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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 35400  
Subject: Bond and F-I FAQs: Part 3 C Date: 2/14/2007 2:26 PM
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Government-Backed Mortgage Securities and Agency Bonds
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What Are Government-Backed Mortgage Securities?

• When consumers take out government-backed mortgages from banks and other lenders, the loans are pooled, repackaged, and sold to the public (and to funds, etc.) in the form of mortgage securities (“pass-through certificates”).

• Some of these are offered by the Government National Mortgage Association (GNMA or “Ginnie Mae”), “supported by the full faith and credit of the U.S. government.”

• Others are sold by the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), nicknamed Fannie Mae and Freddy Mac, both former government agencies, now publicly traded companies.
---Fannie and Freddie are rated AAA, but it is worth reading news stories about accounting practices and questionable loan portfolios, since these companies do not have the same government guarantees as the HUD-based GNMA.
---There is also a Federal Agricultural Mortgage Association (Farmer Mac).

• For more information, look under US Government Agency Bonds on this bondonline link: http://www.bondsonline.com/Educated_Investor_Center/Types_of_Bonds.php


How Do I Buy Mortgage Securities?

• GNMA bonds can be bought periodically as new issues for a minimum of $25,000.

• Fannie and Freddie bonds can be bought in $1000 increments, and new issues are available (with no commission at some brokerages).

• All can be bought and sold on the open market, although Fannie and Freddy bonds are more common.


How Do Mortgage Securities Work?

• Although mortgage securities are issued with a maturity date and coupon payment, like other bonds, they are different in having continuous call provisions and paying off the principal in bits and pieces.

• When a homeowner sells a house, pays off a mortgage early, or refinances, the mortgage ends, and a portion of a mortgage security that owns that mortgage is called.

• The bondholder then receives part of the principal, and future interest payments are based on the remaining principal.
---By time a 30-year mortgage security matures, there may be little left of the principal to be returned.

Are Mortgage Securities a Good Investment?

• Historically, mortgage securities have been popular with investors, because they have paid higher interest (around 100 basis points more on the average) than long and intermediate term Treasuries, with almost as little risk of default.
---Even the periodic prepayment of principal was manageable, since it came in gradually over a long time.

• However, historically most people took out 30-year mortgages and moved infrequently.
---Now, adjustable rate and “creative” mortgages are a widely used, homeowners refinance frequently to take advantage of lower interest rates or to cash out the equity in their homes, and moving is commonplace.
---The result is that mortgage securities are much more subject to being called in bits and pieces than in the past.

• Refinancing tends to occur much more frequently when interest rates are declining.
---This means the bondholder is likely to have large portions of the principal returned when “reinvestment risk” (lower yields) is high.

• On the other hand, refinancing is less likely when interest rates are going up, while the tradable value of the bond is going down.
---This does not affect those who hold the bond to maturity, but the combination of refinancing during declining interest rates and loss of value during rising interest rates takes a considerable toll on bond funds that hold mortgage securities.

Are Bonds Offered by Other Government Agencies?

• Bonds are issued by other government agencies, such as the Tennessee Valley Authority (TVA), The Student Loan Marketing Association (Sally Mae), and The Small Business Administration (SBA).

• These are AAA bonds, usually with call provisions, but without the continuous call and refinancing risk of mortgage securities.
---Look for listings under “Agency Bonds.”

• Agency bonds are not subject to state income tax in most states.
---Mortgage bonds are taxed in full.


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Zero Coupon Bonds and “Strips”
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What Are Zero-Coupon Bonds?

• Most bonds pay dividends on a regular basis, which then need to be reinvested if you want to get compounding.

• If you don't need to spend the dividends and do not want to reinvest, there are some bonds that don't pay dividends and effectively let you compound interest within the bond until it matures, as with CDs or US Savings Bonds.
---This gives you a predictable return, without “reinvestment risk.”

• The way this works is, you buy the bond at a considerable discount to face value.
---When the bond matures, you get back the face value.
---In this way, you can have a precise idea of what your annualized return will be.
---For example, if you buy a bond that matures in 20 years at 50% face value, your annualized return will be 5% per year, about the same as a 3.5% (compounded) EE-bond.

• Although you won't receive any money until maturity, in a taxable account, the IRS does require you to pay taxes on “imputed interest” (as with the inflation adjustment on TIPS).

• Without regular dividend payments, the salable values of Zeros are more sensitive to changes in interest rates than coupon bonds, making them popular with active traders.

• For more on “Zeros,” see
http://www.precision-info.com/bondsonline/tut-2081443166-1.html

Who Issues Zero-Coupon Bonds and Where Can I Buy Them?

• Zero-Coupon Bonds are issued by corporations and municipalities, in lieu of, or in addition to, dividend-paying bonds.
---This allows them to delay any repayment until maturity.

• Because you are not receiving regular dividend payments, there is greater risk of loss if a company or municipality defaults, which should mean you can get a somewhat higher return (if it doesn't default) than on the analogous coupon bond.

• “Strips” are zero-coupon Treasuries sold by brokerages, who buy Treasuries from the government, strip off the coupons, then resell the stripped Treasury at a discount to face value.

• For more information on Strips, see:
http://www.precision-info.com/bondsonline/tut-964763405-2.html

• Zeros and Strips are bought and sold on the open market.


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Tax-Exempt Municipal (“Muni) Bonds
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What Are Municipal Bonds?

• Just like the federal government, state and local governments (municipalities) sometimes need to borrow money, usually to fund special projects where they want to spread the costs over a number of years.

• The money is borrowed in the form of debt securities, known in the trade as Municipal Bonds (Munis).

• Munis are exempt from federal taxes and from taxes in the states and local communities from which they are issued.

• This tax advantage means Muni bonds can be issued with much lower dividend payments than Treasuries, corporate bonds, CDs, etc., because the effective after-tax yields can still be better (which means state and local governments can borrow for less).

Oh Goody, I Won't Have to Pay Taxes, so, What's the Catch?

• Well, what we just said: lower dividends.

• The key is whether in your own, personal, tax situation, your after-tax return will be higher with Munis or with other options of similar risk and maturity.

• Assuming your tax situation remains constant, the calculation is easy.
---Multiply the yield on a Muni bond by 100% plus the % in taxes you would pay on the option to which you are comparing.
---Alternatively, multiply the taxable option by 100% minus the % taxed to get after-tax yield.
---For example, a 4.8% CD with 25% federal bracket and 5% state tax is the equivalent of a 3.2% state tax exempt Muni. A 4.4% Treasury with 25% federal bracket (no state tax) is the equivalent of a 3.3% state tax-exempt Muni.

• Historically, Munis have been geared toward the well-to-do, with a wider applicability only where state and local taxes are very high.
---However, it is always worth crunching the numbers.

• Caution: some Munis are exempt from the Alternative Minimum Tax (AMT), others not.


How Risky Are Munis?

• Like corporate bonds, Muni bonds are given credit ratings.
---Normally higher credit ratings translate into lower yields.

• Some Muni bonds are insured, which means the insurer (who usually is a much bigger financial institution than the bond issuer seeking insurance) guarantees the bond against default.

• Some Munis are low-rated, “high-yield” bonds.

• Historically, Muni bonds have been a better risk than corporate bonds of a similar rating.

• Caution: some states and municipalities have been under their greatest financial stress since the Great Depression, and many have future pension and retiree health obligations they cannot possibly pay.


Where Can I Buy Muni Bonds?

• Muni bonds are bought on the open market, through bond desks at brokerages.

• Muni bonds, especially if you are looking for ones that are exempt from state and local taxes, tend to be hard to find (also hard to sell), and may require help from a broker who specializes in this area and may have higher commissions and mark-ups.


Are There Muni Bond Funds?

• Yes, there are bond funds devoted to Tax-Exempt Municipal Bonds.

• Some of these are national Muni Funds, where the focus is on exemption from federal taxes.

• There are also some state specific Muni funds, mostly for states with high income tax rates.

• Muni funds may be available with different maturities (short, intermediate, long) and with insured or uninsured Muni bonds.

• Some funds specialize on “high-yield” Muni bonds

• Be sure to check about AMT on the Munis held by a fund.

• Vanguard has an extensive set of no-load Muni Funds
http://flagship5.vanguard.com/VGApp/hnw/FundsByType#3

• For discussion of how “interest rate risk” and other risks affect bond funds, see the part of the FAQs about bond funds.
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