A municipal bond or municipal bond fund is suitable for an investor that wants income that is free from federal income tax. This is not an acceptable investment for a tax deferred account like a Traditional or Roth IRA. The information in presented in 4 sections: issuers, holders (investors), taxes, and risk.
Municipal bond issuers
Municipal bonds are issued by states, cities, and counties, or their agencies (the municipal issuer) to raise funds. The methods and traces of issuing debt are governed by an extensive system of laws and regulations, which vary by state. Bonds bear interest at either a fixed or variable rate of interest, which can be subject to a cap known as the maximum legal limit. The issuer of a municipal bond receives a cash payment at the time of issuance in exchange for a promise to repay the investors who provide the cash payment (the bond holder) over time. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer.
Municipal bond holders
Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an upfront investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself. Repayment schedules differ with the type of bond issued. Municipal bonds typically pay interest semi-annually. Shorter term bonds generally pay interest only until maturity; longer term bonds generally are amortized through annual principal payments. Longer and shorter term bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, known as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.
Taxability
One of the primary reasons municipal bonds are considered separately from other types of bonds is their special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt from all federal taxes, as well as state or local taxes depending on the state in which the issuer is located. The type of project or projects that are funded by a bond affects the taxability of income received on the bonds held by bond holders. Interest earnings on bonds that fund projects that are constructed for the public good are generally exempt from federal income tax, while interest earnings on bonds issued to fund projects partly or wholly benefiting only private parties, sometimes referred to as private activity bonds, may be subject to federal income tax.
Risk
The risk ("security") of a municipal bond is a measure of how likely the issuer is to make all payments, on time and in full, as promised in the agreement between the issuer and bond holder. Different types of bonds are secured by various types of repayment sources, based on the promises made in the bond documents. The probability of repayment as promised is often determined by an independent reviewer, or "rating agency". The three main rating agencies for municipal bonds in the United States are Standard & Poor's, Moody's, and Fitch. These agencies can be hired by the issuer to assign a bond rating, which is valuable information to potential bond holders that helps sell bonds on the primary market.
The only risk is default risk with the issuer being unable to repay the full amount. Bonds issued by California with budget problems, and other states with high unemployment, should be avoided. You can reduce this risk by investing in a mutual fund rather than an individual bond.
Sunday, August 30, 2009
US Treasury Bonds
HISTORY LESSON:
The U.S. government knew that the costs of World War I would be great, and the question of how to pay for the war was matter of intense debate. The resulting decision was to pay for the war with a balance between higher taxes and government debt. Traditionally, the government borrowed from other countries, but there were no other countries from which to borrow in 1917: U.S. citizens would have to fully finance the war through both higher taxes and purchases of war bonds. The Treasury raised funding throughout the war by floating $21.5 billion in 'Liberty bonds.'
TYPES
A United States Treasury security is a government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States Federal government, and they are often referred to simply as Treasuries. There are four types of marketable treasury securities: Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation Protected Securities (TIPS).
Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity. Many regard Treasury bills as the least risky investment available to U.S. investors. Regular weekly T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks, about 1 year).
Treasury notes (or T-Notes) mature in two to ten years. They have a coupon payment every six months, and are commonly issued with maturities dates of 2, 3, 5, 7 or 10 years, for denominations from $100 to $1,000,000.
Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from twenty years to thirty years. There are 2 types, a coupon bond with payment every six months like T-Notes, or a without a coupon called a zero coupon bond. They are commonly issued with maturity of thirty years. The secondary market is highly liquid.
Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 10-year and 20-year maturities. This is not good for a long term growth investment.
TREASURY YIELD CURVE
The different time durations have different interest rates and when plotted on a graph form a curve. Some of the rates from yesterday are: 3 month = 0.15%, 6 month = 0.24%, 2 year = 1.06%, 5 year = 2.50%, 10 year = 3.57%, and 30 year = 4.43%. Note that the rate grows with time to compensate for the time risk of holding for a longer time period. This is normal and the shape is called a normal yield curve.
INTEREST RATE CHANGES AND LONG TERM BONDS
The price of the bond changes with the interest rate and the longer the time duration the bigger the change. To best illustrate this point, a 30 year zero coupon will be used. The value of the bond, the price to buy or sell, is shown below for different interest rates.
1% = $749, 2% = $563, 3% = $424, 4% = $320, 5% = $243
6% = $185, 7% = $140, 8% = $107, 9% = $82, 10% = $63
Notice how fast the value drops with rising interest rate. Imagine buying a $1,000 bond with interest rates are at 4%, about like now, and paying $320 and then selling it when the interest rate is at 5% and only having a value of $243 and losing 25% of your money, OUCH. Imagine buying a $1,000 bond with interest rates are at 7% and paying $140 and then selling it when the interest rate is at 5% and having a value of $243 and making 70% of your money, BEAUTIFUL. To get a capital gain you want to buy long bonds when interest rates are falling.
What is the bottom line: With the massive amount of US government spending and having a record deficit, $1.27 trillion so far this year, $180.7 billion in July alone, interest rates are going to go up. DO NOT OWN LONG TERM BONDS NOW, YOU ACCOUNT WILL GO OUCH!!!!!!!!
The U.S. government knew that the costs of World War I would be great, and the question of how to pay for the war was matter of intense debate. The resulting decision was to pay for the war with a balance between higher taxes and government debt. Traditionally, the government borrowed from other countries, but there were no other countries from which to borrow in 1917: U.S. citizens would have to fully finance the war through both higher taxes and purchases of war bonds. The Treasury raised funding throughout the war by floating $21.5 billion in 'Liberty bonds.'
TYPES
A United States Treasury security is a government debt issued by the United States Department of the Treasury through the Bureau of the Public Debt. Treasury securities are the debt financing instruments of the United States Federal government, and they are often referred to simply as Treasuries. There are four types of marketable treasury securities: Treasury bills, Treasury notes, Treasury bonds, and Treasury Inflation Protected Securities (TIPS).
Treasury bills (or T-bills) mature in one year or less. Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity. Many regard Treasury bills as the least risky investment available to U.S. investors. Regular weekly T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks, about 1 year).
Treasury notes (or T-Notes) mature in two to ten years. They have a coupon payment every six months, and are commonly issued with maturities dates of 2, 3, 5, 7 or 10 years, for denominations from $100 to $1,000,000.
Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from twenty years to thirty years. There are 2 types, a coupon bond with payment every six months like T-Notes, or a without a coupon called a zero coupon bond. They are commonly issued with maturity of thirty years. The secondary market is highly liquid.
Treasury Inflation-Protected Securities (or TIPS) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index, the commonly used measure of inflation. The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation. TIPS are currently offered in 5-year, 10-year and 20-year maturities. This is not good for a long term growth investment.
TREASURY YIELD CURVE
The different time durations have different interest rates and when plotted on a graph form a curve. Some of the rates from yesterday are: 3 month = 0.15%, 6 month = 0.24%, 2 year = 1.06%, 5 year = 2.50%, 10 year = 3.57%, and 30 year = 4.43%. Note that the rate grows with time to compensate for the time risk of holding for a longer time period. This is normal and the shape is called a normal yield curve.
INTEREST RATE CHANGES AND LONG TERM BONDS
The price of the bond changes with the interest rate and the longer the time duration the bigger the change. To best illustrate this point, a 30 year zero coupon will be used. The value of the bond, the price to buy or sell, is shown below for different interest rates.
1% = $749, 2% = $563, 3% = $424, 4% = $320, 5% = $243
6% = $185, 7% = $140, 8% = $107, 9% = $82, 10% = $63
Notice how fast the value drops with rising interest rate. Imagine buying a $1,000 bond with interest rates are at 4%, about like now, and paying $320 and then selling it when the interest rate is at 5% and only having a value of $243 and losing 25% of your money, OUCH. Imagine buying a $1,000 bond with interest rates are at 7% and paying $140 and then selling it when the interest rate is at 5% and having a value of $243 and making 70% of your money, BEAUTIFUL. To get a capital gain you want to buy long bonds when interest rates are falling.
What is the bottom line: With the massive amount of US government spending and having a record deficit, $1.27 trillion so far this year, $180.7 billion in July alone, interest rates are going to go up. DO NOT OWN LONG TERM BONDS NOW, YOU ACCOUNT WILL GO OUCH!!!!!!!!
Corporate Bonds
As of 2006, the size of the outstanding U.S. bond market debt was $25.2 trillion. Nearly all of the $923 billion average daily trading volume (as of early 2007) in the U.S. bond market takes place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. The New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly corporate bonds.
For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds fall, since new issues pay a higher yield. When interest rates decrease, the value of existing bonds rise, since new issues pay a lower yield. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes.
Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends, of course, upon the particular corporation issuing the bond, the current market conditions and governments to which the bond issuer is being compared and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds.
Key Point #1: Companies, such as Moody's and Standard and Poors, rate the risk of the bond. Companies with top ratings of A or better are called investment grade and those rated lower are called junk grade. Junk bonds have more risk and compensate the investor by paying a higher rate. The difference above the investment grade bond is called a spread. Conservative investors will choose to invest in primarily investment grade bonds or a mutual fund that invests primarily in investment grade bonds.
Key Point #2: You can make money by holding the bond to maturity and getting the interest that is paid every 6 months called the coupon payment. You can make money by buying and selling bonds and getting a capital gain on the face value of the bond.
Key Point #3: Normally, when interest rates go up the coupon payment stays constant, and the face value of the bond goes down and vice versa. Another factor, key point #4, is the risk of default can also drop the face value of the bond. Interest rate changes are more important for bonds that have a long time to maturity and less important for a shorter term duration. You can mitigate this risk by selecting short term bonds or mutual funds that invest in short term bonds.
Key Point #4: Bond holders have a risk of not getting paid full value. For example owners of GM bonds got paid about half of the face value. When the economy enters a recession and companies can go out of business the face value drops and the drop can be much larger than the gain from the dropping interest rate. This is what happened in 2008 and early 2009 and why virtually every corporate bond dropped in value.
Key Point #5: An investor needs to know where we are in the Business Cycle when investing.
Bottom Line: Given where we are in the Business Cycle, we have much less risk of a default. Face values that dropped last year should be recovered or recovering. Interest rates are rising so staying on the short time duration to maturity makes sense. A conservative investor should pursue a mutual fund with primarily investment grade bonds while a more aggressive investor should pursue a mutual fund with primarily junk bonds.
For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds fall, since new issues pay a higher yield. When interest rates decrease, the value of existing bonds rise, since new issues pay a lower yield. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes.
Compared to government bonds, corporate bonds generally have a higher risk of default. This risk depends, of course, upon the particular corporation issuing the bond, the current market conditions and governments to which the bond issuer is being compared and the rating of the company. Corporate bond holders are compensated for this risk by receiving a higher yield than government bonds.
Key Point #1: Companies, such as Moody's and Standard and Poors, rate the risk of the bond. Companies with top ratings of A or better are called investment grade and those rated lower are called junk grade. Junk bonds have more risk and compensate the investor by paying a higher rate. The difference above the investment grade bond is called a spread. Conservative investors will choose to invest in primarily investment grade bonds or a mutual fund that invests primarily in investment grade bonds.
Key Point #2: You can make money by holding the bond to maturity and getting the interest that is paid every 6 months called the coupon payment. You can make money by buying and selling bonds and getting a capital gain on the face value of the bond.
Key Point #3: Normally, when interest rates go up the coupon payment stays constant, and the face value of the bond goes down and vice versa. Another factor, key point #4, is the risk of default can also drop the face value of the bond. Interest rate changes are more important for bonds that have a long time to maturity and less important for a shorter term duration. You can mitigate this risk by selecting short term bonds or mutual funds that invest in short term bonds.
Key Point #4: Bond holders have a risk of not getting paid full value. For example owners of GM bonds got paid about half of the face value. When the economy enters a recession and companies can go out of business the face value drops and the drop can be much larger than the gain from the dropping interest rate. This is what happened in 2008 and early 2009 and why virtually every corporate bond dropped in value.
Key Point #5: An investor needs to know where we are in the Business Cycle when investing.
Bottom Line: Given where we are in the Business Cycle, we have much less risk of a default. Face values that dropped last year should be recovered or recovering. Interest rates are rising so staying on the short time duration to maturity makes sense. A conservative investor should pursue a mutual fund with primarily investment grade bonds while a more aggressive investor should pursue a mutual fund with primarily junk bonds.
Mortgage Backed Bonds
Mortgage bonds are issued by 3 agencies: FNMA, FHLMC, and GNMA also known as Fannie, Freddie, and Ginnie. These are not the names of 3 donkeys.
The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a stockholder-owned corporation chartered by Congress in 1968 as a government-sponsored enterprise (GSE), but founded in 1938 during the Great Depression. The corporation's purpose is to purchase and securitize mortgages in order to ensure that funds are consistently available to the institutions that lend money to home buyers.
The Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac, is a government sponsored enterprise (GSE) of the United States federal government. Freddie Mac has its headquarters in the Tyson's Corner CDP in unincorporated Fairfax County, Virginia.
The Government National Mortgage Association (GNMA, also known as Ginnie Mae) is a U.S. government-owned corporation within the Department of Housing and Urban Development (HUD).
In 1968, the government converted Fannie Mae into a private shareholder-owned corporation in order to remove its activity from the annual balance sheet of the federal budget. Consequently, Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Government National Mortgage Association (Ginnie Mae). In 1970, the government created the Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, to compete with Fannie Mae and, thus, facilitate a more robust and efficient secondary mortgage market.
Fannie Mae receives no direct government funding or backing; Fannie Mae securities carry no government guarantee of being repaid. This is explicitly stated in the law that authorizes GSEs, on the securities themselves, and in many public communications issued by Fannie Mae. Neither the certificates nor payments of principal and interest on the certificates are guaranteed by the United States government. The certificates do not constitute a debt or obligation of the United States or any of its agencies or instrument other than Fannie Mae.
Ginnie Mae provides guarantees on mortgage-backed securities (MBS) backed by federally insured or guaranteed loans, mainly loans issued by the Federal Housing Administration, Department of Veterans Affairs, Rural Housing Service, and Office of Public and Indian Housing. Ginnie Mae securities are the only MBS that are guaranteed by the United States government. GNMA securities thus have the same credit rating as the government of the United States and for capital purposes have risk-weighting of zero.
On September 7, 2008, James Lockhart, director of the Federal Housing Finance Agency (FHFA), announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA. As of 2008, Fannie Mae and the Federal Home Loan Mortgage Corporation (Freddie Mac) owned or guaranteed about half of the U.S.'s $12 trillion mortgage market.
A key point to remember is that only GNMA bonds are guaranteed by the US government which makes them the choice for anyone wanting to invest in mortgage backed bonds. These are good investments for a conservative investor.
The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a stockholder-owned corporation chartered by Congress in 1968 as a government-sponsored enterprise (GSE), but founded in 1938 during the Great Depression. The corporation's purpose is to purchase and securitize mortgages in order to ensure that funds are consistently available to the institutions that lend money to home buyers.
The Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac, is a government sponsored enterprise (GSE) of the United States federal government. Freddie Mac has its headquarters in the Tyson's Corner CDP in unincorporated Fairfax County, Virginia.
The Government National Mortgage Association (GNMA, also known as Ginnie Mae) is a U.S. government-owned corporation within the Department of Housing and Urban Development (HUD).
In 1968, the government converted Fannie Mae into a private shareholder-owned corporation in order to remove its activity from the annual balance sheet of the federal budget. Consequently, Fannie Mae ceased to be the guarantor of government-issued mortgages, and that responsibility was transferred to the new Government National Mortgage Association (Ginnie Mae). In 1970, the government created the Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, to compete with Fannie Mae and, thus, facilitate a more robust and efficient secondary mortgage market.
Fannie Mae receives no direct government funding or backing; Fannie Mae securities carry no government guarantee of being repaid. This is explicitly stated in the law that authorizes GSEs, on the securities themselves, and in many public communications issued by Fannie Mae. Neither the certificates nor payments of principal and interest on the certificates are guaranteed by the United States government. The certificates do not constitute a debt or obligation of the United States or any of its agencies or instrument other than Fannie Mae.
Ginnie Mae provides guarantees on mortgage-backed securities (MBS) backed by federally insured or guaranteed loans, mainly loans issued by the Federal Housing Administration, Department of Veterans Affairs, Rural Housing Service, and Office of Public and Indian Housing. Ginnie Mae securities are the only MBS that are guaranteed by the United States government. GNMA securities thus have the same credit rating as the government of the United States and for capital purposes have risk-weighting of zero.
On September 7, 2008, James Lockhart, director of the Federal Housing Finance Agency (FHFA), announced that Fannie Mae and Freddie Mac were being placed into conservatorship of the FHFA. As of 2008, Fannie Mae and the Federal Home Loan Mortgage Corporation (Freddie Mac) owned or guaranteed about half of the U.S.'s $12 trillion mortgage market.
A key point to remember is that only GNMA bonds are guaranteed by the US government which makes them the choice for anyone wanting to invest in mortgage backed bonds. These are good investments for a conservative investor.
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