an attractive alternative solution.

Preferred securities fall into two categories: traditional preferreds and newer issues.

Preferred Securities: Traditional Type Description Perpetual Cumulative fixed quarterly distributions; no set maturity date. Adjustable Rate Preferreds (ARPs) Dividend resets every quarter, based on a formula tied to government bond rates. Minimum and maximum rates are set at the time of issue. American Depository Receipts (ADRs) Represents a specified number of shares of a foreign corporation traded on a U.S. Stock exchange. ADRs are issued by U.S. Banks. (Remember, foreign investing is subject to certain risks, such as currency fluctuation and social and political changes. This is not a factor if the securities are issued in the United States.) American Depository Shares (ADSs) Issued by international corporations (mostly banks) that are trying to access the U.S. capital markets. Because they are issued in U.S. dollars, you do not face currency conversion risk. Dividend payments are also made in U.S. dollars. (Remember, foreign investing is subject to certain risks, such as currency fluctuation and social and political changes. This is not a factor if the securities are issued in the United States.) Convertibles Shares can be exchanged for a specified number of common stock shares at a specified time and a specified price. Convertibles give you the opportunity to receive relatively high yields and participate in any rise in the common stock price.

Preferred Securities: Newer Issues Type Description Monthly Income Preferred Securities (MIPS) Issued by a special-purpose company that is created for the sole purpose of issuing preferred securities and lending the proceeds back to the parent company. They make monthly distributions, and payments are deductible by the parent company. They are not direct obligations of the parent company; however, the parent company guarantees their payments. Quarterly Income Preferred Securities (QUIPS) Structured the same as MIPS, but distributions are paid quarterly rather than monthly. Monthly Income Debt Securities (MIDS) Subordinated debentures that have 30- to 50-year maturities. Issued directly to investors by the parent or operating company. Monthly payments are guaranteed by the parent or operating company. Quarterly Income Debt Securities (QUIDS) Subordinated debentures that have 30- to 50-year maturities. Issued directly to investors by the parent or operating company. Quarterly payments are guaranteed by the parent or operating company. Trust Originated Preferred Securities (TOPrS) Issued by a special-purpose business grantor trust that exists only to issue preferred securities and lend the net sale proceeds to the parent company by purchasing a long-term debenture. Payments are quarterly. They are not direct obligations of the parent company; however, the parent company guarantees their payments. Exchangeable Notes After an initial period and at the company's option, the notes can be exchanged or converted into the issuer's preferred stock.

These newer preferred issues may have distinctive tax considerations that you should discuss with your personal tax advisor. For example, if distributions or interest payments on MIPS, QUIPS, MIDS, QUIDS, or TOPrS are suspended, accrued income must still be allocated to the investor in advance of the receipt of actual cash. This "phantom income" may result in a tax liability for income allocated but not yet received. See your tax advisor for more information.

Fixed Income: Mortgage- and Asset-Backed Securities

Most fixed-income securities provide you with periodic interest payments over the stated term of the security and repay the principal in full at maturity. Most mortgage- and asset-backed securities, however, make both principal and interest payments monthly, quarterly, or semi-annually over the life of the security. Interest payments are fully taxable; principal payments are not.

• Most mortgage-backed securities are driven by the principal and interest payments on home mortgages. For example, a government-sponsored enterprise that provides housing loans, such as Fannie Mae, will issue a mortgage-backed security to generate capital for lending. The bondholders later receive their interest and principal in the form of monthly payments, as the mortgages that the funds were used to finance are paid off.
  
  
• Since homeowners have the right to payoff their mortgages at any time, these monthly payments may include additional payments of principal (known as prepayments).
  
  
• Generally, when interest rates decline, prepayments accelerate beyond the initial pricing assumptions, which could cause the average life and expected maturity of the securities to shorten. Conversely, when interest rates rise, prepayments slow down beyond the initial pricing assumptions, and could cause the average life and expected maturity of the securities to extend, and the market value to decline.
  
  
• When prepayments accelerate due to falling interest rates, principal may have to be re-invested at a lower interest rate than the coupon of the security.
  
  
• Similarly, many asset-backed securities are driven by consumer and home equity loans. For this reason, asset-backed securities structures always contain some form of credit enhancement to bring the credit quality to the desired level.
  
  
• In exchange for the cash-flow uncertainty caused by prepayments, mortgage- and asset-backed securities afford you relative safety (provided you hold them to maturity), liquidity, and superior yields, relative to comparable bonds.
  
  
• Most mortgage- and asset-backed securities are available in small denominations, making them a good vehicle for diversifying your portfolio.

Fixed Income: Eurobonds

Eurobonds are bonds denominated in various currencies, including U.S. dollars, and offered outside the issuer's country of origin for intended sale to the global community. Eurobonds typically pay interest annually, except in the case of emerging market bonds, which primarily pay semi-annually. In most cases, Eurobonds have no foreign withholding tax on either coupon or redemption payments. (Note: Foreign investing is subject to certain risks, such as currency fluctuation, plus social and political changes.)

In addition to domestic and international banks and corporations, Eurobonds are issued by supranationals, such as the World Bank and the Inter-American Development Bank, and by sovereigns, such as France, the United Kingdom, Sweden, Mexico, and Argentina. The rating agencies evaluate the credit risk of Eurobond issuers in exactly the same way they evaluate domestic issuers. One variable used in determining foreign issuers' creditworthiness is political risk, which happens to be benign in the United States. Domestic investors looking abroad should be aware that while their fundamentals might be comparable, foreign bond issues might have political sovereign concerns that will constrain their ratings.

Fixed Income: High-Yield Bonds

High-yield securities are corporate bonds that have credit ratings below Moody's Baa3 and Standard & Poor's BBB-. These high-yield bonds, sometimes called "junk bonds," are typically issued by emerging mid-cap corporations to finance growth. Maturities usually range from 7–to–10 years, and interest is paid semi-annually.

The most attractive aspect of high-yield bonds is the high interest income. The coupon is typically 2%-5% (200–500 basis points) higher than on a like-maturity investment-grade corporate bond. Additionally, if you are an aggressive investor, high-yield bonds provide an alternative vehicle to stocks with which you can potentially capitalize on emerging growth industries. As a trade-off for the potentially higher earnings, of course, high-yield bonds are subject to greater risk of loss of principal and interest, including default risk, than higher-rated bonds.