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Author: Lokicious Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35383  
Subject: Bond and F-I FAQs: Part 1 B Date: 2/14/2007 2:14 PM
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What Kinds of “Bonds and Fixed-Income” Investment Options Are There?
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”Cash-in” Options

• Savings Accounts
• Money Market Accounts
• CDs (Certificates of Deposit) (of various maturities)
• US Savings Bonds (I-Bonds and EE-Bonds)

Tradable Bonds

• US Treasury Bonds, Notes, and Bills (of various maturities)
• US Treasury Inflation Protected Securities (TIPS) (of various maturities)
• US Government Backed Mortgage Securities
• US Government Agency Securities
• Federal Tax-Exempt Municipal and State Bonds (“Munis”)
• Corporate Bonds (Investment Grade, “High-Yield” or “Junk”)
• International Bonds (Corporate or Government)

Bond Funds
• Indexed versus Selected Funds
• Passive versus Actively Managed (trading, leveraged) Funds
• Mutual Funds versus Exchange Traded Funds (ETFs)
• Short, Intermediate, Long (or mixed)
• Corporate, Treasury, Inflation Protected Securities, GNMA (or mixed)
• Municipal Bonds (Munis)
• “High-Yield” (“Junk”)
• International
• “Closed-End” Funds
• “Terminal Trusts”

Fixed and Inflation-Adjusted Annuities


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What are the major factors that need to be weighed in choosing between these options?
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• As with any investment, you are trying to maximize your “real” return (after taxes, expenses, and inflation), in this case “income” and (sometimes) capital gains.

• Factors to take into consideration that may interfere with seeking the highest possible available returns (e.g., just getting whatever has the highest yield) include:
---Risks to preserving your original principal (defaults, rising interest rates and calls decreasing the tradable value of bonds or fund share price);
---Taxes (the idea is to get the best after-tax return);
---Liquidity: Having access to income and principal when you want it, which means paying attention to maturity dates, penalties and restrictions on cashing in, and the potential for being forced to sell at a loss;
---Minimums: Many options require minimum investments of $1000 or more;
---Costs: Fees, trading costs, loads, expense ratios, etc.

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“'Income?'” Isn't This, Like, What Us Plain Folk Just Call Interest?
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• Yup! But there is a jargon favored by the fancy folks of finance and, if you want to play with their toys, you should learn to talk their game. Here is some terminology:
---“Income”: A general word for cash that is paid out by an investment on a regular basis (stock dividends, interest on a bank account, an annuity, rents from rental properties, dividends from bonds or funds, etc.). In some cases, you may choose to have income reinvested or you may not have access to the income until some specified date.
---“Interest”: The colloquial word used to represent an amount paid in cash on your invested principal or which you pay on money borrowed, now mostly used on the investment end on Savings and Checking Accounts. (“Interest rate” would be the % paid on the principal.)
---“Dividend”: The preferred word for “interest” paid not only by bonds and bond funds (as well as stocks and stock funds), but by such basic bank instruments as CDs and Money Market accounts.
---“Yield”: The rate of interest currently being paid on the principal you invested. Some investments have a fixed rate until they mature; others have a variable rate.
---“APY” or “Annual Percentage Yield”: The compound interest rate for a year (principally used with CDs), normally involving daily compounding.
---“Fixed-Rate”: A rate of interest that applies to an instrument until it matures or you cash it in. Some instruments, such as I-bonds and TIPS, combine a fixed and adjustable component.
---“Adjustable Rate”: Some instruments adjust the rate of interest paid, based on prevailing interest rates (e.g., money markets and bond funds), on an inflation component (I-bonds, TIPS, some annuities), or on returns on investments by the bank or other institution.

• Here are some additional terms you need to know to understand how income is paid from tradable bonds:
---“Face value”: The principal a bond returns to the investor when it matures (or is called), which may be more or less than the amount you paid to buy the bond.
---“Maturity”: The time left until a bond “matures” (i.e., when the issuer has to pay back the face value of the bond).
---“Coupon”: The interest rate a tradable bond pays based on its “face-value.” If you buy the bond for more or less than its face-value, your actual yield (the interest rate you get for the amount of principal you invested) will be more or less than the bond's coupon rate.
---“Par”: Buying a bond at its face value.
---“Premium”: Paying more for a bond than its face value (also used for closed-end funds relative to the net asset values of their holdings).
---“Discount”: Buying a bond for less than its face value (also for closed-end funds)
---“Current Yield”: Coupon divided by the price paid for the bond. Usually this just is called “yield” or sometimes “simple yield.”
---“Adjusted-Current Yield”: The “current yield” plus or minus the difference between price of the bond and its face value, averaged over the remaining life of the bond. This is probably the best measure for comparison with yields on CDs, bonds bought at or near par, and bond funds.
---“Yield-to-Maturity”: The (annualized) yield you would get if you held a bond until maturity, factoring in the difference between the bond's face value and how much you paid for it, plus a compounding factor (estimated) from how much of a return you will get from reinvesting the dividends at prevailing interest rates. Though an approximation, this is the best basis for comparison with (annualized) compounded interest on “cash-in” options.
---“Call Date”: A date when the issuer of a bond has the right to pay back the face value (sometimes slightly more or less) of the bond, which may be long before the Maturity date. Bonds will typically be called if interest rates go down, because the issuer can then issue new bonds at a lower rate. Some bonds have more than one call date.
---“Yield-to-Call”: Annualized yield, factoring in how much you paid, until the date at which a bond may be 'called,” plus a compounding factor. A variant of this is “yield-to-worst,” which is the worst yield you will get given different call dates (especially important if you are buying at a “premium”).

• A Little More about Yield to Maturity:
---Yield to maturity is the total return on the bond divided by your investment (what you paid for it) averaged over the time between when you buy the bond and when it matures.
---Total return has three components: The total amount of dividends paid from time of purchase to maturity; the difference (plus or minus) between the bond's face value and what you paid for it; and the compounding from the dividends being reinvested.
---The compounding component is important because there may be a large difference between the bond's coupon rate and prevailing interest rates (for new bonds, Money Markets, etc.) at any given time. For example, a bond paying 12%, results in much more compounding than a bond paying 5%, even if dividends from both are reinvested at the same rate.
---The rub is that there is no way of knowing exactly at what rate dividends will be reinvested, since they get paid every six months over a number of years and prevailing interest rates change, sometime dramatically. So calculating YTM is pretty much of a crapshoot, and the YTMs listed when purchasing bonds are likely to be inconsistent and unreliable.

• For more on calculating yield and yield to maturity, see: http://www.investopedia.com/university/advancedbond/advancedbond3.asp

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What are “Interest Rates” and why doesn't what they say on the News make any sense?
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• “Interest Rates” is a vague term referring to various rates of interest that are currently being charged by lenders or paid to investors.
---These range from the “Discount Rate,” proposed as a target by the Federal Reserve (a very short term rate that gets a lot of press) to mortgage rates to yields on Treasury Securities of different maturities.
---It is important not to confuse what you hear about “interest rates” in general with the specific interest rate that applies to a particular bond, bond fund, or other investment or debt.
---The Federal Reserve rate does not directly determine mortgage rates or yields on Treasury Bonds.
---Changes in the Federal Reserve rate usually have a stronger, more-immediate, indirect impact on short-term rates (including for Credit Cards) than on long-term rates.

• “Basis Points” is term used when speaking of interest rates or yields that, once you understand it, is less confusing than “percentage.”
---Basis points are percentage points measured in hundredths (100 basis points = 1 percentage point; 25 basis points = 0.25 percentage points).
---Note, when referring to changes in interest rate, we usually do not mean the change as a percent of the original rate, but changes in percentage points (from 4% to 5% is a change of 1 percentage point or 100 basis points, even though it is a change of 25% from the original rate).

If it isn't just the Federal Reserve, how are Interest Rates set?

• Interest rates are determined by supply and demand for debt financing.
---Supply and demand is specific for different maturities and qualities, though there is a finite supply of capital available for debt financing.

• The supply of capital comes from various sources:
---Individuals putting money into banks or buying bonds or savings bonds or shares in bond funds;
---Institutions (insurance companies, pension plans, etc.) buying bonds;
---Foreigners, foreign institutions, or foreign governments buying bonds (including with money from US trade deficit);
---Surplus contributions to Social Security (and some other US government surpluses);
---The Federal Reserve printing money to loan to banks for less than they loan the money out to those seeking debt financing;
---Foreign central banks (e.g., Bank of Japan) loaning money at low interest rates that can then be reinvested in the US for higher rates;
---Etc.

• Demand for debt financing comes from:
---The US Government's “general fund”;
---State and local government;
---US Government Agencies;
---Other national governments;
---U.S. and foreign corporations;
---Small businesses;
---Individuals (including mortgages, credit cards, big ticket items);
---Etc.

• The amount of capital available for debt financing not only depends on how much total capital is available (nowadays, on a world-wide basis), but also on what percentage of that capital is made available for debt financing, as opposed to equities, commodities, real estate, etc., with derivatives now playing an important part.

• The upshot is that it is very difficult to predict what will happen to interest rates, even if we can identify specific factors that contribute to supply and demand (such as foreign governments buying Treasury Bonds and mortgage securities, flight from stocks to bonds during panics, looming end of the Social Security surplus, government deficits, demand for mortgages, etc.).
---However, if we understand these factors, as well as have a sense of historical rates for different maturities and risk categories, we can make better decisions in choosing between alternatives.


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How do different "Qualities" and maturities affect yields?
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• If we lend someone money, we expect to be paid back, and the higher the risk we won't be paid back, the more interest we will demand (as any self-respecting loan-shark will tell you).
• Also, since tying up money for a longer time involves more risk of default as well as risk of the principal shrinking against inflation and the likelihood we will need to draw on the principal, we normally would demand to be paid more interest for waiting longer to get our principal back.

• Quality is the general term used for the risk a bond will default.
---This risk is assessed by various bond-rating agencies (Moody's, Fitch, S&P), using slightly different letters in their rating schemes. The higher the rating, the less likely the bond is considered to be a default risk. S&P's ratings range from AAA (highest) down to D.
---Investment Grade is anything rated above BB.
---High Yield/Junk is anything rated BB or below.
---Risk Premium refers to the amount of yield paid by lower rated bonds compared to bonds of similar maturities of lower risk.
---We can compare the current risk premiums on different bonds (e.g., the yield on a 10-year Treasury Bond with the yield on a 10-year BB- rated bond).
---For historical risk premiums, compare yields on AAA, Baa, and Treasuries of different maturities using this link (Corporate Bonds are toward the bottom). http://www.federalreserve.gov/releases/h15/data.htm

• Maturity is the length of time until a bond or other instrument matures:
---“Short-term” refers to bonds of shorter maturities, sometimes restricted to maturities of under 1-year but applied, with bond funds, to anything under about 3-years. (“Ultra-short” is used for maturities under 3-6 months.)
---“Long-term” refers to bonds of longer maturities, generally over 10-years.
---Bonds maturing within 3-10 years are usually considered “intermediate.”

• “Yield Curve” refers to the relative amounts of interest paid by the same type of bond of different maturities.
---Usually, long-term rates will be higher than short-term rates for the reasons outlined above.
---A “flat” yield curve means both long and short-term interest rates are quite close.
---An “inverted” yield curve means short-term interest rates are higher than long-term interest rates. (Historically, an inverted yield curve has often occurred shortly before a recession, but not always).
---See this “Living Yield Curve” link for one way of visualizing the yield curve historically: http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve
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