principle value of the security is adjusted for inflation. Also, TIPS pay interest semi-annually while the interest on I Bonds accrues over the life of the bond and is paid at redemption. Finally, TIPS are marketable securities that are traded in the secondary market (similar to stocks). On the other hand, I Bonds cannot be bought or sold in the secondary market. Rather, they can only be bought and subsequently redeemed from the Treasury Department. There is an early redemption penalty of three months interest for I Bonds redeemed within five years of purchase. Corporate Bonds. While corporate bonds come in many forms (i.e., debenture bonds, mortgage bonds, etc.), they generally have the same basic features. They are “certificates of debt” issued by private corporations usually in denominations of $1,000. They are backed by the company’s promise to pay a fixed percent of interest to the investor for a specified period of time. The interest rate on corporate bonds depends on both the current rate being charged to borrow money in the financial market and the company’s credit rating. A company having a good credit rating will pay a lower interest rate on their bonds because there is less risk involved for the investor. Debenture bonds are corporate bonds which are backed by the general reputation and credit standing of the company. On the other hand, corporate mortgage bonds are generally secured by a mortgage on specific company property, such as an office building or a manufacturing plant or facility. Municipal Bonds. Municipal bonds are generally issued by cities, states, school districts, and other government entities. The interest offered on these bonds is usually lower than corporate bond rates because the interest on municipal bonds is not subject to federal income tax. The overall credit rating of the municipal entity offering the bonds plays an important part in determining the interest rate they must pay. To attract bond buyers, a city with a low credit rating will have to offer a higher rate of interest than a city with a good rating. Municipal bonds are generally issued in minimum denominations of $5,000. The popularity of tax–free municipal bonds has resulted in the creation of several large municipal bond funds in which a group of investors pool their money to buy a variety of municipal bonds with different ratings, different maturities, and different purposes. These funds have established a tax–free investment opportunity for many people who were either unable to afford the $5,000 needed to buy a particular bond, or who did not understand enough about the bond market to get involved. The old adage “there’s safety in numbers” seems to prevail.
Bonds. Bonds are debt instruments sold in various denominations by large companies and government entities (federal, state, and local). They generally pay interest every six months and return their face or principle value at maturity. Default risk (the possibility of not getting your money) is dependent upon the financial strength of the issuer. Consequently, the risk characteristics of various bond issues cover a wide range from no risk treasury issues to high risk corporate junk bonds. Financial publishing organizations, such as Moody’s, provide a bond rating service which helps the investor understand the relative default risk of various bond issues. Based upon the issuer, there are three main categories of bonds: Government, Corporate, and Municipal. Government Bonds . The most popular U.S. Government bonds are Series EE and Series I. Both types of bonds are sold in various denominations at face value from $25 to $10,000 and have up to a 30 year maturity period. Series EE Bonds purchased between May 1997 and April 2005 earn a variable rate of interest while bonds purchased after April 2005 earn a fixed rate of interest. The interest on these bonds is collected when the bond is turned in. New EE Bonds are only available electronically through TreasuryDirect at www.treasurydirect.gov. Series I Bonds are inflation–indexed, accrual type securities. The inflation indexing feature of the bond provides for a semi-annual adjustment of the bond’s interest rate. The basic idea is to combine the certainty of a fixed income security with simultaneous protection against earnings lost from inflation. You may purchase I Bonds via TreasuryDirect or with your IRS tax refund. Treasury Inflation-Protected Securities (TIPS) are another popular government investment vehicle. These are marketable securities whose principle is adjusted for changes in the Consumer Price Index. The TIPS principle value is adjusted semi-annually and the investor receives the adjusted principle amount when the TIPS matures. For example, assume that in January you bought a $1,000 TIPS paying 3% interest. If by July inflation has gone up 2%, the first interest payment would be calculated on an adjusted principle of $1,020. In a period of deflation, the interest is calculated against a reduced principle amount. However, at maturity, you will never receive less then the original principle value. TIPS are issued in multiple increments of $100 with maturities of 5, 10, and 30 years. They are sold at TreasuryDirect and through banks and brokers. TIPS are different from I Bonds. With I Bonds the semi- annual interest rate is inflation indexed, while with TIPS the
CHAPTER 10: SAVINGS & INVESTMENTS
Made with FlippingBook. PDF to flipbook with ease