Two Types of Investments:

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Two Types of Investments

• Ownership
• Investors own all or part of an asset
• Examples include
• stock
• real estate
• growth mutual funds
• collectibles

• Loanership
• Investors loan money to companies, government, or
  financial institutions
• Examples include
• bonds
• money market funds
• CDs

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Characteristics of Fixed-Income Investments

• Interest can be fixed or change with market rates
  
• Subject to interest rate risk
• Many have a fixed maturity date
• Principal generally returned at maturity

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Why Buy Fixed Income Investments?

• Adds diversification to portfolio
• Lower volatility than stock
• Predictability of investment return
• Some offer tax advantages
• Capital gains potential

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Categories of Fixed-Income Investments

• Securities sold at banks
• Various types of bonds
• Other fixed-income investments sold by brokers

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Certificates of Deposit (CDs)

• Sometimes called time deposits
• Pay fixed rate of interest for fixed time period
• Typical maturities 30 days to 5 years
• Higher return (generally) on longer maturities
• Bank CDs are federally insured

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CDs

• Penalty charged for early withdrawals
• CDs sold by brokers as well as banks
• Broker-sold CDs often pay higher yields
• Equity-indexed CDs base yield on change in a
  stock market index

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Money Market Mutual Funds

• Fund portfolio consisting of high-quality,
  short-term debt instruments
• Professionally-managed
• Securities mature in 90 days or less
• Minimum initial deposit varies
• Purchase through investment companies or
  financial advisors

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MMMFs

• Different from bank money market deposit accounts
  (MMDAs)
• No FDIC insurance
• Limited check-writing
• Can select tax-exempt MMMFs invest in short term
  government securities

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U.S. Savings Bonds

• Lowest-denomination federal debt
• Income exempt from state/local tax
• Federal tax can be deferred for up to 30 years or
  until bond is cashed in
• Must be held six months to redeem
• 3-month interest penalty bonds not held five
  years

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U.S. Savings Bonds

• EE bonds sold at half of face value
• Interest rate 90 of 5-year Treasuries
• I bonds sold at full face value
• Pay fixed rate inflation adjustment
• Automatic purchase with EasySaver
• Earnings may be tax-free (education)

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Bonds An Overview

• Debts of corporations or governments
• Promise specified interest rate (coupon) and
  return of principal at maturity
• Typically sold by brokers
• Subject to interest rate risk

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More About Bonds

• Interest rate fluctuations affect long-term bonds
  more than short-term bonds
• Some bonds subject to call risk (issuer retires
  bonds and reissues at lower rate)
• Par (face) value is typically 1,000 (5,000 for
  municipal bonds)

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Bond Ratings

• Ratings predict ability of a bond issuer to repay
  debt
• Investment grade top 4 grades
• Baa to Aaa from Moodys
• BBB to AAA from Standard Poors
• Lower ratings substandard grade (a.k.a., junk,
  high yield)

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U.S.Treasury Securities

• Considered the safest fixed-income investment
• Sold at periodic auctions
• Earnings exempt from state and local tax
  (principal of reciprocal immunity)
• 1,000 minimum with 1,000 increments

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U.S. Treasuries

• Types of Treasury Securities
• Bills 3-, and 6-month maturities
• Notes 2-, 5-, and 10-year maturities
• Bonds No longer available
• Can purchase through Treasury Direct at
  www.publicdebt.treas.gov
• Interest is credited electronically

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Municipal Bonds

• Debt of state/local governments or government
  entities
• Generally sold in 5,000 increments
• Two types
• General Obligation (GO) Bond
• Revenue Bond

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Municipal Bonds

• Interest is exempt from federal income tax
• Also state/city tax exemption- if issued by
  state/city of residence
• Attractive to taxpayers in 28 tax bracket and
  above
• Interest is paid semi-annually

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Corporate Bonds

• Bonds issued by for-profit companies to raise
  capital
• Generally sold in 1,000 increments
• Interest paid semi-annually
• Generally pay higher interest than government
  bonds with same maturity and credit rating

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Corporate Bonds

• Types of corporate bonds
• Mortgage Bond backed by a companys land and
  buildings
• Equipment Bond backed by company equipment
  (e.g., airplanes)
• Debenture backed only by a companys future
  earnings (most risk)

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Convertible Bonds

• Hybrid investment which has
• Upside potential of stock
• Downside protection of bonds
• Can be exchanged for specified number of common
  stock shares
• As stock price increases, bond value increases

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Convertible Bonds

• Trade-off converts to fewer shares of stock than
  you can buy for bond price
• Almost all convertible bonds are callable
• Available in 1,000 increments
• Can buy through convertible bond funds

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Zero-Coupon Bonds

• Pay no (zero) periodic interest
• Sold at a deep discount
• Eventually grows to face value
• Very volatile as interest rates change (if sold
  prior to maturity)

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Zero-Coupon Bonds

• Advantages
• Low up-front cost
• Predictable return
• Disadvantage
• Annual increase in value is taxable
• Can put zeros in an IRA or buy tax-exempt zeros
  to avoid this problem

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Unit Investment Trusts

• Professionally selected portfolio of similar
  securities
• Packaged and sold by brokerage firms
• No ongoing portfolio management
• Sold in 1,000 units

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UITs

• Investors promised periodic interest and return
  of principal at maturity
• Interest is taxable (except muni UITs)
• Advantage
• diversification and steady cash flow
• Disadvantages
• high upfront cost
• loss potential if sold prior to maturity

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Bond Mutual Funds

• Primary objective current income
• Corporate, municipal, and Treasury bond funds
  available
• Advantages diversification, liquidity,
  professional management, affordability
• Disadvantage no fixed maturity date

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Bond Mutual Funds

• Share price always subject to interest rate risk
• NAV decreases when interest rates rise
• Key selection criteria
• Historical performance
• Expense ratio (cost as of fund assets)
• Low cost option bond index fund

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Mortgage-Backed Securities

• Investments in mortgage portfolios
• Principal and interest passed through
• Ginnie Maes
• 25,000 initially, 5,000 increments
• Can also buy through UITs mutual funds
• Full faith credit guarantee
• Pay slightly more than Treasury bonds

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Mortgage Securities

• Other issuers (NOT government insured)
• Freddie Mac
• Fannie Mae
• Characteristics of mortgage securities
• uncertain maturity
• irregular monthly payments
• payments include a return of principal

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Collateralized Mortgage Obligations (CMOs)

• Another mortgage-backed security
• Sold in 1,000 increments
• Mortgage portfolio divided into tranches with
  varying maturity dates
• Longer-term tranches generally pay a higher
  return

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CMOs

• Each tranche gets its principal back when
  tranches before it are repaid
• Characteristics
• complexity
• unpredictable repayment of principal
• payments include a return of principal

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Fixed Annuities

• Contract with life insurance company
• Insurance company provides regular income
• Investor deposits lump sum or makes periodic
  payments
• Investment earnings grow tax-deferred until
  withdrawal

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Fixed Annuities

• Like a bank CD, only tax-deferred
• Guarantees a fixed rate of return for a fixed
  time period
• Generally 5,000 minimum investment
• Look for
• low expenses
• highly-rated insurance company

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Preferred Stock

• Technically a form of stock, but behaves like a
  bond
• Preferred stock owners paid before common stock
  owners if company liquidates
• Typically pays fixed dividend rate

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Preferred Stock

• Share prices vary inversely with interest rates
• Par value usually around 25 per share
• Round lot (100 shares) costs around 2,500
• Shares sold through brokerage firms

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Guaranteed Investment Contracts (GICs)

• Fixed-income contracts issued by insurance
  companies
• Pay fixed interest rate for specific time period
• Commonly offered as an investment option in
  401(k) plans
• Sometimes called stable value funds
• Always check rating of issuer

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Five Tips for Fixed-Income Investors

• 1. Know the risks
• 2. Beware of guarantees
• 3. Ladder your portfolio
• 4. Use zero-coupon bonds to hedge stock
  investments
• 5. Match investments with goals

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Action Steps

• Reduce expenses to find money to invest
• Calculate percentage of portfolio in fixed-income
  investments
• Investigate fixed-income investments available in
  employer savings plans
• Identify fixed-income investments that match
  goals and cash flow

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Action Steps

• Compare at least three specific products
• Determine if tax-exempt investments are
  appropriate for your tax bracket
• Get started today!