Bonds:
Other types of Bonds
Zero
coupon bonds (Zeros) - These bonds are issued at a deep discount from
face value (par value) and pay no periodic interest payments during their
term. At redemption, the bondholder receives par value, which includes the
interest that has accrued since issue. For example, you may purchase a zero
coupon bond with a six-year term for $6,500, and collect $10,000 at
maturity. One advantage of zeros is that you can invest relatively small
amounts and choose maturity dates to coincide with times you know you'll
need the money. For example, when college tuition bills will come due. One
drawback of zeros, however, is that income taxes are due annually on the
interest that accrues, even though you don't receive the actual payment
until the bond matures. The exception occurs if you buy tax-exempt municipal
zeros, on which no tax is due either during the term or at maturity. Another
drawback is that zero coupon bonds are volatile in the secondary market, so
if you have to sell before maturity, you might have a loss.
Agency bonds - Government sponsored but
privately owned corporations, including Fannie Mae and Freddie Mac, and
certain federal government agencies, including Ginnie Mae, raise money by
issuing bonds and short-term discount notes for sale to individual and
institutional investors. The money raised by selling these bonds, also
referred to as agency securities, is typically used to make reduced-cost
loans available to specific groups, including home buyers, students, or
farmers. Interest you earn on some-but not all-of these securities is exempt
from state and local income taxes, but it is always federally taxable. Bonds
issued by the federal agencies are backed by the government's full faith and
credit, just as US Treasury securities are, but bonds issued by the
sponsored corporations are generally not guaranteed. While these bonds often
deliver higher returns than Treasury securities because some of them are not
explicitly guaranteed by the federal government, they must often be
purchased from brokers, incurring a commission. They are considered very
safe investments because they would most likely be honored by the government
if default occurred. The most common agency bonds are mortgage-backed
securities.
Mortgage-backed securities are sold by a government agency such as Government
National Mortgage Association (know as Ginnie Mae) or by publicly held
corporations such as Federal National Mortgage Association (Fannie Mae). The
bonds are created when these sponsors buy up mortgages from lenders and packages
them for sale to the public. The money raised by selling the bonds is used to
buy additional mortgages, making more money available to lend.
An individual investor earns interest in
proportion to his stake in the entire pool. Therefore, an investment in a
mortgage-backed security is not tied to any one mortgage. The firm that
assembles the security takes a small fee and insures the pool against credit
risk. One type of mortgage-backed security, the mortgage pass-through security,
is identified by the fact that interest and principal payments are passed
through to the holder, instead of just interest. Payments to investors are
usually made on a monthly basis.
Mortgage-backed securities are
typically priced and traded on the basis of their "average life" rather than
their stated maturity. When mortgage rates fall, homeowners often prepay
mortgages, which may result in an earlier-than-expected return of principal to
an investor. This may reduce the average life of the investment. If mortgage
rates rise, the reverse may be true-homeowners will be slow to prepay and
investors may find their principal committed longer than expected.
Mortgage backed securities are a relatively low-risk investment vehicle.
Securities issued by the Government National Mortgage Association (Ginnie
Mae) are particularly safe because they are backed by the full faith and
credit of the U.S. government. One downside to these investments is the risk
of prepayment by borrowers, or paying back part or all of the loan before it
becomes due, which can lower returns by reducing the interest paid on a
given mortgage.
Ginnie Mae, Fannie Mae, Freddie Mac and Sallie Mae - The Government
National Mortgage Association (Ginnie Mae) is a government-owned agency that
buys mortgages from lending institutions, turns them into securities, and
then sells those securities to investors. Because the payments to investors
are guaranteed by the full faith and credit of the U.S. Government, they
return slightly less interest than other mortgage-backed securities.
The Federal National Mortgage Association (Fannie Mae) is a
congressionally chartered corporation which buys mortgages on the secondary
market, pools them and sells them as mortgage-backed securities to investors
on the open market. The securities contain both conventional mortgages and
mortgages insured by the Federal Housing Administration. Monthly principal
and interest payments are guaranteed by Fannie Mae but not by the U.S.
Government.
The Federal Home Mortgage Corporation (Freddie Mac) is similar to
Fannie Mae except that none of the pooled mortgages are FHA insured.
The Student Loan Marketing Association (Sallie Mae) creates
securities by purchasing student loans instead of mortgages. This is simply
another type of asset-backed security.
Collateralized Mortgage Obligations - Collateralized mortgage
obligations (CMOs) are backed by mortgage-backed securities with a fixed
maturity. They can eliminate the risks associated with prepayment because
each security is divided into maturity classes that are paid off in order.
As a result, they yield less than other mortgage-backed securities. The
maturity classes are called tranches, and they are differentiated by the
type of return. A given tranch may receive interest, principal, or a
combination of the two, and may include more complex stipulations.
One negative aspect of CMOs is the lower interest rates that compensate for
the reduction in prepayment risk and increased predictability of payments.
Also, CMOs can be quite illiquid, which can increase the cost of buying and
selling them.
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What are Brady Bonds?
Brady bonds arose from an
effort in the 1980s to reduce the debt held by less-developed countries that
were frequently defaulting on loans. The bonds are named for Treasury
Secretary Nicholas Brady, who helped international monetary organizations
institute the program of debt-reduction. Defaulted loans were converted into
bonds with U.S. zero-coupon Treasury bonds as collateral. Because the Brady
bonds were backed by zero-coupon bonds, repayment of principal was insured.
The Brady bonds themselves are coupon-bearing bonds with a variety of rate
options (fixed, variable, step, etc.) with maturities of between 10 and 30
years. Issued at par or at a discount, Brady bonds often include warrants
for raw materials available in the country of origin or other options.
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Secured vs. Unsecured Bonds
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