Vous êtes sur la page 1sur 205

c  

Investinginbonds.com is a rich resource for people at every point on the investing spectrum. This site
offers valuable information, real time data, important indicators, as well as market news and commentary.
Whether you are just beginning to think about investing in bonds or you are a seasoned investor, this site
can answer your questions and provide you with the tools you need to invest in the bond market.
Bookmark this page and return to view frequent content additions, and visit the Market at a Glance pages
for current market data.

  



R Start out by learning about Bond Basics²what bonds are and what role they can play in your
portfolio.
R Then take the next step with the What You Should Know section, which builds on what you¶ve
learned in Bond Basics. Here you will learn more about the debt markets and how external
factors can affect your bond investments. This segment also offers a helpful Investor¶s Checklist
which can equip you to begin investing in bonds.
R Next learn about what Types of Bonds you can invest in.
R If you are prepared to invest in debt securities visit our Buying and Selling Bonds. Gain market
and investment insights in our Bond Investment Strategies section
R The Bonds at Your Stage of Life section answers questions about how much of your portfolio
should be invested in bonds at each stage of life.

     



R Would you like to boost your bond knowledge? Are you looking for more information on the key
bond markets sectors? Learn more about individual bond types and markets at:
÷ About Municipal Bonds
÷ About Government/Agency Bonds
÷ About Corporate Bonds
÷ About MBS/ABS
R Do you want to look up a municipal or corporate bond price or check the latest government bond
market commentary? Get news, commentary and a real-time picture of what the individual bond
markets are doing on the Market at a Glance sections for each type of bond offering. Click on the
navigation selections at the top or left to choose your next step.
R If you are prepared to invest in debt securities visit the Buying and Selling Bonds segment which
includes a helpful Investor¶s Checklist. Gain market and investment insights through the Bond
Investment Strategies section.
R The Bonds at Your Stage of Life section answers questions about how much of your portfolio
should be invested in bonds at each stage of life.

G  
                    
           ?              ?
            What is it?        
   Why Do I Care?

3
   



R Get price data, indexes and indicators, and market commentary by visiting links to individual bond
markets on the Market at a Glance sections.
R If you are prepared to invest in debt securities visit our Buying and Selling Bonds. Gain market
and investment insights in our Bond Investment Strategies section.
R The Bonds at Your Stage of Life section answers questions about how much of your portfolio
should be invested in bonds at each stage of life.

Investinginbonds.com can help you build, monitor and manage your wealth wisely. Use this site to learn
more about bonds and keep up to date on the bond markets. Bookmark this page and return to view
content additions, and visit the Market at a Glance pages for current market data.

 



c  

Bonds are a core element of any financial plan to invest and grow wealth. If you are just beginning to
consider investing in bonds, use this section as a resource to educate yourself on all the bond basics. In
this section you will learn:

R what a bond is
R why financial professionals recommend that you have bonds in your diversified investment
portfolio
R key factors to consider when evaluating a potential bond investment
R fundamental strategies for investing in bonds
R about tools and aids that will help you understand bonds

  


A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a
government, municipality, corporation, federal agency or other entity known as an .* In return for
that money, the issuer provides you with a bond in which it promises to pay a specified rate of  
during the life of the bond and to repay the  value of the bond (the ) when it matures, or
comes due.

Among the types of bonds available for investment are: U.S. government securities, municipal bonds,
corporate bonds, mortgage- and asset-backed securities, federal agency securities and foreign
government bonds. The characteristics of several different types of U.S. bonds are described in the Bond
Basics Glossary at the end of this section. Market practices described here apply to the U.S. bond
market, and may differ from those in other countries.

Bonds can be also called bills, notes, debt securities, or debt obligations. To simplify matters, we will refer
to all of these as "bonds."

  
 

Many personal financial advisors recommend that investors maintain a diversified investment portfolio
consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances
and objectives. Whatever your investment goals, your investment advisor can help explain the investment
options available, taking into account your income needs and tolearance for .

Typically, bonds pay interest semiannually, which means they can provide a predictable income stream.
Many people invest in bonds for that expected interest income and also to preserve their capital
investment. Understanding the role bonds play in a diversified investment portfolio is especially important
for retirement planning. During the past decade, the traditional defined-benefit retirement plans
(pensions) have increasingly been replaced by defined contribution programs such as 401(k) plans or
IRAs. Because these plans offer greater individual freedom in selecting from a range of investment
options, investors must be increasingly self-reliant in securing their retirement.

Whatever the purpose²saving for your children¶s college education or a new home, increasing retirement
income or any of a number of other financial goals²investing in bonds may help you achieve your
objectives.

   
  
  
 




All investments carry some degree of risk, which is linked to the return that investment will provide. A
good rule of thumb is the higher the risk, the higher the return. Conversely, safer investments offer lower
returns. There are a number of key variables that comprise the risk profile of a bond: its price, interest
rate, ,   , redemption features,  history, credit ratings and tax status. Together, these
factors help determine the value of your bond investment and whether it is an appropriate investment for
you.

Î 

The price you pay for a bond is based on a whole host of variables, including interest rates, supply and
demand,  , credit quality, maturity and tax status. Newly issued bonds normally sell at or close to
 (100 percent of the face, or principal, value). Bonds traded in the    , however,
fluctuate in price in response to changing interest rates, credit quality, general economic conditions, and
supply and demand. When the price of a bond increases above its face value, it is said to be selling at a
. When a bond sells below face value, it is said to be selling at a   .

 
 

Bonds pay interest that can be fixed, floating or payable at maturity. Most debt securities carry an interest
rate that stays fixed until maturity and is a percentage of the face (principal) amount. Fixed rate bonds
carry any interest rate that is established when the bonds are issued (expressed as a percentage of the
face amount) with semiannual interest payments. For example, a $1,000 bond with an eight
percent interest rate will pay investors $80 a year, in payments of $40 every six months. This $40
payment is called a      . When the bond matures, investors receive the full face amount of
the bond, $1,000.

Some issuers, however, prefer to issue       , the rate of which is reset periodically in line
with interest rates on Treasury bills, the   !  " #  (LIBOR), or some other
benchmark interest-rate index.
The third type of bond does not make periodic interest payments. Instead, the investor receives one
payment at maturity that is equal to the purchase price (principal) plus the total interest earned,
compounded at the original interest rate. Known as *     , they are sold at a substantial
discount from their face amount. For example, a bond with a face amount of $20,000 maturing in 20 years
might be purchased for about $5,050. At the end of the 20 years, the investor will receive $20,000. The
difference between $20,000 and $5,050 represents the interest, based on an annual interest rate
of seven percent, compounded semiannually, until the bond matures. Such    calculations vary
somewhat depending on the specific terms of the bond. Since all the    and principal are
payable only at the bond's maturity, the prices of this type of bond tend to fluctuate more than those of
coupon bonds. If the bond is taxable, the interest is taxed as it accrues, even though it is not paid to the
investor before maturity or redemption.

Bond calculators are widely available on websites such as this one and www.investinginbondseurope.org.

ë  

A bond¶s maturity refers to the specific future date on which the investor¶s principal will be repaid.
Generally, bond terms range from one year to 30 years. Term ranges are often categorized as follows:

R Short-term: maturities of up to 5 years


R Medium-term: maturities of 5 - 12 years
R Long-term: maturities greater than 12 years

The choice of term will depend on when an investor wants the initially invested principal repaid and on
risk tolerance. Short-term bonds, which generally offer lower returns, are considered comparatively stable
and safe becuase the principal will be repaid sooner. Conversely, long-term bonds provide greater overall
returns to compensate investors for greater pricing fluctuations and other market risks.

   




While the maturity date indicates how long a bond will be outstanding, many bonds are structured in such
a way so that an issuer or investor can substantially change that maturity date.

Call Provision

Bonds may have a redemption ± or call ± provision that allows or requires the issuer to redeem the
bonds at a specified price and date before maturity. For example, bonds are often called when interest
rates have dropped significantly from the time the bond was issued. Before you buy a bond, always ask if
there is a call provision and, if there is, be sure to consider the   as well as the   
. (These terms are discussed below and are defined in the glossary). Since a call provision offers
protection to the issuer,    usually offer a higher annual return than comparable  $
  to compensate the investor for the risk that the investor might have to reinvest the proceeds of a
called bond at a lower interest rate.

Put Provision

A bond may have a put provision, which gives an investor the option to sell the bond to an issuer at a
specified price and date prior to maturity. Typically, investors exercise a put provision when they need
cash or when interest rates have risen so that they may then reinvest the proceeds at a higher interest
rate. Since a put provision offers protection to the investor, bonds with such features usually offer a lower
annual return than comparable bonds without a put to compensate the issuer.
Conversion

Some corporate bonds, known as      , contain an option to convert the bond into common
sotck instead of receiving a cash payment. Convertible bonds contain provisions on how and when the
option to convert can be exercised. Convertibles offer a lower coupon rate beacuse they have the stability
of a bond while offering the the potential upside of a stock.

Principal Payments and Average Life

Certain bonds are priced and traded on the basis of their    rather than their stated maturity. In
purchasing mortgage-backed securities, for example, it is important to consider that homeowners often
prepay mortgages when interest rates decline, which may result in an earlier than expected return of
principal, reducing 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.

x

A bond's yield is the return earned on the bond, based on the price paid and the interest payment
received. Usually, yield is quoted in    , or bps. One basis point is equal to one one-hundreth of
a percentage point or 0.01%. For example, 8.00% = 800 bps (8.00% / 0/01% = 800 bps).

There are two types of bond yields:   and    (or  ).

Current yield is the annual return on the dollar amount paid for the bond and is derived by dividing the
bond¶s interest payment by its purchase price. If you bought a $1,000 bond at par and the annual
interest payment is $80, the current yield is 800 bps or 8% ($80 / $1,000). If you bought the same bond
for $900 and the annual interest payment is $80, the current yield is 889 bps or 8.89% ($80 / $900).
Current yield does not take into account the fact that, if you held the bond to maturity, you would receive
$1,000 even though you only paid $900.

Yield to maturity is the total return you will receive by holding the bond until it matures. This figure is
common to all bonds and enables you to compare bonds with different maturities and   . Yield to
maturity equals all the interest you receive from the time you purchase the bond until maturity, including
interest earned plus any gain or loss of principal. Yield to call is the total return you will receive by holding
the bond until it is called ± or paid off before the maturity date ± at the issuer's discretion. In many cases,
an issuer will pay investors a premium for the right to call the bonds prior to maturity. Yield to call is
calculated the same way as yield to maturity, but assumes that a bond will be called and that the investor
will receive the face value of the bond plus any premium on the call date. You should ask your
investment advisor for the yield to maturity and the yield to call on any bond you are considering
purchasing.

i Î x

From the time a bond is originally issued until the day it matures or is called, its price in the marketplace
will fluctuate depending on the particular terms of that bond as well as general market conditions,
including prevailing interest rates, the bond's credit and other factors. Because of these fluctuations, the
value of a bonds will likely be higher or lower than its original face value if you sell it before it matures. In
general, when interest rates fall, prices of outstanding bonds with higher rates rise. The inverse also holds
true: when interest rates rise, prices of outstanding bonds with lower rates fall to bring the yield of those
bonds into line with higher-interest bearing new issues. Take, for example, a $1,000 bond issued at eight
percent. If during the term of that bond interest rates rise to nine percent, it is expected that the price of
the bond will fall to about $888, so that its yeild to maturity will be in line with the market yield of nine
percent ($80 / $888 = 9.00%)

When interest rates fall, prices of outstanding bonds rise until the yield of older bonds match the lower
interest rate on new issues. In this case, if interest rates fall to seven percent during the term of the bond,
the bond price will rise to about $1,142 to match the market yield of seven percent ($80 / $1,142 =
7.00%).

   
  
  
 

i   


 
ë  

Changes in interest rates do not affect all bonds equally. Generally, the longer a bond's term, the more its
price may be affected by interest rate fluctuations. Investors, generally, will expect to be compensated for
taking that extra risk. This relationship can be best demonstrated by drawing a line between the yields
available on similar bonds of different maturities, from shortest to longest. Such a line is called a 
 .

A yield curve could be drawn for any bond market but it is most commonly drawn for the U.S. Treasury
market, which offers bonds of comparable credit quality for many different terms.

By watching the yield curve, as reported in the daily financial press, and online at sites such as this
one and www.investinginbondseurope.org, you can gain a sense of where the market perceives interest
rates to be headed, which is an important factor that could affect the price of bonds.

A normal yield curve would show a fairly steep rise in yields between short- and intermediate-term issues
and a less pronounced rise between intermediate- and long-term issues. This curve shape is considered
normal because, usually, the longer an investment is at risk, the more that investment should earn.

The yield curve is said to be steep, if the yields on short-term bonds are relatively low when compared to
long-term issues. This means you can obtain significantly increased bond income (yield) by buying a
longer maturity than you can with a shorter maturity bond. On the other hand, the yield curve is flat if the
difference between short- and long-term rates is relatively small. This means that there is little reward for
owning longer-dated maturities.

When yields on short-term issues are higher than those on longer-term issues, the yield curve is inverted.
This suggests that investors expect interest rates to decline in the future and/or short term rates are
unusually high for some reason, e.g., a credit crunch.. An inverted yield curve is often indicative of a
recession.

As a bond investor, you need to know how bond market prices are directly linked to economic cycles and
concerns about inflation and deflation. As a general rule, the bond market, and the overall economy
benefit from steady, sustainable growth rates. Such moderate economic growth benefits the financial
strength of governments, municipalities and corporate issuers which, in turn, strenghthens the credit of
those bonds you may hold.

But steep rises in economic growth can also lead to higher interest rates because, in response, the
Federal Reserve Bank may raise interest rates in order to prevent inflation and slow growth. An increase
in interest rates will erode a bond¶s price or value. Fear of this pattern is what causes the bond market to
fall after the government releases positive economic news, for instance about job growth or housing
starts. Since rising interest rates push bond prices down, the bond market tends to react negatively to
reports of strong and potentially inflationary, levels of economic growth, The converse is also true:
negative economic news may indicate lower inflation and expected interest rate cuts and, therefore, may
be positive for bond prices.

£  

Default is the failure of a bond issuer to pay principal or interest when due. Defaults can also occur for
failure to meet obligations unrelated to payment of principal or interest, such as reporting requirements, or
when a material problem occurs for the issuer, such as bankruptcy.

Bondholders are creditors of an issuer, and therefore, have priority to assets before equity holders (e.g.,
stockholders) when receiving a payout from the liquidation or restructuring of an issuer. When default
occurs due to bankruptcy, the type of bond you hold will determine your status.

3   are bonds backed by collateral. If the bond issuer defaults, the secured debt holder has
first claim to the posted collateral.

%   are not backed by any specific collateral. In the event of a default, bond holders will
need to recover their investment from the issuer. Unsecured debt will generally offer a higher interest rate
than those offered by secured debt due to a higher level of risk.
Some bonds, such as    , have priority in making claims over those who hold   
 ; a subordinated bond will typically offer a higher interest rate due to the higher level of risk.

 ! 

The array of credit quality choices available in the bond market ranges from the highest credit quality
Treasury bonds, which are backed by the full faith and credit of the U.S. government, to bonds that are
below    $ and considered speculative, such as bond issues by a start-up company or a
company in danger of bankruptcy. Since a bond may not reach maturity for years to come, credit quality
is an important consideration when evaluating investment in a bond. When a bond is issued, the issuer is
usually responsible for providing details as to its financial soundness and creditworthiness.

This information can be found in a document known as an    ,     or
  , which is the document that explains the bond's terms, features and risks that investors
should know about before investing. This document is usually provided by your investment advisor and
helps an investor evaluate whether the bond issuer will be able to make its regularly scheduled interest
payments for the term of the bond. While no single source of information should be relied on exclusively,
rating agencies, securities firms and bank research staff monitor corporate, government and other
issuers' financial conditions and their ability to make interest and principal payments when due. Your
investment advisor, or sometimes the issuer of the bond, can supply you with current research.

  




In the United States, major rating agencies include Moody¶s Investors Service, Standard & Poor¶s
Corporation and Fitch Ratings. Each of the agencies assigns its ratings based on analysis of the issuer¶s
financial condition and management, economic and debt characteristics, and the specific revenue
sources securing the bond. The highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody¶s).
Bonds rated in the BBB/Baa category or higher are considered investment-grade; bonds with lower
ratings are considered  , or speculative.

Lower ratings are indicative of a bond that has a greater risk of default than a bond with higher ratings. It
is important to understand that the high interest rate that generally accompanies a bond with a lower
credit rating is being provided in exchange for the investor taking on the risk associated with a higher
likelihood of default.
The rating agencies make their ratings available to the public through their ratings information desks and
online through their respective websites. In addition, their published reports and ratings are available in
many local libraries. Rating agencies continuously monitor issuers and may change their ratings of such
issuer¶s bonds based on changing credit factors. Usually, rating agencies will signal they are considering
a rating change by placing the bond on CreditWatch (S&P), Under Review (Moody¶s) or on Rating Watch
(Fitch Ratings).

Not all     evaluations result in the same credit rating, so it is important to review all
available credit ratings. It is also important to read the credit reports and related updates to properly
evaluate the underlying credit risks. You should bear in mind that ratings are opinions, and you should
understand the context and rationale for each opinion. Investors should not rely solely on credit ratings as
a measure of credit risk but, instead, use a multitude of resources to assist in their evaluation and
decision making. Additional sources of information include recent independent news reports, formal
issuer press releases, research reports and company financial statements.

In early April 2010, Fitch Ratings overhauled the way it assigns grades to the credit quality of state and
local governments, recalibrating ratings on 40 states, the District of Columbia, the Virgin Islands and
Puerto Rico. The move affects some 38,000 municipal bond issues. The rating agency's wholesale
recalibration is in part recognition that municipalities were being held to a higher standard than corporate
and sovereign debt. Municipalities historically exhibit stronger repayment patterns than corporate
borrowers in the same credit rating bracket. The municipal rating recalibrations are a way to align
municipal bonds with debt from other sectors.

  
 

The credit quality of a bond can be enhanced by bond insurance, which is provided by a specialized
insurance firm that guarantees the timely payment of principal and interest on bonds in exchange for a
fee. Insured bonds receive the same rating as a corporate rating of the insurer, which is based on the
insurer¶s capital and claims-paying resources. For more information on the role of bond insurance, see
additional sources on this web site and www.investinginbondseurope.org.

i 3  


Some bonds offer special tax advantages. For example, interest from U.S. Treasury bonds is not subject
to state or local income tax. Many municipal bonds are triple tax-free; that is, for investors who live in the
same state as the issuer, the interest received from the bond may be exempt from federal, state and/or
local income tax. However, in certain cases, the interest received may be subject to the individual federal
alternative minimum income tax or may have to be taken into account in calculating the taxable portion of
social security benefits. Furthermore, a portion of the interest on certain tax-exempt obligations earned
by certain corporations may be included in the calculation of adjusted current earnings for purposes of the
corporate federal alternative minimum tax, and interest income may also be subject to (i) a federal branch
profits tax imposed on certain foreign corporations doing business in the United States or (ii) a federal tax
imposed on excess net passive income of certain S corporations. The choice between taxable and tax-
exempt bond income depends on one¶s income tax bracket as well as the difference between what can
be earned from taxable versus tax-exempt bonds at the time of and through the entire period of the
investment.

You may access a yield calculator on this web site and your investment advisor can help you compare
the various tax alternatives. For example, the decision about whether to invest in a taxable bond or a tax-
exempt bond can also depend on whether you will be holding the bonds in an account that is already tax-
preferred or tax-deferred, such as a pension account, 401(k) or IRA.




" i   


There are several ways to invest in bonds, including purchasing individual bonds or investing in  
 or      .

  


There is a wide variety of individual bonds to choose from in creating a portfolio that matches your
investment needs and expectations. Most individual bonds are bought and sold in the over-the-counter
(OTC) market, although some corporate bonds are also listed on the New York Stock Exchange. The
OTC market comprises securities firms and banks that trade bonds; brokers or agents, who buy and sell
bonds on behalf of customers in response to specific requests; and dealers, who keep an inventory of
bonds to buy and sell.

If you¶re interested in purchasing a new bond issue in the   (when it is first issued), your
investment advisor will provide you with the offering document, official statement or prospectus. You can
also buy and sell bonds in the secondary market, after they have already been in issued in the primary
market.

Usually, bonds sold in the OTC market are usually sold in $5,000 denominations. In the secondary
market for outstanding bonds, prices are quoted as if the bond were traded in $100 increments. Thus, a
bond quoted at 98 refers to a bond priced at $98 per $100 of face value, which equates to buying a bond
with a face value of $5,000 for $4,900 (or at a two percent discount).

Bond prices in the secondary market normally include a markup, which consists of the dealer¶s costs and
profit. An additional commission may be added if a broker or dealer has to locate a specific bond that is
not in its inventory. Each firm establishes its own prices, within regulatory guidelines, which will vary
depending upon the type of bond, size of the transaction, and service the firm provides.

There are a number of resources to help investors compare current prices of bonds. SIFMA's investor
education web sites, such as this one, www.investinginbonds.com and www.investinginbondseurope.org,
offer recent and historical price data on corporate and municipal bonds. Investors can sort and search the
data by a variety of criteria and broad categories, such as yields, ratings, or prices. Prices of U.S.
corporate bonds are now more widely available, as mandated by rules issued by the Financial Industry
Regulatory Authority (FINRA). For municipal bonds, transaction price data and daily summary of trading
activity can be obtained from the Municipal Securities Rulemaking Board¶s Electronic Municipal Market
Access portal at http://emma.msrb.org.

For the U.S. government bond market, Treasury bond yields are also posted on both
www.investinginbonds.com and www.investinginbondseurope.org and are updated throughout the day.
SIFMA¶s investor websites also provide links to multiple services that provide price and yield information
on many market segments. There are also a number of other internet sites, media sources and vendors
that provide current and historical information on the primary and secondary markets. You can also
compare prices for specific bonds through your broker or financial advisor.

 


Bond funds, like stock funds, offer professional selection and management of a portfolio of bonds for a
fee. Through a bond fund, an investor can diversify risks across a broad range of issues and opt for a
number of other conveniences, such as the option of having interest payments either reinvested or
distributed periodically.
Some funds are designed to follow a market, in general or a specified index of bonds. These are often
referred to as index or passive funds. Other funds are actively managed according to a stated objective,
with bonds purchased and sold at the discretion of a fund manager. In contrast to an individual bond
investment, a bond fund does not have a specified maturity date because bonds being added to and
eliminated from the portfolio in response to market conditions and investor demand. With $
  , an investor is able to buy or sell a share in the fund at any time at the fund¶s net asset
value. Because the market value of bonds fluctuates, a fund¶s net asset value will change to reflect the
aggregate value of the bonds in the portfolio. As a result, the value of an investment bond fund may be
higher or lower than the original purchase price, depending upon how the underlying portfolio of bonds
has performed. Alternatively,  $    have a specific number of shares that are listed
and traded on a stock exchange. The price of closed-end funds will fluctuate not only with the price of the
underlying portfolio, but also the supply and demand of the shares of the fund, and so may be priced at,
above, or below the net asset value of the fund¶s holdings. Because the fund managers are less
concerned about having to meet investor redemptions on any given day, their strategies can be more
aggressive. &'$  , or ETFs, are similar to closed-end funds, but have transparent
portfolios and are generally passively managed.

There are numerous sources of bond fund information available, including personal finance magazines
and the internet. Fund research firms also provide detailed analyses by subscription to which many
libraries subscribe. In addition, rating agencies also evaluate bond funds for credit and safety.

Most funds charge annual management fees while some also impose initial sales charges or fees for
selling shares. When taken into account, fees and sales charges will lower overall returns, so investors
need to be aware of total costs when calculating expected returns. Many funds also require a minimum
initial investment.

Like individual bonds and other investments, bond fund investments entail risk. Investors should not
automatically conclude that a fund offering a higher rate of return or income is better than a fund offering
lower rates of return or income. Investors need to be aware of several factors, including the total costs,
credit quality, manager quality, risks and the ability to exit these funds before making investment
decisions.

ë ë 


Money market funds refer to pooled investments in short-term, highly liquid securities. These securities
include short-term U.S. Treasuries, municipal bonds, certificates of deposit issued by major commercial
banks, and commercial paper issued by corporations. Generally, these funds consist of securities and
other instruments having maturities of three months or less. Money market funds may offer convenient
liquidity, since most allow investors to withdraw their money at any time. The minimum initial investment is
usually between $1,000 and $10,000.

 #   
 i



Bond unit investment trusts offer a fixed portfolio of investments in government, municipal, mortgage-
backed or corporate bonds, which are professionally selected and remain constant throughout the life of
the trust. One of the benefits of a unit trust is that you know exactly how much you will earn while you are
invested because the composition of the portfolio remains stable. Since the unit trust is not an actively
managed pool of assets, there is usually no management fee, but investors do pay a sales charge, plus a
small annual fee to cover supervision, evaluation expenses and   fees. The minimum initial
investment is usually between $1,000. As an investor, you can earn interest income during the life of the
trust and recover your principal as securities within the trust are redeemed. The trust typically ends when
the last investment matures.




 
 3   
  


As you create your investment portfolio of bonds, there are various techniques you and your investment
advisor can use to help you match your investment goals with your risk tolerance.

  
$Î

 

One important consideration is how a portfolio is managed day to day. A portfolio can be actively
managed, which means the composition of the portfolio and how often it is traded depend, largely, on the
investment decisions made
by you or your investment manager. A passively managed portfolio tends to invest in a basket of stocks
or bonds (usually mimicking an index) and, generally, employs a buy and hold strategy, where purchases
are made for the long term.

£ 
    

Diversification is the allocation of assets to several categories in order to spread, and therefore possibly
mitigate, risk. Regardless of your investment objectives, diversification is an important consideration in
building any portfolio. Diversification can be achieved in any number of ways, including by:

˜ond Type

Diversification by bond type may provide some protection for a portfolio, so if one sector or asset class
experiences a downturn, the performance of other parts of the portfolio may help offset the negative
impact. For example, a bond portfolio might consist of a variety of highyield and investment-grade bonds
in order to balance risk and return.

Laddering

Another diversification strategy is to purchase securities of various maturities in a technique called


laddering. When you buy bonds with a range of maturities, a technique called laddering, you are reducing
your portfolio¶s sensitivity to interest rate risk. If, for example, you invested only in short-term bonds, which
are the least sensitive to changing interest rates, you would have a high degree of stability but low
returns. Conversely, investing only in long-term bonds may result in greater returns, but prices will be
more volatile, exposing you to potenial losses. Assuming a normal yield curve, laddering allows returns
that would be higher than if you bought only short-term issues, but with less risk than if you bought only
long-term issues. In addition, you would be better protected against interest rate changes than with bonds
of one maturity.

For example, you might invest equal amounts in bonds maturing in 2, 4, 6, 8 and ten years. In two years,
when the first bonds mature, you would reinvest the money in a 10-year maturity, maintaining the ladder.

˜arbells

Barbells are a bond investment strategy similar to laddering, except that purchases are concentrated in
the short-term and long-term maturities. This allows the investor to capture high yields from longer
maturities in one portion of their portfolio, while using the lower maturities to minimize risk.

 3
˜   is the sale of a block of bond swaps and the purchase of another block of similar market
value. Swaps may be made to achieve many goals, including establishing a tax loss, upgrading credit
quality, extending or shortening maturity, etc. The most common swap is done to achieve tax savings by
converting a paper loss into an actual loss that could partially or fully offset other capital gains or income.
We strongly recommend that you speak with your financial advisor to learn more about this investment
strategy.

 ë     

  
 

Always talk with your investment advisor to discuss which investments are most appropriate for you. If
you choose to pursue an investment in bonds, be sure to receive more detailed information about each of
the specific types of bonds in which you are interested before investing.

%



Accrued interest

Interest deemed to be earned on a security but not yet paid to the investor.

Ask price (or Offer price)

The price at which a seller offers to sell a security.

Average life

On a mortgage security, the average length of time that each principal dollar is expected to be
outstanding, based on certain assumptions about prepayment speeds.

Basis point

One one-hundredth (.01) of a percentage point. For example, eight percent would be equal to 800
basis points.Yield differences are often quoted in basis points (bps).

Bearer bond

A physical bond that does not indentify its owner and is presumed to be owned by the person
who holds it. In the United States, it has not been legal to issue bearer bonds in the municipal or
corporate markets since 1982. As a result, the only bearer bonds that still exist in the secondary
market are long-dated maturities issued prior to 1982, which are becoming increasingly scarce.
Among the disadvantages of bearer securities are that you must actually clip the coupons and
present them to the issuer's trustee in order to receive your interest; and if the bonds are called,
you will not automatically be alerted by the issuer or trustee as they do not know who the owners
are.

Bid price

The price at which a buyer is willing to purchase a bond.

Bond fund

An investment vehicle, which invests in a portfolio of bonds that is professionally managed. Types
of bond funds include open-ended mutual funds, closed-end mutual funds, and exchange traded
funds.

Bond insurers and reinsurers

Specialized insurance firms serving the fixed-income market that guarantee the timely payment of
principal and interest on bonds they insure in exchange for a fee.

Bond swap

The sale of a block of bonds and the purchase of another block of similar market value.

Book-entry

A method of recording and transferring ownership of securities electronically, eliminating the need
for physical certificates.

Bullet bond / Bullet maturity

A bond that pays regular interest, but that does not repay principal until maturity.

Callable bonds

Bonds that are redeemable by the issuer prior to the maturity date, at a specified price at or
above par.

Call premium

The dollar amount paid to the investor by the issuer for exercising a call provision that is usually
stated as a percent of the principal amount called.

Cap

The maximum interest rate that may be paid on a floating-rate security.

Closed-end mutual fund

A fund created with a fixed number of shares which are traded as listed securities on a stock
exchange.

Collar
Upper and lower limits (cap and floor, respectively) on the interest rate of a floating-rate security.

Compound interest

Interest that is calculated on the initial principal and previously paid interest.

Convertible bond

A corporate bond that can be exchanged, at the option of the holder, for a specific number of
shares of the company's stock. Because a convertible bond is a bond with a stock option built into
it, it will usually offer a lower than prevailing rate of return.

Coupon

A feature of a bond that denotes the amount of interest due, and the date payment will be made.

Coupon payment

The actual dollar amount of interest paid to an investor. The amount is calculated by multiplying
the interest of the bond by its face value.

Coupon rate

The interest rate on a bond, expressed as a percentage of the bond's face value. Typically, it is
expressed on a semi-annual basis.

Credit rating agency

A company that analyzes the credit worthiness of a company or security, and indicates that credit
quality by means of a grade, or credit rating.

Current yield

The ratio of the interest rate payable on a bond to the actual market price of the bond, stated as a
percentage. For example, a bond with a current market price of par ($1,000) that pays eighty
dollars ($80) per year would have a current yield of eight percent.

CUSIP

The Committee on Uniform Security Identification Procedures was established by the American
Bankers Association to develop a uniform method of identifying securities. CUSIP numbers are
unique nine-character alphanumeric identifiers assigned to each series of securities.

Dated date (or Issue date)

The date of a bond issue from which a bond begins to accrue interest.

Default

A failure by an issuer to: (i) pay principal or interest when due, (ii) meet non-payment obligations,
such as reporting requirements or (iii) comply with certain covenants in the document authorizing
the issuance of a bond (an indenture).
Discount

The condition under which the par value of a bond exceeds its market price. For example, a
$1,000 par amound bond, which is valued at $980 would be said to be trading at a 2% discount
[($1000-$980)/$1000=2%].

Discount note

Short-term obligations issued at a discount from face value, with maturities ranging from one to
360 days. Discount notes have no periodic interest payments; the investor receives the note¶s
face value at maturity. For example, a one year, $1,000 face value discount note purchased at
issue at a price of $950, would yield $50 or 5.26 percent ($50/$950).

Discount rate

The interest rate the Federal Reserve charges on loans to member banks.

Duration

The weighted maturity of a bond's cash flows, used in the estimation of its price sensitivity for a
given change in interest rates.

Embedded option

A provision that gives the issuer or the bondholder an option, but not the obligation, to take an
action against the other party. The most common embedded option is a call option, giving the
issuer the right to call, or redeem, the principal of a bond before the scheduled maturity date.

Exchange-traded fund

A fund that tracks an index, a commodity or a basket of assets. It is passively-managed like an


index fund, but traded like a stock on an exchange, experiencing price changes throughout the
day as they are bought and sold. Bond ETFs like bond mutual funds, hold a portfolio of bonds
and can differ widely in their investment strategies.

Extension risk

The risk that investors' principal will be committed for a longer period of time than expected. In
the context of mortgage- or asset-backed securities, this may be due to rising interest rates or
other factors that slow the rate at which loans are repaid.

Face (or Par value or Principal value)

The principal amount of a security that appears on the face of the instrument.

Federal funds rate

The interest rate at which depository institutions lend balances at the Federal Reserve to other
depository institutions overnight. The target federal funds rate is set by the Federal Reserve
Board's Federal Open Market Committee and is a principal tool of monetary policy. For more
information, see www.federalreserve.gov.
Fixed rate bond

A long-term bond with a set interest rate to maturity.

Floating-rate bond (or Variable rate bond or Adjustable rate bond)

A bond whose interest rate is adjusted periodically according to a predetermined formula; it is


usually linked to an interest rate index such as LIBOR.

Floor

The lower limit for the interest rate on a floating-rate bond.

Future value

The value of an asset at a specified date in the future, calculated using a specified rate of return.

General obligation bond

A municipal bond secured by the pledge of the issuer¶s full faith, credit and taxing power.

High grade bond

See Investment-grade bond.

High-yield bond (or junk bond)

Bonds rated Ba (by Moody's) or BB (by S&P and Fitch) or below, whose lower credit ratings
indicate a higher risk of default. Due to the increased risk of default, typically issued at a higher
yield than more creditworthy bonds.

Investment-grade bond (or high grade bond)

Bonds rated Baa (by Moody's) or BBB (by S&P and Fitch) or above, whose higher credit ratings
indicate a lower risk of default. These bonds tend to issue at lower yields than less creditworthy
bonds.

Issue date
See Dated date.
Issuer

The entity obligated to pay principal and interest on a bond it issues.

Interest

Compensation paid or to be paid for the use of assets, generally expressed as a percentage rate
of par.

Junk bond

See High-yield bond.


LIBOR (London Interbank Offered Rate)

The interest rates banks charge each other for short-term eurodollar loans. LIBOR is frequently
used as the base for resetting rates on floating-rate securities.

Liquidity (or marketability)

A measure of the relative ease and speed with which a security can be purchased or sold in a
secondary market.

Marketability

See Liquidity.

Maturity

The date when the principal amount of a security is due to be repaid.

Mortgage-backed bonds or securities (MBS)

Mortgage-backed securities, called MBS are bonds or notes backed by mortgages on residential
or commercial properties²an investor is purchasing an interest in pools of loans or other financial
assets. As the underlying loans are paid off by the borrowers, the investors in MBS receive
payments of interest and principal over time. The MBS market is for institutional investors and is
not suitable for individual investors.

Mutual fund (or Open-end fund)

Investment companies that invest pooled cash of many investors to meet the fund¶s stated
investment objective. Mutual funds stand ready to sell and redeem their shares at any time at the
fund¶s current net asset value: total fund assets divided by shares outstanding.

Non-callable bond

A bond that cannot be called for redemption by the issuer before its specified maturity date.

Offer price

See Ask.

Offering document (Official statement or Prospectus)

The disclsoure document prepared by the issuer that gives in detail security and financial
information about the issuer and the bonds or notes.

Official statement

See Offering document.

Open-end mutual fund


See Mutual fund.

Par value

See Face.

Paying agent

The entity, usually a designated bank or the office of the treasurer of the issuer, that pays the
principal and interest of a bond.

Premium

The amount by which the price of a bond exceeds its principal amount.

Prepayment

The unscheduled partial or complete payment of the principal amount outstanding on a loan, such
as a mortgage, before it is due.

Prepayment risk

The risk that principal repayment will occur earlier than scheduled, forcing the investor to receive
principal sooner than anticipated and reinvested at lower prevailing rates. The measurment of
prepayment risk is a key consideration for investors in mortgage- and asset-backed securities.

Present value

The current value of a future payment or stream of payments, given a specified interest rate; also
referred to as a discount rate.

Primary market

The market for new issues.

Principal

See Face.

Prospectus

See Offering document.

Ratings

Designations used by credit rating agencies to give relative indications as to opinions of credit
quality.

Registered bond
A bond whose owner is registered with the issuer or its agent. Transfer of ownership can only be
accomplished if the bonds are properly endorsed by the registered owner.

Reinvestment risk

The risk that interest income or principal repayments will have to be reinvested at lower rates in a
declining rate environment.

Revenue bond

A municipal bond payable from income derived from tolls, charges or rents paid by users of the
facility constructed with the proceeds of the bond issue.

Risk

The measurable probability that an actual return will be different than expected. There are many
types of risk such as market risk, credit risk, interest rate risk, exchange rate risk, liquidity risk,
and political risk.

Secondary market

Market for issues previously offered or sold.

Secured bond

A bond that is backed by collateral.

Senior bond

A bond that has a higher priority than another bond's claim to the same class of assets.

Settlement date

The date for the delivery of bonds and payment of funds agreed to in a transaction.

Sinking fund

Money set aside by an issuer of bonds on a regular basis, for the specific purpose of redeeming
debt. Bonds with such a feature are known as "sinkers."

Subordinated bond

A bond that has a lower priority than another bond's claim to the same assets.

Trade date

The date upon which a bond is purchased or sold.

Transfer agent
The party appointed by an issuer to maintain records of bondholders, cancel and issue
certificates, and address issues arising from lost, destroyed or stolen certificates.

Trustee

An institution, usually a bank, designated by the issuer as the custodian of funds and official
representative of bondholders. Trustees are appointed to ensure compliance with the trust
indenture and represent bondholders to enfore their contract with the issuers.

Unit investment trust

An investment fund created with a fixed portfolio of investments to provide a steady, periodic flow
of income to investors.

Unsecured bond

A bond that is not secured by collateral.

Yield

The annual percentage rate of return earned on a bond calculated by dividing the coupon interest
rate by its purchase price.

Yield curve

A line tracing relative yields on a type of bond over a spectrum of maturities ranging from three
months to 30 years.

Yield to call

A yield on a bond calculated by dividing the value all interest payments that will be paid until the
call date, plus interest on interest, by the principal amount received on the call date at the call
price, taking into consideration whatever gain or loss is realized from the bond at the call date.

Example: You pay $900 for a five year bond with a face value of $1,000. The bond pays an
annual coupon of ten percent. This bond is called at year three for $1,100.

The yield to call of this bond is 18.4 percent. This reflects the three years of coupon payments
and the difference between the price paid and the call price. Had the bond not been called, the
yield to maturity would have been 12.8 percent. Bond calculators may be found at this web site.

Yield to maturity

A yield on a bond calculated by dividing the value of all the interest payments that will be paid
until the maturity date, plus interest on interest, by the principal amount received at the maturity
date, taking in to consideration whateve gain or loss is realized from the bond at the maturity
date.
Example: You pay $900 for a five year bond at a face value of $1,000. The bond pays an annual
coupon of ten percent.

Here the yield to maturity is 12.8 percent. This reflects the coupon payments and the difference
between the price and the face value of the bond. Bond calculators may be found at this web site.

Zero-coupon bond

A bond which does not make periodic interest payments; instead the investor receives one
payment, which includes principal and interest, at redemption (call or maturity). See Discount
note.

 x 3  




c  

If the first question is ³what are bonds?´, then the next question is ³what else do I need to know to
become a savvy bond investor?´

This section takes you the next step and informs you about issues such as:

R how to think about bonds for your personal portfolio,


R how external factors, such as rate changes, can influence your bond investments,
R how to use information to your advantage
R how you can protect yourself as an investor

i   
 

"  
  x 

The next time you drive on a smoothly paved highway, borrow a new DVD from your library, see an office
park rising up in your neighborhood or hear of a factory expansion that's creating new jobs, consider the
role of the U.S. bond market. Even bigger than the stock market, the largest securities market in the world
plays a vast and vital role on the global stage, in the U.S. economy, and the daily life of every American.
The outstanding value for all U.S. debt issues went from $12 trillion in 1996 to over $34.2 trillion in the
first quarter of 2009.*
 ë    3 ë 
 £i& '(()*+
#$3$ ë
 $1,036.0 Billion
3 ë ' ,x3,3£!ë* $169.1 Billion

The bond market provides local, state and federal governments, and private enterprises the funds needed
to get development and long-term infrastructure projects off the ground. Before people are hired, earth
moved, concrete poured, or products rolled off the factory floor, capital needed for the work is in place.
Chances are bond issues help raise the funds to get started on projects that help maintain our quality of
life, well-being and U.S. competiveness.

The issuance and purchase of bonds help lower costs of infrastructure renovation and replacement for
public works and for new and expanding businesses. Among many examples, bonds help build bridges,
roads, transportation systems, power plants that light and heat our homes, reservoirs and pipes that bring
us water, sewer systems and factories that produce products fundamental to our daily lives. Without
bonds to finance these projects in a timely way, these systems would erode and break down. By the
second half of 2009, issuance in the U.S. bond markets had reached $3.31 trillion. Total issuance in 2008
totaled $4.82 trillion.*

In addition to financing long-term infrastructure projects, bonds help governments manage the ebb of its
cash flow, passing savings onto taxpayers who help the government pay for needed services, such as
those provided by military, police, hospital staff, school teachers, and others.



"  
 

Clearly, bonds are one way our public and private institutions borrow billions and billions of dollars. A
bond is similar to a loan or an IOU. When you purchase a bond, you are like a mini-banker lending to a
large borrower, such as a corporation or government entity.

The borrower (the issuer of the bond) makes a legal promise to repay the amount borrowed back (known
as the principal or the bond's par or face value) to the bondholder on a specific future date (known as the
redemption or maturity date) plus interest (known as the coupon rate or coupon) at a periodic rate, usually
twice a year. For the borrower or issuer, the interest expense is the cost of borrowing; for the investor, the
dependable interest income is compensation for lending the money.

Investments in bonds have burgeoned since the beginning of the twenty-first century. Today's U.S. bond
market exceeds a hefty $34 trillion. The bond market is collectively made up of an array of sectors within
the credit market, with each category of bond consisting of its own network and trading system.

i
 c
 
(in trillions)*

R ë -.$/0
R i
-./$/1
R ë  2 -.)$)/
R    -./$0
R  
-.1$3
R ë ë -.1$4)
R 

 2 -.$/(
Bonds typically are not bought directly from the issuers. (An exception is bonds issued by the U.S.
government.) Broker-dealers at banks or brokerage houses, known as the underwriter, act as
intermediaries between the issuer and the bond buyer. The underwriter buys the bonds from the issuer
and then resells the bonds to investors, bringing them to market. When the bond makes its debut, the
new issues are purchased in what is called the primary market. If the bondholder wishes to sell the bond
before maturity, the bond is sold in what is called the secondary market²where bonds that have been
previously owned are sold.

Bonds, unlike stocks, are mostly bought and sold, and resold in the over-the-counter market (OTC), which
is made up of networks of independent national and regional dealers, organized by type of bonds. There
is not one large organized exchange where bond buyers and sellers trade. However, small quantities of
bonds in the secondary market do trade on the New York Stock Exchange and the American Stock
Exchange and fewer on the NASDAQ.

When bonds make their debut at issue or when they enter the secondary market they can be purchased
through full-service, online or discount brokers, and investment and commercial banks. The inventory and
selection of bonds vary from dealer to dealer. So, the pricing of a particular bond may also vary. When
buying or selling a bond through a brokerage firm, an individual investor will be charged a commission or
spread, which is the difference between the market price and cost of purchase, and sometimes a service
fee. Spreads differ based on several factors including liquidity. To bypass pricing individual bonds,
investors may consider bond mutual funds or bond exchange-traded-funds (ETFs).

The pricing of bonds, however, has become more transparent in recent years due to industry regulation
and partnerships. You can see tickers of real time bond prices for corporate and municipal bonds on
www.investinginbonds.com. You can also see the Financial Industry Regulatory Authority's (FINRA)
TRACE system at www.finra.org/Industry/Compliance/MarketTransparency/TRACE/index.htm and
the Municipal Securities Rulemaking Board's transaction reporting system EMMA at
www.emma.msrb.org/.



 
 


A broad universe of institutions and individuals purchase bonds. As investments, bonds can provide a
means of preserving capital and earning a predictable return. Bond investments create steady streams of
income from investment payments prior to maturity. Bonds can also provide downside investment
protection against the more volatile movements of the stock markets.

Pension funds, insurance companies, banks, and corporations are the biggest customers, buying bonds
to have stable sources of cash flows to meet predictable obligations. For example, insurance companies
use the regular interest payments to meet obligations from policies they sell. Government and business
with big pensions buy bonds in order to ensure that capital is in place to meet obligations for retired
employees and beneficiaries. Mutual funds and international investors, such as central banks, are also
big investors.

 

-

R Î
 

R 
  

R ë 
53(
R " 
 
'    

*
R      


R   
   



 Î 
  

Not all bonds are the same. Primarily two factors affect the worth of a bond after issuance. Bond prices
go up and down depending on interest rate changes and fluctuations in credit quality.

The safety of a bond depends on the issuer's relative ability to pay the interest and return the principal as
promised. The better the reputation and stability of the issuer, the less risk and more certainty that
investors will receive what they are owed. Consequently, the interest rate paid on higher rated bonds, like
those backed by the U.S. Treasury or federal agencies, is lower. Quality debt depends on the reliability of
the issuer: The greater the ability to meet interest and principal payments, the higher the credit rating by
the major rating agencies.

For corporations the story is similar except that companies typically pay a higher interest rate than the
highest rated governments because companies cannot offer the same guarantee of repayment. The
possibility of default or bankruptcy exists. If a company, however, runs into financial trouble, bondholders
have legal priority to repayment of principal before stockholders receive any payment. Companies with
financial heft, a history of success, good business practices and a track record for paying debts, issue
bonds with lower interest rates than companies with lesser ratings.

The level of risk a bondholder incurs is also affected by the length or maturity of the bond. The longer the
bond is in circulation the more time for significant moves in the prevailing interest rate. As rates move up
or down so does the market value of the bond. When interest rates go up prices of existing bonds go
down. New issues offering higher coupons come along, so bonds with a coupon yielding less interest are
less attractive and the prices drop.

Generally speaking when interest rates go down, the prices of bond issues go up. Interest rates change in
response to a number of factors²changes in supply and demand for credit, fiscal policy, exchange rates,
economic conditions, and crucial for the bond market, changes in expectations of inflation. High inflation
reduces the future buying power of interest payments and the value of the principal.

The most widely traded bond in the US and the world is the 10-year Treasury bond. Following the yield on
this key security²the "bellwether" of the bond market²the long bond helps guide investors on interest
rate levels, gaining a sense of where the market perceives interest rates will be heading.



#$3$i
ë 

Treasuries, debt securities issued by the Department of the Treasury on behalf of the Federal
government, carry the full faith and credit backing of the U.S. government, making it the safest and most
popular of investments. The amount of marketable U.S. Treasury securities is huge, with $6.63 trillion in
outstanding bills, notes and bonds as of June 30, 2009.* Trading volume in Treasury securities averaged
over $425.1 billion a day in the fourth quarter of 2008.*

The liquidity and efficiency of the Treasury market allows the federal government to finance ongoing
operations in an efficient way at the lowest possible cost to taxpayers over time.
The Federal Reserve System, through the New York Fed, uses the Treasury market to implement
monetary policy. In order to increase the money supply, it buys Treasury securities, injecting funds into
the economy and reducing interest rates. To reduce the money supply, it sells Treasury securities, taking
money out of the economy and raising interest rates. In this way, the Fed attempts to manage price
inflation in the economy. The most widely circulated type of bond is bought and sold by a wide swath of
global investors²individual investors, pension funds, money market funds, commercial banks, insurance
companies, corporations, state and local governments, and securities dealers. Many large institutional
investors like pension funds and mutual funds also hold Treasuries to benefit individuals.

Treasury securities come in the three forms²new issues of bills, notes and bonds, including TIPS
(Treasury Inflation-Protected Security whose principal amount is adjusted for inflation). Bills have
maturities of one year or less; notes mature between two and ten years, and bonds mature between 20 to
30 years.

Investors can buy or sell Treasuries by holding an account at a brokerage firm. Treasury securities are
also sold directly via the government, which holds regularly scheduled auctions. See the website at
www.TreasuryDirect.gov, the Treasury Department's primary retail system for selling securities. By setting
up an account at Treasury Direct an individual investor can also sell Treasuries in the secondary market
through a Treasury program called Sell Direct.



ë 3  


ë 

Tens of thousands of state and local governments issue bonds to build, repair and improve schools,
streets, hospitals, airports and many other public works. Encompassing a diverse group, municipal bonds,
popularly called "munis" on average traded a daily $21.8 billion in 2008, totaling some 43,383 trades a
day.* Municipal bonds, as a whole, are among the least risky of investments.

The main attraction of municipal bond investments, however, is that, unlike Treasuries, the income most
municipal bonds provide is exempt from federal income taxes. Further, if you live in the state where the
municipal bond is issued, the interest is also free from state income tax. In some cases, an issue can be
triple tax exempt²federal, state and city. Municipal bonds present the greatest opportunities for those in
the highest tax brackets, providing a higher tax-free yield compared to an equivalent yield of a taxable
bond (known as taxable equivalent yield). To compare a tax-free yield with a taxable yield, see
"Calculators" on this website.

When the federal income tax law was adopted in 1913, the interest income on municipal bonds was
excluded from federal taxation. As a result, municipal bond investors are willing to accept lower yields
than those from taxable investments; and state and local governments can borrow at interest rates that
are, on average, 25 to 30 percent lower than would otherwise be possible. (There are situations where
municipal bonds are taxed. For more information see About Municipal Bonds in the "Learn More" section
of this site. For information on Build America Bonds, the new kind of municipal bond authorized under the
Stimulus Act of 2009, see www.investinginbonds.com/index.asp?id=3097.)

Generally, municipalities issue their bonds in two ways:

R %c6   
'%c 
*
R   

Typically, projects that benefit the entire community, such as schools, courthouses and municipal office
buildings, are funded by general obligation bonds, which are repaid by tax revenues. Projects that benefit
only their users, such as utilities, airport facilities and toll roads, are typically funded by revenue bonds,
which are repaid with fees collected from people who use the services or facilities.
General obligation bonds are backed by the full faith and credit of the government entity issuing the bond
and its taxing power. Revenue bonds are relatively riskier, since unlike GO bonds, they depend on the
success of the specific project they are issued to fund, such as toll bridges or airport facilities, to pay
interest to bondholders. Revenue bonds issued for essential services, however, such as electric power, or
water or sewer systems, do provide reliable income streams and are often of high credit quality.

Historically, very few municipal bonds have defaulted, with a record of safety second only to that of U.S.
Treasury securities. Even as conservative investments, municipal bonds, like all investments, carry risk
and vary in quality and returns.

Issuers of municipal bonds have a record of making interest and principal payments in a timely manner.
Issuers disclose details of their financial condition through "official statements" or "offering circulars,"
which are available from your bank, brokerage firm, or on the Internet or through the Municipal Securities
Rulemaking Board's Electronic Municipal Market Access (EMMA) website at http://emma.msrb.org. The
MSRB's portal EMMA also provides free access to annual continuing disclosure about the financial
condition of an issuer as well as additional specific data on individual municipal securities. Another way to
evaluate an issuer is to examine its credit rating. Many bonds are graded by ratings agencies such as
Moody's Investors Service, Standard & Poor's and Fitch Ratings.



    ë 

Corporations use the funds they raise from selling bonds for a variety of purposes, from building facilities
to purchasing equipment to expanding their business. The U.S. corporate bond market is large and liquid,
with daily trading volume estimated at $15.1 billion. Issuance for 2008 was an estimated $702.4
billion.* Outstanding corporate debt stands at $6.7 trillion (1Q, 2009), accounting for nearly 20% of U.S.
fixed-income securities. The number stands in contrast to European Corporate bonds, which represent a
markedly smaller percentage.

The U.S. corporate bond markets have long been an important source of capital for issuers. Early IOUs or
debt obligations financed the country's westward expansion, building the transcontinental railroad and
Erie Canal.

In deciding how to raise capital for investment, corporations can issue equity securities, borrow in the
debt markets or pursue a mix of both. The driving force behind a corporation's financing strategy is the
need to minimize its cost of capital. Corporations have historically relied on the public debt markets as
well as bank lending facilities to fund their business but have more recently begun to rely more heavily on
the public markets as the banking crisis has limited bank lending.

Investors in corporate bonds include both individuals and large financial institutions such as pension
funds, endowments, mutual funds, insurance companies and banks. Individuals, from the very wealthy to
people of modest means, also invest in corporates because of the benefits these securities offer.
Corporate bonds typically yield more than other taxable bonds but can be complex due to considerations
of credit quality, event risk like takeovers and call risk²the risk that the bonds will be redeemed by the
issuer before maturity. Yields among corporate bonds can differ substantially based on the perceived
credit risk of the individual corporation and the outlook for the profitability and competitiveness of its
industry or sector.

To increase price transparency in the U.S. corporate debt market, in July 2002 the National Association of
Securities Dealers (now the Financial Industry Regulatory Authority) unrolled TRACE (Trade Reporting
and Compliance Engine). The initiative mandated that all dealers and inter-dealers report the time of
execution, price, yield and volume of corporate bond trades to its Trade Reporting and Compliance
engine, creating the first regulatory database of the universe of OTC corporate bonds. Individual investors
now can view real time price and volume information for individual corporate bonds on this site and
FINRA's website:
www.finra.org/Industry/Compliance/MarketTransparency/TRACE/CorporateBondData/index.htm.



ë ë  



While governments and corporations typically tap the securities markets for long-term funding needs, they
may also need to issue debt for shorter periods to finance imports, to meet seasonal cash-flow needs or
to create "bridge" financing until conditions are right for longer-term debt issues. To obtain this type of
safe short-term financing (maturities of one year or less), they can turn to the "money market," which
includes bankers' acceptances, commercial paper and certificates of deposit (CDs).

Used primarily in trade finance, bankers' acceptances are guarantees of payment that permit international
trade to function smoothly without the risk that goods shipped will not be paid for or that payments will be
made for goods sold that don't meet specifications. Commercial paper, typically the lowest-cost short-
term financing for creditworthy issuers, consists of unsecured promissory notes, often supported by bank
credit lines, with maturities of up to 270 days, but generally extending less than a month. Foreign
corporations can issue dollar-denominated commercial paper, and municipalities issue tax-exempt
commercial paper or other short-term instruments to raise cash in anticipation of tax receipts or as interim
financing prior to a bond sale. Certificates of deposit are negotiable debt instruments issued by banks and
thrift institutions against funds deposited for specified periods.

The generally short maturities of money market instruments permit firms to be flexible in funding short-
term cash needs that may fluctuate unpredictably and to take advantage of lower interest rates that
typically exist in the shorter maturity ranges. Additionally, the money market's efficiency, liquidity and size,
estimated currently at $3.58 trillion, frequently make these instruments cost-effective alternative funding
sources relative to bank loans

From the investor's perspective, money market instruments represent a liquid, low-risk investment that
generally offers a higher yield than bank deposits. Mutual funds and other large investors are the principal
investors in money market instruments.



 3  


ë 

Many different U.S. government agencies and government-sponsored enterprises (GSEs) issue their own
debt securities to finance activities supported by public policy, such as home ownership, farming, and
small-business operations. These issuers are able to borrow at favorable rates and channel the proceeds
into programs that make credit available to sectors of the economy that would not otherwise enjoy such
affordable sources of funding.

The federal agency market includes debt securities issued by Federal Home Loan Banks, Freddie Mac,
Fannie Mae, Federal Farm Credit Banks and the Tennessee Valley Authority, among others.

Although most agency securities do not carry the government's full-faith-and-credit guarantee, their credit
quality is generally considered to be high though characteristics differ. Debt securities issued by GSEs
are solely the obligation of their issuer and are considered to carry greater credit risk than securities
issued by the U.S. Treasury and certain government agencies (e.g., Ginnie Mae) whose securities have
the guarantee of the U.S. government. For this reason, GSE debt obligations often carry a yield premium
over Treasury securities with comparable maturities. With an estimated $3.14 trillion in debt outstanding,
the agency securities market is smaller than the Treasury market but functions with comparable efficiency
and liquidity due to strong investor interest and competition among dealers.

Investors in agency securities are primarily institutional in nature and include state and local
governments, mutual funds, pension funds, investment trusts and global investors.



ë  3  


Mortgage securities play a crucial role in the availability and cost of housing in the United States. The
creation of mortgage securities helps individuals own homes by reducing the cost of a mortgage, allowing
a potential homeowner to borrow money at the lowest rate available.

Mortgage securities represent an ownership interest in mortgage loans made by institutions, such as
savings and loans, commercial banks, and mortgage companies, to finance the borrower's purchase of a
home or other real estate. Mortgage loans are combined or "pooled" by issuers or servicers, and
securities backed by these loans (mortgage-backed securities) are issued for sale to investors. This
process of creating securities by pooling together various cash-flow producing assets, such as residential
or commercial mortgages, is referred to as "securitization."

The securities are bought by securities dealers and sold to investors around the world. As the underlying
mortgage loans are paid off by the homeowners, the investors receive monthly payments of interest and
principal.

The ability to securitize mortgage loans enables mortgage lenders and mortgage bankers to access a
larger reservoir of capital, to make financing available to home buyers at lower costs and to spread the
flow of funds to areas of the country where capital may be scarce.

Mortgage securities come in two forms: U.S. agency and non-agency issues by private institutions.
Agency mortgage securities are issued by three U.S. agencies: Government National Mortgage
Association (GNMA or Ginnie Mae), which issued the first mortgage security in 1970; Federal Home Loan
Mortgage Corporation (FHMLC or Freddie Mac); and Federal National Mortgage Association (FNMA or
Fannie Mae). Ginnie Mae securities are backed by a government guarantee of repayment; Fannie Mae
and Freddie Mac are not, but are guaranteed by the agencies. Private institutions, such as subsidiaries of
investment banks, financial institutions and home builders, also package various types of mortgage pools.
These non-agency mortgage securities are known as "private label," in contrast to "agency" mortgage
securities.

Investors in the $8.86 trillion mortgage securities market include institutions of all sizes: corporations,
commercial banks, life insurance companies, pension funds, trust funds, mutual funds and charitable
endowments.



 2 ë 

In the mid-eighties the concept of transforming loans into securities gradually spread from mortgages to
other types of assets such as auto loans, student loans, credit cards, equipment loans and leases,
business trade receivables, and the issuance of asset-backed commercial paper, among others. Today's
asset-backed securities market provides a ready source of capital to replenish funds for lending to
consumers, small businesses and other borrowers. It also gives issuers the ability to recycle capital by
shifting the risks associated with carrying loan assets off of their balance sheets.
Asset-backed securities are underwritten by dealers and sold to investors around the world. As the loans
are repaid by the borrowers, the cash flow of interest and principal is passed on to the investors. In some
cases, credit enhancements such as bond insurance or letters of credit back the securities to make them
more attractive to investors.

The asset-backed securities market has burgeoned from its formative days. In 1996 total asset-backed
debt counted $404 billion. At the end of 2008, the number had reached $2.67 trillion.* Investors in asset-
backed securities include pension funds, mutual funds, insurance companies, money market funds and
financial institutions.





The ability of securities firms to price securities effectively and to underwrite issues of government and
corporate debt depends on their ability to finance holdings of these securities in their capacities as
underwriters and market makers. The funding markets (also sometimes called the repurchase or
securities lending markets) are essential to the smooth functioning of all the debt markets. Highly liquid
markets in debt securities require readily available funding sources. In fact, repurchase agreements
(repos) are the most important source of liquidity in the Treasury and agency securities markets. This
liquidity serves to lower the government's cost of money and thereby saves taxpayer dollars. In addition,
the Federal Reserve uses repo transactions to carry out monetary policy.

In a typical repo agreement, a securities dealer wishing to finance a bond position sells the bonds to a
cash investor, while simultaneously agreeing to repurchase them at a later date for an agreed-upon price.
The investor receives a return for providing the funds. A reverse repurchase agreement is simply the flip
side of the transaction, from the buyer's viewpoint not the seller's. The seller executing the transaction
would describe it as a "repo," while the buyer in the same transaction would describe it a "reverse repo."
The transaction is the same but described from opposite viewpoints. The term of the repo can be custom-
tailored for any period, ranging from overnight up to a year.

The repo market originated as a means by which securities dealers could finance their bond positions,
still serving this vital purpose today. Institutional investors can generally earn better short-term yields by
investing their idle cash in the repo market than they can by investing in bank deposits or money market
instruments.

The outstanding volume of repos and reverse repos is enormous²in excess of $4.54 trillion on an
average daily basis in the second quarter of 2009* among Primary Dealers in U.S. government securities
alone. Securities firms, commercial banks, corporations, pension funds, state and local governments, and
mutual and money market funds use the repo market as a safe haven for cash investment and as a
flexible alternative to bank deposits and money market instruments such as CDs and commercial paper.
In the United States, repos are typically done in conjunction with U.S. Treasury bonds, mortgage
securities, corporate bonds or other forms of debt agreed upon by the counterparties to the agreement.

Bonds are not only a way to invest and earn a return on your money; they are also a way to invest in the
security and infrastructure of the nation, the growth of economies, and the expansion of businesses.
Regardless of who issues or invests in them, bonds play a critical role in the daily economic life of the
United States, and around the world.

Explore the www.Investinginbonds.com site. To learn more about the role of bonds in Europe, see our
sister site www.InvestinginbondsEurope.org.


 
7
 


!
 
 
 x   
 3  

 
     

An investment in bonds, like any other investment, should be tailored to your overall investment goals,
tolerance for risk, and other individual circumstances. By answering some fundamental questions and
arming yourself with some basic investment perspectives, you will be better able to make decisions and
work with investment representatives or advisers to find the appropriate mix of securities to achieve your
investment objectives.

R Questions to Ask When Creating Your Investment Strategy


R Questions to Ask Considering an Investment In Bonds
R Questions to Ask When Preparing to Buy or Sell Bonds

 
   
 
 


1. Do I currently have any savings and investments?


÷ Yes
If yes, what percentage of my investments are in:
š % Cash or cash equivalents (savings accounts, CDs, money market funds)
š % Bonds or Bond funds
š % Stocks, stock funds, or stock in the company I work for?
÷ No
2. Is the total of my investment in cash, bonds, and bond funds less than 15% or 20% of my total
investments?
÷ Yes
÷ No
3. I have a lump sum to invest.
÷ Yes
÷ No
4. I expect to invest on a regular basis.
÷ Yes
÷ No

Î
  

Most personal financial advisors recommend that investors maintain a diversified investment portfolio
consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances
and objectives. For example, older or retired investors may typically have a higher proportion of bonds in
their portfolio than younger investors. Whether you already have investments in stocks or bonds or are
just beginning to invest, diversity can provide some protection for your portfolio, so if one sector or asset
class is in the midst of a cyclical downturn, the rising value of another class of assets may help offset the
negative impact.

  
  68  

1. To provide income to use toward my current expenses?
÷ Yes
÷ No
2. To save for retirement?
÷ Yes
÷ No
3. To save for children¶s college education?
÷ Yes
÷ No
4. To accumulate capital?
÷ Yes
÷ No
5. To preserve capital?
÷ Yes
÷ No

Other (such as a short-term goal):

Î
  

Because bonds typically have a predictable stream of payments of interest and repayment of principal,
many people invest in them to receive interest income or to preserve and to accumulate capital. If you are
looking for current income, you will most likely be interested in bonds that pay an interest rate that stays
fixed until maturity with interest that is paid semiannually. However, if you are saving for retirement or a
child¶s education or other capital accumulation goal, you may wish to consider investing in zero coupon
bonds which do not have periodic interest payments. Instead, they are sold at a substantial discount from
their face amount and the investor receives one payment--at maturity--that is equal to the purchase price
(principal) plus the total interest earned, compounded semiannually at the original interest rate.

   6 

R 1 year
R 5 years
R 10 years
R 20 years
R 30 years or more
R Other

Î
  

A bond¶s maturity refers to the specific future date on which the investor¶s principal is expected to be
repaid. Bond maturities generally range from one day up to 30 years. Your choice of maturity will depend
on when you want or need the principal repaid and the kind of investment return you are seeking within
your risk tolerance. Generally, the longer the maturity, the greater the return.

"  


   
R Very little risk. I want the safest investments possible.
R Modest risk. I¶m willing to accept moderate risk of losing my investment if it means I will earn a
higher return.
R Substantial risk. I want the highest possible yield and I¶m willing to accept the chance that I may
lose my investment.

Î
  

Virtually all investments have some degree of risk that you might lose some or all of your investment.
When investing in bonds, it¶s important to remember that an investment¶s return is linked to its credit as
well as market changes. The higher the return, the higher the risk. Conversely, relatively safe investments
offer relatively lower returns. Bond choices range from the highest credit quality U.S. Treasury securities,
which are backed by the full faith and credit of the U.S. government to bonds that are below investment
grade and considered speculative. In assessing your tolerance for risk, ask yourself, "What will I do if my
investment is not there when I need it?" You should also be aware that if you have to sell a bond before it
matures, you will receive the prevailing market price, which may be more or less than its original price.
The value of bonds fluctuates with the market, varying in the opposite direction of movement in interest
rates. Bond funds¶ values fluctuate in the same way.

 6     


  
 

What income tax bracket am I in?

R 10% (single return: $0 to $8,375; joint return: $0 to $16,750)


R 15% (single return: $8,376 to $34,000; joint return: $16,751 to $68,000)
R 25% (single return $34,001-$82,400; joint return $68,001-$137,300)
R 28% (single return $82,401-$171,850; joint return $137,30l-$209,250)
R 33% (single return $171,851-$373,650; joint return $209,251-$373,650)
R 35% (single return $373,651 & over; joint return $373,651 & over)

Is my investment going to be made through a tax-preferred investment vehicle?

R Traditional IRA
R Roth IRA
R 40l(k)
R Pension plan

Î
  

Some bonds offer special tax advantages. There is no state or local income tax on the interest from U.S.
Treasury bonds. There is no federal income tax on the interest from most municipal bonds, and in many
cases no state or local income tax, either. Do you want income that is taxable or income that is tax-
exempt? The answer depends on your income tax bracket--and the difference between what can be
earned from taxable versus tax-exempt securities--not only presently, but also throughout the period until
your bonds mature. The decision about whether to invest in a taxable bond or a tax-exempt bond can
also depend on whether you will be holding the securities in an account that is already tax-preferred or
tax-deferred, such as a pension account, 40l(k) or IRA: for example, a municipal bond will not bring you
the tax benefits it otherwise might if you hold it in a tax-deferred account. In addition to help you can get
from your broker or financial or tax adviser to determine what is the best for you, many brokers and
mutual fund companies offer calculators you can use yourself on the Internet.

3   
-
R Individual bonds?
R Bond funds?
R Unit investment trusts?

Î
  

There are several ways to invest in bonds. You can buy individual bonds, bond funds or unit investment
trusts. Your choice will depend on the amount of money you have to invest in order to achieve
diversification, the degree to which you want professional management of your portfolio and your
willingness to pay for professional selection and portfolio management (bond funds). Generally, investing
in individual bonds is best for preserving your capital assuming they closely match your other objectives
(like maturity); while bond funds offer convenience and diversification even at minimum investment levels.
The minimum investment for bond funds and UITs is typically between $1,000 and $2,500, and $500 for
retirement accounts. Individual bonds are usually sold in $5,000 denominations and dealers sometimes
require a minimum investment of $20,000.


 
Î   

 
Î   

The U.S. government, as well as national and state regulatory agencies, provide numerous protections
for investors. Check out the following list of government and nonprofit websites to keep abreast of current
investment scams and to report and combat fraudulent activity.

R The Bureau of the Public Debt Alerts notifies investors to scams involving securities claimed to be
backed by the U.S. government.
R The Commodity Futures Trading Commission alerts investors to possible fraudulent activity.
R FirstGov for Consumers provides consumers with information from the federal government.
ScamAlert provides information on fraudulent and deceptive investment practices, law-
enforcement contacts and tips for avoiding scams.
R The Investor Education section of the FINRA website offers investor news and Investor Alerts on
various types of investment products. FINRA also provides a service where investors can check
the background of their broker or financial advisor, including any disciplinary action against him or
her.
R The North American Securities Administrators Association is an international organization
devoted to investor protection. It is comprised of securities administrators from the U.S., Canada
and Mexico. Its website carries a list of securities regulators by state and territory as well as an
interactive Investment Fraud Awareness Quiz. The Investor Education section offers Investor
Tips, including top investment scams and information for older Americans on avoiding investment
fraud and abuse.
R The North East Fraud Forum, an organization based in the United Kingdom, offers links to
several fraud advisory sites.
R The Investor Information section of the Securities and Exchange Commission¶s web site provides
Investor Alerts with information on how to spot scams and fraud.
R The Securities Investor Protection Corporation offers several investment fraud education
resources.

"      Î

63 

A sound financial plan requires careful investing. You need to know that the vehicles you are investing in,
and the professionals you are using, are legitimate. Protect your finances by identifying and avoiding
fraudulent investment schemes. Following are some ways to know if you are being offered an investment
that is genuinely too good to be true.

R Do not be pressured, or feel panicked, to invest. If someone you do not know contacts you by
phone, fax, or e-mail, with recommendations based on ³inside,´ ³confidential information´ or
unidentified ³ratings and research reports,´ beware. Likewise with offers claiming extraordinary
profit ³guarantees.´
R Never make an investment with anyone you do not know without receiving proof of his/her
credentials and of the investment they are proposing. Ask for proof that he/she is registered with
the U.S. Securities and Exchange Commission (SEC) and your state¶s security agency (available
through the North American Securities Administrators Association). Your state¶s security agency
can check the Central Registration Depository (CRD) to see if the broker you have been
contacted by, or his/her firm, has a record of disciplinary action or complaints. Your state agency
can also let you know if the investment you are being offered is approved for sale in your state.
R Click here to learn more about ³How to Choose a Financial Professional.´
R Ask for a copy of the prospectus²or official statement, in the case of municipal bonds²for the
investment they recommend and current financial statements from the company. You can check
to see if a company is registered with the SEC through the SEC¶s EDGAR database free of
charge. To check on smaller companies who are not required to register with the SEC, contact
the SEC at (202) 942-8090 begin_of_the_skype_highlighting (202) 942-
8090 end_of_the_skype_highlighting to find out if the firm has filed an offering circular, and to
request a copy.
R Make out checks (or wire funds) only to a brokerage firm, never to an individual broker or sales
representative. Only send, or wire, money to the business address for the firm as listed on an
official print business document.
R Don¶t allow your transaction confirmations or account statements to be sent to anyone other than
yourself, particularly to a sales representative whom you have only talked to by phone.

If you think you may be the victim of fraudulent activity:

R Call and ask to speak with the sales manager or compliance officer of the firm to register a
complaint. Send a written letter to the firm and keep a copy for your files. Ask the manager or
officer to send a written response to your concerns. Keep a file of correspondence (print, e-mail
and fax) and a written record of all phone conversations.
R Call your state securities agency or FINRA to register a complaint or inquire about suspected
fraud activity.
R While most complaints against brokers are handled through FINRA arbitration, if you are
considering legal action against a sales representative/broker or brokerage firm you should
consult an attorney with experience in securities law. The American Bar Association can help you
find a securities attorney in your area.

This page contains hyperlinks to Web sites that are created and maintained by other organizations. The
Securities Industry and Financial Markets Association and Investinginbonds.com do not make any
representations or guarantee the accuracy of the information found on these sites. This is not a complete
list of all sites related to this topic.

    
" ë  x Î   3  


The answer to this question depends on that asset allocation that is right for you, your goals, your age
and your appetite for risk.

    

Asset allocation describes the percentage of total assets invested in different investment categories, also
known as asset classes. The most common broad financial asset classes are stocks (or equity), bonds
(fixed income) and cash. Real estate, precious metals and ³alternative investments´ such as hedge funds
and commodities can also be viewed as asset classes.

Each broad asset class has various subclasses with different risk and return profiles. In general, the more
return an asset class has historically delivered, the more risk that its value could fall as well as rise
because of greater price volatility. To earn higher potential returns, investors have to take higher risk.

Asset classes differ by the level of potential returns they have historically generated and the types of risk
they carry. Virtually all investments involve some type of risk that you might lose money.

Asset subclasses of stocks include:

R  

stocks of large, well established and usually well known companies
R 3 

stocks of smaller, less well known companies
R    

stocks of foreign companies

Large cap, small cap and international stocks can in turn be considered:

R Value stocks whose prices are below their true value for temporary reasons
R Growth stocks of companies that are growing at a rapid rate.

Asset subclasses of bonds include:

R £    


long-term (10 years or longer), intermediate-term (3-10 year) or short-term
(3 years or less)
R £  


government and agencies, corporate, municipal, international
R £   
 6 
callable bonds, zero-coupon bonds, inflation-protected bonds, high-
yield bonds, etc.




Stocks are generally considered a risky investment because, among other things, their values can decline
if the stock market goes down (market risk) or the issuing company does poorly (company risk). As
owners of the company, stockholders are paid after all creditors, including bond holders, are paid. In
theory at least, a stock¶s value can go to zero. Historically, stock prices have been the most volatile of all
the different types of investments, meaning their prices can move up and down quickly, frequently and not
always in a predictable way.

Bonds are considered less risky than stocks because bond prices have historically been more stable and
because bond issuers promise to repay the debt to the bondholders at maturity. That promise is generally
kept unless the issuer falls on hard times; some bonds have credit risk based on the financial health of
their issuer. When a bond issuer goes into bankruptcy, bondholders are paid off before stockholders.
Bonds are also vulnerable to interest rate risk: when interest rates rise, bond prices fall and vice versa.
Cash investments carry opportunity risk. For example, investing in very safe, short-term investments like
Treasury bills may protect you from loss, but you may miss the opportunity of more generous returns
offered by other investments. Even people who keep their money under their mattress have the risk that
their money will be worth less in the future because of inflation that reduces the purchasing power of the
cash.

  

Smart investors do not put all their assets in one type of investment or ³asset class.´ Instead, they spread
or diversify their risk by investing in different types of investments. When one asset class is performing
poorly, another may be doing well and compensating for the poor performance in the other.

Some studies have shown that overall asset allocation is more important to investment success than the
choice of investments within the allocation.

9ë :

    


Investment firms often publish recommended asset allocations based on their outlook for the relative
performance of the stock, bond and money markets.

Personal finance Web sites and different types of investment advisers sometimes offer standard asset
allocation recommendations for people of different age ranges or risk tolerance. The asset allocation that
is right for you, however, depends on several personal factors, such as life and financial goals, and will
change over time with different life events.

Î
;  



Once you establish your optimal asset allocation which takes into account return objectives, risk tolerance
and time horizon, you need to review your investments regularly to see if your portfolio matches your plan
and if your plan is still right for your age and goals. When one asset class performs well or poorly, it can
shift your asset allocation. You can bring it back in line by ³rebalancing´ or selling assets that have
appreciated and buying those that have fallen in price. In this way, asset allocation enforces a good
discipline of selling high and buying low.

Younger investors may want to allocate their longer-term retirement assets to riskier investments such as
equities or stock, because they have time to ride out the market¶s ups and downs. With age, however,
asset allocations may shift toward safer investments such as bonds because retirement is getting closer
and older investors should be more concerned about keeping what they have saved and gained.

Take time every six months to a year or two to be sure your asset allocation matches your plan and that
your plan remains appropriate for your age and goals. If not, you may want to take the steps to make sure
your plan is appropriate for your age and goals and balance your asset allocation to match your plan.
Your investment advisor can help with this process.

 Î 
  ,

  

If you¶re interested in buying or selling bonds, it¶s a good idea to start out by comparing the prices of
similar securities. Just as you would with any important purchase, such as a home or a car, checking out
the current prices of comparable bonds gives you a strong indicator of what your bond will cost to buy, or
what you can expect to receive if you are selling a security.

An easy place to check bond prices is in your morning newspaper, or in the financial media, such as The
Wall Street Journal, Investor¶s Business Daily or Barron¶s. Those papers have extensive tables showing
representative bond prices in recent trades. You should recognize that the prices listed in the papers are
snapshots; bond prices do fluctuate during the day so the price you¶re actually quoted may vary based on
more current trading activity. The Internet has also become a rich source of information, with many sites
providing investor information about bonds. In addition, with the growth of business news channels, such
as CNBC, investors can check on benchmark Treasury bond prices during the day and stay apprised of
the economic releases that tend to affect yields.

"   ë i6




If you¶re more accustomed to reading stock exchange listings, the bond price tables in the newspapers
look somewhat different and, initially, hard to understand. But once you become familiar with a few terms,
the tables are understandable and provide information you need to make informed investment decisions.

In the stock tables, you can look up a specific company and see its high and low prices for the day before.
That¶s because there are far fewer stocks listed on the three major exchanges, approximately 9,000, than
the number of bond issues outstanding at any given time. In addition, the stocks of most firms tend to
trade frequently, making it relatively easy to determine what a given stock¶s recent market price is.

But with more than 1.5 million individual bonds in the municipal market alone, 167 times the number of
stocks listed on the major exchanges, it wouldn¶t be possible for newspapers to list every bond
outstanding in the combined debt markets. Just the municipal market alone would take up close to 100
pages. And, despite the market¶s liquidity (the ability to buy or sell a security quickly), most retail
bondholders purchase their securities with the intent to receive regular interest and hold them until they
mature, reducing the potential amount of daily trading activity.

Fortunately, with so many bonds outstanding, listing daily prices for all of them is neither necessary nor
useful. Since only a small fraction of the outstanding bonds trade in any given day, listing representative
prices provide investors with sufficient benchmark information to gauge what a fair price would be for the
security they are considering. That¶s because similar bonds tend to move up or down in tandem with
interest rates, a key factor affecting the multitude of fixed-income securities. The bond¶s credit quality, as
reflected in its rating from one of the major rating agencies, is another factor that can affect its price.
(Individual stock prices are more directly determined by earnings projection for the specific company.
Thus, the stock price for one retailer may rise during the quarter, while another¶s may fall.)

 ,6


The tables shown in the general and business media, while varying in format, provide the basic
information you need to compare prices for similar treasury, municipal, corporate and mortgage bonds.
When considering bonds as investments, there are several pieces of information you need to know: The
bond¶s coupon rate²or what it will pay in interest; how long before the principal amount of the bond
matures, or if there is a call date; its recent price and current yield. Essentially, all the tables give that
same basic information. The Treasury table (Government agency tables are similar) would be listed in the
paper as shown below:

 ë    


 
5
7 3/4 Feb. 01 105:12 105:14 5.50
5 3/8 Feb. 01 99:26 99:27 5.44

In the first row, the security is paying its bondholders 7 3/4% interest and is due to mature Feb, 2001.
Prices in the bid and ask columns are percentages of the bond¶s face value of $1,000. So, a bid of 105:12
means that a buyer was willing to pay $1053.75, compared to the seller¶s lowest asking price, 105:14, or
$1054.38, a difference of 63 cents per thousand. (The numbers after the colons represent 32nds, so
12/32nds, for example, would equal $3.75, which is appended to the 105 before the colon.) By looking at
the bid and ask prices, you can see that an investor who bought the bond at par when it was first issued
can make a profit of more than 5% if it were sold now.

The reason for the profit can be explained by the rate column. The security pays higher interest than a
newly-issued three-year Treasury would, so is more attractive to an investor. But because the investor
would pay a premium to purchase the existing note, the yield to maturity falls to 5.50%.

In the next row, the bond pays a lower rate, 5 3/8%. Its price was unchanged the day before, closing at
99:27, or $998.44, indicating an investor buying that security would be able to acquire it at a discount
from its par value of $1,000. Because the investor is buying the bond below its par value, the yield to
maturity, 5.44%, exceeds the coupon rate.

ii    ë 

The tax-exempt bond market is the most popular sector for individuals investors interested in the bond
market. About 30% of all outstanding municipal bonds are held by individuals. For that reason, it is
particularly important that investors have an understanding of how to read price information, as below.

   ë  Î x ë  


Nevada GO Bds 5.00 5-15-28 97 1/8 5.19
Nebraska Public Power District 5.00 1-1-28 97 5.20

Looking at those two examples, a buyer would know that a 20-year municipal bond paying 5% interest
would cost about $970. In this case, the slight price variances may be attributable to different credit
ratings and other factors.

In the first row, the State of Nevada general obligation bonds are offering a coupon rate of 5% with a
maturity in May of 2028. The most recent price of this bond, shown as a percent of its face value, was
$971.25, $28.75 less than its initial offering value per $1,000. In other words, if the buyer¶s bid was
accepted, he would pay less than the current bond holder did when the bond was first issued, because
prevailing interest rates are now higher than 5% on similar tax-exempt bonds. Because of the discount,
the buyer would be earning a yield to maturity of 5.19%, more than the stated interest rate, because he
bought the bond at less than its face value.

The second issue, offered by the Nebraska Public Power District, has the same coupon, or interest rate,
5% and matures in January of the same year, 2028. Just as in the Nevada example, the seller would be
receiving less than what he paid for the bond when it was originally issued, $970 per $1,000, a 3% loss.
The lower price, consequently raises the yield to maturity for the buyer to 5.20%.

The Association and Bloomberg News LLP. also provide a yield table for AAA-rated insured revenue
bonds, a useful benchmark for prices of other municipal issues. In addition, the Association and Standard
& Poor¶s also sponsor a phone service which provides subscribers with current prices of up to 25
securities for $9.95. Call 1-800-Bond Info begin_of_the_skype_highlighting 1-800-Bond
Info end_of_the_skype_highlighting for details.
    i 


As with the Treasury and Municipal market bond listings described above, corporate bond listings also
show the coupon, or interest, rate; maturity date, and last price. However, because corporate bonds are
more actively held by large institutional investors, the listing table shows the current yield and includes the
volume traded. Corporate bond listings would look like those below:

 
 $x$& 
, $
BosCelts 6s38 9.2 22 65 3/8 + 1/4
PacBell 6 5/8 34 6.7 5 99 1/8 - 1/8

The companies issuing the bonds are listed in the first column, in this case, the professional basketball
team, The Boston Celtics, and the telecommunications company, Pacific Bell. Immediately after the
names, comes the interest rate paid by the bond as a percentage of its par value. The Celtic¶s bond pays
6%; Pac Bell¶s pay somewhat more, 6 5/8%. (The small ³s´ in the Celtic¶s listing simply separates the
interest rate from the year the bond matures, 2038). The PacBell bond matures in 2034.

The basketball team¶s bond has a current yield of 9.2% based on its closing price of $653.75 per $1,000.
The volume traded on the exchange the day before amounted to $22,000 and the price rose $2.50.
Similarly, the phone company had a volume of $5,000 and closed nearer its par value, $991.25, down
$1.25 for the day.

  


As most investment advisors will tell you, some portion of your portfolio should be in bonds. Investing in
bonds generally provide a high degree of safety with regular, predictable, scheduled payments over the
life of the security. Now that you understand how to read the bond tables in the newspaper and in other
media, you¶ll have a strong base to begin discussing your bond investment needs with your broker.

#
   3  



The condition and direction of the U.S. economy is a major driver of interest rates and bond prices. Even
though no one knows for certain what the future holds, bond traders profit when their expectations for the
economy are correct. Bond market participants follow economic indicators closely, looking for signs of
change that might affect future supply and demand so they can position themselves accordingly. When
economic indicators exceed or fall short of market expectations, bond prices can move quickly and
sharply in response.

Monetary policy makers at the Federal Reserve also closely follow and interpret economic data releases,
looking at the indicators relative to expectations as an indication of the outlook and direction of the
economy and inflation, which can affect Federal Reserve policy. Federal Reserve policy has a significant
impact directly on short-term interest rates and indirectly on longer term interest rates, which in turn affect
bond prices.
Which Indicators Matter Most?

The markets¶ reaction to the release of economic indicators depends on the indicator itself, where we are
currently in the business expansion/contraction cycle, and policymakers¶ reaction to structural changes in
the economy.

Leading indicators, which have historically predicted the future direction of the economy, are more
important than lagging indicators of economic turns that have already occurred.

Relevance, Timeliness and Reliability

The most relevant, timely and reliable indicators have the biggest effect on the market. Retail sales
figures are considered relevant, for example, because consumption spending represents two-thirds of
total U.S. economic activity.

Markets always want the latest news, so indicators that reflect the most current data, such as the Institute
for Supply Management (ISM) Survey released on the first day of the month and reflecting the month just
past, could have a greater impact than the final quarterly report on economic growth (change in Gross
Domestic Product, or GDP) which is released three months after the end of the quarter it reflects.

As for reliability, some figures, such as new, single-family home sales, are subject to large subsequent
revisions or too changeable for valid comparisons. Other indicators also show wide swings from report to
report, compelling analysts to ³smooth´ the data using moving averages to discern trends.

Business Cycle Phase

When the economy is in recession or just starting to expand, the markets are less concerned with inflation
and more sensitive to signals about demand and production. When the economy has been growing for
some time, the fear of inflation rises and the markets focus on signs of increasing wages and prices.

Structural Change and Policy Reaction

Structural changes in the economy also make certain indicators more or less reliable as signals of broad
business conditions or prospects. In the early 1980s, for example, the money supply numbers determined
short-term interest rates because of Fed policy at that time. A Fed policy change in 1982 broke the link
between monetary growth and interest rate changes. In addition, the relationship between changes in
money and economic growth broke down, making the money supply numbers less useful for predicting
future spending and production. The Federal Reserve now may look at a number of indicators, including
relative interest rate levels, commodity prices, inflation and economic growth along with the money
supply.

A Note on Seasonal Adjustment

³Seasonal adjustment´ of economic data applies factors based on recent seasonal patterns so that
indicators can be compared week-to-week and month-to-month for evidence of emerging trends.
Although the seasonal adjustment process is not perfect, without it analysts would only be limited to year-
to-year comparisons and unable to assess the current condition of the economy.

Economic indicators are listed by category, with a description of what the economic indicator is and why a
change in that indicator might be meaningful to an investor.

  ,  c    


The Employment Situation

Source: Department of Labor, Bureau of Labor Statistics


Frequency: Monthly
Released: 8:30 a.m., first Friday of the month (usually)

  
- A report including the civilian unemployment rate; the change in total nonfarm payroll (number
of payroll jobs added or lost); the change in manufacturing payroll employment; the average nonfarm
workweek (number of hours worked); average workweek in manufacturing; average hourly earnings;
index of aggregate weekly hours (total hours worked per week by non-supervisory employees in the
private nonfarm economy); and payroll employment diffusion, the percentage of industries reporting an
increase in payroll employment.

 - Rising employment can be a sign of economic recovery or, in the extreme, an inflationary
pressure. Rising unemployment is consistent with economic slowdown or recession. The change nonfarm
payroll is considered shorthand for the overall tone of the report and affects the outlook for personal
income. The average workweek in manufacturing often leads changes in manufacturing employment, as
employers will adjust workers¶ hours before adding or cutting jobs. Average hourly earnings is an indicator
of wage inflation and is helpful in estimating changes in personal income and the Employment Cost
Index. Payroll employment diffusion indicates the breadth of payroll employment changes and can
foreshadow shifts in overall employment.

-nemployment Insurance Claims

Source: Department of Labor


Frequency: Weekly
Release: 8:30 a.m., Thursday of the following week

  
- Number of initial filings for state unemployment insurance benefits for the previous week and
the total number of persons receiving payments for the week before that.

 - Indicates whether unemployment is up or down. Initial claims suggest the layoff pace,
which can be useful early signal of conditions in the labor market.

Challenger, Gray and Christmas Layoff Announcements

Source: Challenger, Gray and Christmas, Inc., an outplacement firm


Frequency: Monthly
Timing: 10 a.m., First week of the following month

  
- Gross number of layoff announcements by U.S. firms

 - Provides an interesting supplement to unemployment claims report in assessing labor
market¶s health. The numbers show seasonal patterns but are not seasonally adjusted and therefore
better compared on an annual basis.

½elp Wanted Advertising Index

Source: The Conference Board


Frequency: Monthly
Timing: 10:00 a.m., last Thursday of the month for the previous month
  
- A comparison of help-wanted advertising in the classified sections of 51 leading newspapers
in major employment areas nationwide.

 - Over the past 40 years, the index has been a reliable leading indicator of peaks in total
nonfarm payroll employment but a coincident and sometime lagging indicator of business cycle and labor
market lows.

Gross Domestic Product (GDP)

Source: Department of Commerce, Bureau of Economic Analysis


Frequency: Quarterly, revised monthly.
Timing: 8:30 a.m., about four weeks after month end. Advance GDP estimates are released late in the
first month after the quarter ends; preliminary GDP is released a month later; revised GDP is reported late
in the third month after the end of the quarter it refers to.

  
- A measure of the total value of goods and services produced by people, businesses
governments and property located in the United States. Nominal GDP shows current dollar value; real
GDP is adjusted for inflation by reference to a 1996 base year. The indicator is typically reported as an
annualized quarter-to-quarter percentage change.

 - GDP is the broadest available measure of U.S. economic activity. Rising GDP indicates
economic growth. Falling GDP indicates retrenchment. Negative GDP growth for two or more consecutive
quarters defines a recession.

Personal Income

Source: Department of Commerce, Bureau of Economic Analysis


Frequency: Monthly
Timing: 8:30 a.m., four weeks after month end, next business day following GDP report

  
- Total pretax income earned by individuals, non-profit organizations and private trust funds,
expressed at an annual rate. Disposable personal income (DPI) measures personal income minus tax
and non-tax payments. Personal saving subtracts personal consumption expenditures plus interest
payments and net transfers to foreigners from personal income. The personal saving rate is personal
saving stated as a percentage of personal income.

 - Changes in real (inflation-adjusted) DPI often foreshadow changes in consumer spending
patterns; i.e., a rise in income can lead to a rise in spending and vice versa. Consumer spending has an
effect on economic growth because two-thirds of GDP is personal consumption.

Corporate Profits

Source: Department of Commerce, Bureau of Economic Analysis


Frequency: Quarterly, revised monthly along with GDP
Timing: 8:30 a.m., eight to nine weeks following quarter end.

  
- Tax-based profits are derived from corporate tax returns. Adjusted profits are designed to
reflect earnings from current production. Tax-based numbers get the most press, but the adjusted figures
are more economically meaningful.

 - Strength or weakness in corporate profits often foreshadows increases or decreases in the
contribution of capital spending to GDP growth.
c
3 Î      


Institute for Supply Management Survey

Source: Institute for Supply Management


Frequency: Monthly
Timing: 10:00 a.m., first business day of the following month

  
- Results of a survey of 350 purchasing managers on recent trends in orders, production,
employment, delivery speeds (vendor performance), and inventories as well as prices for the products
they buy. Respondents indicate whether activity in each category has been higher, lower or unchanged
from the previous month.

 - An overall index reading above 50% implies expansion of the manufacturing sector; below
43% implies recession. Growth in other sectors²service and construction²can sustain gains for the
whole economy when manufacturing weakness is only moderate. This survey is also considered an
indicator of corporate purchasing managers¶ plans.

ISM Nonmanufacturing Survey

Source: Institute for Supply Management


Frequency: Monthly
Timing: 10:00 a.m., third business day of the month

  
- Results of a survey covering 370 purchasing and supply management professionals from
more than 26 sectors of the economy.

 - Although it dates back only to 1997, the survey is expected to become a valuable guide to
large parts of the economy for which not much economic data exist.

Chicago Purchasing Managers¶ Survey

Source: Purchasing Management Association of Chicago


Frequency: Monthly
Timing: 10:00 a.m., last business day of month

  
- Survey of purchasing managers in Illinois, Indiana and Michigan.

 - This survey moves in the same direction as the Institute for Supply Management survey
about half the time and is followed as a secondary source of corporate purchasing managers plans.

Philadelphia Federal Reserve ˜ank ˜usiness Outlook Survey

Source: Federal Reserve Bank of Philadelphia


Frequency: Monthly
Timing: 10:00 a.m., third Thursday of each month

  
- A poll of manufacturing firms in eastern Pennsylvania, New Jersey and Delaware, the bank¶s
district, on recent developments and expectations with respect to ³general conditions´ and specific
sectoral activities.

 - Indicates changes in regional economic activity.


ansas City Federal Reserve ˜ank Manufacturing Survey

Source: Federal Reserve Bank of Kansas City


Frequency: Monthly
Timing: 11:00 a.m., two weeks after month-end

  
- Reports about their businesses from manufacturers in the Kansas City Federal Reserve Bank
district.

 - Indicates changes in regional economic activity.

Richmond Federal Reserve ˜ank Survey

Source: Federal Reserve Bank of Richmond


Frequency: Monthly
Timing: 10:00 a.m., second Tuesday of the month

  
- Poll of district businesses on conditions in manufacturing, service and retail sectors.

 - Indicates changes in regional economic activity.

Current Economic Conditions (³˜eige ˜ook´)

Source: Federal Reserve Board


Frequency: Eight times per year, every six to eight weeks
Timing: 2:00 p.m., second Wednesday before Federal Open Market Committee Meetings.

  
- A report on regional and economic conditions from each of the 12 Federal Reserve district
banks

 - Based mostly on anecdotal reports, the Beige Book (so-called because of the color of its
cover) can convey a different impression about the economy than what can be gleaned by the numbers
alone. Although the Fed does not seem to assign much importance to the backward-looking report, the
markets can move substantially in response to a change in its tone about regional and economic
conditions.

Durable Good Orders (Advance Report)

Source: Department of Commerce, Bureau of the Census


Frequency: Monthly
Timing: 8:30 a.m., three to four weeks after month end

  
- A report measuring the value of orders placed with U.S. manufacturers for goods with a life
expectancy of at least three years.

 - Within the nondefense orders group, bookings for capital goods are watched particularly
closely as a leading indicator of business spending on durable equipment. The Conference Board¶s index
of leading economic indicators includes this number as well as manufacturers¶ new orders for consumer
goods and materials.
Manufacturers¶ Shipments, Inventories and Orders

Source: Department of Commerce, Bureau of the Census


Frequency: Monthly
Timing: 10:00 a.m., four to five weeks after month end

  
- Data on new orders, unfilled order backlogs, shipments and inventories for both durable and
nondurable goods at U.S. factories.

 - The ratio of factories¶ inventories to shipments, when averaged over two or three months,
can suggest whether inventory imbalances are present or developing at the factory level.

Industrial Production

Source: Federal Reserve Board


Frequency: Monthly
Timing: 9:15 am, two weeks after month end

  
- A measure of domestic production by manufacturing, mining and utility companies.

 - Industrial output accounts for roughly 25-30% of GDP (as of 2000).

Capacity -tilization:

Source: Federal Reserve Board


Frequency: Monthly
Timing: 9:15 a.m., two weeks after month end, coincident with Industrial Production

  
- The percentage of estimated productive capacity in manufacturing, mining and utilities in
operation each month.

 - Historically, utilization rates approaching or exceeding 85% can heighten inflation risks by
creating production bottlenecks and limiting the supply of products.

Manufacturing and Trade Inventories

Source: Department of Commerce, Bureau of the Census


Frequency: Monthly
Timing: 8:30 a.m., six weeks after month end

  
- A report indicating the level of business stocks at the retail, wholesale and manufacturing
levels.

 - The inventory-to-sales ratio included in the report can be helpful in attempting to infer
whether recent changes in the speed of stock building are sustainable or appropriate in the context of
demand trends and is often viewed in conjunction with manufacturers¶ shipments, inventory and order
trends. Inventory data are revised frequently and considered less reliable than other statistics.
Composite Index of Leading Economic Indicators

Source: The Conference Board


Frequency: Monthly
Timing: 10:00 a.m. approximately three weeks after month-end

  
- A composite of ten financial and non financial indicators.

 - These indicators have historically tended to anticipate business cycle peaks and troughs.

 
3

Retail Sales

Source: Department of Commerce, Bureau of the Census


Frequency: Monthly
Timing: 8:30 a.m., two weeks after month-end

  
- A measurement of sales of retail establishments, including e-commerce sales adjusted for
normal seasonal variation, holidays and trading-day differences. Advance estimates are unreliable and
revised a month later and made final a month after that. Large adjustments are the norm, so advance
figures are unreliable.

 - Retail sales are 40% of Personal Consumption Expenditures, which in turn make up two-
thirds of the Gross Domestic Product (GDP). Retail sales is an indication of consumer spending and
confidence.

Personal Consumption Expenditures

Source: Department of Commerce, Bureau of Economic Analysis


Frequency: Monthly
Timing: 8:30 a.m., four weeks after month end

  
- A measure of consumer spending for all goods and services, quoted in both nominal (current-
dollar) and real (inflation adjusted) terms and broken down into broad categories of durable goods,
nondurable goods and services.

 - Personal Consumer Expenditures contribute two-thirds of the Gross Domestic Product
(GDP).

-nit Auto and Truck Sales

Source: Individual company reports, adjusted using seasonal factors provided by the Department of
Commerce, Bureau of Economic Analysis
Frequency: Monthly
Timing: Time varies; one or two business days after month end.

  
- Monthly figures supplied by the major vehicle manufacturers, in conjunction with official
seasonal adjustment factors.

 - Provides useful information about demand trends in this sector, and, by inference, for
other big-ticket items.
˜TM--˜SW Chain-Store Sales Index

Source: Bank of Tokyo-Mitsubishi, UBS Warburg


Frequency: Weekly, for week ending Saturday
Timing: 9:00 a.m., Tuesday

  
- a seasonally adjusted sales index based on private survey information and covering the week
ending the previous Saturday

 - Month-to-month changes in this index have been a coincidental indicator of nominal retail
department store sales.

LJR Redbook Report

Source: Lynch, Jones and Ryan


Frequency: Weekly, for week ending Saturday
Timing: 9:00 a.m., Tuesday

  
- A report designed to measure department store trends, compiled from information from 21
large department store firms.

 - The report has a modest correlation to monthly changes in non auto retail sales.

Goldman Sachs Retail Index for Same-Store Sales

Source: Goldman, Sachs & Co.


Frequency: Monthly
Timing: 11:00 a.m. on the first or second Thursday of the following month

  
- A sales index value and year-to-year percentage change computed by Goldman, Sachs retail
industry analysts based on monthly same-store sales reports from large merchandiser retailer firms

 - Helps discern shifts in tone of broad consumer demand for goods.

Consumer Confidence

Source: The Conference Board


Frequency: Monthly
Timing: 10:00 a.m., last Tuesday of the month to which data apply

  
- Results of a poll of 5,000 households on questions relating to their perception of the economy
as well as personal circumstances such as plans to purchase homes or durable goods

 - Compiled since 1969, the Consumer Confidence Index seems to have a strong negative
correlation to unemployment, though its relationship to consumer spending is loose.

Consumer Sentiment

Source: University of Michigan Survey Research Center


Frequency: Semimonthly
Timing: 10:00 a.m. Preliminary data released on Friday following the second full weekend of the month to
which the data apply; final data published on Friday following the last full weekend of the month.

  
- A nationwide poll of 500 consumers per month on issues relating to views of personal finance
and economic conditions.

 - Conducted since 1950, the poll has over its long history been a valuable guide to changes
in consumer attitudes that might influence spending behavior.

A˜C/Money Magazine Consumer Comfort Index

Source: ABC Inc./ Time Warner


Frequency: Weekly
Timing: 6:30 p.m., Wednesday

  
- A nationwide survey of about 1,000 adults per month on questions concerning the status of
the economy, personal finances and the buying climate.

 - A useful and more frequent measure of consumer attitudes.

Consumer Installment Credit

Source: Federal Reserve Board


Frequency: Monthly
Timing: 3:00 p.m., five weeks after month-end

  
- A measure of the change in the dollar amount of consumer installment credit outstanding
during the month, including loans to individuals by banks and finance companies.

 - An indication of consumer spending that has become less useful since non mortgage
interest lost its tax-deductible status in 1986.

" 
 
  

½ousing Starts and ˜uilding Permits

Source: Department of Commerce, Bureau of the Census


Frequency: Monthly
Timing: 8:30 a.m., two to three weeks after month end

  
- The total number of private housing units on which construction has started and permits
issued by 19,000 localities during the month, expressed at an annual rate.

 - The housing sector tends to lead the rest of the economy, so its strength is a sign of
economic recovery or continuing strength, and its weakness can signal economic contraction.

New Single-Family ½ome Sales

Source: Department of Commerce, Bureau of the Census


Frequency: Monthly
Timing: 10: a.m., four to five weeks after month end
  
- The annualized unit sales level and monthly percentage change for new single-family homes,
seasonally adjusted, as well as the number of new homes offered for sale.

 - The housing sector tends to lead the rest of the economy. Changes in the inventory of
unsold new homes relative to home sales often presage the opposite direction for housing starts.

Existing ½ome Sales

Source: National Association of Realtors


Frequency: Monthly
Timing: 10:00 a.m., the 25th day of the following month or next business day

  
- Seasonally adjusted data on sales of existing dwellings.

 - Turnover in housing stock can be a valuable leading indicator of demand for household
durables. Home purchases typically stimulate spending on furnishings, and the transactions frequently
pump more cash into the economy by liquefying capital gains on real estate investments.

Residential Construction Spending

Source: Department of Commerce, Bureau of the Census


Frequency: Monthly
Timing: 10:00 a.m., four to five weeks after month end

  
- Total new public and private construction outlays, seasonally adjusted and reported in both
nominal and real (inflation-adjusted) terms.

 - Construction spending data figure directly into the computation of several components of
the quarterly GDP report. However, because these figures are frequently revised, the financial markets
are more likely to move in response to housing starts and new home sales.

National Association of ½ome ˜uilders Survey

Source: National Association of Home Builders (NAHB)


Frequency: Monthly
Timing: 1:00 p.m., mid-month

  
- A survey of NAHB members regarding current sales conditions, buyer traffic and sales
expectations for the next six months.

 - Buyer traffic and sales expectations usually coincide with or slightly lead housing starts,
while current sales have a modest positive correlation with new homes sales as reported by the
Department of Commerce.

Mortgage ˜ankers Association Weekly Survey

Source: Mortgage Bankers Association (MBA)


Frequency: Weekly
Timing: early Wednesday morning

  
- Index value or measure of overall volume of mortgage applications received by MBA
members. There are also two sub-indices for purchase mortgage and mortgage refinancing.
 - Provides an early signal of changes in housing transactions and mortgage refinancing
activities, which can be leading indicators of total consumer expenditures. Home purchases typically
trigger other outlays while loan refinancing lowers monthly expenses and leaves consumers with more
cash to spend.

 i

International Trade ˜alance

Source: Department of Commerce, Bureau of the Census


Frequency: Monthly
Timing: 8:30 a.m., six weeks after month end

  
- Difference between U.S. exported and imported goods and services, expressed in billions of
dollars.

 - Differences in trade figures from expectations or official assumptions can significantly
change GDP growth estimates, especially for the current quarter.

Current Account ˜alance

Source: Department of Commerce, Bureau of Economic Analysis


Frequency: Quarterly
Timing: 10:00 a.m., ten to eleven weeks after quarter-end

  
- A measurement of net U.S. trade in merchandise, services, and certain financial transactions.

 - Changes in the current account balance imply a corresponding shift in the flows of capital
between the United States and the rest of the world. If the current account deficit goes up, then capital
inflows into the United States also go up. This indicator is widely followed and referred to as the ³trade
deficit´ measure.

Financial Account ˜alance

Source: Department of Commerce, Treasury Department


Frequency: Monthly or quarterly, depending on series
Timing: n/a

  
- A measure of U.S. assets abroad and foreign assets in the United States.

 - Shows the percentage of U.S. Treasury securities held by foreign investors, which can
affect market demand.

Î 

Î    

GDP-˜ased Price Indices

Source: Department of Commerce, Bureau of Economic Analysis


Frequency: Quarterly data, revised monthly
Timing: 8:30 a.m., four weeks after month-end
  
- Part of the quarterly Gross Domestic Product (GDP) report showing quarter-to-quarter percent
change in weighted price indices for the various components of GDP, for gross domestic purchases
(excludes exports) and for the ratio of nominal (current-dollar) GDP to real (inflation-adjusted) GDP

 - The broadest measure of inflation in the economy.

Producer Price Index (PPI)

Source: Department of Labor, Bureau of Labor Statistics


Frequency: Monthly
Timing: 8:30 a.m., two weeks after month end.

  
- An index of prices received by U.S. producers of goods and commodities covering 3200
commodity groups and prices for 100,000 items. Indices in the report include: PPI for finished goods, or
products ready to be shipped to wholesalers and retailers; PPI for intermediate goods that are not quite
finished; and PPI for crude goods and materials, or raw commodities.

 - An indicator of inflation at the producer level. A higher cost of producing goods can get
passed along to consumers in the form of higher prices. The PPI for finished goods gets the most
attention from the markets as an indicator of inflation prospects. Changes in the PPI for intermediate
goods can be a leading indicator for finished goods prices.

Consumer Price Index

Source: Department of Labor, Bureau of Labor Statistics


Frequency: Monthly
Timing: 8:30 a.m., two or three weeks after month ends

  
- A measurement of prices for a fixed basket of goods and services bought regularly by U.S.
consumers, reported for Urban Wage Earners and Clerical Workers (CPI-W) and for All-Urban
Consumers (CPI-U), which includes professional and self-employed people.

 - An indicator of inflation at the retail level. The CPI-W Index is used to make annual cost-of-
living adjustments to social security benefits and wages covered by collective bargaining agreements. It is
also used as the measure to adjust Treasury Inflation-Protected Securities (TIPS) on a semiannual basis.

Employment Cost Index (ECI)

Source: Department of Labor, Bureau of Labor Statistics


Frequency: Quarterly
Timing: 8:30 a.m., four weeks after quarter end

  
- A measure of changes in wage and benefit payments for specific types of work.

 - By including benefits and management categories, the ECI becomes a more
comprehensive labor-cost inflation indicator.

Goldman Sachs Commodity Index

Source: Goldman, Sachs & Co.


Frequency: Daily
Timing: n/a
  
- Performance benchmark for commodity investments providing information about commodity
price behavior on a production-weighted basis and a measure of total return achievable through an
unleveraged investment in commodities over time.

 - Sustained increases in commodity prices over time can be a precursor to an increase in
consumer prices and an inflation indicator. Conversely, declines can be a precursor of dis-inflation and at
the extreme, deflation.

˜ridge/Commodity Research ˜ureau (CR˜) Indices

Source: Bridge/CRB
Frequency: Daily
Timing: n/a

  
- Daily indices for 23 different commodity price measures.

 - Sustained increases in commodity prices over time can be a precursor to an increase in
consumer prices and an inflation indicator.

Productivity and Costs

Source: Department of Labor, Bureau of Labor Statistics


Frequency: Quarterly data, revised monthly
Timing: 10:00 a.m., five to six weeks after quarter end

  
- Productivity measures the change in output per hour of work, seasonally adjusted. The report
also provides quarterly statistics on total labor compensation.

 - Productivity gains suggest the possibility of economic growth without a corresponding
increase in inflation. It is also an indictor as efficiency of the labor market and has an significant effect on
the outlook for employment

Import and Export Prices

Source: Department of Labor, Bureau of Labor Statistics


Frequency: Monthly
Timing: 10:00 a.m., 10 days after month end

  
- Detailed monthly international price indices used to deflate the monthly merchandise trade
balance figures for conversion into real (volume) terms.

 - Movements in the price index for imports excluding the petroleum component provide a
good indication of the underlying pricing for foreign-produced goods is influencing overall U.S. inflation
among goods.

%   




Federal ˜udget ˜alance

Source: Department of the Treasury, Financial Management Service


Frequency: Monthly
Timing: 2:00 p.m., 15th business day of the month
  
- Monthly deficit or surplus in the federal budget, not seasonally adjusted.

 - Over time, budget deficits can put upward pressure on interest rates because they
increase the supply of U.S. treasury securities issued to finance the debt. However, such factors as
inflation, Federal Reserve policy and the value of the dollar can have an even greater effect on rates.
Higher interest rates in turn can slow economic growth.

- S Treasury ˜orrowing Schedule

Source: Department of Treasury, via Federal Reserve Bank of New York acting as fiscal agent.
Frequency: Weekly for Treasury bills; monthly for 2-year Treasury notes; quarterly for 5- and 10-year
Treasury notes and, for 5-, 10- and 20-year Treasury Inflation Protection Securities, according to the
schedule established by the Treasury Department.
Timing: Announcements made at 2:30 p.m.; auctions held at 1:p.m.; day varies.

  
- A picture of the amount of U.S. Treasury securities coming to market

 - Indication of supply, which, when compared to demand, affects bond prices and therefore
yields.

ë 3ë



Monetary Aggregates

Source: Federal Reserve Board


Frequency: Weekly, for week ending Monday
Timing: 4:30 p.m., every Thursday, ten days after reporting period

  
- M1, M2, M3 and L are measures of money circulating in the economy, each more inclusive of
various cash equivalents than the previous. The Debt figure includes outstanding credit market debt of
federal, state and local governments and the private non financial sector.

 - In monetarist economic theory, changes in the money supply over time should yield fairly
predictable changes in nominal economic output. Accelerations or decelerations would be expected to
influence real economic activity in the short term, but for the long term it is argued that money growth
affects only the inflation rate. However, deregulation and globalization have caused these relationships to
break down since the 1980s.

Monetary ˜ase

Source: Federal Reserve Bank of St. Louis, Federal Reserve Board


Frequency: Weekly
Timing: n/a

  
- A measure of the supply of ³high-powered´ money in the economy that can be leveraged by
the banking system for future lending activities.

 - Monetarists believe that changes in the growth of the money base predict similar changes
in monetary aggregate growth rates.


 Î  £



FOMC Policy Announcements

Source: Federal Reserve Board/Federal Open Market Committee (FOMC)


Frequency: varies with meeting schedule
Timing: around 2:15 on FOMC meeting dates

  
- An announcement of any monetary policy changes undertaken by the Federal Reserve Board,
most often relating to changes in the federal funds rate, or the interest rate at which depository institutions
lend balances at the Federal Reserve to other depository institutions overnight. A statement that explains
the reason for the target Fed funds rate and FOMC views on relative inflation and economic growth risks
accompanies the announcement.

 - The Federal Reserve lowers the federal funds rate when it wants to bring overall interest
rates down and stimulate the economy, and increases it when it perceives the economy to be growing too
fast and becoming inflationary. Federal Reserve ³watchers´ and analysts of monetary policy consider the
accompanying statement an important indication of the direction of monetary policy and the interpretation
of that statement is reflected in movements of Treasury yields immediately after the announcement is
made public. At times, the statement is considered at least as important as the decision on the Fed funds
rate.

FOMC Minutes and Transcripts

Source: Federal Open Market Committee (FOMC)


Frequency: varies with meeting schedule
Timing: 2:00 p.m. on the Thursday following the next FOMC meeting date

  
- Official minutes from the previous FOMC meeting, summarizing the panel discussions and
vote and describing the economic conditions that were present at the time.

 - Provides insight into FOMC thinking and its rationale for policy decisions. It is a more
detailed and complete description of FOMC thinking than found in the announcement immediately
following the FOMC meeting when any change in the target Fed funds rate is announced. (See FOMC
Policy Announcements description above.)

Further reading:

Goldman Sachs' Understanding US Economic Statistics

  


 x 3   £ 


When you invest in a bond, you buy the debt of its issuer, which might be the U.S. government or an
affiliated entity, a state or city government or borrowing authority, or a corporation. Every bond has certain
characteristics:

R A definite maturity date when the bond issuer promises to repay the bondholder who owns the
security at the time.
R A promise to pay taxable or tax-exempt interest at a stated ³coupon´ rate in defined intervals over
the life of a bond.
R A yield, or return on investment, which is a function of the bond¶s coupon rate and the price the
investor pays, which may be more or less than the bond¶s face value depending on a variety of
factors.
R A credit rating indicates the likelihood that the issuer will be able to repay its debt.



    


While generally considered safer and more stable than stocks, bonds have certain risks:

R Interest rate risk: when interest rates rise, bond prices fall. If you need money and have to sell
your bond before maturity in a higher rate environment, you will probably get less than you paid
for it. Interest rate risk declines as the maturity date gets closer.
R Credit risk: if the issuer runs into financial difficulty or declares bankruptcy, it could default on its
obligation to pay the bondholders.
R Liquidity risk: if the bond issuer¶s credit rating falls or prevailing interest rates are much higher
than the coupon rate, it may be hard for an investor who wants to sell before maturity to find a
buyer. Bonds are generally more liquid during the initial period after issuance as that is when the
largest volume of trading in that bond generally occurs.
R Call risk or reinvestment risk: If a bond is callable, the issuer can redeem it prior to maturity, on
defined dates for defined prices. Bonds are usually called when interest rates are falling, leaving
the investor to reinvest the proceeds at lower rates.

£ 
 
6Î   

Bond investors can diversify risk by purchasing bonds from different issuers with different maturities.

Treasury securities are available in $1,000 increments, but the minimum purchase for municipal and
corporate bonds can be $5,000 or more. The cost of buying a bond includes a commission or a ³markup´
on the price, depending on whether you are buying from a firm acting as an agent who is getting the bond
from someone else, or as principal, meaning the firm owns the bond it is selling.

Executing an effective diversification strategy requires a significant minimum investment to start. While
there is no absolute requirement, a rule of thumb says it often takes at least $10,000 or more to build a
fully diversified bond portfolio.

 
-    6   
£ 
 Î     
< 

£  


Bond funds²including mutual funds (open-end and closed-end, actively managed and indexed),
exchange-traded funds and unit investment trusts²offer a convenient and affordable way to invest in a
diversified portfolio of bonds, but a bond fund investment can differ from a bond investment in ways that
are important to understand.

When you buy a bond fund, you buy shares in a portfolio of bonds that is created or managed to pursue a
specific investment objective such as current income, current tax-exempt income, total return, or to match
the performance of a market index. The portfolio might invest in a particular type of bond (government,
municipal, mortgage or high-yield) or a particular maturity range (short-term: three years or less;
intermediate term: three to 10 years; or long-term: usually 10 years or longer).

Many bond funds make monthly or quarterly ³dividend´ payments, as opposed to the semiannual
payment schedule common to most bonds. Their price is based on their Net Asset Value (NAV), or the
total market value of the portfolio divided by the total number of fund shares outstanding. A fund¶s NAV
changes daily with market conditions and in some cases with cash inflows and outflows to and from the
fund portfolio.

i
 6  


Bond mutual funds can be actively managed or indexed, open-end, closed end or exchange traded funds.
For more details, see the comparison table.

R    bond funds, as their names suggest, have managers who buy and sell bonds
in pursuit of their investment objective. They sometimes sell bonds at a profit, creating a capital
gain, or at a loss if they need cash to pay shareholders who want to sell their shares.
R  6  
are not actively managed but constructed to match the composition of a given
bond index, such as the Lehman 10-year Bond Index. When the index changes, the portfolio
changes automatically.
R Sponsors of 2 bond funds (usually a mutual fund company) offer new shares and
redeem existing shares continuously, requiring their managers to invest cash coming into the
fund and liquidate positions when they need cash to meet redemptions. Investors in open end
funds have the choice to collect their interest income and capital gains or reinvest them
automatically in new funds shares.
R 
2 bond funds have a fixed number of shares that trade on exchanges similar to stocks
at a price that may be above or below net asset value depending on supply and demand. Closed-
end bond funds can be indexed or actively managed. To buy or sell shares in a closed end fund,
you have to go through a broker and pay a commission.
R    
(ETFs) represent shares in a ³basket´ of bonds that mirrors an index,
but the number of shares is not fixed. ETFs trade on an exchange, with shares bought and sold
through brokers who charge commissions.
R #  
  

are a portfolio of bonds held in a trust that sells a fixed number of shares.
On the trusts¶ maturity date, the portfolio is liquidated and the proceeds returned to unit holders
on a pro rata basis. UITs are usually created by brokerage firms that maintain a limited secondary
market for the units. Unit holders who want to sell before maturity may have to accept less than
they paid.



   
 


All investments offer a balance between risk and potential return. The risk is the chance that you will lose
some or all the money you invest. The return is the money you stand to make on the investment.
The balance between risk and return varies by the type of investment, the entity that issues it, the state of
the economy and the cycle of the securities markets. As a general rule, to earn the higher returns, you
have to take greater risk. Conversely, the least risky investments also have the lowest returns.

The bond market is no exception to this rule. Bonds in general are considered less risky than stocks for
several reasons:

R Bonds carry the promise of their issuer to return the face value of the security to the holder at
maturity; stocks have no such promise from their issuer.
R Most bonds pay investors a fixed rate of interest income that is also backed by a promise from
the issuer. Stocks sometimes pay dividends, but their issuer has no obligation to make these
payments to shareholders.
R Historically the bond market has been less vulnerable to price swings or volatility than the stock
market.

The average returns from bond investments have also been historically lower, if more stable, than
average stock market returns.

"

="x


A specific bond¶s risk level is reflected in its yield, another name for return on a bond investment.
³Current´ yield is a function of the bond¶s:

R Coupon rate: the annual interest rate the issuer promises to pay the investor, stated as a
percentage of the bond¶s face value or ³par,´ which is the amount the investor can expect to have
returned on the bond¶s maturity date.
R Current price, which may be a premium (more than) or discount (less than) in relation to the
bond¶s face or par value.

Yield-to-maturity reflects the relationship between the total coupon interest payments remaining between
now and maturity, and the difference between today¶s market value (price) and par value. Yield-to-call is
the same calculation based on the total coupon interest payments remaining between now and the first
call date (rather than the maturity date) as well as the difference between today¶s market value (price)
and the call price.

The higher the risk in a given bond, the higher its yield needs to be to compensate the investor for taking
the risk. When the market perceives the yield on a bond to be too low, its price will fall to bring the yield in
line with market expectations or prevailing interest rates.

>
   9


:i
x


Bonds issued by the U.S. Treasury are backed by the full faith and credit of the U.S. government and
therefore considered to have no credit risk. The market for U.S. Treasury securities is also the most liquid
in the world, meaning there are always investors willing to buy. U.S. Treasury yields will almost always be
lower than other bonds with comparable maturities because they have the fewest risks.

Relative yields²which may be discussed in terms of ³spread´ or difference in yield between a given bond
and a ³riskless´ U.S. Treasury security with comparable maturity²vary with the type of bond, maturity
date, the issuer and the economic cycle.

Callable bonds are riskier than non-callable bonds, for example, and therefore offer a higher yield,
particularly if the call date is soon and interest rates have declined since the bond was issued, making it
more likely to be called.
Short-term bonds with maturities of three years or less will usually have lower yields than long-term bonds
with maturities of 10 years or more, which are more susceptible to interest rate risk. All bonds have more
risk when interest rates are rising, but those with the lowest coupons stand to lose the most value.

#
 

 x   


Bonds have a role to play in virtually every investor¶s portfolio (See the article on Asset Allocation for
more information.) Before you invest, however, you need to understand these risks of bond investments.



  
 
 6 
-%  ë    ë  2
6 5

 26 
  
'ë353*

 
 
 When interest rates rise, bond prices fall; conversely, when rates decline, bond prices
rise. The longer the time to a bond¶s maturity, the greater its interest rate risk.

£  


The modified duration of a bond is a measure of its price sensitivity to interest rates movements, based
on the average time to maturity of its interest and principal cash flows. Duration enables investor to more
easily compare bonds with different maturities and coupon rates by creating a simple rule: with every
percentage change in interest rates, the bond¶s value will decline by its modified duration, stated as a
percentage. For example, an investment with a modified duration of 5 years will rise 5% in value for every
1% decline in interest rates and fall 5% in value for every 1% increase in interest rates.

Bond portfolio managers increase average duration when they expect rates to decline, to get the most
benefit, and decrease average duration when they expect rates to rise, so minimize the negative impact.
If rates move in a direction contrary to their expectations, they lose.

 
 
 When interest rates are declining, investors have to reinvest their interest income and
any return of principal, whether scheduled or unscheduled, at lower prevailing rates.

   
 Inflation causes tomorrow¶s dollar to be worth less than today¶s; in other words, it reduces
the purchasing power of a bond investor¶s future interest payments and principal, collectively known as
³cash flows.´ Inflation also leads to higher interest rates, which in turn leads to lower bond prices.
Inflation-indexed securities such as Treasury Inflation Protection Securities (TIPS) are structured to
remove inflation risk.

ë 
 The risk that the bond market as a whole would decline, bringing the value of individual
securities down with it regardless of their fundamental characteristics.

3  
 The risk that an investor chooses a security that underperforms the market for reasons
that cannot be anticipated.

i
 The risk that an investment performs poorly after its purchase or better after its sale.


        
   The risk that the costs and fees associated with an
investment are excessive and detract too much from an investor¶s return.

  

 
       6 



  
 The risk that a change in the tax code could affect the value of taxable or tax-exempt
interest income.

 Some corporate, municipal and agency bonds have a ³call provision´ entitling their issuers to
redeem them at a specified price on a date prior to maturity. Declining interest rates may accelerate the
redemption of a callable bond, causing an investor¶s principal to be returned sooner than expected. In that
scenario, investors have to reinvest the principal at the lower interest rates. (See also Reinvestment risk.)

If the bond is called at or close to par value, as is usually the case, investors who paid a premium for their
bond also risk a loss of principal. In reality, prices of callable bonds are unlikely to move much above the
call price if lower interest rates make the bond likely to be called.

 
 The risk that investors may have difficulty finding a buyer when they want to sell and may
be forced to sell at a significant discount to market value. Liquidity risk is greater for thinly traded
securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had
their credit rating downgraded or bonds sold by an infrequent issuer. Bonds are generally the most liquid
during the period right after issuance when the typical bond has the highest trading volume.

  

     6 
  26  

 26 

  


 
 The risk that a borrower will be unable to make interest or principal payments when they are
due and therefore default. (See also Default risk.) This risk is minimal for mortgage-backed securities
issued by government agencies or government-sponsored enterprises²also known as ³agency´
securities issued by Ginnie Mae, Fannie Mae or Freddie Mac²and most asset-backed securities, which
tend to carry bond insurance that guarantees payments of interest and principal to investors.)

£  
 The possibility that a bond issuer will be unable to make interest or principal payments when
they are due. If these payments are not made according to the agreements in the bond documentation,
the issuer can default. This risk is minimal for mortgage-backed securities issued by government
agencies or government-sponsored enterprises²also known as ³agency´ securities issued by Ginnie
Mae, Fannie Mae or Freddie Mac²and most asset-backed securities, which tend to carry bond insurance
that guarantees payments of interest and principal to investors.

  
 The risk that a bond¶s issuer undertakes a leveraged buyout, debt restructuring, merger or
recapitalization that increases its debt load, causing its bonds¶ values to fall, or interferes with its ability to
make timely payments of interest and principal. Event risk can also occur due to natural or industrial
accidents or regulatory change. (This risk applies more to corporate bonds than municipal bonds.)

  

  6  26 
  


,      
 the convexity of a bond shows the rate of change of the dollar duration of a
bond (modified duration expressed in dollars rather than years or percentage). Used in conjunction with
modified duration, convexity improves the estimate of price sensitivity to large changes in interest rates.
Option free bonds have positive convexity; bonds with embedded options, such as callable bonds and
mortgage-backed securities, have negative convexity, meaning the graph of the relationship between
their price and yield is convex rather than concave. Negative convexity creates extension risk when
interest rates rise, and contraction risk when interest rates fall.

  

   26 
  


Î 
 For mortgage-backed securities, the risk that declining interest rates or a strong
housing market will cause mortgage holders to refinance or otherwise repay their loans sooner than
expected and thereby create an early return of principal to holders of the loans.
    
 For mortgage-related securities, the risk that declining interest rates will accelerate the
assumed prepayment speeds of mortgage loans, returning principal to investors sooner than expected
and compelling them to reinvest at the prevailing lower rates.

 
 
 For mortgage-related securities, the risk that rising interest rates will slow the assumed
prepayment speeds of mortgage loans, delaying the return of principal to their investors and causing
them to miss the opportunity to reinvest at higher yields.

  

 

 26 
  


  ;  


 Early amortization of asset-backed securities can be triggered by events
including but not limited to insufficient payments by underlying borrowers and bankruptcy on the part of
the sponsor or servicer. In early amortization, all principal and interest payments on the underlying assets
are used to pay the investors, typically on a monthly basis, regardless of the expected schedule for return
of principal. For more information, see An Investor¶s Guide to Asset-Backed Securities.

 
x   



 x 3  

A variety of events or occurrences that can affect the ability of an issuer to repay the principal and interest
on its debt may cause a bond¶s rating to change. These can include changes in the economy or business
climate, demographic changes within a jurisdiction, an acquisition or management changes, an increase
or decrease in tax rates or projected revenues, or regulatory changes. For investors, here are some
things to consider when a bond¶s rating is raised or lowered:

Question

First of all, who rates bonds?

Answer

Rating agencies rate bonds. They are private companies that evaluate a bond issuer¶s financial
health and assess its ability to repay its obligations in a timely manner. A rating is an evaluation of
the likelihood that an issuer will repay the principal and interest of a particular bond on time and in
full. In the United States, the major rating agencies are Moody¶s Investors Service, Standard and
Poor¶s, and Fitch Ratings.

Question

What will happen to my bonds if the rating is downgraded? Upgraded?

Answer

Investors¶ perception is key. In many instances, the price of your bonds will go down when their
credit ratings are lowered. This is not always the case, however, because prices are determined
by investors in the marketplace and investors consider many factors other than ratings in making
investment decisions. For that reason, bond prices can also change prior to a rating action as
investors make their own assessments of the changing risks. Alternatively, of course, when a
credit rating is raised, the price of your bond could go up.

Question

Will owning an insured bond help?

Answer

Bond insurance, widely available on municipal securities, and also found on some other types of
bonds, can provide an additional measure of protection against credit risks. A bond insurer
guarantees timely payment of principal and interest in the event of a default. As a result, insured
bonds usually carry the highest credit rating, or Triple-A, and are thus not as affected by changes
in the issuers¶ credit rating.

Bond insurance is usually purchased by bond issuers at the time bonds are initially sold. Bond
insurance is not available for purchase by individual investors.

Question

Should I sell my bonds when they are downgraded?

Answer

When a bond¶s rating is downgraded, investors should assess whether the problem is temporary
or longer term. You should also determine your risk tolerance and review your investment
strategy. Your investment advisor can help you determine if the bonds still fit your investment
objectives.

Question

How can I monitor the bonds¶ rating and find out about any rating changes?
Ratings agencies make bond ratings and warnings of potential rating changes known by issuing
press releases and posting the information on their Web sites. They also respond to telephone
inquiries. The chart above describes common bond ratings.

In early April 2010, Fitch Ratings overhauled the way it assigns grades to the credit quality of
state and local governments, recalibrating ratings on 40 states, the District of Columbia, the Virgin
Islands and Puerto Rico. The move affects some 38,000 municipal bond issues. The rating
agency's wholesale recalibration is in part recognition that municipalities were being held to a
higher standard than corporate and sovereign debt. Municipalities historically exhibit stronger
repayment patterns than corporate borrowers in the same credit rating bracket. The municipal
rating recalibrations are a way to align municipal bonds with debt from other sectors.

Bond issuers are also required to publicly disclose information that could potentially affect their
securities. If such an event occurs, it will usually be reported in the financial or general press.
Your investment advisor can also be a source of information.

    ?x   


 

 "
   
 
  

When a public company files for bankruptcy, everyone with a stake in the company, from employees to
creditors to bondholders, is concerned about the future of the company and the outcome of the
bankruptcy proceeding. For bondholders, here's some general information to help understand what could
happen to your investment.

Question

What is bankruptcy?

Answer

Generally, bankruptcy is the inability of a company to pay its debts as they become due. Public
companies file for protection under the federal bankruptcy laws when their liabilities or debts
exceed the value of their assets, or they are unable to pay their bills. A bankruptcy filing gives a
company an opportunity to reorganize its business in hopes of returning to profitability or
completely closing down operations and selling off assets, then using the money to pay off its
debts in a process known as liquidation.

Question

What happens when a company files for bankruptcy?

Answer

Public companies can file for bankruptcy protection under either Chapter 7 or Chapter 11 of the
federal bankruptcy laws.

     $$$


In a bankruptcy, assets and proceeds are distributed to satisfy claims in order of the claims'
priority. Investors who take the least amount of risk are paid first. As a result, creditors and
bondholders who lend a company money will be paid before its stockholders, who have
purchased an ownership stake. Creditors are paid after legal and administrative costs have been
covered.

1. 3   
 whose claims are protected by specific assets or collateral, such as
real estate, are paid first.
2. Then 
   
 which often include bank lenders, bondholders and
suppliers, are next in line.
3. 3  
 who have purchased a portion of the company, are paid last, if there is
money available after the secured and unsecured creditors' claims have been paid.

Under Chapter 7, the corporation is liquidated after the federal courts have determined that a
reorganization is not worthwhile. A court-appointed trustee will liquidate all of the company's
assets and distribute the proceeds in order to satisfy claims. Claims are considered   
  .

Under Chapter 11, a company will attempt to reorganize and continue operations. Management
continues to run the day-to-day operations, but a bankruptcy court must approve all major
business decisions.

The U.S. Trustee Program, a component of the Department of Justice responsible for overseeing
the administration of bankruptcy cases, will establish and oversee several committees to
represent the interest of parties including creditors, such as banks and bondholders, and
stockholders. The committees work with the company to develop a reorganization plan.

The reorganization plan must be approved by creditors, and stockholders and confirmed by the
bankruptcy court. However, even if some of the groups vote to reject the plan, the court can
approve it if it believes the plan treats creditors and stockholders fairly.

Question

What will happen to my bonds?

Answer

Bonds represent debt which a company has agreed to repay with interest. As such, when a
company files for federal bankruptcy protection, bondholders have a better chance of getting
repaid than stockholders. While bankruptcy laws determine the order of repayment, stockholders,
considered owners of the company, have the last claim on assets.

In a Chapter 7 bankruptcy, bondholders may receive a portion of the value of their bonds. After
being notified of the bankruptcy filing, bondholders should file a claim so they can receive a
payment if cash is available after other expenses have been paid. Proof of claim forms are
available on the Administrative Office U.S. Courts Web site.

£ 

When a company fails to pay principal and interest when due, a default occurs. In a corporate
bankruptcy or liquidation, although secured creditors, bondholders and holders of other senior
debt issues may receive some distribution of corporate assets, it is rarely enough to "make
whole" their total investment. Bonds of companies in default may trade at very low prices, if they
trade at all, and liquidity may disappear.

Bonds may continue to trade once a company has filed for bankruptcy under Chapter 11.
However, bondholders will stop receiving principal and interest payments, causing a   to
occur. Also the value of the securities could decline sharply and trading could be extremely
limited.

In addition, as a part of the court-approved reorganization plan, bondholders may receive new
stock, new bonds, or a combination of new stock and bonds in exchange for their bonds. The new
securities may also be worth less than the old ones.

Question

How will I know if a company has filed for bankruptcy?

Answer

Often, news reports provide investors with their first information about a company's bankruptcy
filing. However, if you hold bonds through a broker, your broker should contact you, forwarding
information from the company. If the bonds are held in your name, then you should receive
information directly from the company. Investors should also contact their brokers or investment
advisor if they do not receive any information from the company.

Investors may be asked to vote on a company's reorganization plan. Before you do, you should
receive a copy of the plan and a ballot, as well as a court-approved disclosure statement and
information on any court hearings on the plan's confirmation and deadlines for filing objections to
the plan.

     



If securities lose their value as the result of a bankruptcy filing, investors may be able to take an
income tax deduction for worthless securities.

An accountant, tax or bankruptcy attorney or investment advisor can provide additional


information, or contact the Internal Revenue Service for information and publications to find out if
your securities meet the IRS criteria.

Visit www.irs.gov for information and forms on worthless securities, frequently asked questions
regarding worthless securities, and theGain/Loss Publication.

Question

How can I find out more information?

Answer

The U.S. Bankruptcy Courts can be a source of information. The Administrative Office of the
United States Courts provides a listing of the bankruptcy courts in each region, as well as links to
their Web sites.
The Administrative Office of the U.S. Courts' Web site also provides information on bankruptcy
procedures as well as official bankruptcy forms, including a creditor's proof of claim form.

At the company, the investor relations officer can be a contact for information. Search the
company Web site for information on how to contact the investor relations office. In addition,
companies operating under Chapter 11 are still required to file financial reports with the Securities
and Exchange Commission disclosing material financial information and business developments.
Companies are required to file reports through the SEC's EDGAR database.

The United States Trustee Program's Web site contains information about the program and the
federal bankruptcy system. Regional trustees often have Web sites offering updates on important
cases.

Also, a securities or bankruptcy attorney may be able to provide additional information about
bankruptcy proceedings.

For more information about corporate bonds see An Investor's Guide to Corporate Bonds and An
Investor's Guide to High Yield Bonds.

3    Î 

 

More than likely you will work with a financial professional to invest in bonds. There are a variety of
people who can help you invest in bonds²they go by different titles including financial advisors, brokers,
sales representatives, stockbrokers, account executives, or registered representatives. How do you
decide whom to use? Do you want to use a full-service or discount broker? Are you comfortable investing
through an online firm? How can you know that your broker has access to the types of bonds you are
interested in? How is he or she compensated? Here are some tips to help you get the answers.

R Your Options
R Considerations for Evaluating a Financial Professional
R Questions to Ask Before Selecting a Financial Professional
R Evaluating a Current Broker

x c  


A bond broker is someone who is licensed or registered to buy and sell bonds for institutional or individual
investors. Brokers are required to pass an exam and register with the Financial Industry Regulatory
Authority (FINRA). Brokers may work within bond firms or they may work as independent brokers.
Different types of brokers offer different levels of service and varying access to bonds.

2
  6 
offer clients a wide range of services including: helping clients develop investment
goals, researching and recommending investment opportunities for individual clients, as well as executing
purchases and sales of bonds for a client¶s portfolio. Another difference between full service brokers and
other types of brokers is that full service brokerage firms maintain an inventory of various bonds to offer
directly to clients.
£
 6 
execute buy and sell orders for clients, but they generally do not make investment
recommendations and they often do not hold a large inventory of bonds. Instead they purchase bonds
from full-service brokers or bond issuers and then resell them to individual investors at a mark-up (price
increase) for their services.

c6  


offer full and discount services for investors who would rather invest
directly through the internet. Online brokerage firms may enable you to compare bond inventories across
multiple dealers, research bond types, and place orders online. Not all online brokerage firms offer bonds
and not all online firms offer you the ability to compare across dealers. You purchase and sell bonds by
opening an online account. You can purchase Treasuries and savings bonds commission- and fee-free
online through the U.S. Treasury¶s website.

i 6 


do not carry an inventory of bonds. Rather they bid for bonds for individual investors
from a wide variety of dealers. Think of third party brokers as ³bond headhunters.´

ë6
also offer customers the ability to invest in bonds through on-staff registered
representatives.

 
  
   Î   Î 

 

Consider the following four areas when evaluating a potential financial professional to help you achieve
your wealth-building goals.


   $ Make sure he or she has the education, experience, and credentials necessary, as
well as proven success in the field. You want to know that your potential broker has experience investing
for clients in the type of bonds you are most interested in, and is registered with the U.S. Securities and
Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) and is licensed to
do business in your state.

3  

  6 
  
$ Not every broker has immediate access to the
types of bonds you may be interested in. For example, full service brokers keep a large inventory of
various bonds for individual investors while discount brokers maintain a much smaller inventory. Know
what type of bonds you are most interested in (U.S. Treasuries, munis, corporate bonds) and determine if
your broker has the best access to those bonds.

i  $ Ask whether or not he or she has a history of regulatory disciplinary problems. You
can check on a brokers¶ background through the Financial Industry Regulatory Authority 's FINRA Broker
Check online service or through the U.S. Securities and Exchange Commission Investment Adviser
Public Disclosure service.

       $ Unless you choose to use an online brokerage firm, you will be working
with an individual to invest in bonds. You need to feel confident about this person¶s knowledge of the
market as well as his or her ability to maintain and manage a professional relationship with you.

!
 
 
 3  Î 

 

Be well-prepared when meeting with a financial professional for the first time in order to determine
whether you want to use him or her to invest in bonds. Following are some suggested questions:

R "    6  


  
6 
  

You want to know that he or she has accumulated experience in the field.
R   
 6 
     6
  

 For
example, if you are most interested in munis, consider whether or not you want to use a broker
whose background is primarily in corporate bonds. If you are primarily interested in high-yield
corporate bonds with a higher degree of credit risk, does your potential broker have more
experience in lower-risk U.S. Treasuries?
R     
   
     
A reputable professional should provide you with a list of references upon request.
R  
      
He or she should let you know of anyone else in the office who may also work on your account.
R "  
As compensation for their services for bond transactions, brokers typically receive a portion of the
commission charged, if any, or a portion of the dealer markup or markdown that is factored into
the price of the bond. Some brokers may charge a flat fee based on the size of your account and
your level of trading activity rather than imposing charges on each transaction.
Brokers expect experienced investors to ask questions about prices and fees. Your broker should
be able to explain any transaction costs or fees to you as well as the relationship between those
costs and his or her compensation. You can always ask your broker if he or she will consider
negotiating commissions or prices on orders. Don¶t be afraid to shop around between brokers for
the best possible price. For more information see Investor Costs Associated with Buying and
Selling Bonds
R   
 
 6  , find out if they charge a flat fee or if the
firm charges a markup that is built into the price you are offered onscreen.

    

½ow do I know if I¶m getting the best service from a broker I¶m already working with?

Just as it is a good idea to periodically review your portfolio balance and asset allocations, it¶s always a
good idea to periodically evaluate what type of advice and service your broker is giving you and if he or
she is helping you achieve your financial goals. Here are a few questions to ask:

R Does your broker consistently suggest bonds that are outside your stated investment
preferences? For example, if you have told your broker that you prefer U.S. Treasuries, does he
or she routinely pitch you on high-yield issues instead?
R Are you satisfied with your portfolio¶s performance? Does your broker keep you informed on
market influences and possible alternative bond investments given your financial objectives?
R When your broker advises you to buy, sell or hold a particular bond or bond fund, does he or she
explain why? You should always know how a recommendation fits into your personal financial
plan.
R Is your broker communicative? Does your broker call you or keep in touch via email or letters
regularly, regardless of what the bond markets are doing? Is your broker responsive to your calls
and emails?
R Does your broker routinely recommend one or two types of bond investments over others? If so,
why?

Ultimately you are responsible for managing your personal wealth-building strategy. Determine your
financial objectives, identify what types of bonds are appropriate for your portfolio, research brokers, and
regularly review your investments¶ performance with your financial professional to stay on target.

 




  3 


Investors buy and sell bonds through financial professionals who get compensated for their services.
This professional will typically be a broker working for a brokerage firm. Many but not all brokerage firms
are also dealers, or broker-dealers, meaning they buy and sell securities from each other and hold some
of these securities in inventory.

ë
ë 


Broker-dealers who hold bonds in inventory increase or ³mark up´ the price when a customer buys a bond
from them, and reduce or ³mark down´ the price when a customer sells a bond back to them. This markup
or markdown is built into the customer¶s price rather than identified separately.

This pricing method of these so-called ³principal´ transactions is similar to that used by any retail store. A
store that sells stereos, for example, will buy a stereo from the manufacturer for one price and sell it to the
customer for a higher price. Built into the difference or markup is the storeowners¶ proportional cost of
rent and other overhead, the salaries of the salespeople, some compensation for the risk that the price
may have to be reduced if the stereo doesn¶t sell, and a profit for themselves. The person who buys the
stereo does not know the amount of the markup, but can shop around for the best price.

Bond dealers face virtually the same issues: they have overhead costs, they need to pay their
salespeople, they face the risk that interest rates or market conditions might cause a bond they hold in
inventory to decline in value, and they need to make a profit. Their markups and markdowns may also be
affected by the size of the transaction²the larger the amount, the lower the cost²and the liquidity of the
security. Bonds that trade frequently should have lower markups and markdowns than thinly traded
securities.

Both the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board
(MSRB) have rules governing how much a broker-dealer can mark up (or mark down) the price of a bond
he or she sells (or buys from) you.

You can sometimes estimate the amount of the markup if you know the ³bid-ask´ spread, or the difference
between a price a dealer is willing to pay for a bond (the bid) and the usually higher price the dealer is
willing to sell the same bond for (the ask).

 

 


Brokers who are not also dealers or who do not have the particular bond you want in inventory will have
to go into the marketplace to get it. In this case, the broker acts as an agent rather than as a principal,
and the trade is sometimes called an agency transaction. In most cases, brokers will charge investors
commissions on agency transactions, and the amount of the commission will be identified on the trade
confirmation. (Remember, though, the agency broker also pays a markup to the dealer selling the bond.)
Sometimes the commission will be based on a percentage of the bond¶s price, and this percentage may
decline as the size of the transaction increases. Other times, especially in the case of a discount or on-
line broker, the commission may be a flat fee.

Keep in mind that the markup or commission is the fee imposed by the brokerage firm; the individual
broker you work with will get a portion of that amount.

The bottom line is that you want the best price, and the broker you work with deserves to be
compensated. To get the best price, you may have to shop around. Or you may decide that the service
you receive from your broker is worth a higher price. If you build a relationship with a particular broker,
you may also find that your transaction costs can be negotiated.





 
x   



 x 3  

The bond markets are extremely active, with interest rates constantly changing in response to a number
of factors including changes in the supply and demand of credit, Federal Reserve policy, fiscal policy,
exchange rates, economic conditions, market psychology and, above all, changes in expectations about
inflation. Currently, rising interest rates and expectations for economic recovery are impacting bond
prices. As interest rates change, so do the values of all bonds in the marketplace. If you are thinking
about buying bonds, or have recently bought some, you need to be aware of the effect of rising rates on
your holdings. Here are some questions you should consider.

Question

Now that interest rates have started to rise, how will that affect bonds?

Answer

Interest rates, which recently hovered at their lowest levels in 40 years, are rising. Just as bond
prices go up when yields go down, the prices of bonds you own now will generally drop as
yields²interest rates²go up.

Question

When rates go up, do all bonds lose the same value?

Answer

No, changes in interest rates don't affect all bonds equally. Generally speaking, the longer the
bond's maturity, for example a bond that matures in ten years versus another that matures in two
years, the more it's affected by changing interest rates. A ten year bond will usually lose more of
its value if rates go up than the two year note. Also, the lower a bond's "coupon" rate, the more
sensitive the bond's price is to changes in interest rates. Other features can have an effect as
well. For example, a variable rate bond probably won't lose as much value as a fixed rate
security.

Question

What should I do as interest rates rise? Should I hold onto my bonds or sell them?

Answer

If you buy a bond and hold onto it until it matures, which many investors do, rising rates won't
have any effect on the income you receive. You simply redeem your maturing bond and get back
par, or the face value, of the bond. In the meantime, you will continue to earn or accrue interest at
the rate you expected when you bought the bond. Here's an example provided by Bloomberg, LP:
 @-" 
You buy a 10 year U.S. Treasury Note with a face value of $1,000 and an interest rate of
4.26%. If you keep the bond until it matures, you'll receive $42.60 each year for ten
years, plus the original $1,000.
Question

What happens if rates go up and I need to sell my bonds?

Answer

If interest rates go up and you need to sell your bonds before they mature, you need to be aware
their value may have gone down and you may have to sell at a loss. Remember bond prices
move in the opposition direction as yield. Here's an example again provided by Bloomberg, LP:

 @
Sell before Maturity & Interest Rates have gone up.
An investor buys a 10 year U.S Treasury Note with a face value of $1,000 and an interest
rate of 4.26%. If the investor sells the bond before it matures and interest rates have
risen 2%, he or she would only receive $863.34 (plus any interest paid before the sale).
Question

At some point, though, rates will go down. What will happen if I sell then?

Answer

If interest rates have gone down since you bought your bonds, the value of your bonds will have
actually gone up, giving you what's known as a "capital gain." That's because your bond is worth
more. Here's another example using the Bloomberg data:

 @1
You Sell Your Bond Before It Matures & Interest Rates have gone down.
You buy a 10 year U.S. Treasury Note with a face value of $1,000 and an interest rate of
4.26%. If you sell your bond before it matures and interest rates have dropped 2%, you
will receive $1,118.54 (plus any interest paid before the sale).
Question

What happens to my bond fund if interest rates rise?

Answer

Since a bond fund doesn't have a specific maturity date, the chances are the fund's total return
will go down. Total return encompasses both change in prices and interest rate payments. If
interest rates rise, the values of bonds held by the fund would fall, negatively affecting total return.
However, the fund will continue to receive interest payments from the bonds it holds and will pass
them along to investors regularly, maintaining current yield. Bond fund investors also enjoy
professional management and asset diversification.

Question

Besides rising interest rates, are there any other risks I should consider?

Answer
Yes, virtually all investments carry some degree of risk that you might lose some or all of your
investment. When investing in bonds other than government-guaranteed securities, it's important
to remember that an investment's return is linked to its credit as well as market changes. The
higher the return, the higher the risk. Conversely, relatively safe investments offer relatively lower
returns. Bond choices range from U.S. Treasury securities, which are backed by the full faith and
credit of the U.S. government and are free from credit risk, to bonds that are below investment
grade and considered speculative. In assessing your tolerance for risk, ask yourself, "What will I
do if my investment is not there when I need it?"

Question

Should I buy bonds now?

Answer

Most personal financial advisors recommend that investors maintain a diversified investment
portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual
circumstances and objectives. You need to be aware of the risks, particularly now, of rising
interest rates. But if you are planning to buy bonds and hold them to maturity, they will provide a
predictable stream of payments and repayment of principal. Many people invest in bonds to
preserve and increase their capital or to receive dependable interest income. Whatever your
investment goals-saving for your children's college education or a new home, increasing
retirement income or any of a number of other worthy financial goals-investing in bonds can help
you achieve your objectives.

i i6


In addition to the Federal tax brackets, each state sets its own brackets for state income tax. Use this
table to see where your tax bracket lies, and to see special circumstances where indicated (roll your
mouse over to read) for the taxation of municipal bonds for residents of that state. To see what your total
effective tax rate is, including federal income tax, refer to our calculator.

Tax brackets shown here are estimated for the 2010 tax year, and are compiled from sources believed to
be reliable. Before investing check with a local tax professional to confirm the tax treatment of any
specific bond.


 , 3  £ i 

  and   impose no income tax.

1. Bonds issued by U.S. possessions and/or territories are exempt. U.S. possessions include Guam,
Puerto Rico, and the Virgin Islands.
2. Subject to intangible property tax.
3. Interest from some obligations is exempt from tax.
4. Taxable only if long form is used.
5. Some bonds may be exempt by state law.
6. Tennessee¶s 6% tax applies only to taxable interest and dividend income that is in excess of
$1,250 ($2,500 if married, filing jointly).

3 


c  

Once you decide to become a bond investor, you will face a series of decisions on what bonds to buy,
how best to buy them, how long you want to hold them in your portfolio and when you might think about
selling bonds.

This section can help inform your buy, hold and sell decisions by explaining:

R How to invest in bonds


R How to choose and use an investment professional to help you invest
R Why you might want to swap your bonds and how to do it
R Considerations unique to municipal bonds

Making the best decisions for your unique circumstances requires an understanding of the way bonds can
be used to achieve a variety of your financial goals as well as a sense of how bonds are priced, the
dynamics that drive the market and the various risks involved.

The ³Investor¶s Checklist ´ gives you a one-stop, interactive step-by-step guide to collecting the
information you need to test and confirm your decisions before you invest or sell.

Check back here often for the latest information and perspectives that will help equip you to be a bond
investor.

" i   


There are several ways to invest in bonds, including purchasing individual bonds or investing in  
 or      .

  


There is a wide variety of individual bonds to choose from in creating a portfolio that matches your
investment needs and expectations. Most individual bonds are bought and sold in the over-the-counter
(OTC) market, although some corporate bonds are also listed on the New York Stock Exchange. The
OTC market comprises securities firms and banks that trade bonds; brokers or agents, who buy and sell
bonds on behalf of customers in response to specific requests; and dealers, who keep an inventory of
bonds to buy and sell.

If you¶re interested in purchasing a new bond issue in the   (when it is first issued), your
investment advisor will provide you with the offering document, official statement or prospectus. You can
also buy and sell bonds in the secondary market, after they have already been in issued in the primary
market.

Usually, bonds sold in the OTC market are usually sold in $5,000 denominations. In the secondary
market for outstanding bonds, prices are quoted as if the bond were traded in $100 increments. Thus, a
bond quoted at 98 refers to a bond priced at $98 per $100 of face value, which equates to buying a bond
with a face value of $5,000 for $4,900 (or at a two percent discount).

Bond prices in the secondary market normally include a markup, which consists of the dealer¶s costs and
profit. An additional commission may be added if a broker or dealer has to locate a specific bond that is
not in its inventory. Each firm establishes its own prices, within regulatory guidelines, which will vary
depending upon the type of bond, size of the transaction, and service the firm provides.

There are a number of resources to help investors compare current prices of bonds. SIFMA's investor
education web sites, such as this one, www.investinginbonds.com and www.investinginbondseurope.org,
offer recent and historical price data on corporate and municipal bonds. Investors can sort and search the
data by a variety of criteria and broad categories, such as yields, ratings, or prices. Prices of U.S.
corporate bonds are now more widely available, as mandated by rules issued by the Financial Industry
Regulatory Authority (FINRA). For municipal bonds, transaction price data and daily summary of trading
activity can be obtained from the Municipal Securities Rulemaking Board¶s Electronic Municipal Market
Access portal at http://emma.msrb.org.

For the U.S. government bond market, Treasury bond yields are also posted on both
www.investinginbonds.com and www.investinginbondseurope.org and are updated throughout the day.
SIFMA¶s investor websites also provide links to multiple services that provide price and yield information
on many market segments. There are also a number of other internet sites, media sources and vendors
that provide current and historical information on the primary and secondary markets. You can also
compare prices for specific bonds through your broker or financial advisor.

 


Bond funds, like stock funds, offer professional selection and management of a portfolio of bonds for a
fee. Through a bond fund, an investor can diversify risks across a broad range of issues and opt for a
number of other conveniences, such as the option of having interest payments either reinvested or
distributed periodically.

Some funds are designed to follow a market, in general or a specified index of bonds. These are often
referred to as index or passive funds. Other funds are actively managed according to a stated objective,
with bonds purchased and sold at the discretion of a fund manager. In contrast to an individual bond
investment, a bond fund does not have a specified maturity date because bonds being added to and
eliminated from the portfolio in response to market conditions and investor demand. With $
  , an investor is able to buy or sell a share in the fund at any time at the fund¶s net asset
value. Because the market value of bonds fluctuates, a fund¶s net asset value will change to reflect the
aggregate value of the bonds in the portfolio. As a result, the value of an investment bond fund may be
higher or lower than the original purchase price, depending upon how the underlying portfolio of bonds
has performed. Alternatively,  $    have a specific number of shares that are listed
and traded on a stock exchange. The price of closed-end funds will fluctuate not only with the price of the
underlying portfolio, but also the supply and demand of the shares of the fund, and so may be priced at,
above, or below the net asset value of the fund¶s holdings. Because the fund managers are less
concerned about having to meet investor redemptions on any given day, their strategies can be more
aggressive. &'$  , or ETFs, are similar to closed-end funds, but have transparent
portfolios and are generally passively managed.

There are numerous sources of bond fund information available, including personal finance magazines
and the internet. Fund research firms also provide detailed analyses by subscription to which many
libraries subscribe. In addition, rating agencies also evaluate bond funds for credit and safety.

Most funds charge annual management fees while some also impose initial sales charges or fees for
selling shares. When taken into account, fees and sales charges will lower overall returns, so investors
need to be aware of total costs when calculating expected returns. Many funds also require a minimum
initial investment.

Like individual bonds and other investments, bond fund investments entail risk. Investors should not
automatically conclude that a fund offering a higher rate of return or income is better than a fund offering
lower rates of return or income. Investors need to be aware of several factors, including the total costs,
credit quality, manager quality, risks and the ability to exit these funds before making investment
decisions.

ë ë 


Money market funds refer to pooled investments in short-term, highly liquid securities. These securities
include short-term U.S. Treasuries, municipal bonds, certificates of deposit issued by major commercial
banks, and commercial paper issued by corporations. Generally, these funds consist of securities and
other instruments having maturities of three months or less. Money market funds may offer convenient
liquidity, since most allow investors to withdraw their money at any time. The minimum initial investment is
usually between $1,000 and $10,000.

 #   
 i



Bond unit investment trusts offer a fixed portfolio of investments in government, municipal, mortgage-
backed or corporate bonds, which are professionally selected and remain constant throughout the life of
the trust. One of the benefits of a unit trust is that you know exactly how much you will earn while you are
invested because the composition of the portfolio remains stable. Since the unit trust is not an actively
managed pool of assets, there is usually no management fee, but investors do pay a sales charge, plus a
small annual fee to cover supervision, evaluation expenses and   fees. The minimum initial
investment is usually between $1,000. As an investor, you can earn interest income during the life of the
trust and recover your principal as securities within the trust are redeemed. The trust typically ends when
the last investment matures.

3    Î 

 

More than likely you will work with a financial professional to invest in bonds. There are a variety of
people who can help you invest in bonds²they go by different titles including financial advisors, brokers,
sales representatives, stockbrokers, account executives, or registered representatives. How do you
decide whom to use? Do you want to use a full-service or discount broker? Are you comfortable investing
through an online firm? How can you know that your broker has access to the types of bonds you are
interested in? How is he or she compensated? Here are some tips to help you get the answers.

R Your Options
R Considerations for Evaluating a Financial Professional
R Questions to Ask Before Selecting a Financial Professional
R Evaluating a Current Broker

x c  


A bond broker is someone who is licensed or registered to buy and sell bonds for institutional or individual
investors. Brokers are required to pass an exam and register with the Financial Industry Regulatory
Authority (FINRA). Brokers may work within bond firms or they may work as independent brokers.
Different types of brokers offer different levels of service and varying access to bonds.

2
  6 
offer clients a wide range of services including: helping clients develop investment
goals, researching and recommending investment opportunities for individual clients, as well as executing
purchases and sales of bonds for a client¶s portfolio. Another difference between full service brokers and
other types of brokers is that full service brokerage firms maintain an inventory of various bonds to offer
directly to clients.

£
 6 
execute buy and sell orders for clients, but they generally do not make investment
recommendations and they often do not hold a large inventory of bonds. Instead they purchase bonds
from full-service brokers or bond issuers and then resell them to individual investors at a mark-up (price
increase) for their services.

c6  


offer full and discount services for investors who would rather invest
directly through the internet. Online brokerage firms may enable you to compare bond inventories across
multiple dealers, research bond types, and place orders online. Not all online brokerage firms offer bonds
and not all online firms offer you the ability to compare across dealers. You purchase and sell bonds by
opening an online account. You can purchase Treasuries and savings bonds commission- and fee-free
online through the U.S. Treasury¶s website.

i 6 


do not carry an inventory of bonds. Rather they bid for bonds for individual investors
from a wide variety of dealers. Think of third party brokers as ³bond headhunters.´

ë6
also offer customers the ability to invest in bonds through on-staff registered
representatives.

 
  
   Î   Î 

 

Consider the following four areas when evaluating a potential financial professional to help you achieve
your wealth-building goals.


   $ Make sure he or she has the education, experience, and credentials necessary, as
well as proven success in the field. You want to know that your potential broker has experience investing
for clients in the type of bonds you are most interested in, and is registered with the U.S. Securities and
Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) and is licensed to
do business in your state.

3  

  6 
  
$ Not every broker has immediate access to the
types of bonds you may be interested in. For example, full service brokers keep a large inventory of
various bonds for individual investors while discount brokers maintain a much smaller inventory. Know
what type of bonds you are most interested in (U.S. Treasuries, munis, corporate bonds) and determine if
your broker has the best access to those bonds.

i  $ Ask whether or not he or she has a history of regulatory disciplinary problems. You
can check on a brokers¶ background through the Financial Industry Regulatory Authority 's FINRA Broker
Check online service or through the U.S. Securities and Exchange Commission Investment Adviser
Public Disclosure service.

       $ Unless you choose to use an online brokerage firm, you will be working
with an individual to invest in bonds. You need to feel confident about this person¶s knowledge of the
market as well as his or her ability to maintain and manage a professional relationship with you.

!
 
 
 3  Î 

 

Be well-prepared when meeting with a financial professional for the first time in order to determine
whether you want to use him or her to invest in bonds. Following are some suggested questions:

R "    6  


  
6 
  

You want to know that he or she has accumulated experience in the field.
R   
 6 
     6
  

 For
example, if you are most interested in munis, consider whether or not you want to use a broker
whose background is primarily in corporate bonds. If you are primarily interested in high-yield
corporate bonds with a higher degree of credit risk, does your potential broker have more
experience in lower-risk U.S. Treasuries?
R     
   
     
A reputable professional should provide you with a list of references upon request.
R  
      
He or she should let you know of anyone else in the office who may also work on your account.
R "  
As compensation for their services for bond transactions, brokers typically receive a portion of the
commission charged, if any, or a portion of the dealer markup or markdown that is factored into
the price of the bond. Some brokers may charge a flat fee based on the size of your account and
your level of trading activity rather than imposing charges on each transaction.
Brokers expect experienced investors to ask questions about prices and fees. Your broker should
be able to explain any transaction costs or fees to you as well as the relationship between those
costs and his or her compensation. You can always ask your broker if he or she will consider
negotiating commissions or prices on orders. Don¶t be afraid to shop around between brokers for
the best possible price. For more information see Investor Costs Associated with Buying and
Selling Bonds
R   
 
 6  , find out if they charge a flat fee or if the
firm charges a markup that is built into the price you are offered onscreen.

    

½ow do I know if I¶m getting the best service from a broker I¶m already working with?

Just as it is a good idea to periodically review your portfolio balance and asset allocations, it¶s always a
good idea to periodically evaluate what type of advice and service your broker is giving you and if he or
she is helping you achieve your financial goals. Here are a few questions to ask:

R Does your broker consistently suggest bonds that are outside your stated investment
preferences? For example, if you have told your broker that you prefer U.S. Treasuries, does he
or she routinely pitch you on high-yield issues instead?
R Are you satisfied with your portfolio¶s performance? Does your broker keep you informed on
market influences and possible alternative bond investments given your financial objectives?
R When your broker advises you to buy, sell or hold a particular bond or bond fund, does he or she
explain why? You should always know how a recommendation fits into your personal financial
plan.
R Is your broker communicative? Does your broker call you or keep in touch via email or letters
regularly, regardless of what the bond markets are doing? Is your broker responsive to your calls
and emails?
R Does your broker routinely recommend one or two types of bond investments over others? If so,
why?

Ultimately you are responsible for managing your personal wealth-building strategy. Determine your
financial objectives, identify what types of bonds are appropriate for your portfolio, research brokers, and
regularly review your investments¶ performance with your financial professional to stay on target.

 




  3 


Investors buy and sell bonds through financial professionals who get compensated for their services.

This professional will typically be a broker working for a brokerage firm. Many but not all brokerage firms
are also dealers, or broker-dealers, meaning they buy and sell securities from each other and hold some
of these securities in inventory.

ë
ë 


Broker-dealers who hold bonds in inventory increase or ³mark up´ the price when a customer buys a bond
from them, and reduce or ³mark down´ the price when a customer sells a bond back to them. This markup
or markdown is built into the customer¶s price rather than identified separately.

This pricing method of these so-called ³principal´ transactions is similar to that used by any retail store. A
store that sells stereos, for example, will buy a stereo from the manufacturer for one price and sell it to the
customer for a higher price. Built into the difference or markup is the storeowners¶ proportional cost of
rent and other overhead, the salaries of the salespeople, some compensation for the risk that the price
may have to be reduced if the stereo doesn¶t sell, and a profit for themselves. The person who buys the
stereo does not know the amount of the markup, but can shop around for the best price.

Bond dealers face virtually the same issues: they have overhead costs, they need to pay their
salespeople, they face the risk that interest rates or market conditions might cause a bond they hold in
inventory to decline in value, and they need to make a profit. Their markups and markdowns may also be
affected by the size of the transaction²the larger the amount, the lower the cost²and the liquidity of the
security. Bonds that trade frequently should have lower markups and markdowns than thinly traded
securities.

Both the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board
(MSRB) have rules governing how much a broker-dealer can mark up (or mark down) the price of a bond
he or she sells (or buys from) you.

You can sometimes estimate the amount of the markup if you know the ³bid-ask´ spread, or the difference
between a price a dealer is willing to pay for a bond (the bid) and the usually higher price the dealer is
willing to sell the same bond for (the ask).

 

 

Brokers who are not also dealers or who do not have the particular bond you want in inventory will have
to go into the marketplace to get it. In this case, the broker acts as an agent rather than as a principal,
and the trade is sometimes called an agency transaction. In most cases, brokers will charge investors
commissions on agency transactions, and the amount of the commission will be identified on the trade
confirmation. (Remember, though, the agency broker also pays a markup to the dealer selling the bond.)
Sometimes the commission will be based on a percentage of the bond¶s price, and this percentage may
decline as the size of the transaction increases. Other times, especially in the case of a discount or on-
line broker, the commission may be a flat fee.

Keep in mind that the markup or commission is the fee imposed by the brokerage firm; the individual
broker you work with will get a portion of that amount.

The bottom line is that you want the best price, and the broker you work with deserves to be
compensated. To get the best price, you may have to shop around. Or you may decide that the service
you receive from your broker is worth a higher price. If you build a relationship with a particular broker,
you may also find that your transaction costs can be negotiated.

 3

i 
     
        

What is a ˜ond Swap?

A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously purchase
another bond with the proceeds from the sale. Fixed-income securities make excellent candidates for
swapping because it is often easy to find two bonds with similar features in terms of credit quality,
coupon, maturity and price.

In a bond swap, you sell one fixed-income holding for another in order to take advantage of current
market and/or tax conditions and better meet your current investment objectives or adjust to a change in
your investment status. A wide variety of swaps are generally available to help you meet your specific
portfolio goals.

Why You Would Consider Swapping

Swapping can be a very effective investment tool to:

R increase the quality of your portfolio;


R increase your total return;
R benefit from interest rate changes; and
R lower your taxes.
These are just a few reasons why you might find swapping your bond holdings beneficial. Although this
booklet contains general information regarding federal tax consequences of swapping, we suggest you
consult your own tax advisor for more specific advice regarding your individual tax situation.

Swapping for Quality

A quality swap is a type of swap where you are looking to move from a bond with a lower credit quality
rating to one with a higher credit rating or vice versa. The credit rating is generally a reflection of an
issuer¶s financial health. It is one of the factors in the market¶s determination of the yield of a particular
security. The spread between the yields of bonds with different credit quality generally narrows when the
economy is improving and widens when the economy weakens. So, for example, if you expect a
recession you might swap from lower-quality into higher-quality bonds with only a negligible loss of
income.

Standard rating agencies classify most issuers¶ likelihood of repayment of principal and payment of
interest according to a grading system ranging from, say, triple-A to C (or an equivalent scale), as a
quality guideline for investors. Issuers considered to carry good likelihood of payment are ³investment
grade´ and are rated Baa3 or higher by Moody¶s Investors Service or BBB- or higher by Standard &
Poor¶s Ratings Services and Fitch Ratings. Those issuers rated below Baa3 or below BBB- are
considered ³below investment grade´ and the repayment of principal and payment of interest are less
certain. Suppose you own a corporate bond rated BBB (lower-investment-grade quality) that is yielding
7.00% and you find a triple-A-rated (higher-investment-grade quality) corporate bond that is yielding
6.70%.1 You could swap into the superior-credit, triple-A-rated bond by sacrificing only 30 basis points
(one basis point is 1/100th of one percent, or .01%). Moreover, during an economic downturn, higher-
quality bonds, which represent greater certainty of repayment in difficult market conditions, will typically
hold their value better than lower-quality bonds.

Also, if a market sector or a particular bond has eroded in quality, it may no longer meet your personal
risk parameters. You may be willing to sacrifice some current income and/or yield in exchange for
enhanced quality.

Swapping to Increase Yield

You can sometimes improve the taxable or tax-exempt returns on your portfolio by employing a number
of different bond-swapping strategies. In general, longer-maturity bonds will typically yield more than
those of a shorter maturity will; therefore, extending the average maturity of a portfolio¶s holdings can
boost yield. The relationship between yields on different types of securities, ranging from three months to
30 years, can be plotted on a graph known as the yield curve. The curve of that line is constantly
changing, but you can often pick up yield by extending the maturity of your investments, assuming the
yield curve is sloping upward. For example, you could sell a two-year bond that¶s yielding 5.50% and
purchase a 15-year bond that is yielding 6.00%. However, you should be aware that the price of longer-
maturity bonds might fluctuate more widely than that of short-term bonds when interest rates change.

When the difference in yield between two bonds of different credit quality has widened, a cautious swap
to a lower-quality bond could possibly enhance returns. But sometimes market fluctuations create
opportunities by causing temporary price discrepancies between bonds of equal ratings. For example, the
bonds of corporate issuers may retain the same credit rating even though their business prospects are
varying due to transient factors such as a specific industry decline, a perception of increased risk or
deteriorating credit in the sector or company. So, suppose you purchased in the past (at par) a 30-year A-
rated $50,000 corporate bond with a 6.25% coupon. Assume that comparable bonds are now being
offered with a 6.50% coupon. Assume that you can replace your bond with another $50,000 A-rated
corporate bond having the same maturity with a 6.50% coupon. By selling the first bond and buying the
second bond you will have increased your annual income by 25 basis points ($125). Discrepancies in
yield among issuers with similar credit ratings often reflect perceived risk in the marketplace. These
discrepancies will change as market conditions and perceptions change.

Swapping for Increased Call Protection

Swaps may achieve other investment objectives, such as building a more diversified portfolio, or
establishing better call protection. Call protection is useful for reducing the risk of reinvestment at lower
rates, which may occur if an issuer retires, calls or pre-refunds its bonds early. Call protection swaps are
particularly advantageous in a declining interest rate environment. For example, you could sell a bond
with a short call, e.g., five years, and purchase a bond with 10 years of call protection. This will enable
you to lock in your coupon for an additional five years and not worry about losing your higher-coupon
bonds in the near future. You may have to sacrifice yield in exchange for the stronger call protection.

Anticipating Interest Rates

If you believe that the overall level of interest rates is likely to change, you may choose to make a swap
designed to benefit or help you protect your holdings.

If you believe that rates are likely to decline, it may be appropriate to extend the maturity of your holdings
and increase your call protection. You will be reducing reinvestment risk of principal and positioning for
potential appreciation as interest rates trend down. Conversely, if you think rates may increase, you might
decide to reduce the average maturity of holdings in your portfolio. A swap into shorter-maturity bonds will
cause a portfolio to fluctuate less in value, but may also result in a lower yield.

It should be noted that various types of bonds perform differently as interest rates rise or fall, and may be
selectively swapped to optimize performance. Long-term, zero-coupon2 and discount bonds3 perform
best during interest rate declines because their prices are more sensitive to interest rate changes.
Floating-rate, short- and intermediate-term, callable and premium bonds4 perform best when interest
rates are rising because they limit the downside price volatility involved in a rising yield environment; their
price fluctuates less on a percentage basis than a par or discount bond.

However, you should remember that rate-anticipation swaps tend to be somewhat speculative, and
depend entirely on the outcome of the expected rate change. Moreover, shorter- and longer-term rates do
not necessarily move in a parallel fashion. Different economic conditions can impact various parts of the
yield curve differently. To the extent that the anticipated rate change does not come about, a decline in
market value could occur.

Swapping to Lower Your Taxes

Tax swapping is the most common of all swaps. Anyone who owns bonds that are selling below their
amortized purchase price and who has capital gains or other income that could be partially, or fully, offset
by a tax loss can benefit from tax swapping.

You may have realized capital gains from the sale of a profitable capital asset (e.g., real estate, your
business, stocks or other securities). Or you may expect to sell such an asset at a potential profit in the
near future. By swapping those assets that are currently trading below the purchase price (due to a rise in
interest rates, deteriorating credit situation, etc.) you can reduce or eliminate the capital gains you would
otherwise have paid on your other profitable transactions in the current tax year.

The traditional tax swap involves two steps: (1) selling a bond that is worth less than you paid for it and
(2) simultaneously purchasing a bond with similar, but not identical, characteristics. For example, assume
you own a $50,000, 20-year, triple-A-rated municipal bond with a 5.00% coupon that you purchased five
years ago at par. If interest rates increase (such that new bonds are now being issued with a 5.50%
coupon), the value of your bond will fall to approximately $47,500. If you sell the bond, you will realize a
$2,500 capital loss, which you can use to offset any capital gains you have realized. If you have no capital
gains, you can use the capital loss to offset ordinary income. You then purchase in the secondary market
a replacement triple-A-rated 5.00% municipal bond (from a different issuer), maturing in 15 years, at an
approximate cost of $47,500. Your yield, maturity and quality of bond will be the same as before, plus you
will have realized a loss that will save you money on taxes in the year of the bond sale. Of course, if you
hold the new bond to maturity, you will realize a $2,500 gain in 15 years, taxable as ordinary income at
that time. By swapping, you have converted a ³paper´ loss into a real loss that can be used to offset
taxable gain.

Some Important Rules for Tax Swapping

Under current tax law, the maximum tax rate on long-term capital gains is lower than the maximum rate
on short-term capital gains. In order to be entitled to the lower long-term capital gains rate, a taxpayer
must hold the asset for more than one year. Because of ongoing discussions concerning possible
changes in the tax treatment of capital gains, investors should consult their tax advisor for up-to-date
advice.

Capital losses from swap transactions are reflected on Schedule D of your tax return. If you have short-
term or long-term capital gains, the losses from the swap transactions will offset these gains first²long-
term losses will offset long-term gains, and short-term losses will offset short-term gains; net losses in
either category will then offset gains in the other category. If the net result is an overall capital loss, the
excess loss can be used to offset ordinary income dollar-for-dollar (up to a maximum of $3,000). If an
investor has both net short-term and net long-term capital losses, the ordinary income is first offset by the
short-term capital losses, then by the long-term losses. Excess capital losses can be carried forward
indefinitely to reduce capital gains liability and ordinary income in future years.

The tax basis of the new bonds will be their cost (the price paid for the bonds). If the new bonds are
bought at a discount and held to maturity, or are sold at a price higher than their cost, a taxable gain will
often result, unless also offset by losses. To the extent such gain represents accrued market discount, it
will be taxed as ordinary income, with the balance treated as capital gain.

Ask your tax advisor about the use of original-issue discount or market discount bonds, or the use of
bonds issued at a premium, in tax swaps.

Other Tax Strategies

Changes in the tax laws always present an opportunity to review your bond holdings.

Investors who expect their tax rate to increase will frequently swap taxable bonds for tax-exempt
(municipal) bonds. This is done with the expectation that tax-exempt bonds will become relatively more
desirable in the marketplace than fully taxable bonds and will benefit from price appreciation.

Investors not subject to the Alternative Minimum Tax (AMT) can obtain additional yield by purchasing
municipals that are subject to that tax. Taxpayers who are subject to AMT can save taxes by swapping to
non-AMT bonds.

½ow to Avoid a Wash Sale

The Internal Revenue Service will not recognize a tax loss generated from the sale and repurchase within
30 days before or after the trade or settlement date of the same or a substantially identical security²
typically called a ³wash sale.´ While the term ³substantially identical´ has not been explicitly defined in this
context, two bonds have generally not been considered substantially identical if (1) the securities have
different issuers, or (2) there are substantial differences in either maturity or coupon rate.

For a Personal Appraisal

To learn more about what bond swapping may mean to you, consider your objectives and discuss
them your financial consultant.

Swap Objectives and General Information

1. Do you wish to establish a tax loss or realize a gain?


2. Do you wish to improve quality?
3. Do you wish to increase yield?
4. Do you wish to increase call protection?
5. Is there a change in your tax status?
6. What is your tax bracket?
7. What type of bond are you swapping?
8. Do have any other specific investment parameters?

To accomplish any of these objectives are you willing to...

1. Extend maturity? _____Yes _____No


2. Adjust credit ratings? _____Yes _____No
3. Invest additional funds? _____Yes _____No

1. All examples are for illustrative purposes and are not representative of actual market yields.
2. A zero-coupon bond is a bond for which no periodic interest payments are made. The investor
receives one payment at maturity equal to the principal invested plus interest earned
compounded semiannually at the original interest rate to maturity.
3. A discount bond is a bond sold at less than par.
4. A premium bond is a bond priced greater than par.




3  



c  

How do you make bonds work for your investment goals? Strategies for bond investing range from a buy-
and-hold approach to complex tactical trades involving views on inflation and interest rates. As with any
kind of investment, the right strategy for you will depend on your goals, your time frame and your appetite
for risk.

Bonds can help you meet a variety of financial goals such as: preserving principal, earning income,
managing tax liabilities, balancing the risks of stock investments and growing your assets. Because most
bonds have a specific maturity date, they can be a good way to make sure that the money will be there at
a future date when you need it.

This section can help you:

R Decide how bonds can best work for you


R Understand where bonds fit within your asset allocation
R Learn about how different types of bonds help you reach different goals
R Think about sophisticated trading strategies based on market views and signals
R Discern the difference between bonds and bond funds

Your goals will change over time, as will the economic conditions affecting the bond market. As you
regularly evaluate your investments, check back here often for information that can help you see if your
bond investment strategy is still on target to meet your financial goals.

   
 3  


The way you invest in bonds for the short-term or the long-term depends on your investment goals and
time frames, the amount of risk you are willing to take and your tax status.

When considering a bond investment strategy, remember the importance of diversification. As a general
rule, it¶s never a good idea to put all your assets and all your risk in a single asset class or investment.
You will want to diversify the risks within your bond investments by creating a portfolio of several bonds,
each with different characteristics. Choosing bonds from different issuers protects you from the possibility
that any one issuer will be unable to meet its obligations to pay interest and principal. Choosing bonds of
different types (government, agency, corporate, municipal, mortgage-backed securities, etc.) creates
protection from the possibility of losses in any particular market sector. Choosing bonds of different
maturities helps you manage interest rate risk.
With that in mind, consider these various objectives and strategies for achieving them.

Î
 Î   


If keeping your money intact and earning interest is your goal, consider a ³buy and hold´ strategy. When
you invest in a bond and hold it to maturity, you will get interest payments, usually twice a year, and
receive the face value of the bond at maturity. If the bond you choose is selling at a premium because its
coupon is higher than the prevailing interest rates, keep in mind that the amount you receive at maturity
will be less than the amount you pay for the bond.

When you buy and hold, you need not be too concerned about the impact of interest rates on a bond¶s
price or market value. If interest rates rise, and the market value of your bond falls, you will not feel any
effect unless you change your strategy and try to sell the bond. Holding on to the bond means you will not
be able to invest that principal at the higher market rates, however.

If the bond you choose is callable, you have taken the risk of having your principal returned to you before
maturity. Bonds are typically ³called,´ or redeemed early by their issuer, when interest rates are falling,
which means you will be forced to invest your returned principal at lower prevailing rates.

When investing to buy and hold, be sure to consider:

R The coupon interest rate of the bond (multiply this by the par or face value of the bond to
determine the dollar amount of your annual interest payments)
R The yield-to-maturity or yield-to-call. Higher yields can mean higher risks.
R The credit quality of the issuer. A bond with a lower credit rating might offer a higher yield, but it
also carries a greater risk that the issuer will not be able to keep its promises.

ë ;  

If your goal is to maximize your interest income, you will usually get higher coupons on longer-term
bonds. With more time to maturity, longer-term bonds are more vulnerable to changes in interest rates. If
you are a buy-and-hold investor, however, these changes will not affect you unless you change your
strategy and decide to sell your bonds.

You will also find higher coupon rates on corporate bonds than on U.S. treasury bonds with comparable
maturities. In the corporate market, bonds with lower credit ratings typically pay higher income than
higher credits with comparable maturities.

High-yield bonds (sometimes referred to as junk bonds) typically offer above-market coupon rates and
yields because their issuers have credit ratings that are below investment grade: BB or lower from
Standard & Poor¶s; Ba or lower from Moody¶s. The lower the credit rating, the greater the risk that the
issuer could default on its obligations, or be unable to pay interest or repay principal when due.

If you are thinking about investing in high-yield bonds, you will also want to diversify your bond
investments among several different issuers to minimize the possible impact of any single issuer¶s default.
High yield bond prices are also more vulnerable than other bond prices to economic downturns, when the
risk of default is perceived to be higher.

ë  
 
-
6


Buy-and-hold investors can manage interest rate risk by creating a ³laddered´ portfolio of bonds with
different maturities, for example: one, three, five and ten years. A laddered portfolio has principal being
returned at defined intervals. When one bond matures, you have the opportunity to reinvest the proceeds
at the longer-term end of the ladder if you want to keep it going. If rates are rising, that maturing principal
can be invested at higher rates. If they are falling, your portfolio is still earning higher interest on the
longer-term holdings.

With a barbell strategy, you invest only in short-term and long-term bonds, not intermediates. The long-
term holdings should deliver attractive coupon rates. Having some principal maturing in the near term
creates the opportunity to invest the money elsewhere if the bond market takes a downturn.

3 c  Î   3   





Because stock market returns are usually more volatile or changeable than bond market returns,
combining the two asset classes can help create an overall investment portfolio that generates more
stable performance over time. Often but not always, the stock and bond markets move in different
directions: the bond market rises when the stock market falls and vice versa. Therefore in years when the
stock market is down, the performance of bond investments can sometimes help compensate for any
losses. The right mix of stocks and bonds depends on several factors. To learn more, read Asset
Allocation.

3  £   % 

If you have a three-year-old child, you may face your first college tuition bill 15 years from now. Perhaps
you know that in 22 years you will need a down payment for your retirement home. Because bonds have
a defined maturity date, they can help you make sure the money is there when you need it.

Zero coupon bonds are sold at a steep discount from the face value amount that is returned at maturity.
Interest is attributed to the bond during its lifetime. Rather than being paid out to the bondholder, it is
factored into the difference between the purchase price and the face value at maturity.

You can invest in zero coupon bonds with maturity dates timed to your needs. To fund a four-year college
education, you could invest in a laddered portfolio of four zeros, each maturing in one of the four
consecutive years the payments will be due. The value of zero coupon bonds is more sensitive to
changes in interest rates however, so there is some risk if you need to sell them before their maturity
date. It is also best to buy taxable (as opposed to municipal) zeros in a tax-deferred retirement or college
savings account because the interest that accumulates on the bond is taxable each year even though you
do not receive it until maturity.

A bullet strategy can also help you invest for a defined future date. If you are 50 years old and you want
to save toward a retirement age of 65, in a bullet strategy you would buy a 15-year bond now, a 10 year
bond five years from now, and a five-year bond 10 years from now. Staggering the investments this way
may help you benefit from different interest rate cycles.



x ë 3  ë  

Investors following a buy-and-hold strategy can encounter circumstances that might compel them to sell a
bond prior to maturity for the following reasons:

1. They need the principal. While buy-and-hold is generally best used as a longer-term strategy, life
does not always work out as planned. When you sell a bond before maturity, you may get more
or less than you paid for it. If interest rates have risen since the bond was purchased, its value will
have declined. If rates have declined, the bond¶s value will have increased.
2. They want to realize a capital gain. If rates have declined and a bond has appreciated in value,
the investor may decide that it¶s better to sell before maturity and take the gain rather than
continue to collect the interest. This decision should be made carefully, as the proceeds of the
transaction may have to be reinvested at lower interest rates.
3. They need to realize a loss for tax purposes. Selling an investment at a loss can be a strategy for
offsetting the tax impact of investment gains. Bond swapping can help achieve a tax goal without
changing the basic profile of your portfolio.
4. They have achieved their return objective. Some investors invest in bonds with the objective of
total return, or income plus capital appreciation or growth. Achieving capital appreciation requires
an investor to sell an investment for more than its purchase price when the market presents the
opportunity.

i  

Using bonds to invest for total return, or a combination of capital appreciation (growth) and income,
requires a more active trading strategy and a view on the direction of the economy and interest rates.
Total return investors want to buy a bond when its price is low and sell it when the price has risen, rather
than holding the bond to maturity.

Bond prices fall when interest rates are rising, usually as the economy accelerates. They typically rise
when interest rates fall, usually when the Federal Reserve is trying to stimulate economic growth after a
recession. Within different sectors of the bond market, differences in supply and demand can create
short-term trading opportunities. For some ideas, read the content articles under ³Profiting from Market
Signals´ and ³Which Trade?´²in Learn More-Strategies Section.

Various futures, options and derivatives can also be used to implement different market views or to hedge
the risk in different bond investments. Investors should take care to understand the cost and risks of
these strategies before committing funds.

Some bond funds have total return as their investment objective, offering investors the opportunity to
benefit from bond market movements while leaving the day-to-day investment decisions to professional
portfolio managers.

i  3  


#
63  


Many investors use callable securities within a total return strategy²with a focus on capital gains as well
as income²as opposed to a buy and hold strategy focused on income and preservation of principal.

Owners of callable securities are expressing the implicit view that yields will remain relatively stable,
enabling the investor to capture the yield spread over noncallable securities of similar duration. They must
also have views on the likely range of rates over the investment period and the market¶s perception of
future rate uncertainty at the horizon date for reasons explained in Risks of Investing in Callable
Securities. If an investor has the view that rates may well be volatile in either direction over the near term
but are likely to remain in a definable range over the next year, an investment in callable securities can
significantly enhance returns.

Premium callables may be used when the bullish investor believes that rates are unlikely to fall very far.
Discount callables are a better choice when the investor believes volatility will be low but prefers more
protection in an environment of rising interest rates.

i     


If you are in a high tax bracket, you may want to reduce your taxable interest income to keep more of
what you earn. The interest on U.S. government securities is taxable at the federal level, but exempt at
the state and local level, making these investments attractive to people who live in high tax states.
Municipal securities offer interest that is exempt from federal income tax, and, in some cases, state and
local tax as well. Because of variables in supply and demand, tax-exempt yields in the municipal market
can sometimes be quite attractive when compared to their taxable equivalents (see the 2010 Tax Year
Tax-Exempt/Taxable Yield Equivalents).

Ladders, barbells and bullets can all be implemented with municipal securities for a tax-advantaged
approach best achieved outside of a qualified, tax-deferred retirement or college savings account. Buying
municipals in a tax-deferred account is like wearing a belt and suspenders.

Bond swapping is another way to achieve a tax-related goal for investors who are holding a bond that has
declined in value since purchase but have taxable capital gains from other investments. The investor sells
the original bond at a loss, which can be used to offset the taxable capital gain or up to $3,000 in ordinary
income. He or she then purchases another bond with maturity, price and coupon similar to the one sold,
thus reestablishing the position. To comply with the IRS ³wash sale´ rule, which does not recognize a tax
loss generated from the sale and repurchase within 30 days of the same or substantially identical
security, investors should choose a bond from a different issuer.

£ 
 
6  
 


Investors who want to achieve automatic diversification of their bond investments for less than it would
cost to construct a portfolio of individual bonds can consider investing in bond mutual funds, unit
investment trusts or exchange-traded funds. These vehicles each have specific investment objectives and
characteristics to match individual needs. To learn more, see Bonds and Bond Funds.

3 c c68  




A tax loss is not the only reason to swap a bond. Investors can also swap to improve credit quality,
increase yield or improve call protection. Remember to factor the sell and buy transaction costs into your
estimations of return. For more information, see Bond Swapping.

 " x    



-i 6 i 2£  


In a taxable investment account, your capital gains and investment income are subject to taxation in the
year they are earned. In a qualified tax-deferred account such as an IRA or some college savings
account, income and capital gains are not taxed until you start taking withdrawals, presumably at a future
date.

Bonds and bond funds can be held in either type of account, but some investors will have a reason to
choose one account type over the other. Municipal investments, for example, are best held in a taxable
account, where they can serve to reduce the taxable returns. Taxable zero coupon bonds are best held in
a tax-deferred account because their annual interest credits are taxable when earned, even though the
investor does not actually receive them until the bond matures.

Since the maximum tax on capital gains was reduced to 15% in 2003, total return investors in a high
income tax bracket may find advantages to holding their bonds in a taxable account. Others may prefer to
invest for maximum income in their tax deferred accounts. The best solution depends on your individual
circumstances and tax situation. Your tax or investment advisor can help you analyze the alternatives and
reach the best solution.




    

" ë  x Î   3  




The answer to this question depends on that asset allocation that is right for you, your goals, your age
and your appetite for risk.

    

Asset allocation describes the percentage of total assets invested in different investment categories, also
known as asset classes. The most common broad financial asset classes are stocks (or equity), bonds
(fixed income) and cash. Real estate, precious metals and ³alternative investments´ such as hedge funds
and commodities can also be viewed as asset classes.

Each broad asset class has various subclasses with different risk and return profiles. In general, the more
return an asset class has historically delivered, the more risk that its value could fall as well as rise
because of greater price volatility. To earn higher potential returns, investors have to take higher risk.

Asset classes differ by the level of potential returns they have historically generated and the types of risk
they carry. Virtually all investments involve some type of risk that you might lose money.

Asset subclasses of stocks include:

R  

stocks of large, well established and usually well known companies
R 3 

stocks of smaller, less well known companies
R    

stocks of foreign companies

Large cap, small cap and international stocks can in turn be considered:

R Value stocks whose prices are below their true value for temporary reasons
R Growth stocks of companies that are growing at a rapid rate.

Asset subclasses of bonds include:

R £    


long-term (10 years or longer), intermediate-term (3-10 year) or short-term
(3 years or less)
R £  


government and agencies, corporate, municipal, international
R £   
 6 
callable bonds, zero-coupon bonds, inflation-protected bonds, high-
yield bonds, etc.




Stocks are generally considered a risky investment because, among other things, their values can decline
if the stock market goes down (market risk) or the issuing company does poorly (company risk). As
owners of the company, stockholders are paid after all creditors, including bond holders, are paid. In
theory at least, a stock¶s value can go to zero. Historically, stock prices have been the most volatile of all
the different types of investments, meaning their prices can move up and down quickly, frequently and not
always in a predictable way.
Bonds are considered less risky than stocks because bond prices have historically been more stable and
because bond issuers promise to repay the debt to the bondholders at maturity. That promise is generally
kept unless the issuer falls on hard times; some bonds have credit risk based on the financial health of
their issuer. When a bond issuer goes into bankruptcy, bondholders are paid off before stockholders.
Bonds are also vulnerable to interest rate risk: when interest rates rise, bond prices fall and vice versa.

Cash investments carry opportunity risk. For example, investing in very safe, short-term investments like
Treasury bills may protect you from loss, but you may miss the opportunity of more generous returns
offered by other investments. Even people who keep their money under their mattress have the risk that
their money will be worth less in the future because of inflation that reduces the purchasing power of the
cash.

  

Smart investors do not put all their assets in one type of investment or ³asset class.´ Instead, they spread
or diversify their risk by investing in different types of investments. When one asset class is performing
poorly, another may be doing well and compensating for the poor performance in the other.

Some studies have shown that overall asset allocation is more important to investment success than the
choice of investments within the allocation.

9ë :

    


Investment firms often publish recommended asset allocations based on their outlook for the relative
performance of the stock, bond and money markets.

Personal finance Web sites and different types of investment advisers sometimes offer standard asset
allocation recommendations for people of different age ranges or risk tolerance. The asset allocation that
is right for you, however, depends on several personal factors, such as life and financial goals, and will
change over time with different life events.

Î
;  



Once you establish your optimal asset allocation which takes into account return objectives, risk tolerance
and time horizon, you need to review your investments regularly to see if your portfolio matches your plan
and if your plan is still right for your age and goals. When one asset class performs well or poorly, it can
shift your asset allocation. You can bring it back in line by ³rebalancing´ or selling assets that have
appreciated and buying those that have fallen in price. In this way, asset allocation enforces a good
discipline of selling high and buying low.

Younger investors may want to allocate their longer-term retirement assets to riskier investments such as
equities or stock, because they have time to ride out the market¶s ups and downs. With age, however,
asset allocations may shift toward safer investments such as bonds because retirement is getting closer
and older investors should be more concerned about keeping what they have saved and gained.

Take time every six months to a year or two to be sure your asset allocation matches your plan and that
your plan remains appropriate for your age and goals. If not, you may want to take the steps to make sure
your plan is appropriate for your age and goals and balance your asset allocation to match your plan.
Your investment advisor can help with this process.


 3

i 
     
        

What is a ˜ond Swap?

A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously purchase
another bond with the proceeds from the sale. Fixed-income securities make excellent candidates for
swapping because it is often easy to find two bonds with similar features in terms of credit quality,
coupon, maturity and price.

In a bond swap, you sell one fixed-income holding for another in order to take advantage of current
market and/or tax conditions and better meet your current investment objectives or adjust to a change in
your investment status. A wide variety of swaps are generally available to help you meet your specific
portfolio goals.

Why You Would Consider Swapping

Swapping can be a very effective investment tool to:

R increase the quality of your portfolio;


R increase your total return;
R benefit from interest rate changes; and
R lower your taxes.

These are just a few reasons why you might find swapping your bond holdings beneficial. Although this
booklet contains general information regarding federal tax consequences of swapping, we suggest you
consult your own tax advisor for more specific advice regarding your individual tax situation.

Swapping for Quality

A quality swap is a type of swap where you are looking to move from a bond with a lower credit quality
rating to one with a higher credit rating or vice versa. The credit rating is generally a reflection of an
issuer¶s financial health. It is one of the factors in the market¶s determination of the yield of a particular
security. The spread between the yields of bonds with different credit quality generally narrows when the
economy is improving and widens when the economy weakens. So, for example, if you expect a
recession you might swap from lower-quality into higher-quality bonds with only a negligible loss of
income.

Standard rating agencies classify most issuers¶ likelihood of repayment of principal and payment of
interest according to a grading system ranging from, say, triple-A to C (or an equivalent scale), as a
quality guideline for investors. Issuers considered to carry good likelihood of payment are ³investment
grade´ and are rated Baa3 or higher by Moody¶s Investors Service or BBB- or higher by Standard &
Poor¶s Ratings Services and Fitch Ratings. Those issuers rated below Baa3 or below BBB- are
considered ³below investment grade´ and the repayment of principal and payment of interest are less
certain. Suppose you own a corporate bond rated BBB (lower-investment-grade quality) that is yielding
7.00% and you find a triple-A-rated (higher-investment-grade quality) corporate bond that is yielding
6.70%.1 You could swap into the superior-credit, triple-A-rated bond by sacrificing only 30 basis points
(one basis point is 1/100th of one percent, or .01%). Moreover, during an economic downturn, higher-
quality bonds, which represent greater certainty of repayment in difficult market conditions, will typically
hold their value better than lower-quality bonds.
Also, if a market sector or a particular bond has eroded in quality, it may no longer meet your personal
risk parameters. You may be willing to sacrifice some current income and/or yield in exchange for
enhanced quality.

Swapping to Increase Yield

You can sometimes improve the taxable or tax-exempt returns on your portfolio by employing a number
of different bond-swapping strategies. In general, longer-maturity bonds will typically yield more than
those of a shorter maturity will; therefore, extending the average maturity of a portfolio¶s holdings can
boost yield. The relationship between yields on different types of securities, ranging from three months to
30 years, can be plotted on a graph known as the yield curve. The curve of that line is constantly
changing, but you can often pick up yield by extending the maturity of your investments, assuming the
yield curve is sloping upward. For example, you could sell a two-year bond that¶s yielding 5.50% and
purchase a 15-year bond that is yielding 6.00%. However, you should be aware that the price of longer-
maturity bonds might fluctuate more widely than that of short-term bonds when interest rates change.

When the difference in yield between two bonds of different credit quality has widened, a cautious swap
to a lower-quality bond could possibly enhance returns. But sometimes market fluctuations create
opportunities by causing temporary price discrepancies between bonds of equal ratings. For example, the
bonds of corporate issuers may retain the same credit rating even though their business prospects are
varying due to transient factors such as a specific industry decline, a perception of increased risk or
deteriorating credit in the sector or company. So, suppose you purchased in the past (at par) a 30-year A-
rated $50,000 corporate bond with a 6.25% coupon. Assume that comparable bonds are now being
offered with a 6.50% coupon. Assume that you can replace your bond with another $50,000 A-rated
corporate bond having the same maturity with a 6.50% coupon. By selling the first bond and buying the
second bond you will have increased your annual income by 25 basis points ($125). Discrepancies in
yield among issuers with similar credit ratings often reflect perceived risk in the marketplace. These
discrepancies will change as market conditions and perceptions change.

Swapping for Increased Call Protection

Swaps may achieve other investment objectives, such as building a more diversified portfolio, or
establishing better call protection. Call protection is useful for reducing the risk of reinvestment at lower
rates, which may occur if an issuer retires, calls or pre-refunds its bonds early. Call protection swaps are
particularly advantageous in a declining interest rate environment. For example, you could sell a bond
with a short call, e.g., five years, and purchase a bond with 10 years of call protection. This will enable
you to lock in your coupon for an additional five years and not worry about losing your higher-coupon
bonds in the near future. You may have to sacrifice yield in exchange for the stronger call protection.

Anticipating Interest Rates

If you believe that the overall level of interest rates is likely to change, you may choose to make a swap
designed to benefit or help you protect your holdings.

If you believe that rates are likely to decline, it may be appropriate to extend the maturity of your holdings
and increase your call protection. You will be reducing reinvestment risk of principal and positioning for
potential appreciation as interest rates trend down. Conversely, if you think rates may increase, you might
decide to reduce the average maturity of holdings in your portfolio. A swap into shorter-maturity bonds will
cause a portfolio to fluctuate less in value, but may also result in a lower yield.

It should be noted that various types of bonds perform differently as interest rates rise or fall, and may be
selectively swapped to optimize performance. Long-term, zero-coupon2 and discount bonds3 perform
best during interest rate declines because their prices are more sensitive to interest rate changes.
Floating-rate, short- and intermediate-term, callable and premium bonds4 perform best when interest
rates are rising because they limit the downside price volatility involved in a rising yield environment; their
price fluctuates less on a percentage basis than a par or discount bond.

However, you should remember that rate-anticipation swaps tend to be somewhat speculative, and
depend entirely on the outcome of the expected rate change. Moreover, shorter- and longer-term rates do
not necessarily move in a parallel fashion. Different economic conditions can impact various parts of the
yield curve differently. To the extent that the anticipated rate change does not come about, a decline in
market value could occur.

Swapping to Lower Your Taxes

Tax swapping is the most common of all swaps. Anyone who owns bonds that are selling below their
amortized purchase price and who has capital gains or other income that could be partially, or fully, offset
by a tax loss can benefit from tax swapping.

You may have realized capital gains from the sale of a profitable capital asset (e.g., real estate, your
business, stocks or other securities). Or you may expect to sell such an asset at a potential profit in the
near future. By swapping those assets that are currently trading below the purchase price (due to a rise in
interest rates, deteriorating credit situation, etc.) you can reduce or eliminate the capital gains you would
otherwise have paid on your other profitable transactions in the current tax year.

The traditional tax swap involves two steps: (1) selling a bond that is worth less than you paid for it and
(2) simultaneously purchasing a bond with similar, but not identical, characteristics. For example, assume
you own a $50,000, 20-year, triple-A-rated municipal bond with a 5.00% coupon that you purchased five
years ago at par. If interest rates increase (such that new bonds are now being issued with a 5.50%
coupon), the value of your bond will fall to approximately $47,500. If you sell the bond, you will realize a
$2,500 capital loss, which you can use to offset any capital gains you have realized. If you have no capital
gains, you can use the capital loss to offset ordinary income. You then purchase in the secondary market
a replacement triple-A-rated 5.00% municipal bond (from a different issuer), maturing in 15 years, at an
approximate cost of $47,500. Your yield, maturity and quality of bond will be the same as before, plus you
will have realized a loss that will save you money on taxes in the year of the bond sale. Of course, if you
hold the new bond to maturity, you will realize a $2,500 gain in 15 years, taxable as ordinary income at
that time. By swapping, you have converted a ³paper´ loss into a real loss that can be used to offset
taxable gain.

Some Important Rules for Tax Swapping

Under current tax law, the maximum tax rate on long-term capital gains is lower than the maximum rate
on short-term capital gains. In order to be entitled to the lower long-term capital gains rate, a taxpayer
must hold the asset for more than one year. Because of ongoing discussions concerning possible
changes in the tax treatment of capital gains, investors should consult their tax advisor for up-to-date
advice.

Capital losses from swap transactions are reflected on Schedule D of your tax return. If you have short-
term or long-term capital gains, the losses from the swap transactions will offset these gains first²long-
term losses will offset long-term gains, and short-term losses will offset short-term gains; net losses in
either category will then offset gains in the other category. If the net result is an overall capital loss, the
excess loss can be used to offset ordinary income dollar-for-dollar (up to a maximum of $3,000). If an
investor has both net short-term and net long-term capital losses, the ordinary income is first offset by the
short-term capital losses, then by the long-term losses. Excess capital losses can be carried forward
indefinitely to reduce capital gains liability and ordinary income in future years.
The tax basis of the new bonds will be their cost (the price paid for the bonds). If the new bonds are
bought at a discount and held to maturity, or are sold at a price higher than their cost, a taxable gain will
often result, unless also offset by losses. To the extent such gain represents accrued market discount, it
will be taxed as ordinary income, with the balance treated as capital gain.

Ask your tax advisor about the use of original-issue discount or market discount bonds, or the use of
bonds issued at a premium, in tax swaps.

Other Tax Strategies

Changes in the tax laws always present an opportunity to review your bond holdings.

Investors who expect their tax rate to increase will frequently swap taxable bonds for tax-exempt
(municipal) bonds. This is done with the expectation that tax-exempt bonds will become relatively more
desirable in the marketplace than fully taxable bonds and will benefit from price appreciation.

Investors not subject to the Alternative Minimum Tax (AMT) can obtain additional yield by purchasing
municipals that are subject to that tax. Taxpayers who are subject to AMT can save taxes by swapping to
non-AMT bonds.

½ow to Avoid a Wash Sale

The Internal Revenue Service will not recognize a tax loss generated from the sale and repurchase within
30 days before or after the trade or settlement date of the same or a substantially identical security²
typically called a ³wash sale.´ While the term ³substantially identical´ has not been explicitly defined in this
context, two bonds have generally not been considered substantially identical if (1) the securities have
different issuers, or (2) there are substantial differences in either maturity or coupon rate.

For a Personal Appraisal

To learn more about what bond swapping may mean to you, consider your objectives and discuss
them your financial consultant.

Swap Objectives and General Information

9. Do you wish to establish a tax loss or realize a gain?


10. Do you wish to improve quality?
11. Do you wish to increase yield?
12. Do you wish to increase call protection?
13. Is there a change in your tax status?
14. What is your tax bracket?
15. What type of bond are you swapping?
16. Do have any other specific investment parameters?

To accomplish any of these objectives are you willing to...

4. Extend maturity? _____Yes _____No


5. Adjust credit ratings? _____Yes _____No
6. Invest additional funds? _____Yes _____No


5. All examples are for illustrative purposes and are not representative of actual market yields.
6. A zero-coupon bond is a bond for which no periodic interest payments are made. The investor
receives one payment at maturity equal to the principal invested plus interest earned
compounded semiannually at the original interest rate to maturity.
7. A discount bond is a bond sold at less than par.
8. A premium bond is a bond priced greater than par.

Î     


  

 A    


In chemistry, a      refers to a combination of two or more elements that cannot be
separated. In math, a       means a fraction that has a numerator, a denominator, or both
that contain fractions. In finance,      means you¶re likely to achieve your financial goals
sooner.

The earlier you begin a regular investment program, the earlier compounding interest can go to work for
you. As with most fixed-income securities, zero coupon bonds offer investors a high degree of safety
when held to maturity and the opportunity to earn compound interest over the life of the bond. In addition,
if you purchase a zero coupon bond issued by a state or local government entity, the interest compounds
free of federal taxes, and in most cases, state and local taxes, too.

With conventional bonds, the investor pays the face amount of the bond and receives interest payments
every six months based on the coupon, or interest rate, offered when the bond is sold. When the bond
matures, the investor then is reimbursed the full principal amount invested.

When purchasing a conventional bond, you invest an amount equal to the face value of the security. As
long as you own the bond, you receive regular interest payments and recoup the initial investment when
the bond matures.

A zero coupon bond, on the other hand, is sold at a discount from its face value and the issuer makes no
interest payments during the life of the security. When it matures, you receive the full face amount which
equals your initial investment plus accumulated interest compounded over the life of the bond. (The
examples cited refer to issues sold in primary market offerings.)
For example, an investor could purchase a 20-year municipal zero coupon bond with a face amount of
$20,000 for approximately $6,757. When the bond matures, the investor receives the full, face amount,
$20,000. The $13,243 difference is attributable to the accumulated compounded interest, in this case
calculated on the basis of a 5.5% rate of return.

Because the bonds are sold at a discount to their face value, the investor also benefits from having a
lower upfront amount to invest, an advantage for those who are just starting out or have more modest
amounts to invest.

Zero coupon bonds were introduced to the fixed-income market in mid-1982. Today, the three largest
categories of zero coupon securities are offered by the U.S. Treasury, corporations, and state and local
government entities.

As with all bond issues, zero coupons issued by the Treasury are generally considered the safest
because they are backed by the full faith and credit of the U.S. government. Municipal zeros also offer a
high degree of safety, and, because the interest earned is usually tax-free, can generate higher returns
when calculated on a taxable equivalent basis.

For example, an investor filing a joint return in the 27.5% tax bracket would have to purchase a zero
coupon bond at 7.59% to equal the tax-exempt municipal yield of 5.5%. The savings add up further if the
municipal zero coupon bond is issued by an entity in the investor¶s own state.

Corporate zeros offer a potentially higher degree of risk, depending on the financial strength of the issuing
corporation, but they also offer the opportunity to achieve a higher return. A zero coupon bond issued by
a corporation or the U.S. Treasury is also taxable, unlike those offered by a municipal issuer. Even
though you do not receive your interest payments in cash while you hold the bonds, you must pay income
taxes each year on the interest as if you had. For that reason, you may want to purchase a taxable zero
coupon bond for your Individual Retirement Account (IRA) or other tax-sheltered retirement account, such
as a 401(k) plan.

Zero coupon bonds enable investors to tailor their purchases according to their own time horizons. For
instance, there are zeros with maturities ranging from one to 40 years, with the majority between 8 and 20
years. So, if you¶re investing for a specific objective, such as retirement, or the start of college tuition, zero
coupon bonds provide you with the ability to time the maturities to when you need the money.

There are also different types and grades of bonds and, as with all bonds, credit quality is a factor. Most
corporate and municipal zero coupon bonds are rated by the major rating agencies, Moody¶s Investors
Service, Standard & Poor¶s, Fitch IBCA, and Duff & Phelps.

The benefits of compound interest, which zero coupon bonds provide, may be the way you can get
started toward meeting your financial goals.


i
 ë  &


How do you choose the best trade for implementing a given macroeconomic view, such as a change in
the rate of economic growth, inflation or expectations about Federal Reserve policy? The Global Fixed
Income and Foreign Exchange Strategy team at JPMorgan Securities ranked dozens of trades across
liquid asset classes by their sensitivity to macro forces and discovered the best tactical trades are often
the simplest ones.

 
  
      

For all implementing views on growth, inflation or Fed expectations, five instruments proved to be
generating the highest risk-adjusted returns:

R Eurodollar futures
R Two-year U.S. Treasury Notes
R 5s/30s curve
R Swap spreads
R Commodity futures

The trades tested were buys (or a steepener in the case of the curve trade) when growth expectations
fall, inflation expectations fall, and the Fed is expected to lower rates and sells (or flattener on the curve
trade) when the consensus expectations were an increase in each area.


 
  
      

For investors with a view on growth, the best trades were two-year U.S. Treasury notes, Eurodollar
futures, the U.S. 5s/30s curve, EUR/USD, USD/CHF, swap spreads, BBB credit, EMBI, S&P vs. U.S.
Treasuries and industrial metals. Cross-market government spread trades, outright equity positions and
precious metals were less efficient for trading on growth expectations.

For investors with a view on inflation, the best trades were swap spreads, two-year U.S. Treasury notes,
Eurodollar futures, 10-year U.S. Treasury notes, S&P outright, industrial metals and energy futures.
Credit, S&P vs. U.S. Treasuries, cross-market government spreads and foreign exchange were less
efficient means of positioning.

For investors with a view on Fed policy, the best trades are two-year U.S. Treasury notes, Eurodollar
futures, the U.S. 5s/30s curve, swap spreads, the 10-year U.S. Treasury note and industrial metals.
Equities, credit and foreign exchange are comparatively worse markets in which to position.

Consult your financial advisor if you want to discuss ideas like this further.

i ë 3




How do investors translate market signals into successful trades? The Global Fixed Income and Foreign
Exchange Strategy team at JPMorgan Securities identified seven bond market signals in four market-
driving categories, tested their theories and combined the signals into a composite bull/bear index on the
market known as the Bond Barometer.

Following are the seven signals by category and the trades they were tested on:

  - 

Two fundamental forces drive bond yields: growth and inflation. If you understand that bond prices are
present values of future cash flows, then you know that forecasts of future growth and inflation are more
important than historical data reports on what has already occurred.

Signal one: Market consensus for year-ahead GDP growth, as measured monthly in the Blue Chip survey
of 50 professional forecasters.

Signal two: Market consensus for year-ahead inflation, as measured monthly in the Blue Chip survey of
50 professional forecasters.

Trade: Buy the 10-year US Treasury note when the consensus lowers its estimate of year-ahead growth
and inflation, suggesting interest rates will go down and bond prices will go up. Sell the 10-year Treasury
note when the consensus raises its estimate of year-ahead growth and inflation, suggesting rates will rise
and prices will fall. Hold for one month until next consensus figures are released. Roll trade if consensus
moves in same direction; reverse if consensus turns; close if consensus in unchanged.

  -&

Presuming that asset prices fluctuate around a stable, long-term equilibrium, extreme deviations serve as
lead indicators of trend reversals.

Signal three: Real (inflation-adjusted) yields.

Trade: Buy the 10-year US Treasury note when real yields are more than one standard deviation above
the long-term moving average sell when they are more than one standard deviation below. Hold the
position until real yields cross the opposite threshold.

Signal four: Ratio of the S&P 500 earnings yield to the 30-year Treasury yield.

Trade: Buy bonds when the ratio is more than half a standard deviation below its long-run moving
average (bonds are cheap relative to stocks) sell when it¶s more than half a standard deviation above its
long-run moving average (stocks are cheap relative to bonds).

  -
  

Risk appetite refers to investors¶ relative preference for safe and risky assets, prompted by business cycle
fluctuations, policy developments or exogenous events.

Signal five: JP Morgan Credit Appetite Index, where zero represents minimum appetite (widest spreads,
positive for U.S. government bonds) and 100 represents maximum appetite (tightest spreads, negative for
U.S. government bonds).

Trade: Sell U.S. government bonds when credit appetite is high, as signaled by the CAI being more than
one standard deviation above its 50-day moving average, and buy when it is low, or more than one
standard deviation below its 50-day moving average.

  -i  


Technical indicators trace market patterns in price and volume.

Signal six: Price data.


Trade: Buy when the short-term moving average of prices crosses the long-term average from below sell
when it crosses from above. In this momentum measure, the strongest returns were generated when
short-term was 10 days and long-term was 20 days.

Signal seven: Flow data, defined as net purchases of U.S. bond market mutual funds, as an indicator of
cash flow into the bond market

Trade: Buy the 10-year Treasury when the flow indicator is more than one standard deviation above the
long-term moving average sell when it¶s more than one standard deviation below.

JP Morgan¶s testing of their Bond Barometer showed that trading rules offer no holy grail, but they can
exploit systematic relationships in the market. In addition, diversification pays no single indicator works at
all times or in all trading environments. In the absence of foresight, a diversified strategy that combines
different information sources (fundamentals, value, risk appetite and technicals), trading strategies
(momentum and contrarian) and holding periods (daily, weekly and monthly) far outperforms narrower
approaches over the longer term.

Consult your financial advisor if you want to discuss this information further.

  


 x 3   £ 

When you invest in a bond, you buy the debt of its issuer, which might be the U.S. government or an
affiliated entity, a state or city government or borrowing authority, or a corporation. Every bond has certain
characteristics:

R A definite maturity date when the bond issuer promises to repay the bondholder who owns the
security at the time.
R A promise to pay taxable or tax-exempt interest at a stated ³coupon´ rate in defined intervals over
the life of a bond.
R A yield, or return on investment, which is a function of the bond¶s coupon rate and the price the
investor pays, which may be more or less than the bond¶s face value depending on a variety of
factors.
R A credit rating indicates the likelihood that the issuer will be able to repay its debt.



    


While generally considered safer and more stable than stocks, bonds have certain risks:

R Interest rate risk: when interest rates rise, bond prices fall. If you need money and have to sell
your bond before maturity in a higher rate environment, you will probably get less than you paid
for it. Interest rate risk declines as the maturity date gets closer.
R Credit risk: if the issuer runs into financial difficulty or declares bankruptcy, it could default on its
obligation to pay the bondholders.
R Liquidity risk: if the bond issuer¶s credit rating falls or prevailing interest rates are much higher
than the coupon rate, it may be hard for an investor who wants to sell before maturity to find a
buyer. Bonds are generally more liquid during the initial period after issuance as that is when the
largest volume of trading in that bond generally occurs.
R Call risk or reinvestment risk: If a bond is callable, the issuer can redeem it prior to maturity, on
defined dates for defined prices. Bonds are usually called when interest rates are falling, leaving
the investor to reinvest the proceeds at lower rates.

£ 
 
6Î   

Bond investors can diversify risk by purchasing bonds from different issuers with different maturities.

Treasury securities are available in $1,000 increments, but the minimum purchase for municipal and
corporate bonds can be $5,000 or more. The cost of buying a bond includes a commission or a ³markup´
on the price, depending on whether you are buying from a firm acting as an agent who is getting the bond
from someone else, or as principal, meaning the firm owns the bond it is selling.

Executing an effective diversification strategy requires a significant minimum investment to start. While
there is no absolute requirement, a rule of thumb says it often takes at least $10,000 or more to build a
fully diversified bond portfolio.

 
-    6   
£ 
 Î     
< 

£  


Bond funds²including mutual funds (open-end and closed-end, actively managed and indexed),
exchange-traded funds and unit investment trusts²offer a convenient and affordable way to invest in a
diversified portfolio of bonds, but a bond fund investment can differ from a bond investment in ways that
are important to understand.

When you buy a bond fund, you buy shares in a portfolio of bonds that is created or managed to pursue a
specific investment objective such as current income, current tax-exempt income, total return, or to match
the performance of a market index. The portfolio might invest in a particular type of bond (government,
municipal, mortgage or high-yield) or a particular maturity range (short-term: three years or less;
intermediate term: three to 10 years; or long-term: usually 10 years or longer).

Many bond funds make monthly or quarterly ³dividend´ payments, as opposed to the semiannual
payment schedule common to most bonds. Their price is based on their Net Asset Value (NAV), or the
total market value of the portfolio divided by the total number of fund shares outstanding. A fund¶s NAV
changes daily with market conditions and in some cases with cash inflows and outflows to and from the
fund portfolio.

i
 6  


Bond mutual funds can be actively managed or indexed, open-end, closed end or exchange traded funds.
For more details, see the comparison table.

R    bond funds, as their names suggest, have managers who buy and sell bonds
in pursuit of their investment objective. They sometimes sell bonds at a profit, creating a capital
gain, or at a loss if they need cash to pay shareholders who want to sell their shares.
R  6  
are not actively managed but constructed to match the composition of a given
bond index, such as the Lehman 10-year Bond Index. When the index changes, the portfolio
changes automatically.
R Sponsors of 2 bond funds (usually a mutual fund company) offer new shares and
redeem existing shares continuously, requiring their managers to invest cash coming into the
fund and liquidate positions when they need cash to meet redemptions. Investors in open end
funds have the choice to collect their interest income and capital gains or reinvest them
automatically in new funds shares.
R 
2 bond funds have a fixed number of shares that trade on exchanges similar to stocks
at a price that may be above or below net asset value depending on supply and demand. Closed-
end bond funds can be indexed or actively managed. To buy or sell shares in a closed end fund,
you have to go through a broker and pay a commission.
R    
(ETFs) represent shares in a ³basket´ of bonds that mirrors an index,
but the number of shares is not fixed. ETFs trade on an exchange, with shares bought and sold
through brokers who charge commissions.
R #  
  

are a portfolio of bonds held in a trust that sells a fixed number of shares.
On the trusts¶ maturity date, the portfolio is liquidated and the proceeds returned to unit holders
on a pro rata basis. UITs are usually created by brokerage firms that maintain a limited secondary
market for the units. Unit holders who want to sell before maturity may have to accept less than
they paid.

 
 x 3   

c  

It¶s a common misconception that bonds are only for very old, very rich or very conservative investors or
very young (savings bonds for kids). In fact, bonds are an important component of a strategically-
balanced portfolio at every stage of any investor¶s life. Bonds can:

R provide investment stability to help buffer against the volatility of the stock market
R pay a steady stream of income, sometimes tax-free income, which can help with living expenses
R provide high rates of return to grow your capital
R play different roles at different points in your life to help you achieve your financial goals

The key to a well-balanced portfolio is asset allocation and diversification. Asset allocation is spreading
your money across a good mix of equity investments (stocks), debt investments (bonds) and cash
instruments to maximize the return of the entire portfolio. Diversification is investing in various vehicles
across asset classes to reduce the risk that any one investment may pose to your overall portfolio.

Unfortunately there is no hard and fast rule, or formula, about how much to invest and where to invest.
Your investment strategy will change over time, reflecting your investment horizon (how much time there
is between now and when you want to access the money you are investing) and your risk tolerance (how
much risk you are willing to take in exchange for a possible higher rate of return.)

So whether you are just starting out in your career or you are already enjoying retirement, or if you are
somewhere in between, bonds should be a part of your investment portfolio. Let¶s look at the role bonds
can play at each stage of your life.

R Starting Out (20s and 30s)


R In the Middle (30s and 40s)
R Nearing Retirement (50s and 60s)
R Retirement (60+)

x 3   

3  c -  
x (
1(


R  
 %   
3  Maximize Capital
             
R  
 " ;  Very Long (30 - 40+ years)
            
R 
i   High
          

At the beginning of your career you may have a hard time imagining life 15, 30 or 40 years from now.
Chances are that you are more concerned about paying bills and saving money toward big-ticket items
such as a car, a wedding, a house or having a baby.

Your ability to reach your goals and achieve financial security, however, depends in part on maximizing
your current income through investments. You have the opportunity to create the important habits of
saving and strategically investing now so you can enjoy its benefits in your later years. The work that
you¶re doing now is laying a foundation for future financial freedom. For example, having money
withdrawn from your paycheck and automatically deposited into an employer-sponsored 401(k) retirement
savings plan can provide you with a solid nest egg when you leave the workforce.

Since you have a longer horizon for investing (the amount of time between now and when you want/need
to access your money), you are in a better position to consider investing in higher-yield, higher-risk
instruments. There are higher-risk bonds that carry high coupons (interest rates) You may be interested in
assuming that risk to potentially make significant interest on your investment.

Keep in mind, however, that even at this early stage of the investment game, you want to aim for a well-
blended portfolio to balance risk and market volatility. While your higher-yield investments can appear
more exciting (because of their potential to earn more interest), it¶s important to round out your portfolio
with some strategically chosen lower- and medium-risk investments as well, including bonds.

Depending on your circumstances bonds can help you:

R %     2 


There are high-risk/high-yield bonds that may be of
interest to you as you look to grow financially. Remember that when you invest in higher-risk
instruments you face a greater potential for loss due to interest rate risk and credit risk. Carefully
research each bond offering and know a bond issue¶s conditions and terms (including its¶ rating,
call features and whether or not it is insured) prior to investing. A financial advisor may be able to
help you. Click here to learn more about ³Selecting and Working with a Financial Professional.´
R Î
  
 
 6   
 If you are saving money for a large future
purchase²a car, a wedding, a house²you might consider investing that savings in a low-risk
bond with a maturity date that matches the date you will need the money. For example, new issue
U.S. Treasury bills, notes and bonds are available directly from the Federal Reserve in three-
month, six-month, and two-year and three-year maturities in $1,000 increments starting at
$1,000. You can also buy outstanding Treasury or corporate bonds with maturities timed to your
needs in the secondary market through a bank or a broker. Prices and yields will vary.
R £ 
   2
 
   If your 401(k) or other employer-
sponsored retirement plan offers a variety of mutual funds, you might want to allocate some
portion of your assets toward bond funds to diversify your holdings and spread your risk. Because
the stock and bond markets do not often move in the same direction, bond investments can
stabilize and even enhance your overall returns. You might look into high-yield and long-term
bond funds if you want to take more risk for the possibility of higher returns.
R 3    Maybe you¶ve received an inheritance or other large sum of money.
Investing it in bonds can help you preserve the principal for the future while generating interest
income that you can spend now. Depending on how much you have to invest, you might want to
consider constructing a bond portfolio yourself with the help of an advisor, or investing in another
type of bond investment such as a unit trust or bond fund.
R £  
  2
  One of the common myths about investing is
that you have to have a lot of money to do it. That¶s a good reason to consider dollar-cost
averaging. If you can only invest a small amount at a time, or if you are uncomfortable investing
large chunks of money at once, dollar cost averaging can be a way to invest in bonds
automatically on a regular schedule. First, consider working with a financial advisor to determine
what types of bond investments are appropriate for your portfolio. Next, select a regularly
scheduled date to have a pre-determined amount of money automatically withdrawn from an
account of your choice and have it deposited into your brokerage account to purchase (or
earmark toward purchase) the bonds you have chosen. Making small deposits over time will add
up to consistent investments which can reap significant dividends over the long term. Think you
don¶t have enough money to invest? Consider the dollar-cost averaging approach to purchase
bonds for your portfolio.

 ë-  
x 1(
3(


R  
 %  Capital Growth
                 
R  
 " ;  Long (20²30+ years)
            
R 
i   Moderate
          

The middle years²mid-30s to late 40s²are crucial to accumulating and wisely investing toward your
retirement and long-term financial goals. Even if you didn¶t, or couldn¶t, start saving and investing earlier
you need to begin making up for lost time.

If you¶re between 35 and 55, you are probably earning enough to live more comfortably now than when
you were younger, but are increasingly concerned about funding your retirement and paying for your
children¶s education. While you still have time in your investment horizon to be able to recover from a
market downturn, you don¶t want to have your portfolio so heavily loaded in high-risk investments that you
could lose the bulk of your money if the stock market or your individual stocks decline significantly.

Because your investment horizon is somewhat shorter than when you were first starting out in your
twenties, you should rebalance your portfolio to make sure that you have allocated your assets
appropriately. Financial advisers usually recommend that at this point in your investment life it would be
prudent to shift your investments to focus more on medium-risk and low-risk instruments, while still
maintaining a healthy, but smaller, percentage of investments in higher-risk instruments. Remember that
the key is spreading, or allocating, your assets across investments of varying degrees of risk to blend the
risk you¶re taking and to maximize your interest-earning potential. Consult a financial advisor for
investment recommendations and assistance.

Bonds should represent a larger portion of your asset allocation than they did when you were younger.
Bonds provide a stable backbone and more predictable income generation than equities.

Following are some bond strategies to consider at this stage in your investment life. As always, it¶s a good
idea to consult a financial advisor before making any investment decisions.

R A   6 
 
    
Zero coupon bonds are sold at a steep discount from
their face value. When the bond matures, the face value reflects both the principal and the
interest accumulated. Buying a zero coupon now with a maturity that coincides with the year your
child starts college or the year you would like to retire can be a cost-effective way to increase the
likelihood that you will have the money you need when you need it. Zero coupon bonds work best
in a qualified, tax-deferred retirement or college savings account because the interest is taxable
when it is credited to the bond, even though you can¶t spend it until maturity.
R i 2  6  
 If you¶re in a high tax bracket, tax-advantaged municipal bonds
issued by state and city governments may be more attractive than corporate bonds that pay
taxable interest income. Interest paid on most U.S. government securities is exempt from state
and local income tax, which can be important if you live in a high-tax state. Municipal bonds pay
interest that is exempt from federal income tax, and, depending on the issuer, possibly from state
and city income tax as well. To see how much you would have to earn on a fully taxable
investment to match the return of a tax-exempt investment you¶re considering, use the Taxable
Equivalent Yield calculator. You can earn tax-exempt interest on bonds and bond funds that
qualify. In most cases, you don¶t want to put this kind of investment in a tax-deferred retirement or
college savings account, however, so you don¶t waste the tax exemption feature.
R  
     6 
If you have not yet started investing a portion of your
assets in bonds, now may be a good time to start. If you are willing to take a little more risk for the
possibility of higher returns, consider high-yield or longer-term bonds or bond funds.

,  -  
x 4(
/(


R  
 %  Conserve capital
             
R  
 " ;  Moderate (5 - 15 years)
             
R 
i   Low
          

Hopefully by this point the hard work and discipline of saving and investing is creating a solid portfolio that
enables you to look forward to financial freedom in your retirement.

As retirement approaches, your investment horizon shrinks. In other words, the closer you are to
retirement, the less chance you want to take that you could lose a sizable portion of your investments.
You want to more aggressively protect your assets from the stock market¶s volatility. Many advisors
suggest that people at this point begin increasing the bond portion of their portfolio to 50% or more to
lower their overall investment risk.

Some issues to consider when evaluating bonds for your portfolio:

R  
  
 The bond markets offer investors many choices and sectors, each with
a slightly different risk and return profile. As with all investments, diversification is important in
your bond investments too. Because many kinds of bonds can only be bought in minimum
increments of $5,000, creating a bond portfolio that includes different issuers, market sectors,
maturities and credit qualities can require a significant amount of assets. Bond funds, unit trusts
or exchange-traded funds may be a better choice for more convenient and affordable
diversification, although they don¶t offer the comfort of a single bond¶s promise that your principal
will be returned on the maturity date.
R i 2  6  
 If you¶re in a high tax bracket, tax-advantaged bonds issued by
federal, state and city governments may be more attractive than corporate bonds paying taxable
interest income. Interest paid on most U.S. government securities is exempt from state and local
income tax, which can be important if you live in a high-tax state. Municipal bonds pay interest
that is exempt from federal income tax, and, depending on the issuer, possibly from state and city
income tax as well. To see how much you would have to earn on a fully taxable investment to
match the return of a tax-exempt investment you¶re considering, use the Taxable Equivalent Yield
calculator. You can earn tax-exempt interest on bonds and bond funds that qualify. In most
cases, you don¶t want to put this kind of investment in a tax-deferred retirement or college savings
account, however, as that would be wasting the tax exemption.
R ë 
 
 The rule of thumb is that when interest rates rise, bond prices fall
and vice versa. If you buy a bond with a 5% coupon and interest rates on the same maturity rise
to 6%, not only will your bond be worth less if you want to sell it before maturity, but you will also
be missing the opportunity to earn higher interest. One way to manage this risk is with laddering.
Creating a portfolio of bonds with maturities staggered over one, three, five and ten years, for
example, helps you do well in any interest rate environment. When rates are rising, you will have
short-term bonds maturing that allow you to reinvest the principal at higher rates. When rates are
falling, you will still have the longer-term bonds paying higher coupons.

  -  
x /(


R  
 %  Preserve Capital
             
R  
 " ;  Short (Immediate Access to Funds)
          
R 
i   Very Low
          

During retirement your main investment focus is ensuring your financial security. Most financial advisors
say you'll need about 70 percent of your pre-retirement earnings to comfortably maintain your pre-
retirement standard of living. If you have average earnings, your Social Security retirement benefits will
replace only about 40 percent. Your investments and your employer¶s plan, if you have one, will have to
make up the rest. Bonds can generate an important source of retirement income while preserving your
principal.

When thinking about bonds, think about:

R ë ;     The right kind of bond investments for you will depend on your
life expectancy, your tax bracket, and the amount of risk you can afford to take. High yield and
longer-term bonds may have higher coupons, but they also can put your principal at risk if you
need to sell the bond before it matures and the issuer¶s credit quality has declined or interest
rates have risen. Consider a balanced bond fund where you can supplement your regular income
with a percentage of your earnings while still maintaining enough capital in the fund to outpace
inflation. If you¶re in a higher tax bracket you may benefit from the federal (as well as possibly
state and local) tax-exempt interest from municipal bonds.
R %
    Retirees living on a ³fixed income´ can lose purchasing power if
inflation increases. To help guard against this risk, you might consider including Treasury Inflation
Protection Securities (TIPS) or Treasury Inflation Indexed Securities in your investment portfolio.
TIPS have a fixed coupon rate, but their principal amount is adjusted every six months according
to changes in the Consumer Price Index. As a result, the amount of your income that should stay
represents equivalent purchasing power. At maturity, you get the higher of the original face value
or the inflation-adjusted amount. Another way to guard against inflation is to keep a small
percentage of your portfolio invested in stocks for their greater growth potential.
R 3    6  
Remember that if you¶re in a position where your cash assets
won¶t cover ongoing or one-time expenses you will want to dip into your taxable investment
accounts first. Taking money from a tax-advantaged retirement plan, such as a 401(k) or IRA, can
have tax implications and early withdrawal penalties. Keep an eye on CD maturity and bond
maturity rates in your portfolio and consider cashing those out and retaining a portion before
rolling the sum into another vehicle when they mature.
R    If you want to preserve your assets so they can be passed on to future
generations or your favorite charity according to your wishes, you may want to establish an estate
plan using investments held in trusts. Bonds often play a vital role in the investment strategy for
an estate plan, but be sure to consult an attorney and accountant so you understand all the legal
and tax implications.

 Î

Bonds can help you achieve a variety of financial goals at any stage of life. By gaining insight into the
factors affecting bonds, and determining key issues to consider before investing in bonds, you can be
well-poised to invest with confidence. This section provides financial planning information and resources
to help you determine what role bonds can play at each stage of your life.

Your portfolio and your financial goals will change over time so when you review your financial plan,
returning to this section may be helpful.

Î   

One of the quiet revolutions of the second half of the 20th century was the dramatic increase in the health
and life expectancy of retired people. As a result, conventional ideas about retirement have changed.
Robust retirees are leading longer, far more active²and more expensive²lives.

People retiring in the near future will need more financial resources, and these resources will have to last
longer. Most financial advisors say you'll need about 70 percent of your pre-retirement earnings to
comfortably maintain your pre-retirement standard of living. If you have average earnings, your Social
Security retirement benefits will replace only about 40 percent. But some general principles of investment
for retirement remain unchanged.

Virtually all financial advisers recommend that some portion of your retirement portfolio be invested in
bonds.

 6 

Bonds represent money investors have lent to corporations or government entities. Generally, investors
receive a fixed amount of interest regularly for the life of the bond. The face amount, or principal, is repaid
at the end. This gives the investor a predictable flow of cash. This steady cash flow provides a needed
element of stability to the retirement portfolio.

For people nearing retirement, the recommended percentage of bonds in a portfolio varies widely,
ranging from as little as 15% to as much as 60%.

These percentages are influenced by several factors:

R How many years you have until retirement.


R How dependent you are on your investments for retirement income.
R How comfortable you are with investment risks.
R And whether you still need to accumulate money for expenses such as your children¶s education
or a new home.

If you are looking to retire in 20 years, you are likely still accumulating your nest egg. Since you probably
still need to build your assets, you can take a fairly aggressive investment stance. There¶s plenty of time
to ride out the ups and downs of the stock market²within your own comfort zone. If the stock market
makes you nervous, a mix of stocks and bonds may be appropriate.

If, on the other hand, you're just a few years from retirement, or have already retired, you need more
protection against the possibility of a sharp stock market decline. A greater proportion of fixed-income
securities makes sense.

In both instances, people likely to be in high tax brackets after retirement may prefer to hold a high
proportion of municipal bonds, which are generally exempt from federal tax and sometimes from state
and local taxes as well.

The message here is that bonds can be used cautiously or aggressively in any portfolio. Regardless of
the investment style, though, bonds have a definite place in a retirement nest egg.

A good starting point is a survey of your resources. To get an estimate of the amount of money you will
get each month from Social Security when you retire, you can get in touch with the Social Security
Administration at its Web site, or by phone at 1-800-772-1213
begin_of_the_skype_highlighting 1-800-772-1213 end_of_the_skype_highlighting from 7 a.m
to 7 p.m. Your employer¶s human resources department can supply or get for you an estimate of your
monthly income from your retirement plan. Total the two numbers and compare them with an estimate of
your monthly post-retirement expenses. If the total is less than your monthly expenses, your investments
will have to provide the balance.

Below are some questions about the sort of plan that might be right for you:

" 
   

R 10 years or more.
R Less than 10 years but more than five.
R Five years or less.

" 
     

R None.
R Just 1.
R More than one.

"   6   



    

R They will have to provide a quarter or less.


R They will have to provide more than a quarter but less than half.
R They will have to provide half or more of my retirement income.

"    



      
  


R Whatever risk is necessary to achieve goals.


R Some risk.
R As little risk as possible.

How you answer these questions could suggest different investment approaches ranging from a more
aggressive strategy, using a greater percentage of equities and high-yield bonds, to a more conservative
strategy, using a greater percentage of bonds than equities, or something in between.

This simple quiz is intended only to get you thinking about your possible investment strategy for
retirement and is by no means definitive or intended to serve as investment advice. Many other
evaluation matrixes are available from financial advisers and companies that offer specific investment
products. Several are available on the Internet. A search for ³retirement asset allocation´ will lead you to
several sites that offer evaluations.

% 3  

The first step in devising an investment strategy for retirement is to survey your resources and needs, as
discussed above. After you've assembled the necessary information, you should consult with a financial
professional about how your assets should be allocated to best meet your goals, consistent with your
perception of risk. You may find that your risk tolerance will increase as you acquire a better
understanding of the relationship between risk and reward. But no matter what your needs and your risk
perception may be, bonds have a definite place in your portfolio.

ë 3  

ë 
  
(or 
) are exempt debt securities issued by state and local governments in the
United States and its territories. They include securities issued by agencies or authorities established by
those governments. Munis are used to fund items such as infrastructure, schools, libraries, general
municipal expenditures or refundings of old debt.

When the United States introduced a federal income tax in 1913, the taxability of interest from municipal
securities was challenged based on the constitutional principal of states' rights. That argument was
upheld by the Supreme Court for much of the twentieth century but was finally rejected in a 1983 case.
Today, congress has a right to tax interest income from municipal securities, but it currently chooses not
to. Many states also exempt their securities from their own taxes, which makes those securities
particularly attractive investments for their own residents. Of course, capital gains from buying or selling
munis in the secondary market are fully taxed.

Because of their tax-exempt status, munis have nominal yields below those of corporate bonds or
Treasury bonds. To compare a muni's yield to that of a taxable bond, investors calculate the muni's  2
   using the formula

This indicates the yield a taxable bond would have to earn in order to match, after taxes, the yield
available on the untaxed muni. Here     is the tax rate that would apply to one additional
dollar of income if the investor earned one additional dollar, what fraction of that dollar would be lost to
federal, state and local income taxes?

Consider an individual investor who pays a marginal tax rate of 34% due to federal, state and local
income tax. To compare a muni paying 3% with a taxable corporate bond paying 4%, she would apply
formula [1] to obtain a tax-equivalent yield for the muni of 4.55%. Barring other factors, she would likely
invest in the muni, since its tax-equivalent yield is superior to the 4% yield on the corporate.

Obviously, tax-equivalent yield depends on the investor's marginal tax rate. If a property and casualty
insurance company is losing money, its marginal tax rate will be 0%. If it compares the same muni paying
3% and corporate paying 4% as in the previous example, it would apply formula [1] to obtain a tax-
equivalent yield for the muni of 3%. Barring other factors, the company would probably invest in the
corporate.

Munis are not always tax exempt. Interest on some munis is taxed under the Alternative Minimum Tax
(AMT). These are called ëi6 
. If a municipality issues debt to fund a commercial enterprise, such
as a shopping mall or sports stadium, the securities are called      6 
. To prevent
municipalities from engaging in tax arbitrage issuing debt at tax-free yields while earning a commercial
rate or return on the proceeds interest on private activity bonds is taxable.

To preclude tax arbitrage by securities dealers, any interest paid to finance a position in munis is not
deductible as a business expense.

Unlike, the Federal government, which can print money, municipalities cannot. This means that munis
entail credit risk. There have been a number of spectacular municipal bankruptcies, so the risk of default
is real. Munis are rated, just like corporate bonds, with ratings varying from AAA to D. Some munis are
issued with credit enhancement. This may include credit insurance or a bank guarantee, such as a letter
of credit.
Long-term munis are called  6 
. These typically pay semiannual coupons, but some are
zero-coupon or accrued-coupon bonds. These instruments fall into two general categories:

i 26 6 
are backed by anticipated tax, penalty or fee revenue. These instruments include
 6  6 
, which are baked by the general tax revenue of the issuer. Some are are
structured like a securitization of specific revenues, such as sales taxes or fees. There are also a number
of structures issued by state or local agencies with some sort of credit enhancement from the state or
local government.

 6 
are issued to finance specific revenue-producing projects, such as toll roads,
airports, public housing or higher education. Interest and principal are paid out of revenue from the
project. The bonds are classified by project type, so you will hear of utility revenue bonds, hospital
revenue bonds, transportation revenue bonds, housing revenue bonds, etc.

A third category of municipal bond is refunded bonds.

 6 
(also called  6 
) are tax-backed or revenue bonds that the issuer has
allocated funds to fully retire. The issuer hasn't retied the debt yet, either because it is not yet callable or
for some other reason. Instead, the issuer has used the allocated funds to buy an offsetting portfolio of
bonds, which are placed in escrow or a trust for the benefit of bondholders. The portfolio may hold
Treasury securities, agency securities or other high-quality debt. It is structured so its cash flows offset
the cash flows due on the refunded bonds. This may be done in anticipation of the bonds being called at
the first opportunity, or it may be done assuming that the bonds will be outstanding until maturity.
Because they are fully baked by high-quality collateral, refunded bonds tend to have excellent credit
quality.

Municipalities issue a number of shorter-term instruments. Most common are municipal notes.

ë  
have maturities from three months to three years. Some are issued as discount
instruments, but most are coupon bearing. Typically, notes are issued to address mismatches in the
timing of expenditures and offsetting revenues. i      
(TANs) are issued in anticipation
of tax revenues.       
(RANs) are issued in anticipation of other revenues, such
as federal aid. i       
(TRANs) anticipate either tax and/or other revenue.
%      
(GANs) are issued in anticipation of receiving a grant.      
 
(BANs) are issued in anticipation of funding from the issuance of municipal bonds. Most notes are
issued with credit enhancement, such as a bank letter of credit.

In the past, municipalities used commercial paper to meet much of their short-term funding needs. This
had the advantage that municipalities didn't have to perform a new public offering each time they issued
short-term debt. Municipal issuance of commercial paper was severely restricted by the 1986 Tax Reform
Act. Since then, municipalities have turned to various floating rate instruments, which were first employed
in the 1970s. These have long maturities, so issuers can have infrequent offerings. They also have
liquidity features that make them essentially money market instruments.

&6  6  


(VRDOs), also called 6  
(VRDNs), are
floating rate instruments with terms of as much as 40 years. They pay interest monthly or quarterly based
on a floating rate that is reset daily or weekly based on an index of short-term municipal rates. VRDOs
are purchased at par. Liquidity is provided with a put feature, which allows the holder to put the the
security for par plus accrued interest on any interest rate reset date, usually with one or seven days
notice. A remarketing agent a bank or other entity serves as liquidity provider. VRDOs are put back to it
rather than the issuer. The remarketing agent tries to resell those VRDOs or, failing that, holds them in its
own inventory. VRDOs almost always have credit enhancement either a letter of credit from the
remarketing agent or bond insurance. The issuer generally has an option to convert a VRDO to a fixed
rate instrument. Due to the put feature, tax-exempt money market funds generally can hold VRDOs.

   
  
(ARS) are structured much like VRDOs, but rates are reset and liquidity is
provided through a periodic Dutch auction. Investors who wish to acquire an ARS submit bids in that
auction. Investors who already hold the ARS have a choice to hold (agree to receive whatever rate is set
in the auction), bid (bid in the auction, and relinquish their holding if their bid is not accepted), or sell
(redeem their investment at par plus accrued interest, irrespective of auction results). For tax-exempt
ARS, auctions are typically held every 7, 28 or 35 days. Interest is usually paid the day after the auction,
but less frequent coupon dates are possible. Instruments usually have some form of credit enhancement.
Tax-exempt money market funds generally can't hold ARSs.

While VRDOs and ARSs are unusual, most municipal securities are issued as traditional public offerings.
There is an active over-the-counter secondary market for munis. Tax exempt investors, such as pension
plans, don't generally invest in munis. Most munis are held by property and casualty insurance
companies, wealthy individuals who have the highest marginal tax rate, and mutual funds that invest
exclusively in munis. Banks or other dealers also hold inventories of municipal securities.

The phrase  2  6  refers to any bond whose interest is not subject to taxation by one or more
authorities. In the United States, the term is often used synonymously with municipal bonds. However,
non-profit entities like hospitals and museums also issue bonds that are tax exempt. These are structured
much like munis, and they are sold to mostly the same investors.

    


Cross-boarder bond investing has existed for centuries. There was little activity for much of the 20th
century, due to capital and currency controls, but the 1973 collapse of the Bretton Woods system opened
the door for the emergence of today's active markets. This article describes the types of instruments that
are traded.
Most countries have some system of financial regulation that applies to securities issued for sale to
domestic investors (see articles on United States and European regulations). £ 
 6 
are
issued in a country by a domestic issuer for domestic investors. They are denominated in that country's
currency and are subject to that country's regulations. Some investors purchase another country's
domestic bonds. To do so effectively, they must understand that country's trading, settlement and
accounting practices. They may have to deal with inconvenient time-zone and language differences. The
bonds pose foreign exchange risk, and securing reliable credit information can be difficult.

Some bond issuers explicitly want to attract foreign investors. They issue what are known as 
6 
. These are bonds issued in one country and denominated in that country's currency by a foreign
issuer. The issuer must satisfy all regulations of the country in which it issues the bonds. An example is
x6 
, which are foreign bonds sold by some corporations, but mostly by supranational
agencies or foreign governments, to investors in the United States.  
,   
, 6
,
and

are foreign bonds issued in the United Kingdom, Spain, the Netherlands and Japan,
respectively.

A  6  is something different. It is not a foreign bond issued within the European Union. Rather, it is
a bond issued and traded within the mostly unregulated Euromarket. While that market originated within
Europeöand is still largely centered thereöit is a truly international market. Transactions are not subject
to any particular nation's regulations. Bonds are issued in bearer form and usually pay annual (as
opposed to semiannual) coupons. They are denominated in various currencies. Since the launch of the
euro in 1999, many European corporations have turned to the Eurobond market to diversify their funding
away from bank loans. In this way, the Eurobond market has become both an international market and
somewhat of an unregulated domestic bond market for Europe.

Arbitrage between the foreign bond and Eurobond markets lead to the development of  66 
.
These are bonds that blend characteristics of foreign bonds and Eurobonds and are issued in both
markets simultaneously.

 6 is debt that is issued by governments or corporations in countries whose


economies are striving to emerge from under development. The sector includes domestic bonds, but
foreign investors primarily buy bonds issued as Eurobonds or global bonds. Credit risk is a significant
issue, and many outstanding bonds are restructured bank loans or restructured defaulted bonds.

3   

3   is a form of lending in which a group of lenders collectively extend a loan to a single
borrower. The group of lenders is called a
  . The loan is called a
   in contrast to
a 6  , which is a loan made by a single lender to a single borrower. Syndicated loans are
routinely made to corporations, sovereigns or other government bodies. They are also used in project
finance and to fund leveraged buyouts.
Syndicated loans are primarily originated by banks, but a variety of institutional investors participate in
syndications. These include mutual funds, collateralized loan obligations, insurance companies, finance
companies, pension plans, and hedge funds.

Syndicate members play different roles. Some just lend money. Others also facilitate the process. It is
common to speak of an , 6 or  that originates the loan, forms the syndicate
and processes payments. But several syndicate members may share these tasks. Syndications with two
or more arrangers are not uncommon. In a world where bragging rights are important for securing future
deals, a bank may be called an arranger for nothing more than contributing a large part of the loan.

Most syndicated loans are floaters, paying a spread over Libor, but other structures abound. Fixed-rate
term loans, revolving lines of credit and even letters of credit are syndicated. Loans may be structured
specifically to appeal to institutional investors. These might have two tranches:

a Tranch A structured as a typical bank loan, such as a floater or revolver, and offered to bank
lenders, and

a Tranch B structured as a fixed-rate term loan and offered to non-bank institutional investors.

Loans can be underwritten or originated on a best efforts basis. In the former case, the arrangers commit
to a particular sized loan. It is up to them to recruit enough syndicate members to secure that full amount.
Should they fail, they make up the shortfall, extending a larger portion of the loan than they had perhaps
wanted. With a best efforts deal, the arrangers try to recruit enough syndicate members to achieve a
desired loan size. If they fail, however, the borrower simply receives a smaller loan than it had hoped for.

The borrower in a syndicated loan incurs two expenses. One is the interest on the loan. The other is fees.
These can take various forms, depending on how the loan is structured. Fees may include an
administration fee, upfront fee, underwriting fee, commitment fee, facility fee, utilization fee, etc.

Syndicated loans, like most loans, pose credit risk for the lenders. This can be extreme, as with some
leveraged buyouts or loans to some sovereigns. Credit risk is assessed as with any other bank loan.
Lenders rely on detailed financial information disclosed by the borrower. As syndicated loans are bank
loans, they have higher seniority in an insolvency than bonds.

Syndication has been used for decades on an as-needed basis by banks wanting to spread the risk of
large loans. The market took off following the first, 1973, oil shock. As the price of oil skyrocketed, banks
recycled deposits from oil exporting countries as syndicated loans to oil importing countries, especially
less-developed countries in Latin America. The second oil shock, of 1981, and the Fed's
experimentations with monetarism, caused interest rates to shoot up in the early 1980s. A number of
less-developed countriesöincluding Argentina, Brazil, Mexico, the Philippines and Venezuelaödefaulted
on their floating-rate loans. Former Treasury Secretary Nicholas Brady spearheaded a bailout on behalf
of the US Government. This combined considerable debt forgiveness with a repackaging of loans as
bonds collateralized by US Treasuries. Called 6 
, these instruments were actively traded in a
secondary market.

As the market for syndicated lending to less-developed countries dried up, Michael Milken was launching
a wave of leveraged buyouts (LBOs) financed in part by syndicated loans. The market experienced
retrenchment again as LBOs faltered, but syndicated lending entered the 1990s as a mature market
serving a variety of sovereign and corporate borrowers.

During the 1990s, an active secondary market for syndicated loans emerged. This was fueled partly by
the recession of 1991, which forced some banks to trim their balance sheets. Secondary market trading
continued a convergence of the syndicated loan and bond markets. As those markets converge, the
disparity in how they are regulated presents both opportunities and legal uncertainties. In the United
States, most bonds are regulated under the 1933 Act and 1934 Act. Bank loans generally are not, and
arrangers of syndicated loans invoke a number of exemptions under those acts to avoid regulation.

#3i
3  


United States i



  
(also called i

) are fixed income instruments issued by the
United States Department of Treasury. They are direct obligations of the Federal Government, so they
are considered free of credit risk. Interest income from Treasuries is taxed by the Federal Government but
not by US state or local governments. Due to their favorable tax treatment, lack of credit risk and the fact
that Treasuries are generally not callable, Treasuries offer yields below those of high-quality corporate
securities.

At any given time, there are several trillion dollars of Treasuries outstanding. As old debt matures or
federal budget deficits create a need for additional funds, the Treasury issues new securities.
Accordingly, both the primary and secondary markets for Treasuries are large, active and highly liquid.

Treasuries are issued in various forms. By convention, these are categorized as

Treasury bills, which are discount instruments with initial maturities of up to a year.

Treasury notes, which pay semiannual coupons and have initial maturities of more than one year and
up to ten years.

Treasury bonds, which pay semiannual coupons and have initial maturities greater than ten years.

A more recent development is Treasury Inflation-Protected Securities (TIPS), which are coupon paying
instruments with a principal amount that is adjusted over time for inflation.
The primary market for Treasuries is conducted as a Dutch auction open to the public and run by the
Treasury. About 150 auctions are held a year. Most are for bills. Notes or bonds are auctioned less
frequently. The Treasury publishes an informal long-term schedule for auctions. This is modified as the
federal government's funding needs evolve.

Some auctions are called  


. At these, the treasury auctions more of a previously issued
security. For example, if a 4.25% coupon 30-year bond is issued in a February auction, more of those
same 4.25% bonds will be offered in the August reopening. They will have the same maturity date as the
previously issued bonds, so they will have just 29.5 years to maturity when issued..

i
  3 
Exhibit 1

6
- weekly

2 - monthly

12 - Feb, May, Aug, Nov

42 - monthly

Feb, Mar*, May, Jun*, Aug, Sep*, Nov,


(2 -
Dec*

1(2
Feb, Aug*
6 -

42i Î3- April, Oct*

(2
Jan, April*, July, Oct*
i Î3-
(2
Jan, Jul*
i Î3-
This table summarizes the Treasury auction schedule as of
January 2006. Reopenings are marked with an asterisk. There are
no reopenings for securities auctioned weekly or monthly.

A more recent development is Treasury Inflation-Protected Securities (TIPS), which are coupon paying
instruments with a principal amount that is adjusted over time for inflation.
The primary market for Treasuries is conducted as a Dutch auction open to the public and run by the
Treasury. About 150 auctions are held a year. Most are for bills. Notes or bonds are auctioned less
frequently. The Treasury publishes an informal long-term schedule for auctions. This is modified as the
federal government's funding needs evolve.

Some auctions are called  


. At these, the treasury auctions more of a previously issued
security. For example, if a 4.25% coupon 30-year bond is issued in a February auction, more of those
same 4.25% bonds will be offered in the August reopening. They will have the same maturity date as the
previously issued bonds, so they will have just 29.5 years to maturity when issued..

i
  3 
Exhibit 1

6
- weekly

2 - monthly

12 - Feb, May, Aug, Nov

42 - monthly

Feb, Mar*, May, Jun*, Aug, Sep*, Nov,


(2 -
Dec*

1(2
Feb, Aug*
6 -

42i Î3- April, Oct*

(2
Jan, April*, July, Oct*
i Î3-
(2
Jan, Jul*
i Î3-
This table summarizes the Treasury auction schedule as of
January 2006. Reopenings are marked with an asterisk. There are
no reopenings for securities auctioned weekly or monthly.

For newly issued coupon instruments, the coupon rate is set by rounding the stop-out yield down to the
nearest eighth of a percent, so securities are always first issued at or below par. For example, the ten-
year note maturing November 15, 2015 was first issued with a stop-out yield of 4.578. Its coupon was set
at 4.500, and all bidders paid 99.379727 per 100 dollars of par value. Securities reissued in a reopening
have the same coupon as the original issue, so they may be issued above par.

Treasury securities are all held in book entry form. There is an active OTC market for Treasuries, typically
for next day settlement. Large financial institutions act as dealers, buying from or selling to their clients.
Those that the New York Federal Reserve transacts with in its open market operations are called 
  
  

(or 
). In exchange for the Fed's business, primary
dealers are expected to participate meaningfully in Treasury auctions, provide the Fed a reasonable bid-
offer spread on open market transactions, and be a source of market intelligence for the Fed. There are
usually about twenty-five primary dealers, and they dominate the secondary market.

Î%  3  


£

Exhibit 2

ABN AMRO Bank, N.V. Dresdner Kleinwort Wasserstein Securities


BNP Paribas Securities LLC.
Corp. Goldman, Sachs & Co.
Banc of America Securities Greenwich Capital Markets, Inc.
LLC HSBC Securities (USA), Inc.
Barclays Capital, Inc. J. P. Morgan Securities, Inc.
Bear, Stearns & Co., Inc. Lehman Brothers, Inc.
CIBC World Markets Corp. Merrill Lynch Government Securities, Inc.
Citigroup Global Markets, Mizuho Securities USA, Inc.
Inc. Morgan Stanley & Co. Inc.
Countrywide Securities Corp. Nomura Securities International, Inc.
Credit Suisse First Boston UBS Securities LLC.
LLC
Daiwa Securities America,
Inc.
Deutsche Bank Securities,
Inc.

Primary dealers as of January 2006. Source: Federal Reserve Bank of New York.

Dealers trade with one another through interdealer brokers, including BrokerTec, Cantor Fitzgerald,
Garban-Intercapital, Hilliard Farber, and Tullett & Tokyo Liberty. Brokers provide dealers with proprietary
screens that indicate best bids and offers available from other dealers as well as recent transaction
details. The system is anonymous. A dealer who transacts at one of the displayed bids or offers pays the
broker a modest fee.
The majority of secondary transactions are for 2 2 securities. These are Treasuries issued in the
most recent auction. Typically, dealers have acquired large holdings in that auction and are selling them
to clients. Securities issued in earlier auctions are called 2 2. There is less liquidity for off-the-run
securities, and they trade at modestly lower prices.

Treasuries also trade in the secondary market during the days leading up to their auction. These are
called 2


  
. The trades are forward transactions to be settled the same day the
securities are issued. When-issued trading provides price transparency in anticipation of the auction.
Also, by allowing dealers to advance-sell securities to clients, it reduces the risk they take in bidding on
large blocks of securities in the auction.

 3  




Historically, debt financing of the US Federal Government has occurred at two levels. Direct spending
authorized by Congress was financed by the US Treasury through the issuance of Treasury securities.
Entities formed by Congress might also issue debt. These entities fall into two categories:

Federal agencies are a part of the Federal Government and include entities like the Federal Housing
Administration, Export-Import Bank and Small Business Administration.

%  
 
 

(GSE) are private corporations chartered by the Federal
Government and granted privileges so they can advance specific purposes.

Debt obligations of these entities are collectively called  


  
or simply  
.

Having federal agencies competing with the US Treasury for investors' funds drove up the government's
cost of financing. It also imposed incremental costs due to the redundancy of each agency maintaining a
separate debt issuance program. In 1973, Congress formed the  . Under the
general supervision of the Secretary of the Treasury, it consolidated the debt issuances of federal
agencies. Since then, the Tennessee Valley Authority has been the only federal agency to issue
significant amounts of its own securities.

As private corporations, GSEs still issue their own debt. The vast majority of issuances are by Fannie
Mae, Freddie Mac and the Federal Home Loan Banks. Agency securities are less standardized than are
Treasuries. There are discount notes, which are comparable with Treasury bills, as well as fixed and
floating rate medium term notes. Agencies directly issue some zero-coupon securities. Like corporate
bonds, many longer-term issues are callable.

Agencies are exempt securities, and interest on many are exempt from state and local taxes. Securities
are publicly offered in various ways through investment banks or direct sales to investors. In the late
1990s, Fannie Mae started auctioning standardized bills and notes to the public in much the same way
that the Treasury auctions its securities. The goal was to increase liquidity and to establish agency yields
as somewhat of a benchmark comparable to Treasury yields or swap rates. Freddie Mac and the Federal
Banks launched similar benchmark securities programs.

As with most debt instruments, the secondary market for agencies is entirely over the counter. There are
several trillion dollars of agencies outstanding. The liquidity of issues varies. Agencies are generally not
as liquid as Treasuries, but most are more liquid than corporate bonds.

Agencies pose credit risk, but this is considered minimal. All GSEs have stable businesses, and several
have authority to borrow from the US Treasury. While there may be no explicit government guarantees,
there is a widespread belief that the Federal Government will intervene to prevent any GSE from
defaulting on its debt.

6  %  5  




c  

One of the world¶s largest and most liquid bond markets is comprised of debt securities issued by the
U.S. Treasury, by U.S. government agencies and by U.S government-sponsored enterprises. U.S.
Treasury securities, used to finance the federal government debt, are also considered to have the bond
market¶s lowest risk because they are guaranteed by the U.S. government¶s ³full faith and credit´ or, in
other words, its taxing authority. Government agencies and government-sponsored enterprises such as
Ginnie Mae, Fannie Mae and Freddie Mac also issue debt to support their role in financing mortgages.

Use this section to learn more about:

R The different types of U.S. government and agency securities


R The advantages and risks of investing in Treasuries and government securities

Go to the Government/Federal Agency Market At A Glance page to get news affecting the government
and federal agency bond markets as well as recent price and yield information on:

R Treasury bills with maturities of less than one year


R Treasury notes with maturities between one and ten years, and
R Treasury bonds with maturities of 10 years or more
R Federal agency bonds

Stay informed on government bond market news and opportunities by visiting this page often for new
content and market information.




 #$3$i
3  


U.S. Treasury securities²such as bills, notes and bonds²are debt obligations of the U.S. government.
When you buy a U.S. Treasury security, you are lending money to the federal government for a specified
period of time.

Because these debt obligations are backed by the ³full faith and credit´ of the government, and thus by its
ability to raise tax revenues and print currency, U.S. Treasury securities ± or "Treasuries" ± are generally
considered the safest of all investments. They are viewed in the market as having virtually no ³credit risk,´
meaning that it is highly probable your interest and principal will be paid fully and on time.

Because of this unique degree of safety, interest rates are generally lower for this class of secruities than
for other widely traded debt, riskier debt securities such as corporate bonds. A good rule of thumb to
follow is that safer investments offer lower returns. Conversely, the higher the risk, the higher the return.

The amount of marketable U.S. Treasury securities is huge, with $7.3 trillion in outstanding bills, notes
and bonds as of December 31, 2009*. The Treasury market is one of the world's most liquid debt
markets, meaning it is one where pricing, executing and settling a trade is very efficient and thus
inexpensive due, in part, to very tight bid/ask spreads. The average daily trading volume in U.S.
Treasuries was $409.8 billion in 2009** and these securities trade virtually 24 hours a day with the U.S.
primary dealers making live and continuous markets in these securities each business day via trading
desks in cities across the globe like Tokyo, London, and New York.

In 2009, the U.S. Federal Reserve estimated that 10.2% of bills, notes and bonds were held by
individuals, 11.7% by banks and mutual funds, 6.6% by public and private pension funds, 47.7% by
foreign investors, 6.8% by state and local governments and 16.9% by other investors.

The focus of this section is on marketable U.S. Treasury securities, those that are of most interest to
individual investors because they trade on the open market. There are other classes of Treasury debt²
non-marketable securities²that are not transferable but can be purchased from and redeemed by the
government. U.S. Savings Bonds fall into this category, and, even though they are non-marketable, are
discussed here because they are designed for individual investors.

* Source: U.S. Treasury

** As reported by the primary dealers to the Federal Reserve Bank of New York. Specific statistics can be
found at http://www.newyorkfed.org/markets/gsds/search.cfm.

i  #$3$i


3  
  
 Î   

The primary advantage of U.S. Treasury securities is safety. No other investment carries as strong a
guarantee that interest and principal will be paid on time. Because these payments are predictable, many
people invest in them to preserve and increase their capital and to receive a dependable income stream.

The benefit of predictability is enhanced by the fact that Treasuries generally do not have ³call´
provisions. In fact, the U.S. Treasury has not issued ³callable´ securities since 1985. Call provisions,
common in municipal and corporate bonds, permit the issuer to pay off the bond in full before its
scheduled maturity. This is especially likely to happen when interest rates decline, as an issuer will
refinance its debt to obtain the lower prevailing interest rate. When that happens, the investor would be
forced to pay more to earn the same interest rate. If you own Treasuries that have no call provisions, you
know exactly how long your income stream will last.

Another advantage of Treasuries is that they are available with a wide range of maturity dates. This
allows an investor to structure a portfolio to specific time horizons.

Because many consider them the safest investments available, Treasury securities pay somewhat lower
interest rates than other taxable fixed-income investments. Many investors accept this as a trade-off for
security. In a diversified portfolio, U.S. Treasury securities usually represent money that investors want to
keep safe from risk.

An added benefit of Treasuries is that their interest payments are exempt from state and local income
taxes (but not federal taxes). This has the effect of increasing the after-tax benefits of these investments.
Investors in high-tax states should take special note of this benefit.

Another important characteristic of the U.S. Treasury market is its high level of liquidity, which means that
Treasuries are easy to buy and sell. Because they trade so frequently in large volume, the spreads
between what a dealer would be willing to pay and what a dealer would be willing to sell for is lower than
for other securities. Lower trade transaction costs and more efficient price discovery (determining the best
possible price for buyers and sellers) result from such great liquidity in the U.S. Treasury market, benefits
which are ultimately translated to the individual investor.

ë 
#$3$i
3  


Although Treasuries are considered to have very low free credit risk, they are affected by other types of
risk, mainly interest-rate risk and inflation risk. While investors are effectively guaranteed to receive
interest and principal payments as promised, the underlying value of the bond itself may change
depending on the direction of interest rates.

As with all fixed-income securities, if interest rates in general rise after a U.S. Treasury security is issued,
the value of the issued security will fall, since bonds paying higher rates will come into the market.
Similarly, if interest rates fall, the value of the older, higher-paying bond will rise in comparison with new
issues.
In a period of low inflation and moderate shifts in interest rates, investors often are content to hold their
bonds to maturity, disregarding the interim changes in market value of their bonds. However, some
investors strive to structure their bond holdings to minimize market risks and take advantage of market
opportunities. One such technique is called ³laddering.´ Here, the portfolio is structured so that securities
mature at regular intervals, allowing the investor to make new investments with cash available from the
maturing securities.

To help investors deal with inflation risk, the U.S. Treasury has created inflation-indexed notes and bonds
called TIPS, and inflation-indexed savings bonds called I Bonds. Please see the section entitled Other
U.S. Treasury Securities for more information.

U.S. Treasury securities, like all things that are bought and sold, are affected by the laws of supply and
demand. From 1997 until 2001, the U.S. Treasury reduced the total amount of its outstanding marketable
securities. It did this by curtailing, and ultimately eliminating, the sale of certain securities²in particular
30-year bonds. In addition, long-dated bonds held by the public were repurchased by the U.S. Treasury
before their due dates. Together, these actions resulted in a perceived ³shortage´ of long-maturity U.S.
Treasury securities. Prices for outstanding ³long-bond´ securities rose and yields fell. By mid-2003, as the
fiscal situation had reversed from surplus to deficit, the U.S. Treasury had ceased to buy back existing
bonds, significantly increasing the amount outstanding. The U.S. Treasury has also reintroduced 3-year,
7-year and 30-year maturities.

* as of March 20, 2010

For the most current information on treasury offerings visit the Treasury¶s Bureau of the Public Debt Web
site.
6  
, 
 


You don¶t actually receive a certificate when you buy a U.S. Treasury bill, note or bond. Your investment
is tracked in a book-entry system of accounts that generates a receipt and periodic statements.
Investors should understand the differences among Treasury bills, notes and bonds.

i

, as the table "Treasury Securities at a Glance" indicates, are short-term instruments with
maturities of no more than one year. They fill investment needs similar to money market funds and
savings accounts. They could be a place to "hold" money an investor may need to be able to access
quickly, for example in the event of an emergency. The Treasury bill market is highly liquid; investors can
quickly convert bills to cash through a broker or bank. Treasury bills function like zero-coupon bonds,
which do not pay periodic interest payments. Investors buy bills at a discount from the par, or face value,
and then receive the full amount when the bill matures. For example, an individual could buy a 26-week
bill that pays the full $1,000 at maturity for $970.28 at the time of purchase, effectively earning an
annualized yield of 6.28% on the investment.

i
, 
are intermediate- to long-term investments, typically issued in maturities of two, three,
five, seven and 10 years. These are typically purchased for specific future expenses, such as college
tuition, or used to generate cash flow during retirement. Interest is paid semi-annually.

i
 
cover terms of longer than 10 years, and are currently being issued in maturities of 30
years. Interest is also paid semi-annually.

c #$3$i
3  


Three other forms of U.S. Treasury securities available to individual investors are, TIPS, STRIPS, and
U.S. Savings Bonds.

i
    2Î  3  
'Bi Î3B*$

In 1997, the U.S. Treasury introduced notes and bonds in a new form designed to protect the investor
from the effects of inflation. These inflation-indexed securities are known as Treasury Inflation-Protected
Securities, or "TIPS". Using the Consumer Price Index (CPI) as a guide, the value of the principal is
adjusted to reflect the effects of inflation. A fixed rate of interest is paid semi-annually on this adjusted
principal. At maturity, if inflation has increased the value of the principal, the investor receives the higher,
adjusted value back. If deflation has decreased the value, the investor nevertheless receives the original
face amount of the security.

Here¶s an example of how inflation-indexed securities work. Let¶s say you invested $1,000 in January in a
new 10-year inflation-indexed note. The note pays 3% annualized interest semi-annually. At mid-year, the
Consumer Price Index indicates that inflation has been 1% during the first six months. Your principal is
adjusted upward to $1,010 ($1,000 times $101%) and your resulting interest payment would be $15.15
($1,010 times 3% divided by 2, as interest payments are made semi-annually). At the end of the year, the
index indicates that inflation was 3%, which brings the value of your principal to $1,030. Your second
interest payment is $15.45 ($1,030 times 3% divided by 2).
Because of the built-in inflation protection, these securities usually offer lower interest rates than U.S.
Treasuries of similar maturities without the protection feature.

The U.S. Treasury suspended issuance of the 30-year TIPS in 2001, but reinstated this offering in 2009.
However, they had also issued five- and 20-year TIPS during those years in addition to the 10-year
offering.

3 i 


  
Î 3  
'B3i Î3B*$

For many years, securities firms have offered special products to investors by separating the principal and
interest components of U.S. Treasury securities, a process called ³coupon stripping.´ Initially, stripped
securities were available only through proprietary programs of a few firms. Since 1985, the process has
been facilitated through a program created by the U.S. Treasury Department²Separate Trading of
Registered Interest and Principal Securities (³STRIPS´). STRIPS components, also called ³zero-coupon´
securities or ³zeros,´ are traded as individual securities. Stripping a bond with 20 years to maturity, for
example, generates 40 coupon STRIPS (one for each semiannual coupon payment) plus one principal
STRIP. Once a bond is stripped, investors can buy any or all of the available components.

#$3$3 
 
$

U.S. Savings Bonds are available in either a Series EE or Series I. An investor may buy as much as
$5,000 per year, and may redeem the bonds anytime after 12 months (there is a 3-month penalty loss of
interest if redeemed prior to five years).

Popular gifts, the familiar Series EE savings bonds are sold electronically at face value in any amount
between $25 and $5,000, and are sold in paper at one half the face value in standard denominations.

Series EE bonds issued in May 2005 or later earn a fixed interest rate based on 10-year U.S. Treasury
note market yields, which are adjusted twice a year. Series EE bonds that were issued from May 1997
through April of 2005 accrue interest according to a floating rate±90% of the average market yields on 5-
year Treasuries±that is also adjusted twice a year. The holder doesn¶t receive the interest until the bonds
are cashed in. If the bonds are redeemed less than five years from the time they are purchased, the
holder must sacrifice three-months worth of interest. The U.S. Treasury guarantees that Series EE bonds
will mature at full face value in no more than 17 years. If you want to hold them longer, they will continue
to accrue interest for 30 years.

Series I savings bonds have a built-in inflation adjustment. They are sold electronically at face value in
any amount between $25 and $5,000, and are sold in paper at full value in standard denominations.
While issued in the same denominations as Series EE bonds, Series I savings bonds pay interest
according to an earning rate that is partly a fixed rate of return and partly adjusted for inflation. Other rules
are similar, but not identical, to Series EE bonds.

Unlike most investments, Series EE and I bondholders are allowed to defer paying income taxes on the
interest earned until they redeem the bonds. Under certain circumstances, the interest may be tax-
deductible when it is applied against expenses for higher education.

"  3#$3$i
3  

Treasuries can be bought and sold through an investment professional, a commercial bank or an on-line
broker. They can provide you with the most recent issues that are trading in the secondary market. There
often is no commission charged for buying or selling U.S. Treasury securities. Dealers earn a profit by
buying bonds at one price and selling them at a slightly higher price.

Some individuals prefer to buy new issues directly from the government at auction through a Treasury
Direct account with the U.S. Treasury. If you plan to sell Treasuries held in a Treasury Direct account, the
Federal Reserve Bank of Chicago will sell your security in the secondary market for a fee; the process is
the same with both a Legacy Treasury Direct account (through the Sell Direct program) and Treasury
Direct program. If you use the Treasury Direct program to buy a security and wish to sell it through a
dealer, you must arrange to move it out of your account with the U.S. Treasury. You can¶t buy securities
in the secondary market through the U.S. Treasury.

Investors may choose to invest in a mutual fund specializing in Treasuries. Some funds hold other fixed-
income securities or derivatives along with Treasuries, so investors should be sure they understand the
purpose of the fund and the makeup of its portfolio.

U.S. Savings Bonds may be purchased directly from the U.S. Treasury or from commercial banks and are
often available through employee savings plans. The owner of a savings bond receives a registered
certificate and, unlike other U.S. Treasury securities discussed in this guide, cannot resell or even give
the bond away to another individual. When purchasing a U.S. Savings Bond as a gift, the recipient will be
registered as the sole owner of the bond and it will not count towards your annual purchase limit, nor will
you incur any tax liability.

#
Î x    

There is a tremendous amount of information available on prices and yields of Treasuries from a wide
variety of sources. Local and national newspapers, cable TV stations, investment advisors and a
multitude of websites offer in-depth background and up-to-the-minute data. Two useful websites to look
for general information are the U.S. Treasury¶s Bureau of the Public Debt and Investing in Bonds, this
website from the Securities Industry and Financial Markets Association.

The price and yield of a U.S. Treasury security are linked. From the time a bond is originally issued until
the day it matures or is called, its price in the marketplace will fluctuate depending on the particular terms
of that bond as well as general market conditions, including prevailing interest rates, the bond¶s credit and
other factors. Because of these fluctuations, the value of a bond will likely be higher or lower than its
original face value if you sell it before it matures. In general, when interest rates fall, prices of outstanding
bonds with higher rates rise. The inverse also holds true: when interest rates rise, prices of outstanding
bonds with lower rates fall to bring the yield of those bonds into line with higher-interest bearing new
issues. Take for example, a $1,000 bond issued at eight percent. If during the term of that bond interest
rates rise to nine percent, it is expected that the price of the bond will fall to about $888, so that its yield to
maturity will be in line with the market yield of nine percent ($80 / $888 = 9.00%).

When interest rates fall, prices of outstanding bonds rise until the yield of older bonds match the lower
interest rate on new issues. In this case, if interest rates fall to seven percent during the term of the bond,
the bond price will rise to about $1,142 to match the market yield of seven percent ($80 / $1,142 =
7.00%).
As a first step, it¶s helpful to learn how to read the prices and yields that are reported in daily newspapers.
Below, please find an example of a typical news article on Treasury bond and note prices. The
calculations are based on a purchase of $1,000 face amount.

i

$ Treasury bills are quoted differently from quotes for other government obligations since
Treasury bills are issued at a discount from par, or face value, with the holder receiving full value at
maturity.

"
  i ,
i6$



R As was mentioned earlier, Treasury bills are short-term instruments with maturities of no more
than one year. This particular Treasury bill matures in 43 days, on May 25, 2010.
R The "bidB is the price at which the buyer is willing to purchase the security, while the "asked" is
the price being sought for the security by the seller.
R Change shows that yesterday¶s bid price was 5.60.
R The ask yield is the return investors would receive if they paid the ask price and held the bond to
maturity.

#$3$i
3  
%



Accrued interest.

Interest deemed to be earned on a security but not yet paid to the investor.

Ask price.

The price at which the sellers offers to sell a security.

Ask yield.

The return an investor would receive on a Treasury security if he or she paid the ask price.

Bid price.

The price at which a buyer is willing to purchase a security.

Book-entry.

A method of recording and transferring ownership of securities electronically, eliminating the need
for physical certificates.

Callable bonds.

Bonds that are redeemable by the issuer prior to the maturity date, at a specified price at or
above par. (The Treasury has not issued callable bonds since 1985.)

Coupon.

A feature of a bond that denotes the amount of interest due and the date payment will be made.

Current yield.

The ratio of the interest rate payable on a bond to the actual market price of the bond, stated as a
percentage. For example, a bond with a current market price of par ($1,000) that pays eighty
dollars ($80) per year in interest would have a current yield of eight percent.
Discount.

The amount by which the par value of a security exceeds its purchase price. For example, a
$1,000 par amount bond which is currently valued at $980 woud be said to be trading at a two
percent discount.

Face (or Par value or Principal value).

The principal amount of a security that appears on the face of the instrument.

Hedge.

An investment made to minimize the impact of adverse movements in interest rates or securities
prices.

Issuer.

The entity obligated to pay interest and principal on a bond it issues.

Laddering.

A technique for reducing the impact of interest-rate risk by structuring a portfolio with different
bond issues that mature at different dates.

Maturity.

The date when the principal amount of a security is due to be repaid.

Off-the-run Treasuries.

Those sold in the secondary market rather than "on-the-run" Treasury securities, which are those
most recently issued by the Government.

Secondary market.

Market for issues previously offered or sold.

Yield.

The annual percentage rate of return earned on a bond calculated by dividing the coupon interest
rate by its purchase price.

Yield to maturity.

The yield on a bond calculated by dividing the value of all the interest payments that will be paid
until the maturity date, plus interest on interest, by the principal amount recieved at the maturity
date, taking into consideration whatever gain or loss is realized from the bond at the maturity
date.

Zero-coupon bond
A bond which does not make periodic interest payments; instead the investor receives one
payment, which includes principal and interest at redemption (call or maturity).

i#$3$i
ë     2Î  3  


The United States Department of the Treasury currently offers a special kind of security, called a Treasury
Inflation-Protected Security (TIPS)*, whose principal amount is adjusted for inflation. The Treasury
Department issues TIPS because it believes their issuance will reduce interest costs to the Treasury over
the long term and will increase the different types of investors that buy their debt instruments.

*Prior to 2004 this security was referred to by Treasury as a Treasury Inflation-Indexed Security.
However, Treasury renamed these securities to ³inflation-protected´ securities so that the resulting
acronym, TIPS, conforms with the way these securities are commonly referred to by market participants
and the press.

Î   
   



TIPS offer a number of potential benefits for investors. TIPS are direct obligations of the United States
government, and are backed by the full faith and credit of the government. The principal is protected
against inflation.

Since the principal is indexed to the Consumer Price Index and grows with inflation, the investor is
guaranteed that the real purchasing power of the principal will keep pace with the rate of inflation.**
Although deflation could cause the principal to decline, Treasury will pay at maturity an amount that is no
less than the par amount as of the date the security was first issued.

Interest is also protected from inflation. The investor will receive semiannual interest payments, based on
a fixed semiannual interest rate applied to the inflation-adjusted principal, so that the investor is
guaranteed a real rate of return above inflation.

**Based on the Reference CPI-U, which has a three-month lag. See The Index.

Î    


Americans want to save for retirement, education and a home. While inflation is lower now than at any
time since the 1960s, many people are concerned that investments, including Treasury securities, may
lose purchasing power over the long run.

Institutional investors, such as pension funds, mutual funds, unit investment trusts, endowments,
insurance companies and others looking for diversification or to match liabilities can use these securities
to help ensure their investment goals are met and to protect the value of their investments.

Because of the tax treatment of these securities, tax-advantaged purchasers, such as qualified pension
funds and tax deferred retirement accounts, including 40l(k) plans and individual retirement accounts
(IRAs), may view an investment in inflation-protected securities as appropriate. (See the section on
General Tax Treatment.)

3  3    

Î   $

The principal amount of TIPS are adjusted for changes in the level of inflation. The inflation adjusted
principal amount of the securities can be calculated daily. However, the inflation adjustment will not be
payable by Treasury until maturity, when the securities will be redeemed at the greater of their inflation-
adjusted principal amount or the principal amount of the securities on the date of original issuance (i.e.,
par). (See the section on Payment at Maturity below.)

 $

The index for measuring the inflation rate is the nonseasonally adjusted CPI-U.* CPI-U was selected by
Treasury because it is the best known and most widely accepted measure of inflation.

 

$

Every six months Treasury pays interest based on a fixed rate of interest determined at auction.
Semiannual interest payments are determined by multiplying the inflation-adjusted principal amount by
one-half the stated rate of interest on each interest payment date.

Î    $

If at maturity the inflation-adjusted principal is less than the par amount of the security (due to deflation),
the final payment of principal of the security by Treasury will not be less than the par amount of the
security at issuance. In such a circumstance, Treasury will pay an additional amount at maturity so that
the additional amount plus the inflation-adjusted principal amount will equal the par amount of the
securities on the date of original issuance.

ë  $

Currently, TIPS are issued with 5-year, 10-year, and 20-year maturities.

3 $
TIPS are eligible for the STRIPS program (Separate Trading of Registered Interest and Principal of
Securities) as of the first issue date.

  " i Î3 

Suppose an individual invests $1,000 on January 15 in a new inflation-protected 10-year note with a 3%
real rate of return.

R If inflation was 1% during the first six months of that year, then by mid-year the inflation-adjusted
principal amount of the security would be $1,010. ($1,000 x 1.01 = $1,010).
R In addition, at mid-year, on July 15, the investor would receive the first semiannual interest
payment of $15.15 ($1,010 times 3% divided by 2).
R Suppose, then, that inflation accelerated during the second half of the year, so that it reached 3%
for the full year.
R By the second semiannual interest payment date, January 15, the inflation-adjusted principal
amount of the security would be $1,030. ($1,000 x 1.03 = $1,030).
R The second semiannual interest payment would be $15.45 ($1,030 times 3% divided by 2).

i  

£
     $

The CPI-U is published monthly by the Bureau of Labor Statistics of the U.S. Department of Labor. It is a
measure of the average change in consumer prices over time for a fixed market basket of goods and
services, including food, clothing, shelter, fuels, transportation, charges for doctors¶ and dentists¶ services,
and drugs.

In calculating the index, price changes for the various items are averaged together with weights that
represent their importance in the spending of urban households in the United States. The contents of the
market basket of goods and services and the weights assigned to the various items are updated
periodically to take into account changes in consumer expenditure patterns.

The CPI-U is expressed in relative terms in relation to a time base reference period for which the level is
set at 100. For example, if the CPI-U for the 1982-84 reference period is 100, an increase of 16.5% from
that period would be shown as 116.5. The CPI-U for a particular month is released and published during
the following month.

"     Î 2#$

The Bureau of Labor Statistics of the U.S. Department of Labor is the primary source of the monthly CPI-
U numbers. The CPI-U numbers are also widely available on the major financial wire services. Treasury
issues a press release monthly that will provide the nonseasonally adjusted CPI-U for each of the prior
three months. Treasury also provides this information through media such as the Internet and automated
facsimile systems. Treasury maintains the records of this information for reference going forward, which
will be available to the public. Treasury also publishes on an initial basis the daily Reference CPI-Us and
the daily index ratios for outstanding inflation-protected securities.


  Î 2#$

Revisions to a previously released CPI-U will not be used in calculations of inflation adjustments on
outstanding Treasury inflation-protected securities. The base reference period for a particular inflation-
protected security will be provided in the Treasury offering announcement for that security. If the CPI-U is
rebased to a different year, Treasury will continue to use the old base reference period for outstanding
securities. If, while an inflation-protected security is outstanding, the CPI-U is discontinued or, in the
judgment of the Secretary of the Treasury (i) fundamentally altered in a manner materially adverse to the
interests of an investor, or (ii) altered by legislation or Executive Order in a manner materially adverse to
the interests of an investor, Treasury will substitute an appropriate alternative index after consultation with
the Bureau of Labor Statistics.

i  

$

The inflation-adjusted principal amount of TIPS can be calculated daily by multiplying the stated principal
amount at issuance, or par amount, by an index ratio. To calculate the inflation-adjusted principal amount
for a particular valuation date, the par amount is multiplied by an index ratio applicable to that valuation
date. The index ratio for any valuation date is the ratio of the Reference CPI-U applicable to such date to
the Reference CPI-U applicable to the original issue date of the security.

  Î 2#$

The Reference CPI-U for any valuation date incorporates a three-month lag. Thus, the Reference CPI-U
for the first day of any calendar month is the CPI-U published for the third preceding calendar month. For
example, the Reference CPI-U applicable to April 1 in any calendar year is the CPI-U published for
January. The Reference CPI-U for any other day of the month is determined by a linear interpolation
between the Reference CPI-U applicable to the first day of the month in which such a day falls (in the
example, January) and the Reference CPI-U applicable to the first day of the month immediately following
(in the example, February). Thus, in the example, the Reference CPI-U for any day of April, after April 1,
will be determined by a linear interpolation between the Reference CPI-U for April (i.e., the CPI-U
published for January) and the Reference CPI-U for May (i.e., the CPI-U published for February).




%i i  

  $

The semiannual interest payments on TIPS are taxable to a holder of securities when received. This is
consistent with the tax treatment of other Treasury securities. If the holder is a corporation or other
institutional investor, the interest payments will be taxable when received or accrued, in accordance with
the holders¶ method of accounting.

Investors will also be taxed on inflation adjustments to the principal in the year in which the adjustments
occur, even though the principal adjustments would not actually be received from Treasury until maturity
(a situation that is sometimes described as taxing ³phantom income´). Conversely, a decrease in the
inflation-indexed principal amount (due to deflation) will first reduce the interest income attributable to the
semiannual interest payments for the year of the adjustment; and if the amount of the decrease exceeds
the income attributable to the semiannual interest payments, the excess will generally be an ordinary
deduction to the extent that interest from the security was previously included in income. Any remaining
decrease will be carried forward to reduce interest income on the inflation-protected security in future
years. A taxpayer will generally recognize a capital loss if the taxpayer sells or exchanges the inflation-
protected security, or if the security matures, before the taxpayer has used all that decrease.

If a Treasury Inflation Protected Security is purchased at a discount you should consult your tax advisor.

3    $

Like all securities issued by the U.S. Treasury, TIPS are exempt from taxation by a state or a political
subdivision of a state, except for state estate or inheritance taxes and other exceptions provided by law.

Consult your tax adviser for advice appropriate to your particular circumstance.

 
  
  


 $

The U.S. Treasury securities market is one of the largest and most liquid securities market in the world,
and there is currently an active secondary market for TIPS with over $8 billion traded each day.


  Î 2#$

While the CPI-U measures changes in the prices for goods and services, movements in the CPI-U that
have occurred in the past are not necessarily indicative of changes that may occur in the future.

i2    Î 2#$


The index ratio which is used to determine the amount of the inflation adjustment to the original principal
amount incorporates an approximate three-month lag in the Reference CPI-U that is applicable to any
valuation date. Thus, the Reference CPI-U applicable to April in any calendar year is the CPI-U published
for January. The three-month lag in the Reference CPI-U for any month may have an impact on the price
of the securities in the secondary market, particularly during periods of significant, rapid changes in the
CPI-U.

Î  


 6 $

An investment in securities with principal or interest determined by reference to an inflation index involves
factors not associated with an investment in a fixed-principal security. Such factors may include the
possibility that the inflation index may be subject to significant changes, that changes in the index may or
may not correlate to changes in interest rates generally or with changes in other indexes, that the
resulting interest may be greater or less than that payable on other securities of similar maturities and
that, in the event of sustained deflation, the amount of the semiannual interest payments and the inflation-
adjusted principal amount of the security will decrease. However, if at maturity the inflation-adjusted
principal amount is less than a security¶s par amount, an additional amount will be paid at maturity so that
the additional amount plus the inflation-adjusted principal amount equals the original par amount.
Regardless of whether or not such an additional amount is paid, interest payments will always be based
on the inflation-adjusted principal as of the interest payment date.

3

      2Î  3  




  
$

The U.S. Treasury currently auctions 10-year TIPS on a quarterly basis and has an expanded auction
schedule to include semi-annual 5- and 20-year TIPS issuances. Thus, auctions currently occur in
January, April, July and October of each year. Specific terms and conditions of each issue are announced
prior to each auction. The offering announcement issued by the Department of the Treasury for each new
TIPS offering contains the specific details for that offering. Similar to Treasury fixed-principal securities,
the Treasury¶s Inflation-Indexed Securities are sold at discount, par or at a premium, depending on
auction results.

3       2 


  
$

After original issue, the securities can be bought or sold in what is known as the secondary market at
prevailing market prices through financial institutions and government securities brokers and dealers.
(See discussion of liquidity risks.)

ë   
$

The securities will be available in denominations as small as $1,000 and multiples thereof.

Î  
$

The inflation-adjusted principal amount or the original par amount, whichever is greater, will be paid on
the maturity date as specified in the offering announcement. Interest is payable on a semiannual basis on
the interest payment dates specified in the offering announcement through the date the principal
becomes payable. In the event any principal or interest payment date is a Saturday, Sunday or other day
on which the Federal Reserve Banks are not open for business, the amount is payable (without additional
interest) on the next business day.

   
$

Ownership of Treasury Inflation-Protected Securities, like fixed-principal Treasury securities, is evidenced


through book-entry. That means the issuance and maintenance of these securities are represented by an
accounting entry or electronic record and not by a certificate. The securities will be maintained and
transferred in the commercial book-entry system at their par amount, i.e., not at their inflation adjusted
principal amount.

"  i Î3

Treasuries can be bought and sold through an investment professional, a commercial bank or an online
broker. Some individuals prefer to buy new issues directly from the government at auction through its
TreasuryDirectsm program.

You can sell a Treasury held in a TreasuryDirect account, through a Treasury program called Sell
Direct®.

For more information on TreasuryDirect, visit the Bureau of Public Debt¶s Web site.

TIPS are available for purchase as individual securities and in mutual funds. Ten-year TIIS notes can be
purchased in minimum denominations of $1,000 and multiples of thereof.

     2 


  
 6

Treasury issues another type of inflation-adjusted security called Series I savings bonds. They are sold at
face value in denominations ranging from $50 to $10,000 and pay interest according to an earning rate
that is partly a fixed rate of return and partly adjust for inflation. I Bonds earn interest for up to 30 years.

Interest earnings on Series I bonds are exempt from state and local taxes and investors may qualify for
certain federal tax exemptions on all or part of the interest if the proceeds are used to pay for tuition and
fees at eligible post secondary educational institutions.

Series I bonds may be purchased directly from the Treasury or from commercial banks and are often
available through employee savings plans. The owner of a savings bond receives a registered certificate
and unlike other Treasury securities, savings bonds cannot be resold or given away.
For more information on Series I bonds and on TIPS, visit the U.S. Treasury Department¶s Web site, or
Treasury¶s Bureau of the Public Debt site.

   2Î  3  


%



Auction

Sealed-bid public sale of Treasury securities; method of determining the rate or yield.

Bill

A short-term direct obligation of the U.S. Treasury that has a maturity of not more than one year
(for example, 4 -, 13- or 26- week maturity).

Bond

A long-term direct obligation of the U.S. Treasury that typically has a maturity of more than 10
years (for example, a 30-year maturity).

Book-entry security

A security, the issuance and maintenance of which are represented by an accounting entry or
electronic record and not by a certificate.

CPI-U

The nonseasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban
Consumers, published by the Bureau of Labor Statistics of the U.S. Department of Labor. Index
ratio: For any particular date and any particular inflation-protected security, the Reference CPI-U
applicable to such date divided by the Reference CPI-U applicable to the original issue date (or
dated date, when the dated date is different from the original issue date). Inflation-adjusted
principal: For an inflation-protected security, the principal amount of the security, derived by
multiplying the par amount by the applicable index ratio.

Interest rate

The annual percentage rate of interest paid on the inflation-adjusted principal of a specific issue
of notes or bonds.

Note

A medium-term direct obligation of the U.S. Treasury that has a maturity of at least one year but
not more than 10 years.

Par amount
The stated principal amount of a security at original issuance.

Real yield

For an inflation-indexed security, the yield based on the payment stream in constant dollars, i.e.,
before adjustment by the index ratio.

STRIPS (Separate Trading of Registered Interest and Principal of Securities)

The Treasury Department¶s program under which eligible securities are authorized to be
separated into principal and interest components, and transferred separately. These components
are maintained in commercial book-entry accounts and transferred in TRADES (Treasury/
Reserve Automated Debt Entry System).

Yield

For an inflation-indexed security, yield means the real yield.

  


Agency bonds are issued by two types of entities²1) Government Sponsored Enterprises (GSEs),
usually federally-chartered but privately-owned corporations; and 2) Federal Government agencies which
may issue or guarantee these bonds²to finance activities related to public purposes, such as increasing
home ownership or providing agricultural assistance. Agency bonds are issued in a variety of structures,
coupon rates and maturities.

Each GSE and Federal agency issues its own bonds, with sizes and terms appropriate to the needs and
purposes of the financing. There are usually minimums to invest in agency bonds²$10,000 for the first
investment and increments of $5,000 for additional investments. Investing in Ginnie Mae Federal Agency
bonds requires a $25,000 minimum investment. The degree to which an agency bond issuer is
considered independent from the federal government impacts the level of its default risk. The interest
from most but not all agency bond issues is exempt from state and local taxes; some of the biggest
issuers such as GSE entities Freddie Mac and Fannie Mae are fully taxable.

In general the agency bond market is considered a liquid market, in which investments can quickly and
easily be bought and sold. However, as explained below, some agency bond issues have features that
make the bond issues more "structured" and complex, which can reduce liquidity of these investments for
investors and make them unsuitable for individual investors.

  


6 %3
<Bonds issued by GSEs such as the Federal Home Loan Mortgage
Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae) and the Federal
Home Loan Banks provide credit for the housing sector. Federal Agricultural Mortgage Corporation
(Farmer Mac); the Farm Credit Banks and the Farm Credit System Financial Assistance Corporation do
the same for the farming sector. The bulk of all agency bond debt²GSEs and Federal Government
agencies²is issued by the Federal Home Loan Banks, Freddie Mac, Fannie Mae and the Federal Farm
Credit banks. GSEs are not backed by the full faith and credit of the U.S. government, unlike U.S.
Treasury bonds. These bonds have credit risk and default risk and the yield on these bonds is typically
slightly higher than on U.S. Treasury bonds.

Some GSEs such as Fannie Mae and Freddie Mac are publicly traded companies that register their stock
with the SEC and provide publicly available documents such as annual reports on the SEC website.

  


6%   


²Bonds issued or guaranteed by Federal
Government agencies such as the Small Business Administration, the Federal Housing Administration
and the Government National Mortgage Association (Ginnie Mae) are backed by the full faith and credit of
the U.S. government, just like U.S. Treasury bonds.* Full faith and credit means that the U.S.
government is committed to pay interest and principal back to the investor at maturity. Because different
bonds have different structures, bonds issued by federal government agencies may have call risk. In
addition, agency bonds issued by Federal Government agencies are less liquid than Treasury bonds and
therefore this type of agency bond may provide a slightly higher rate of interest than Treasury bonds.

*A significant exception to this full faith and credit guarantee for Federal Government agency bonds are
those issued by the Tennessee Valley Authority (TVA). Its bonds are secured by the power revenue
generated by the Authority.

i
 3  
   

As noted above, most agency bonds pay a fixed rate of interest or fixed coupon rate semi-annually. Most
agency bonds are non-callable or bullet bonds. Like all bonds, agency bonds are sensitive to changes in
interest rates²when interest rates increase, agency bond prices fall and vice versa.

However, in addition to fixed rate coupon and non callable agency bonds, agencies do structure their
bond issues to meet different investor needs.

Variable or floating coupon rate agency bonds: so-called "floating rate" or "floaters" are agency bonds that
have interest rates that adjust periodically. Adjustments are usually linked to an index such as U.S.
Treasury bond yields or LIBOR according to a predetermined formula (with limits on how much the
interest or coupon rate can change).

No-coupon agency bond notes or "discos": no-coupon discount notes are issued by agencies to meet
short-term financing needs and are issued at a discount to par value. Investors who sell such discos prior
to maturity may lose money.

Callable agency bonds with "step up" coupon rates: callable agency bonds that have a pre set coupon
rate "step up" that provides for increases in interest rates or coupon rate as the bonds approach maturity
to minimize the interest rate risk for investors over time. Step ups are often called by issuers at a time of
declining interest rates. Declining interest rates may accelerate the redemption of a callable bond,
causing the investor's principal to be returned sooner than expected. As a consequence, an investor
might have to reinvest principal at a lower rate of interest.

The interest from most but not all agency bond issues is exempt from state and local taxes and it is
important for investors to understand the tax consequences of agency bonds; some of the biggest agency
bond issuers such as GSE entities Freddie Mac and Fannie Mae are fully taxable for example. Capital
gains or losses when selling agency bonds are taxed at the same rates as stocks. Consult your financial
advisor before determining whether agency bonds are a suitable investment for you.

3  

Agency securities are generally bought and sold through brokers and are likely to include fees or
transaction costs.

The agency bond market in which individuals might participate is considered relatively liquid. However,
not all kinds of agency bond issues are considered liquid, including some of which may be structured for a
particular issuer or class of investors and may not be suitable for individual investors. Investment dollar
minimums may make buying and selling individual bonds less suitable to many individual investors than
buying an agency bond fund or U.S. Treasuries directly. Investors should take into account that the tax
status of various agency bond issues varies depending on the agency issuer. As with any investment, it is
important to understand the work of the agency or enterprise that is issuing the bonds and know the credit
rating of the issue. This allows an investor to know the basis on which a bond is being issued.

Go to the Government/Federal Agency Market-at-a-Glance page to see Agency bond price


information. You can find helpful information in The GSE Debt Market: An Overview.

For additional investor resources on bond issuance programs see the following:

R For more information and documentation for investors on Federal Farm Credit Banks Funding
Corporation bond issuance programs, click here.
R For more information and documentation for investors on Federal Home Loan Banks Office of
Finance (FHLB) bond issuance programs, click here.
R For more information and documentation for investors on Federal Home Loan Mortgage
Corporation (FHLNC, also known as Freddie Mac) bond issuance programs, click here.
R For more information and documentation for investors on Federal National Mortgage Association
(FNMA, also known as Fannie Mae) bond issuance programs, click here.
R For more information and documentation for investors on Government National Mortgage
Association (GNMA, also known as Ginnie Mae) bond issuance programs, click here.
R For more information and documentation for investors on Tennessee Valley Authority (TVA) bond
issuance programs, click here.

i%3£6 ë -c  

%3


i ,


Government-sponsored enterprises (GSEs) are financing entities created by Congress to fund loans to
certain groups of borrowers such as homeowners, farmers and students. Through the creation of GSEs,
the government has sought to address various public policy concerns regarding the ability of members of
these groups to borrow sufficient funds at affordable rates.

GSEs are also sometimes referred to as federal agencies or federally sponsored agencies. The reader
should note, however, that there are organizational differences among the GSEs although all are
established with a public purpose: Federal National Mortgage Association (Fannie Mae) and Federal
Home Loan Mortgage Corporation (Freddie Mac) are privately owned corporations, while the Federal
Home Loan Banks and the Federal Farm Credit Banks are systems comprising regional banks.

All GSE debt is not guaranteed by the federal government, whereas government agencies such as
Government National Mortgage Association (Ginnie Mae) are divisions of the government whose
securities are backed by the full faith and credit of the United States.
To conduct their lending business, GSEs have significant funding requirements. While many are
stockholder-owned companies that can raise equity capital, most GSEs rely primarily on debt financing to
fund their day-to-day operations. Among the most active issuers of debt securities are:

R Federal Home Loan Banks


R Freddie Mac
R Fannie Mae
R Federal Farm Credit Banks and
R Tennessee Valley Authority (TVA).

Supranational and international institutions, such as the World Bank, also issue debt securities. See
complete descriptions of each GSE.

Buyers of GSE-issued debt securities include domestic and international banks, pension funds, mutual
funds, hedge funds, insurance companies, foundations, other corporations, state and local governments,
foreign central banks, institutional investors and individual investors.

i !  %3




In general, debt securities issued by GSEs are considered to be of high credit quality. The senior debt of
the GSEs is rated AAA/Aaa, while the subordinated debt of Fannie Mae and Freddie Mac is currently
rated AA-/Aa-. Some GSEs have explicit, though limited, lines of credit from the U.S. Treasury. As a
group, GSEs benefit from a perceived tie to the federal government as institutions established under
federal legislation. In September 2008, the Federal Housing Finance Agency became the conservator of
the housing GSEs. In connection with the conservatorship, Treasury has now committed to provide
necessary funding to correct any deficiencies in their net worth.

However, debt securities issued by GSEs are solely the obligation of their issuer and, unless explicitly
stated, do not carry any guarantee by the federal government. They are considered to carry greater credit
risk than securities issued by the U.S. Treasury and certain government agencies (e.g., Ginnie Mae)
whose securities have the full-faith-and-credit guarantee of the U.S. government. For this reason, GSE
debt obligations often carry a yield premium over Treasury securities with comparable maturities. The
premium varies with market volatility, and the structure, maturity, and general supply and demand for the
particular security.

i% #
 

 Î 


?  


The GSEs utilize a variety of issuance formats for their securities. Most long-term debt is issued in public
monthly security sales through designated dealer groups using both syndicate and auction pricing
methodologies. Currently, the majority of GSE term debt is issued through various programmatic issuance
formats, as outlined in greater detail below. All the GSEs have created issuance programs that
incorporate funding calendars for large-size issues. Due to differences in the GSEs¶ organizational and
corporate structures, the separate funding calendars will vary as to specified issuance details.

In 1997, the Federal Home Loan Banks Office of Finance began using auctions in its issuance of short-
term discount notes. Since then Freddie Mac and Fannie Mae have also incorporated auction formats in
their programmatic short-term funding. Additionally, all the GSEs post daily rates for discount notes.
Currently, most of the non-callable term debt that is issued is in the form of conventional notes having
maturities of one, two, three, five, ten and thirty years. However, many GSEs have incorporated floating-
rate and callable securities into their issuance programs and regularly issue these structures as well.

Today, GSEs increasingly choose to raise funds through a variety of formal debt issuance programs.
R Freddie Mac µReference NotesŒ¶, µReference BondsŒ¶ and µReference BillsŒ¶;
R Fannie Mae µBenchmark NotesŒ¶, µBenchmark BondsŒ¶ and µBenchmark BillsŒ¶;
R Federal Home Loan Bank µTAP IssuesŒ¶; and
R Federal Farm Credit Bank µDesignated BondsŒ¶ and Calendar Bond ProgramŒ

have all been developed to brand these particular securities with certain attributes of liquidity and pricing
transparency.

The selective application of auction methodology in debt issuance by the GSEs in the last few years has
introduced greater regularity and transparency to the securities pricing process and made possible for the
first time a true ³when issued´ (WI) market in those short- and long-term issues which are scheduled to be
auctioned.

Working through the Securities Industry and Financial Markets Association, the dealers and issuers have
helped establish commonly used trading guidelines that govern WI trading in GSE auctioned issues of
term debt with a maturity of two years and longer. (See ³Practice Guidelines for When-Issued Trading in
GSE Auctioned Securities´.)

Additionally, advances in technology have enhanced the market for customized interest rate swaps,
options and futures, and allowed the GSEs to issue a variety of structured products that can be highly
tailored to simultaneously meet the very specific needs of issuers and investors.

For instance, the GSEs have various medium-term-note (MTN) programs that allow them to come to
market on a continuous basis with different debt offerings. As a result, GSEs have gained the flexibility to
structure the size and terms of their debt issues to meet the requirements of a particular investor or class
of investors. Under these programs, issuers may choose a variety of maturities with either callable or
fixed maturities as well as floating interest rates, interest rates linked to one or more market indices,
different interest payment dates and other key features. The same flexibility can be achieved through
individually negotiated security offerings.

The variety of issued securities enable GSEs to lower their cost of funding by targeting an issue to a
particular investor need, since investors are typically willing to pay a premium to obtain a desired cash
flow or implement a particular market view.

Issuers also use the structures to obtain options from investors in a cost-effective manner. For example,
an investor will demand a yield premium for allowing the issuer the option to call a bond or note, but if
interest rates decline the issuer might ultimately save money by exercising the call option.

In connection with these structures, issuers often enter into customized options and/or swap agreements
with a third party. The third party may be an investment bank, a subsidiary of an investment bank, a swap
dealer or another entity.

Under these agreements, the issuer receives a cash flow needed to fulfill the terms of the security offering
while agreeing to pay its counterparty a rate that might better match the incoming cash flow on its assets.
The GSE issuer assumes all counterparty credit risk; a default by the issuer¶s counterparty on an option
or swap agreement does not change the issuer¶s obligations to investors in the related security.

c  




R Resolution Funding Corporation (REFCORP)


R Tennessee Valley Authority (TVA)
R Federal Farm Credit System
R Financing Corporation (FICO)
R The Private Export Funding Corporation (PEFCO)
R Government Trust Certificates (GTC)
R The U.S. Agency for International Development (AID)
R The Financial Assistance Corporation (FAC)
R The General Services Administration (GSA)
R The Small Business Administration
R The U.S. Postal Service

You can find out more about Agency Bonds here.

 
 


The variety of GSE-issued debt securities and programs offer investors a unique combination of high
credit quality, liquidity, pricing transparency and cash flows that can be customized to closely match an
investor¶s objective to:

R implement a current interest rate or currency view;


R hedge a specific risk;
R enhance portfolio liquidity:
R balance portfolio performance characteristics; or
R minimize transaction costs.

The wide range of debt securities can be viewed as a way of enabling investors to achieve the benefits
available from interest rate (and other) swap and option arrangements without incurring the operational
and transactional expenses required to establish and manage swap agreements and the related
counterparty credit risk.

 




The wide variety of GSE debt structures require a level of investor sophistication and awareness.
Different structures behave differently when interest rates, yield curve shapes, exchange rates and/or
other market indices change.

Typically, structured debt securities preserve investors¶ principal if purchased at par and held to maturity.
However, some structured securities add features that can accelerate final maturities and place interest
flows, and in some cases principal, at risk. Certain structures have become common, while others remain
unique in both issuance and investor applicability.

As the variations expand, it is crucial that investors know exactly how the instrument is affected by market
changes.
Investors should fully understand the price sensitivity and performance characteristics of the instrument
they are considering, and make a complete analysis of both potential risks and benefits. The key to
success in this market is to be fully aware of all the characteristics of the particular instrument and to
understand how the security will react to changes in relevant market rates and in combination with other
portfolio holdings. Once investors purchase these securities, they should also monitor their performance
continuously.

Furthermore, certain MTN issues can have limited liquidity. Certain structured securities have a narrower
base of potential investors, because securities that have been structured for a particular investor¶s needs
may not match the needs of other investors. With such products, buyers in the secondary market may be
much more difficult to find.

? 

 c 
   %3


To assure that the GSEs continue to fulfill their public mission of reducing borrowing costs for certain
groups, their activities are monitored and periodically reviewed by their respective regulators and
congressional oversight committees. Recent changes in the GSE oversight structure include the creation
of the Federal Housing Financing Board in 2008 as the regulator of the housing GSEs. In addition, as part
of President Obama's Financial Regulatory Reform proposal, the Treasury and HUD will develop
recommendations for the future of housing GSEs.

Public criticism of the GSEs can obviously create some level of political uncertainty and price volatility in
these markets. This ³political headline´ risk has so far never affected the current credit of outstanding
GSE debt, but it can impact trading spreads and temporarily disrupt liquidity in the GSE market.

Investors should therefore remain cognizant that, as large as the GSE debt market has become,
Congress and other federal oversight authorities will continue to play a key role in assuring that the GSEs
do their utmost to fulfill their missions, maintain their high credit ratings and adhere to their charters.

At times this may create a certain amount of short-term volatility in these markets. Yet, responsible
federal oversight ultimately helps strengthen the long-term viability of the GSE debt market.

%£
   %3£6 3  


GSE-issued debt securities can be structured to offer investors fixed or floating interest rates. While the
basic structures share many characteristics of non-structured fixed- or floating-rate debt, many variations
are possible. This overview attempts to describe some forms common in today¶s market, moving from the
simplest to the most complex


 2 3  


3  2  




Fixed-rate debt securities have fixed interest rates and fixed maturities. If held to maturity, they offer the
benefits of preservation of principal and certainty of cash flow. Prior to maturity, however, the market
value of fixed-rate securities fluctuates with changing interest rates. In a falling-rate environment, market
values will rise, with the degree of increase determined by the time remaining to maturity or call date,
creating the potential for capital gains. In a rising-rate environment, prices will fall, creating the risk of loss
when securities that have declined in market value are sold prior to maturity.

£6 &  


Callable Securities

These structures give the issuer the right to redeem the security on a given date or dates (known as the
call dates) prior to maturity. Essentially, an option to call the security is sold by the investor to the issuer,
and the investor is compensated with a higher yield.

The value of the call option at any time depends on current market rates relative to the interest rate on the
callable securities, the performance of assets funded with the proceeds of callable issues, and the time
remaining to the call date. The period of call protection between the time of issue and the first call date
varies from security to security. Documentation for callable securities usually requires that investors be
notified of a call within a prescribed period of time.

Issuers typically exercise call options in periods of declining interest rates, thereby creating reinvestment
risk for the investor. On the other hand, if an investor expects a security to be called and it is not, the
investor faces an effective maturity extension that may or may not be desirable. Certain securities may be
called only in whole (i.e., the entire security is redeemed), while others may be called in part (i.e., a
portion of the total face value is redeemed) and possibly from time to time as determined by the issuer.

The three most common callable features are:

R European²callable only at one specific future date;


R Bermudian²callable only on interest payment dates; and
R American²callable on any date, normally with 30 days notice.

In almost all cases, the right of the issuer to exercise a call is deferred to the end of an initial ³lock-out
period.´

The Valuation of Callable GSE Debt

When interest rates move, the values of almost all debt securities change. For non-callable fixed-rate
instruments, the price of the security will go down as rates go up (and up as rates go down) so that yields
remain in line with prevailing market rates.

For securities with embedded options, however, the market price also has to account for the change in
the value of the embedded option. A call option, for example, becomes more valuable to the issuer as
interest rates fall and the yield to investors adjusts to reflect that higher value. The degree of such shifts,
however, may be difficult to determine accurately in advance. Market volatility will also affect the price
investors are willing to pay for a given security.
Several valuation methods are available to help investors calculate the value of a specific debt security.
Results can vary widely from model to model. While no single valuation method is universally preferred,
some are used more commonly than others.

The option-adjusted spread (OAS), for example, calculates the annual value of an embedded call option
(in basis points, based on an assumed rate of volatility) and subtracts it from the security¶s yield spread.
This adjusted spread can then be compared to the available spread on a non-callable security of similar
credit quality with the same maturity. If the callable GSE security¶s adjusted spread is less than the yield
on a non-callable GSE security, the non-callable security may be a better investment choice.

The current calculations of the OAS on most outstanding GSE structured debt securities are available
through leading information vendors.

Other approaches involve comparing the risk/reward profile of the security to that of other securities;
performing a forward-rate analysis, which assumes forward rates will reflect current yield curve
assumptions; reviewing the range of performance possibilities based on historical distribution of interest
rates or under a stress scenario (e.g., a 200-basis-point shift in the yield curve); and calculation of an
instrument¶s internal rate of return.

Step--p Securities

An initial fixed interest rate is paid until a specified date, generally a call date. On a five-year note, for
example, the call date may be two years after issuance. On the prescribed date, if the security has not
been called, the interest payment ³steps up´ to a specified higher rate that was fixed prior to the issuance
of the security. A single security can have more than one step-up period.

Step-up securities are typically structured so that they are callable by the issuer at any interest payment
date on or after the first call, or step-up, date. Some step-up securities have been issued so that they are
continuously callable after the first call date, meaning they can be called at any time, not just on the
payment dates.

A less common variation is the step-down security, also callable, which provides the investor with a higher
initial interest rate but greater uncertainty about maturity.

Indexed Amortization Notes

(IANs; also known as Indexed Principal Redemption Bonds, Principal Amortization Notes or Indexed
Sinking-Fund Debentures.) These securities pay a fixed rate of interest and repay principal usually
according to an amortization schedule which is typically linked to the level of a designated interest rate
index such as the three-month U.S. dollar London Interbank Offered Rate (LIBOR). The amortizing
principal payments usually begin at the end of a prescribed ³lock-out´ period.

For example, a five-year IAN might have a two-year lockout period during which interest is paid on the full
principal amount. Between years three and five, investors receive partial repayments of principal, at an
amortization rate determined by the designated index, and interest based on the amount of principal still
outstanding. At the stated maturity date, any outstanding principal is retired regardless of the level of the
index.

Note: IANs are often compared to Planned Amortization Class (PAC) tranches in collateralized mortgage
obligations (CMOs). Like some CMO PAC bonds, they have a guaranteed minimum life and an expected
amortization schedule, although the actual amount of future cash flows remains unknown because it
depends on interest rate movements. Unlike with CMO PAC bonds, however, any prepayment risk that
exists is created by movements in the selected index rather than by actual prepayments on underlying
mortgage loan collateral. Furthermore, an IAN does not depend on the amount or timing of principal
repayment of other tranches in the same offering, as is typical in the case of CMO PAC bonds.

  2 3  




Rather than paying a fixed rate of interest, floating-rate securities (or floaters) offer interest payments
which reset periodically, with rates tied to a representative interest rate index. Floaters were first issued
during a period of extreme interest rate volatility during the late 1970s.

From the investor¶s perspective, floaters can offer enhanced yields when compared to a strategy of rolling
over comparably rated short-term instruments and paying the related costs associated with each
transaction. Floating-rate securities also allow investors to match asset and liability cash flows.

3  
-

˜ase Index

Indices used to set the interest rate on floaters include:

R CMT: Constant Maturity Treasury Index


R COFI: Cost of Funds Index, typically the one published by the 11th District Federal Home Loan
Bank
R CP: Federal Reserve Commercial Paper Composite
R Fed Funds Rate
R LIBOR: London Interbank Offered Rate for U.S. dollars and other currencies: three-month, six-
month or one year
R Prime Rate
R Treasury bill rates: three-month, six-month or one year
R Foreign interest rate or currency exchange rate: see non-dollar section. page 15.

The rate may also be set as some combination of the above, such as Prime minus 10-year CMT plus
three-month LIBOR. The glossary beginning on page 23 describes each index in more detail.

Yield Spreads

Floater yields are typically defined as a certain number of basis points (or spread) over or under the
designated index. Floaters based on indices such as T-bills will generally add the spread (e.g., the
interest rate will be T-bill plus 40 basis points), while those based on other indices such as the prime rate
might have the spread subtracted from the rate (e.g., the interest rate will be Prime minus 240 basis
points). Typically, spreads are set when the securities are priced and remain fixed until maturity so that
changing interest rates affect the amount of interest paid on the security but not the spread.

When floating-rate securities are purchased at a price other than par, the difference between the
purchase price and par is converted to a percentage and discounted for the remaining life of the security
to calculate an effective yield, also known as the discount margin or sometimes as ³spread for life.´
Reset Periods

The interest rate on floaters may be reset daily, weekly, monthly, quarterly, semiannually or annually. In
some cases, the reset period will be determined by the index used. Fed funds floaters, for example, might
reset daily because the rate is an overnight rate, while T-bill floaters usually reset weekly following the
weekly T-bill auction. Some floaters, particularly those with more frequent resets, set their rate as of a
date prior to the coupon payment date.

The period between the date the rate is set and the payment date is referred to as a ³lock-out´ period.
Floaters with longer reset periods may be more vulnerable to interest rate and price volatility.

Day Count Periods

Floating-rate securities generally use a month/year day count convention of 30/360, actual/360 or
actual/actual to calculate the number of days in the interest payment period.

For example, a security with a 30/360 convention assumes there are 30 days in every month and 360
days in every year. As a result, the rate of interest accrues daily at 1/360th of the nominal interest rate for
the calculated number of days in the interest period; even in a 31-day month, interest is calculated on the
basis of 30 days.

Actual/360 uses the actual number of days in the month and a 360-day year; actual/actual uses the actual
number of days in both the month and the year. Day count periods can vary by issuer and by issue. They
are disclosed in offering documents.

Payment Periods

Interest payments on floaters may be made monthly, quarterly, semiannually or annually. Interest on
floaters is usually not compounded, but the more frequent the payments, the more the investor stands to
earn from reinvesting. The higher the prevailing interest rate for reinvested funds, the more noticeable this
potential compounding effect will be.

Maturity

Floaters may be issued with any maturity, and those with longer maturities generally carry a slight yield
premium. With a fixed-rate security, the yield premium for longer maturities tends to compensate
investors for credit and interest rate risk during the time the security is outstanding. Yield premiums for
longer maturities on floating-rate securities can also reflect the possibility of credit changes and, to a
lesser degree, interest rate movements.

Interest Rate or Coupon

Because the interest payment on a floater is tied to an index through some formula, the actual interest
paid may be lower than the rate paid on a conventional fixed-rate debt security. For some issues, a zero
interest rate is possible.

Note too that floaters tied to indices such as COFI or Prime, which tend to lag behind the market, may
perform better in a falling-rate environment, while floaters tied to coincident market indices such as LIBOR
may do better in a rising-rate environment.
Floaters tied to T-bills, meanwhile, can suffer from falling rates created by high T-bill demand during times
of political crisis or extreme market shifts. Investors should remember that not all indices perform alike
under different interest rate scenarios.

Valuation

The secondary market value of a floater is based on the volatility of the base index, the time remaining to
maturity, the outstanding amount of such securities, market interest rates and the credit quality or
perceived financial status of the issuer. Each of these factors is dynamic, and can result in higher or lower
secondary market values.

As with all securities, supply and demand must be taken into consideration. With respect to demand,
investors should keep in mind that securities structured to meet the needs of a particular investor may
have limited liquidity because of the challenge of finding another buyer.

˜asis Risk

Basis generally refers to the difference between two indices. Basis risk refers to the possibility that this
difference will change in an unanticipated manner. For example, if an investor with liabilities tied to one
index, such as the T-bill rate, matches those liabilities to assets tied to another rate, such as LIBOR, the
investor could be subject to basis risk if the two rates move in different directions than expected or at
differing rates of change.

, 2£ Î 


3  


Programmatic and MTN platform±issued debt securities with either fixed or floating-rate interest may
incorporate features that allow investors to hedge foreign currency risk or to participate in higher overseas
interest rates. Investors may also use these structures to take a position on an expected movement in
foreign exchange or interest rates. For example, an inverse floater tied to an overseas interest rate would
allow the investor to benefit from falling interest rates in that particular market.

These structures may be denominated in a currency other than U.S. dollars, or they may have their
interest rate payment linked to a non-dollar interest rate or to an exchange rate between two or more
currencies. Interest can be payable in a foreign currency or in U.S. dollars even though the rate is based
on a foreign rate.

Generally, structures that are denominated in U.S. dollars and pay in U.S. dollars do not expose the
investor to currency risk, although some of the other variations will be denominated and pay interest in a
foreign currency.

Maturities generally range from two to 10 years and can be accompanied by an issuance calendar and a
highly liquid secondary market. The special risk in these instruments is related to the possibility of
changing relationships in foreign exchange rates and/or a marked change in the value of the dollar¶s
exchange rate with a particular foreign currency.

If the spread between the U.S. interest rate and the relevant foreign interest rate changes in an
unexpected way, investors may earn a lower or higher relative rate.




Î%3

 Î 




Federal Farm Credit Banks


Designated BondsŒ, MasterNotessm, Calendar Bond ProgramŒ, Discount Notes
Federal Home Loan Banks
TAP IssuesŒ, Medium-Term Notes, MasterNotessm, Discount Notes
Freddie Mac
Reference NotesŒ, Reference BondsŒ, Reference BillsŒ, Euro Reference ProgrammeŒ,
Discount Notes, Medium Term Notes, FreddieNotesŒ, and EstateNotesŒ
Fannie Mae
Benchmark NotesŒ and Benchmark BondsŒ, Benchmark BillsŒ, Callable Benchmark NotesŒ,
Discount Notes, Medium-Term Notes and Fannie Mae Investment NotesŒ
TVA
ElectronotesŒ, Power BondsŒ and Discount Notes


c £     %33  £6 3  




In offering structured debt securities, GSEs generally prepare disclosure documents that discuss all the
material terms of the investment. Dealers routinely provide these documents before settlement, and
investors may obtain documentation directly from the issuer or, in some cases, from one of several
financial information vendors. The investor should carefully read and fully understand the information in
the offering documentation.

i3 ë  %3£6 

A liquid and active secondary market in most of the GSEs¶ programmatic debt issues has developed over
the last few years. The enhanced liquidity of GSE progammatic debt issues, with regular and broad
investor distribution, has been accompanied by an active repo and securities lending market in many of
these issues.

Almost all of the programmatic issues and many of the MTNs are quoted through electronic information
systems, and secondary market prices are provided by many domestic and foreign dealers. Further, a
number of electronic exchanges have listed programmatic GSE debt in their systems.

It is important for investors to understand that GSE-issued MTNs are often tailored to the needs of a
particular investor or class of investors. As a result, they are generally intended to be held until maturity.

The underwriter of a GSE-issued structured debt security will usually agree to make a market for a
customer who wants to sell the security prior to maturity; in fact, some issuers have obligated their
underwriting dealers to do so. However, the high level of customization in this market can make it difficult
to find another buyer.
Still, as stated earlier, investors need to understand the characteristics of structured securities before they
invest in them, particularly the ways in which their value will be affected by different interest rate scenarios
and other market conditions.

In most cases, they should be prepared to hold the investment to maturity or to risk a loss of principal due
to both interest rate movements and illiquid markets if they need to sell before maturity. They should also
consider the potential impact of changing values if they have to mark the securities to market for financial
reporting purposes.

   i   




Apart from legal investment issues, the variations of structured debt securities make it impossible to
generalize about appropriate tax and accounting treatment for an investor. Investors should consult with
their own tax advisors and accountants prior to investment.

!
 
  

3 
    
 


Many dealers and information vendors provide detailed research and product information on GSE debt
securities. Additionally, the GSEs¶ own Web sites contain much descriptive information about their debt
securities.

Following are some questions that should be asked before investing in any GSE debt securities:

1. Does this investment conform to my investment guidelines?


2. Does it also conform to my suitability standards in terms of: portfolio objectives, liquidity needs,
cash-flow requirements, credit diversity and structure diversity?
3. What interest rate assumptions are embedded in this security?
4. How much additional yield am I receiving in this structure and for what risk?
5. What is the best-case interest rate scenario for this product?
6. How might it perform if rates move in the opposite direction?
7. What is the worst-case interest rate scenario?
8. Is there leverage in this structure? If so, how does it apply in the best-case and worst-case
scenarios?
9. If the investment has a floating rate, is there a cap, floor or collar? If so, how will these features
affect the security¶s performance under different interest rate scenarios?
10. Am I taking the risk of a zero or negative interest payment?
11. How is my principal repayment affected under different interest rate scenarios? To what extent is
principal at risk?
12. Will there be a buyer for this security at a price that reflects its current value if I have to sell it
sooner than I anticipate?
13. Are there high minimum denominations indicating a complex security that may have a limited
universe of possible buyers?
14. Have I seen all the relevant documentation on this issue?
15. How can I get a price and analysis on this security?
16. Do I understand the structure, the issuer and its business?
Investors should keep asking questions until they feel completely secure in their knowledge of the
security they are considering for purchase and of the ways it fits with their investment goals.

i


- i £ i£ 

 3
'*

Created by Congress in 1916, this nationwide system of banks and associations provides mortgage
loans, credit and related services to farmers, rural homeowners, and agricultural and rural cooperatives.
The banks and associations are cooperatively owned, directly or indirectly, by their respective borrowers.
The banks of the Farm Credit System issue securities on a consolidated basis through the Federal Farm
Credit Banks Funding Corporation.

"  3


'"
*

Created in 1932, this system consists of 12 regional banks, which are owned by private member
institutions and regulated by the Federal Housing Finance Board. Functioning as a credit reserve system,
the system facilitates extension of credit through its owner-members in order to provide access to housing
and to improve the quality of communities. Federal Home Loan Bank issues are joint and several
obligations of the 12 Federal Home Loan Banks and issued through the Federal Home Loan Banks Office
of Finance.

ë 

A stockholder-owned corporation established by Congress in 1970 to provide a continuous flow of funds


to mortgage lenders, primarily through developing and maintaining an active nationwide secondary
market in conventional residential mortgages. Freddie Mac purchases a large volume of conventional
residential mortgages and uses them to collateralize mortgage-backed securities. Freddie Mac is a
publicly held corporation; its stock trades on the New York Stock Exchange.

ë

A federally chartered but privately owned corporation which traces its roots to a government agency
created in 1938 to provide additional liquidity to the mortgage market. Today, Fannie Mae carries a
congressional mandate to promote a secondary market for conventional and FHA/VA single- and
multifamily mortgages. Fannie Mae is a publicly held company whose stock trades on the New York Stock
Exchange.

i

&   'i&*

A wholly owned corporation of the U.S. government that was established in 1933 to develop the
resources of the Tennessee Valley region in order to strengthen the regional and national economy and
the national defense. Power operations are separated from non-power operations.

TVA securities represent obligations of TVA, payable solely from TVA¶s net power proceeds, and are
neither obligations of nor guaranteed by the United States. TVA is currently authorized to issue debt up to
$30 billion. Under this authorization, TVA may also obtain advances from the Treasury of up to $150
million.


%3£6 3  


%



Amortization

Repayment of debt principal through periodic installment payments rather than in a lump sum

Average life

On a security where principal is subject to prepayment, the average time to receipt of each dollar
of principal, weighted by the amount of each principal prepayment, based on prepayment
assumptions

Benchmark and Reference Notes

Large ($2 to $4 billion minimum size) debt tranches issued by Fannie Mae and Freddie Mac,
respectively, in a non-scheduled but regular pattern of maturity and size meant to establish a
yield curve framework for the government and the GSE marketplace.

Blended yield to maturity

The combination and average of two points on the yield curve to find a yield at the midpoint

Bond

An interest-bearing debt obligation

Bond equivalent yield

An adjustment to yield on a note which has monthly or quarterly interest payments. The
frequency of such interest payments, compared to semiannual interest payments on most other
types of securities, may result in a different present value of the interest income.

Bought Deals

GSE-issued securities sold through negotiated direct placements or competitive bids, with terms
and size determined by the immediate needs of the GSE

Bullet

A security with a fixed maturity and no call feature

Call risk

See Reinvestment risk


Callable security

A security that the issuer has the right to redeem prior to maturity

Cap

A maximum interest rate on a floating-rate security. The rate paid can never exceed the cap even
though the calculation of the rate at the time might be higher

CMT

See Constant Maturity Treasury Series

COFI

See Cost of Funds Index

Collar

Upper and lower limits (cap and floor, respectively) on the interest rate of a floating-rate security

Constant Maturity Treasury Series (CMT)

The average yield of a range of U.S. Treasuries with various fixed maturities. The five- and ten-
year CMTs are commonly used as indices on floating-rate notes whose rates are tied to long-term
interest rates. The index may be found in the Federal Reserve H.15 Report

Convexity

A measure of the change in a security¶s duration with respect to changes in interest rates. The
more convex a security is, the more its duration will change with interest rate changes

Cost of Funds Index (COFI), 11th District

The monthly weighted average cost of funds for savings institutions in Arizona, California and
Nevada that are members of the 11th Federal Home Loan Bank District. Published on the last
day of the month, the rate reflects the cost of funds for the prior month and is used to set rates on
adjustable-rate mortgages, mortgage-backed securities and public issues of floating-rate debt.
Some issues may use the national COFI rather than the 11th District¶s.

CP Index

Usually the Federal Reserve Commercial Paper Composite calculated each day by the Federal
Reserve Bank of New York by averaging the rate at which the five major commercial paper
dealers offer ³AA´ industrial Commercial Paper for various maturities. Most CP-based floating-
rate notes are reset according to the 30- and 90-day CP composites

Credit Spread

A yield difference, typically in relation to a comparable U.S. Treasury security, that reflects the
issuer¶s credit quality. Credit spread also refers to the difference between the value of two
securities with similar interest rates and maturities when one is sold at a higher price than the
other is purchased.

Coupon

The stated interest rate on a security

Day Count

The convention used to calculate the number of days in an interest payment period. A 30/360
convention assumes 30 days in a month and 360 days in a year. An actual/360 convention
assumes the actual number of days in the given month and 360 days in the year. An actual/actual
convention uses the actual number of days in the given interest period and year.

Discount margin

The effective spread to maturity of a floating-rate security after discounting the yield value of a
price other than par over the life of the security

Discount note

Short-term obligations issued at discount from face value with maturities ranging from overnight
to 360 days. Discount notes have no periodic interest payments; the investor receives the note¶s
face value at maturity

Duration

A measure of the price sensitivity of fixed-income securities for a given change in interest rates.

Fed Funds effective rate

The overnight rate at which banks lend funds to each other, usually as unsecured loans from
regional banks to money center banks. The Fed Funds rate is the average dollar-weighted rate of
overnight funds. It is reported with a one-day lag (Monday¶s rate is reported Tuesday morning)
and may be found in various financial information services.

Federal Reserve Commercial Paper Composite

See CP Index.

Floor

The lower limit for the interest rate on a floating-rate security

Global Debt Facility

The issuance platform used by most GSEs when issuing ³global´ debt into the international
marketplace or a particular foreign market. Has same credit characteristics as nonglobal debt but
is more easily ³cleared´ through international clearing facilities

Inflation-Indexed Securities
Notes periodically issued by the GSEs whose return is adjusted with changes in the PPI or CPI

Lock-Out Period

A prescribed period of time before principal repayments begin on a security that has amortizing
principal repayments. On some floating-rate securities, the term ³lock-out period´ also applies to
the interval between the day the rate for the current interest period is set and the actual payment
date, which may be several days apart (see page 10)

Maturity

The date on which a bond or note must be fully redeemed by its issuer if not subject to prior call
or redemption

Medium-Term Note

A debt security issued under a program that allows an issuer to offer notes continuously to
investors through an agent. The size and terms of medium-term notes may be customized to
meet investors¶ needs. Maturities can range from one to 30 years

Note

In the government securities market, a note is a coupon issue with a maturity of one to ten years

Option-Adjusted Spread (OAS)

For a security with an embedded option, the yield spread over a comparable Treasury security
after deducting the cost of the option

Optional Principal Redemption Bond

Term used to describe callable securities issued with either fixed- or floating-rate structures.

Perpetual floating-rate note

A floating-rate note with no stated maturity date

Prime Rate

A commercial bank¶s stated reference rate for lending

Rate reset

The adjustment of the interest rate on a floating-rate security according to a prescribed formula

Reinvestment risk

For an investor, the risk that interest income or principal repayments will have to be reinvested at
lower rates in a declining-rate environment. Reinvestment risk applies to fixed-rate callable
securities. Because issuers typically call fixed-rate securities when rates are falling, the investors
will have to reinvest their returned principal at a lower prevailing rate. This risk is sometimes
referred to as call risk
Sinkers

A security with a sinking fund. In a sinking fund, an issuer sets aside money on a regular basis,
sometimes from current earnings, for the specific purpose of redeeming debt

Subordinated debt (Sub-debt)

A type of debt that places the investor in a lien position behind or subordinated to a company¶s
primary creditors. Securities issued as subordinated debt will pay interest and principal but only
after all interest that is due and payable has been paid on any and all senior debt.

T-Bill Rate

The weekly average auction rate of the three-month Treasury bill stated as the bond equivalent
yield

Term funding

A financing done to meet specific cash-flow needs for a specific period of time

Trigger

The market interest rate at which the terms of a security might change. Triggers are common on
index amortization notes and range securities

Undated issue

A floating-rate note with no stated maturity date (see also Perpetual floating-rate note)

Volatility

A representation of the uncertainty of future securities prices. Technically, volatility is the amount
of price variation around a general trend. It is a major determinant of the value of any option

Yield

The annual percentage rate of return earned on a security, as computed in accordance with
standard industry practice. Yield is a function of a security¶s purchase price and coupon interest
rate

Yield curve

The charting of yields on a particular type of security over a spectrum of maturities ranging from
three months to 30 years

Yield to call

A yield on a security calculated by assuming that interest payments will be paid until the call date,
at which point the security will be redeemed.

Yield to maturity
A yield on a security calculated by assuming that interest payments will be paid until the final
maturity date, at which point the principal will be repaid by the issuer

     




Corporate bonds (also called corporates) are debt obligations, or IOUs, issued by private and public
corporations. They are typically issued in multiples of $1,000 and/or $5,000. Companies use the funds
they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to
expanding their business.

When you buy a bond, you are lending money to the corporation that issued it. The corporation promises
to return your money (also called principal) on a specified maturity date. Until that time, it also pays you a
stated rate of interest, usually semiannually. The interest payments you receive from corporate bonds are
taxable. Unlike stocks, bonds do not give you an ownership interest in the issuing corporation.

 "2x 


All bonds are debt securities issued by organizations to raise capital for various purposes. When you buy
a bond, you lend your money to the entity that issues it. In return for the loan of your funds, the issuer
agrees to pay you interest and ultimately to return the face value (principal) when the bond matures or is
called, at a specified date in the future known as the ³maturity date´ or ³call date.´

High-yield bonds are issued by organizations that do not qualify for ³investment-grade´ ratings by one of
the leading credit rating agencies²Moody¶s Investors Service, Standard & Poor¶s Ratings Services and
Fitch Ratings. Credit rating agencies evaluate issuers and assign ratings based on their opinions of the
issuer¶s ability to pay interest and principal as scheduled. Those issuers with a greater risk of default²not
paying interest or principal in a timely manner²are rated below investment grade. These issuers must
pay a higher interest rate to attract investors to buy their bonds and to compensate them for the risks
associated with investing in organizations of lower credit quality. Organizations that issue high-yield debt
include many different types of U.S. corporations, certain U.S. banks, various foreign governments and a
few foreign corporations.1

1
High-yield bonds issued by foreign governments and foreign corporations will not be addressed within
the scope of this booklet, which will primarily focus on high-yield bonds issued by U.S. corporations.

 2   


 

           2c   




Fixed-rate capital securities were developed in the early 1990s to meet the needs of income-oriented
investors while creating a cost-efficient source of capital for issuers. From the investor¶s perspective,
fixed-rate capital securities combine features of corporate debt securities and preferred stock to offer the
benefits of:
R attractive yields,
R fixed monthly, quarterly or semiannual income,
R investment time frames that are generally predictable (i.e., 20-49 years, although there are some
perpetual),
R liquidity and
R investment-grade credit quality (in most cases).

Like corporate debt securities, fixed-rate capital securities generally:

R rank senior to common and preferred shares in the issuer¶s capital structure and
R most have a stated maturity date.

Like preferred stock, fixed-rate capital securities generally:

R have a $25 liquidation value (although some are now being issued with a $1,000 liquidation
value),
R trade on a major securities exchange (for retail-targeted offerings) and
R are priced at a flat rate that includes accrued income, where applicable.

Unlike preferred stock, however, they offer no tax benefits to corporate investors. Fixed-rate capital
securities also carry certain risks, including ³call´ risk, the possibility of deferred payments and, in some
cases, ³extension´ risk, in addition to other risks commonly associated with fixed-income securities, which
are explained in more detail later in this brochure.

Because of their typically attractive yields and investment-grade credit ratings, fixed-rate capital securities
can help investors achieve enhanced returns without sacrificing credit quality. As part of a diversified
portfolio, they may be suitable for both individual and institutional investors. Prior to investment, however,
all investors are advised to understand thoroughly the characteristics of the security they are purchasing
and the various factors that may affect its value.

    
 £
 

This brochure provides you with basic information about investing in certificates of deposit (³CDs´) issued
by banks, savings associations and other depository institutions* whose deposits are insured by the
Federal Deposit Insurance Corporation (³FDIC´).

i 
 Î   

Before choosing any investment, you should put together a financial plan: outline your goals, clarify your
tolerance for risk, and set savings targets that make sense given your income and living expenses. A
successful investment strategy requires a long-term perspective and staying on course ± even when the
financial markets are declining. When developing and implementing your strategy, consider choosing an
investment professional who can help you make the right financial decisions.

The basic building blocks of any portfolio are



, 6 
or  
,   
, and  
2
 


. Typically, your investment plan should include a healthy mix of all four. Deciding
how much money you should allocate to each type of investment depends on your age and goals, and
the amount of risk that you can accept. The important principle to remember is diversification ± don¶t put
your entire savings into just on basket or one type of investment. Depending on the features, CDs may be
an appropriate investment for your portfolio.

CDs are available from several sources, including the bank in which you deposit your money, securities
brokers and other financial institutions. Institutions sometimes referred to as deposit brokers.

     
 £
 

CDs are time deposits ± you agree to place your funds on deposit with the bank for a stated period of
time. During the term of the CD your funds earn interest at a stated interest rate or based upon an agreed
method of calculating the rate, such as the percentage increase in the stock market.

Because you agree with the bank to keep your funds on deposit for a period of time, CDs may offer you a
higher rate of interest than other types of deposit accounts that allow you more immediate access to your
funds, such as checking and savings accounts. Generally, the longer you are willing to let the bank keep
your funds, the higher the rate you will receive on your CD.

Most banks are members of the FDIC, a government agency that insures bank deposits. You are eligible
for $100,000 of deposit insurance for all the deposits you own at one bank in each recognized ownership
capacity. For example, all the deposits (CDs, checking accounts, etc.) you own at one bank in your own
name are insured up to a total of $100,000. You are eligible for an additional $100,000 for all deposits you
own at one bank in joint accounts and another $100,000 for Individual Retirement Accounts.

The FDIC¶s brochure x  ! (  explains deposit insurance coverage in more detail. You can
obtain the publication from the FDIC and from most banks and securities brokers. You can contact the
FDIC by mail (550 17th Street, N.W., Washington, DC 20429), by phone (800-276-6003
begin_of_the_skype_highlighting 800-276-6003 end_of_the_skype_highlighting) or by e-mail.
You can also visit the FDIC web site.

   


 £


All CDs do not have the same features. Banks are free to offer CDs with different maturities (i.e., three
months, one year, five years), methods of determining interest and payment features. Banks are not
required to permit you to withdraw your funds prior to the CD¶s maturity, even if you were to pay a penalty.
If early withdrawal is permitted, there are no strict guidelines governing the penalty that a bank may
impose.

When selecting a CD you should carefully review its terms and conditions. The å )   3 
G requires all FDIC-insured depository institutions and deposit brokers to disclose certain information to
you when advertising the rate on a CD. The information must include the ³Annual Percentage Yield´ or
³APY´ (the rate that reflects the amount of interest you will earn on your deposit), the maturity, the
minimum required deposit and whether there is a penalty for early withdrawal. Other significant features,
such as the right of the institution to redeem or ³call´ the CD, must also be disclosed.

The Federal Reserve Board¶s brochure,  3  3 , explains the APY and other disclosure
requirements. You can obtain the brochure from the Board by writing to: Publications Services, MS-127,
Board of Governors of the Federal Reserve System, Washington, DC 20551 (or calling 202-452-3244
begin_of_the_skype_highlighting 202-452-3244 end_of_the_skype_highlighting) or on the
web site of the Federal Consumer Information Center.

 
 

Fixed Rate

Many CDs pay interest at a fixed rate for the term of the CD. The interest may be compounded or simple.
Interest may be paid to you periodically during the term of the CD or at maturity.

Variable Rate

CDs may offer rates that change periodically during the CD¶s term. With such CDs you need to
understand how the interest rate is calculated and how often the rate can be re-set.

CDs that re-set the rate periodically are referred to as ³floating rate´ CDs because the rate ³floats´ during
the term of the CD. These CDs may re-set the rate at pre-determined intervals against any number of
common financial references ± Treasury securities, the prime rate or some other index. If these indices
decline, so will the rate on the CD. The APY will reflect the rate in effect at the time you purchase the CD.

CDs that change to a pre-determined rate at pre-determined times are referred to as ³step rate´ CDs.
These CDs will have an interest rate that is fixed for a period of time and then ³step up´ or ³step down´ to
another fixed rate. The steps may occur more than once before the CD matures. The APY on step rate
CDs will reflect the total interest to be paid during the life of the CD, so it will be less than the highest step
rate, but more than the lowest step rate.

Contingent Rate

The rate on some CDs is determined by the outcome of some event or the performance of a financial
index. For example, many banks offer CDs that pay interest linked to the performance of the stock
market. You receive the percentage increase in the value of the stock market over a period of time. If the
value of the stock market does not increase, you may receive no interest. In many cases, a contingent
rate CD will have an APY of 0%. This reflects the fact that the CD has no stated interest rate and the
interest rate cannot be determined at the time you purchase the CD.

Zero Coupon

Zero coupon CDs are sold at a discount to their face amount and pay the entire face amount at maturity.
For example, you may pay $900 for a $1,000 CD and receive the full $1,000 at maturity. At maturity, you
will have received $100 in interest.

   




Call Features

Some CDs allow the bank to redeem or ³call´ the CD at its sole discretion. These CDs are termed
³callable CDs.´ On pre-determined dates, the bank can choose to give you your money back (including
accrued interest) and cancel the CD. A call provision does not give you the right to redeem the CD. Call
features are typically incorporated in CDs with longer terms and the call feature may be combined with
other features, such as a step rate.

Typically, the bank will call your CD when interest rates have declined below the rate on your CD
because the bank can attract deposits at a lower rate. If your CD is called you may not be able to reinvest
your money at the same rate as the CD that was called. This risk is termed ³reinvestment risk.´
Callable CDs are sometimes referred to in terms of their maturity and the period during which they cannot
be called. For example, ³15 year, non-call one´ means the CD matures in 15 years, but may be called at
pre-determined dates or, in some cases, at any time after the first year.

Banks and deposit brokers must inform you that a CD is callable. However, the APY on a callable CD is
not required to reflect the call feature. This will be significant if the CD has step rates because the CD
could be called before the CD steps to a more favorable rate. In that case you will receive less than the
advertised APY. You should be sure you understand both the APY you will receive on the CD if it is held
to maturity and the APY you will receive on the CD if it is called.

Early Withdrawal

As stated Earlier, banks are not required to permit early withdrawal. You should determine whether early
withdrawal is permitted and, if so, the amount of the penalty that the bank will impose if you withdraw your
funds. If you think you may need your money before the CD matures, you should decide if the penalty is a
reasonable amount to pay for the opportunity to get your money early. If not, you should place your
money in a shorter term CD or keep it in a different type of account.

Though not required to do so, banks may permit early withdrawal without penalty in certain
circumstances, such as your death or incapacity.

Is The Interest On My CD Taxable?

Yes. You may be able to defer taxes on your CD interest by holding it in an IRA or other retirement
account. You may owe taxes when your funds are distributed from those accounts.

You may be required to pay taxes annually on zero-coupon CDs and some contingent interest CDs if you
hold the CD outside a retirement account even though these CDs do not pay interest annually. This tax
consequence ± referred to as Original Issue Discount ± may be significant to you.

If you have questions about the tax consequences of a particular CD, you should consult your tax adviser.

What Are ˜rokered CDs?

Brokered CDs are CDs issued by banks that are made available to the customers of a deposit broker.
Most, though not all, deposit brokers are securities brokers registered with the Securities and Exchange
Commission. Other deposit brokers are subject to regulation by different regulatory bodies or may not be
subject to regulation at all. This description of brokered CDs is based upon standard practices in the
securities industry. You should compare these practices to the practices of any deposit broker offering
you a CD.

Brokered CDs are obligations of the bank, not the broker. Brokered CDs generally have the features of
CDs available directly from banks and are eligible for the same deposit insurance as CDs purchased
directly from banks.

Generally, the CD is sold to you without a fee because the broker receives its compensation from the
bank. You have a right to know the amount of the fee paid to the broker by the bank.

Brokers may provide certain services to you that would normally be provided by the bank. The broker will
hold your CD as your custodian and keep a record of your holdings. The broker will include your CD
holdings in the periodic account statements you receive concerning the assets you have with the broker.
Tax information concerning the amount of interest you should include in y our income for tax purposes will
also be provided by the broker.
Unlike banks, securities brokers are required to provide you with an estimated market value of your CD
on your periodic account statement. This is an estimate of the amount you might receive if you were able
to sell your CD prior to its maturity. You may not be able to sell your CD for the amount listed on the
statement. Also, the amount on the statement does not affect your deposit insurance, which is based on
the outstanding principal amount of your CD, not the estimated market value.

When you hold your CD through a broker you have certain rights, including the right to dismiss the broker
as your agent and move the CD to an account at another broker or establish the CD directly with the
bank. Once you establish the CD directly with the bank your broker has no further obligation with respect
to the CD.

Within a few days of your CD purchase, a securities broker will provide you with a trade confirmation that
sets forth the terms of your CD. In addition, the broker will send you a CD disclosure document describing
your rights with respect to the CD, the availability of deposit insurance coverage and other important
considerations. The disclosure document will usually be sent with the trade confirmation, but is also
available upon request. You should review these documents carefully and ask your broker if you do not
understand the terms and conditions of your CD or if the terms and conditions are different than you were
told when you placed your order.

Liquidity

Though not obligated to do so, some securities brokers may be willing to purchase, or arrange for the
purchase of, your CD prior to maturity. The broker may refer to this activity as a secondary market. This is
not early withdrawal. The price you receive for your CD will reflect a number of factors, including then-
prevailing interest rates, the time remaining until the CD matures, the features of the CD and
compensation to the broker for arranging the sale of the CD. Depending on market conditions, you may
receive more or less than you paid for your CD. The broker is free to discontinue offering you this service
at any time.

Early Withdrawal

Banks usually limit early withdrawal of CDs offered through brokers. You may not be permitted to
withdraw your funds even if you are willing to pay a penalty. Banks generally permit early withdrawal of
brokered CDs without penalty upon the death or adjudication of incompetence of the depositor.

Information About Your ˜roker

You can find out if your broker is a registered or licensed securities broker by contacting your state
securities regulator or the Public Disclosure Program of the National Association of Securities Dealers.
Call 800-289-9999 begin_of_the_skype_highlighting 800-289-
9999 end_of_the_skype_highlighting or log on to www.nasdr.com and click on ³Know Your Broker´ to
verify a broker¶s license or registration and obtain a background report on the broker detailing any existing
legal or regulatory problems.

 !
 
3  
 £

1. Does the CD meet your investment objectives?


2. What are its terms, i.e., APY, maturity, early withdrawal, call features, etc.?
3. What are the terms offered on other available CDs?
4. Is the interest paid to you periodically throughout the term of the CD, or at maturity?
5. Will you need your funds before the CD matures?
6. Are your total deposits at the bank within the FDIC¶s $100,000 limit?
7. If the CD is callable, what is the first date the bank can call it and how frequently after that can it
be called?
8. Do you understand the tax consequences associated with the CD?
9. If purchasing a CD from a broker, are you familiar with the broker¶s reputation and comfortable
with your salesperson¶s advice?
10. Have you asked for copies of the disclosure materials available from the bank or the broker?

November 2001

The Securities Industry and Financial Markets Association is the trade association representing the
largest securities markets in the world, the $33 trillion debt markets. Its membership includes securities
firms and banks that underwrite, trade and sell debt securities. The Association acts as an advocate for
industry positions and informs and educates the public about the role of the bond markets and the global
economy. The Association publishes newsletters and education materials, presents seminars and
conferences and published bond markets-related statistics. These efforts are aimed at increasing the
level of professionalism in the industry and raising public awareness of the importance of the bond
markets. More information about the Association is available on its website.

The Securities Industry and Financial Markets Association also brings together the shared interests of
nearly 700 securities firms to accomplish common goals. SIFMA member firms (including investment
banks, broker-dealers, and mutual fund companies) are active in all U.S. and foreign markets and in all
phases of corporate and public finance. The U.S. securities industry manages the accounts of nearly 80
million investors directly and indirectly through corporate, thrift, and pension plans, and generates $358
billion of revenue. Securities firms employ approximately 760,000 individuals in the United States. (More
information about SIFMA is available on its website).

*For purposes of this brochure, all FDIC-insured institutions are referred to as banks.

    2i




Fixed income exchange-traded funds (ETFs), whose shares are traded on major stock exchanges, are a
special type of mutual fund designed to track the performance of a specific bond market index. A bond
market index is a statistical composite, created and maintained by a financial institution or financial
information service, that tracks the performance of the overall bond market or of a specific sector
(government, corporate, or mortgage-backed), maturity range or credit quality within the larger market.
Different ETFs offer investors the opportunity to achieve broad or targeted bond market exposure.

Like bond market indices, ETFs are also created and managed by financial firms, but not necessarily by
the same institutions that create and manage the index on which they are based. Common brand names
for ETFs include iShares, SPDRs (short for Standard& Poor¶s Depository Receipts, also known as
³spiders´), Diamonds and Vipers. ETFs based on equity indices are more common, but some of these
brands include fixed income ETFs as well. Each has different firms as sponsors and administrators.
Unlike most bonds, ETFs generally trade on organized exchanges like the New York Stock Exchange or
the American Stock Exchange.

3 
  

Prices of fixed income ETF shares are affected by the same factors that influence bond prices:

R changes in interest rates (rising interest rates mean declining bond prices and vice versa)
R changes in yield spreads (the difference in yield between a U.S. Treasury security and another
type of bond with comparable maturity)
R changes in the yield curve (the relationship among yields of bonds with different maturities)

£  
6 i
 


Fixed Income ETFs usually distribute monthly dividends which can include both interest income on the
underlying bonds and capital gains (if any). Most bonds pay interest semi-annually.

Unlike bonds, ETFs have no maturity date. Although bonds in the fund mature eventually, the proceeds
are reinvested in new bonds rather than returned to investors. The only way for an ETF investor to get his
or her principal back is to sell the shares. The price received may be more or less than what was paid,
depending on the direction of interest rates and other bond market conditions in the interim.

ETFs trade on stock exchanges, whereas bonds are generally bought and sold through dealer firms.
Trading on a stock exchange means that investors can execute trades just as they would with any listed
stock. Also, price quotes and trading history for ETFs are available in the same manner as for listed
stocks.

Furthermore, individual investors can execute trading strategies in ETFs that may be cumbersome using
bonds themselves. For example, ETFs can generally be sold short just as any listed stock, and for most
fixed-income ETFs, there are actively traded options chains available to individual investors. Short sales
and options on individual bonds generally are not available to individual investors.

£  
6 i
c2   ë 


R Fixed income ETF shares are bought and sold on a stock exchange, while open-end mutual fund
shares are bought and sold directly through the fund sponsor.
R ETF shares are priced continuously throughout the day, and traditional open-end mutual fund
shares are priced once daily.
R ETF shares can be bought or sold at any time during the day. Open-end fund shares can only be
bought or sold at the end of the trading day.
R ETF investors pay a brokerage commission on the trade, while traditional open end mutual fund
investors may have to pay a sales charge or other fees to enter or exit the fund.
R Many open-end mutual funds are actively managed, meaning the portfolio manager makes
investment decisions in an effort to enhance performance relative to the market as a whole. As a
result, open-end funds tend to impose relatively higher management fees than passively
managed (indexed) funds. ETFs are always indexed and tend to have management fees and
expense ratios significantly lower than actively managed funds and in some cases lower than
other index funds.

63  
2     
A callable municipal, corporate, federal agency or government security gives the issuer of the bond the
right to redeem it at predetermined prices at specified times prior to maturity. Take, for example, a U.S.
agency 10-year note noncallable for 3 years, maturing in 10 years, which can be ³called´ or redeemed by
the agency issuer at the end of the third year after issuance²known as a ³10nc3.´ The three-year
noncallable period is known as the ³lockout´ period.

Yields on callable bonds tend to be higher than yields on noncallable, ³bullet maturity´ bonds because the
investor must be rewarded for taking the risk the issuer will call the bond if interest rates decline, forcing
the investor to reinvest the proceeds at lower yields.

With a callable security, the investor¶s compensation for selling the option is reflected in a higher yield and
lower price as compared to a similar bullet security with the same maturity. In an example from 1997, A
U.S. agency 10nc3 was offered at a yield of 6.856 percent while a 10-year bullet with the same coupon
carried a yield of 6.236 percent. The difference in dollar price between these two securities would
represent the value of the call option.

The investor has to determine the value of the option and the level of compensation required for the
associated risks in a callable security.

i 
 6   


The type of embedded option in a callable security affects the option¶s value.

R American options are continuously callable at any time after the lockout period expires.
R Bermudian options give the issuer the right to call the bond on specified dates after the lockout
period that typically coincide with coupon dates.
R European options have a one-time call feature coinciding with the expiration of the lockout
1
period.

        


Coupled with the time to maturity, the lockout period also affects the option¶s value. For example, the
embedded option in a 10-year noncallable for six months (10nc6M) can be likened to a 6-month
European option on a 9.5-year security. The embedded option in a 10nc3 European callable is the same
as a 3-year option on a 7-year security. The uncertainty or risk associated with 7-year rates three years
from now is higher than the uncertainty of 9.5 year rates 6 months from now, so the first option should
have a higher value.

Î
£



Prices on callable bonds depend on the market¶s expectation of interest rates at the time the call feature
on a bond becomes active in relation to the coupon rate on the callable bond. If the market expects
interest rates at the time the option becomes active to be such that the issuer will exercise its option and
call the bond, the option is said to be ³in the money,´ which can cause the security to trade at a premium
to par, or a price higher than the bond¶s face value. Discount callables, priced below face value, or par,
with a coupon below the going market rate, have embedded options that are ³out of the money.´ This
means that the market expects interest rates at the time the bond becomes callable will be such that the
issuer will not exercise its option.



   
63  


Premium callables trade at ³yield to call´²meaning that the price of the bond is calculated with the
assumption that the bond will be called²and carry extension risk. If interest rates rise before the end of
the lockout period, the bond¶s embedded option becomes worth less, as the security is less likely to be
called. Discount callables trade like bullets²non-callable bonds²to maturity and carry compression risk.
If interest rates fall, they become more likely to be called. Callable securities that are at the money²
where interest rates are very close to the point where the option will be exercised²have the most
sensitivity to changes in market rates and implied volatility.

Unlike a noncallable bond, a callable security¶s duration, or sensitivity to interest rate changes, decreases
when rates fall and increases when rates rise. The spread or difference in yield over comparable
noncallable securities compensates callable investors for this ³negative convexity.´

In addition to interest rate risk, the value of the options embedded in callables is sensitive to changes in
the slope of the yield curve.2 The value of the options is a function of forward rates,3 which are dependent
on the spot4 level of rates and spot yield spreads.5

Volatility risk in callables takes two forms. The first is realized volatility: large swings in rates can
necessitate frequent rehedging, with its associated costs, as well as underperformance. Implied volatility,
or the market forecast of future rate uncertainty, is the second. When a position is unwound or sold, the
value of the callable security will depend on the new level of implied volatility. If implied volatility is higher,
callable security prices will be depressed.

 
 3  
#
63  


Many investors use callable securities within a total return strategy²with a focus on capital gains as well
as income²as opposed to a buy and hold strategy focused on income and preservation of principal.

Owners of callable securities are expressing the implicit view that yields will remain relatively stable,
enabling the investor to capture the yield spread over noncallable securities of similar duration. They must
also have views on the likely range of rates over the investment period and the market¶s perception of
future rate uncertainty at the horizon date for reasons explained in 

   
6
3  
above. If an investor has the view that rates may well be volatile in either direction over the
near term but are likely to remain in a definable range over the next year, an investment in callable
securities can significantly enhance returns.

Premium callables would generally be used when the bullish investor believes that rates are unlikely to
fall very far. Discount callables would generally be chosen when the investor believes volatility will be low
but prefers more protection in an environment of rising interest rates.

Lehman Brothers¶ Callable Securities - An Introduction

1. Note that the names used to describe the types of options do not necessarily relate to where
securities with these features are sold or traded.
2. The yield curve is the collection of interest rates at a variety of maturities. In most cases, the
longer the maturity on a bond, the higher its yield. A steeply sloped yield curve indicates a
relatively big difference between yields on bonds with shorter and longer maturities.
3. Forward rates are the market¶s projection about the level of interest rates at some point in the
future.
4. ³Spot rates´ refers to the current level of interest rates.
5. Yield spreads in this case refers to the difference between the interest rates of bonds of two
different maturities, or two points on the yield curve.


6  ë353

c  

When you invest in mortgage-backed (MBS) and asset-backed (ABS) securities you are purchasing an
interest in pools of loans or other financial assets. In the case of mortgage-backed securities, these are
usually first mortgages on residential properties. With asset-backed securities, the assets might be credit
card receivables, auto loans and leases or home equity loans. As the underlying loans are paid off by the
borrowers, the investors in MBS/ABS receive payments of interest and principal over time. These
securities help make credit available to more people by giving lenders access to large pools of capital as
well as help them manage their risk.

The largest sector of the MBS market is the ³agency´ securities market. Agency securities are issued by a
government agency such as Ginnie Mae or a government-sponsored enterprise such as Fannie Mae or
Freddie Mac. These agencies typically guarantee the interest and principal payments on their securities
and are considered to offer strong credit quality due to their explicit government backing (in the case of
Ginnie Mae) or access to support from the U.S. Treasury (in the case of Fannie Mae and Freddie Mac).
The mortgage-backed securities market also includes ³private-label´ mortgage securities issued by
subsidiaries of banks, financial institutions and home builders, but this market is smaller than the Agency
MBS market.

Asset-backed securities (ABS) often carry some form of credit enhancement, such as bond insurance, to
make them attractive to investors.

This section explains some of the ins and outs of investing in mortgage-backed and asset-backed
securities. Use the information here to learn more about:

R Different types of mortgage-backed and asset-backed securities


R Collateralized Mortgage Obligations (CMOs) and Real Estate Mortgage Investment Conduits
(REMICs)

Visit the ³MBS/ABS Market At a Glance´ page to get news and market data.

3  ;  -c  

3 *  * is the process of creating securities by pooling together various cash-flow producing
financial assets. These securities are then sold to investors. Securitization, in its most basic form, is a
method of financing assets.

Any asset may be securitized as long as it is cash-flow producing. The terms  $  (ABS)
and   $  (MBS) are reflective of the underlying assets in the security.

Securitization provides funding and liquidity for a wide range of consumer and business credit needs.
These include securitizations of residential and commercial mortgages, automobile loans, student loans,
credit card financing, equipment loans and leases, business trade receivables, and the issuance of asset-
backed commercial paper, among others.
Securitization transactions can take a variety of forms, but most share several common characteristics.
Securitizations typically rely on cashflows generated by one or more underlying financial assets (such as
mortgage loans), which serve as the principal source of payment to investors, rather than on the general
credit or claims-paying ability of an operating entity. Securitization allows the entity that originates or
holds the assets to fund those assets efficiently, since cashflows generated by the securitized assets can
be structured, or ³tranched,´ in a way that can achieve targeted credit, maturity or other characteristics
desired by investors.

*Terms that appear in italics are defined in the glossary found at the end of this guide.

 2 3  

An 

 26 
   (ABS) is a securitized interest in a pool of assets. Conceptually, the structure
is similar to a mortgage-backed security (MBS), so it is convenient to describe the structure according to
its differences from MBS.

MBSs are backed by mortgages fixed rate, floating rate, residential, commercial, single family, multi-
family, etc. ABSs are backed by non-mortgage assets. This includes auto loans, credit card receivables,
home equity loans, student loans, etc. Due to government guarantees, MBSs typically entail no credit
risk. ABSs generally lack such guarantees, so they entail credit risk. Due to diversification of the
underlying assets, as well as credit enhancements, that risk tends to be modest. ABSs can be subject to
prepayment risk, but this is slight compared to that of MBSs. Consumers are more likely to refinance a
home than an auto in response to a drop in interest rates.

ABSs are appealing to issuers because the structure allows them to get assets off their balance sheets,
freeing up capital for further receivables. Also, ABSs make it possible for issuers whose unsecured debt
is below investment grade to sell investment grade even AAA-rated debt.

To create an ABS, a corporation creates a special purpose vehicle to which it sells the assets. While is is
common to speak of the corporation as the issuer of the ABS, legally, it is the trust or special purpose
vehicle that is the issuer. It sells securities to investors. To protect investors from possible bankruptcy of
the corporation, there are three legal safeguards:

Transfer of assets from the corporation is a non-recourse, true sale.

Investors receive a perfected interest in the assets' cash flows.

A non-consolidation legal opinion is obtained certifying that assets of the trust or special purpose
vehicle cannot be consolidated with the corporation's assets in the event of bankruptcy.
These same safeguards allow the corporation to remove the assets from its balance sheet. The
corporation generally continues to service the assets collecting interest and principal payments, pursuing
delinquencies, etc. It is paid out of asset cash flows for providing these ongoing services.

For investors, ABSs are an alternative to highly-rated corporate debt. They generally offer similar or
superior liquidity. Because the underlying assets are diversified, they are less subject to credit surprises.

ABSs can be structured into different classes or tranches, much like collateralized mortgage obligations
(CMOs). There may be senior or subordinated classes of debt, which have different credit ratings.
Tranches may be structured with different average maturities. Choice of structure depends upon investor
demand as well as the nature of the underlying assets.

ë  2 3  

A   26 
   (MBS) is a securitized interest in a pool of mortgages. It is a bond. Instead
of paying investors fixed coupons and principal, it pays out the cash flows from the pool of mortgages.
The simplest form of mortgage-backed security is a   

2  . With this structure, all


principal and interest payments (less a servicing fee) from the pool of mortgages are passed directly to
investors each month.

A 30-year fixed-rate residential mortgage makes a fixed payment each month until its maturity. Each
payment represents a partial repayment of principal along with interest on the outstanding principal. Over
time, as more of the principal is paid off, the size of the interest payment declines. Accordingly, the
portion of each payment representing principal repayment increases over the life of the mortgage. This is
illustrated in Exhibit 1:

3 
 
 1(2x 2 
ë  
Exhibit 1
A 30-year fixed-rate residential mortgage makes a fixed
payment each month until its maturity. Each payment
represents a partial repayment of principal and interest.
Over time, as more of the principal is paid off, interest
payments reflect a decreasing portion of each cash flow.

Although the scheduled payments on a mortgage are fixed from one month to the next, the cash flows to
the holder of a mortgage pass-through are not fixed. This is because mortgage holders have the option of
prepaying their mortgages. When a mortgage holder exercises that option, the principal prepayment is
passed to investors in the pass-through. This accelerates the cash-flows to the investors, who receives
the principal payments early but never receive the future interest payments that would have been made
on that principal.

A possible pattern of payments, taking into account principal pre-payments, of a mortgage pass-through
is illustrated in Exhibit 2:

6
 
 ë  Î

2i 
Exhibit 2

Possible cash flows for a pass-through are illustrated.


Principal and interest are paid to investors. Servicing fees
are deducted from interest payments and are paid to
whomever services the pooled mortgages usually the
originator.
Pooled mortgages continue to be serviced by
the originator who collects a monthly fee for doing so. This servicing fee is a fixed percent of outstanding
principal, say 0.25% annualized. The fee is subtracted from interest payments to investors. If a pool of
mortgages has an average mortgage rate of 8.50% and the servicing fee is 0.25% annualized, then
investors in the pool receive an average yield of 8.25% annualized. Their actual rate of return depends
upon what they pay for the pass-through.

The originator may sell the rights to service the mortgages to a third party. There is a market for such
servicing rights.

Prepayments introduce uncertainty into the cash flows of a mortgage pass-through. The rate at which
fixed-rate mortgagors prepay is influenced by many factors. A significant factor is the level of interest
rates. Mortgagors tend to prepay mortgages so they can refinance when mortgage rates drop. By acting
in their own best interest, mortgagors act to the detriment of the investors holding the mortgage pass-
through. They tend to return principal to investors when reinvestment rates are unattractive, and they tend
to not do so when reinvestment rates are attractive.

Risk due to uncertainty in prepayment rates is called  


. To compensate investors for
taking pre-payment risk, pass-throughs offer higher yields than comparable fixed income instruments
without embedded options.

Despite their prepayment risk, mortgage pass-throughs entail little credit risk. In the United States, most
have principal and interest payments guaranteed by government sponsored enterprises ë,
ë , or %ë that explicitly or implicitly have the full backing of the US Treasury.

The Federal National Mortgage Association (FNMA) was formed by the US Federal Government in 1938.
Its purpose was to promote home ownership in the United States. It did so by purchasing mortgages from
originators. This freed up the originators' capital so they could originate more mortgages. Market
participants dubbed the firm "Fannie Mae." The Government National Mortgage Association and the
Federal Home Loan Mortgage Corporation were formed in 1968 and 1970, respectively. They play a
similar role to Fannie Mae, but target different segments of the mortgage market. Today, they are called
Ginnie Mae and Freddie Mac.

Ginnie Mae issued the first mortgage pass-through in 1970. Today, all three organizations actively
repackage and sell mortgages as pass-throughs. Ginnie Mae guarantees timely payment of principal and
interest on its pass-throughs. Fannie Mae and Freddie Mac guarantee payment of principal and interest.

Private firms banks or mortgage originators also pool mortgages and sell them as pass-throughs
without implicit government guarantees. Such   6ë3 traditionally had some form of credit
enhancement to obtain a triple-A credit rating. Credit enhancement fees would be subtracted from
mortgage cash flows along with servicing fees.
Starting in the early 2000s, private label MBS were increasingly issued with little or no credit
enhancement and on pools of risky sub-prime mortgages. For the first time, MBS posed significant credit
risk. Because credit risk made these instruments fundamentally different from earlier mortgage pass-
throughs, many market participants avoided calling them MBS, preferring to label them asset-backed
securities instead. Volume in these risky instruments grew rapidly until 2007, when defaults accelerated
and the market values of the instruments plunged. This caused a liquidity crisis that spilled into other
segments of the capital markets. A number of hedge funds with leveraged exposures to sub-prime
mortgages folded.

It is possible to segregate the cash flows from a pool of mortgages into different bonds offering different
maturity, risk and return characteristics. The bonds can then be sold to investors with different investment
objectives. Such mortgage-backed securities are called collateralized mortgage obligations (CMO).

In addition to structural differences and issuer differences between mortgage-backed securities, there are
profound differences that depend upon the underlying mortgages. Mortgages take many forms: single
family home, multi family home, 30-year fixed, 15-year fixed, adjustable rate mortgages, etc. Also,
mortgage pools exhibit different patterns of prepayment, depending upon such factors as the mortgagors'
income level and geographic location. The age of mortgage collateral can also influence prepayment
rates. All such factors affect the risk and pricing of mortgage-backed securities.

Mortgage-backed securities are issued in countries around the world, including countries in Latin America
and Southeast Asia. Volume is high in Europe and Japan. Some important markets are described in the
books recommended below.

3  ;  

A
  ;   is a financial transaction in which assets are pooled and securities representing interests
in the pool are issued. An example would be a financing company that has issued a large number of auto
loans and wants to raise cash so it can issue more loans. One solution would be to sell off its existing
loans, but there isn't a liquid secondary market for individual auto loans. Instead, the firm pools a large
number of its loans and sells interests in the pool to investors. For the financing company, this raises
capital and gets the loans off its balance sheet, so it can issue new loans. For investors, it creates a liquid
investment in a diversified pool of auto loans, which may be an attractive alternative to a corporate bond
or other fixed income investment. The ultimate debtors the car owners need not be aware of the
transaction. They continue making payments on their loans, but now those payments flow to the new
investors as opposed to the financing company.
All sorts of assets are securitized:

auto loans

student loans

mortgages

credit card receivables

lease payments

accounts receivable

corporate or sovereign debt, etc.

Assets are often called collateral.

In a typical arrangement, the owner or "originator" of assets sells those assets to a special purpose
vehicle (SPV). This may be a corporation, US-style trust, or some form of partnership. It is established
specifically to facilitate the securitization. It may hold the assets collateral on its balance sheet or place
them in a separate trust. In either case, it sells bonds to investors. It uses the proceeds from those bond
sales to pay the originator for the assets.

Most collateral requires the performance of ongoing servicing activities. With credit card receivables,
monthly bills must be sent out to credit card holders; payments must be deposited, and account balances
must be updated. Similar servicing must be performed with auto loans, mortgages, accounts receivable,
etc. Usually, the originator is already performing servicing at the time of a securitization, and it continues
to do so after the assets have been securitized. It receives a small, ongoing
    for doing so.
Because of that fee income,
  
are valuable. The originator may sell servicing rights to a
third party. Whoever actually performs servicing is called the
   .

Cash flows from the assets minus the servicing fees flow through the SPV to bond holders. In some
cases, there are different classes of bonds, which participate differently in the asset cash flows. In this
case, the bonds are called  
. If the securitization is structured as a pass-through, there is only
one class of bonds, and all investors participate proportionately in the net cash flows from the assets.

When assets are transferred from the originator to the SPV, it is critical that this be done as a legal sale. If
the originator retained some claim on those assets, there would be a risk that creditors of the originator
might try to seize the assets in a bankruptcy proceeding. If a securitization is correctly implemented,
investors face no credit risk from the originator. They also face no credit risk from the SPV, which serves
merely as a conduit for cash flows. Whatever cash flows the SPV receives from the collateral are passed
along to investors and whatever party is providing servicing.

Depending on the nature of the collateral, it may or may not pose credit risk. For example, people may fail
to make their credit card payments, so credit card receivables entail credit risk. On the other hand, many
mortgage-backed securities in the United states have little or no credit risk. Ginnie Mae guarantees timely
payment of principal and interest on its mortgage pass-throughs. Ginnie Mae is backed by the full faith
and credit of the US government, so the pass-throughs are free of credit risk.

If collateral entails credit risk, a securitization will often be structured with some sort of credit
enhancement. This may include over-collateralization, a third party guarantee, or other enhancements.
Also, by their nature, securitizations diversify the default risk of the underlying assets.

Credit ratings are often obtained for those securitizations that entail credit risk, and most ratings are
investment grade. If a securitization has different classes of bonds, each may receive a different credit
rating. Credit ratings can be misleading for novices. The fact that a securitization has a AAA rating doesn't
mean it is risk free. It only means that the chance of a bond holder incurring a loss attributable to default
on the underlying assets is remote. Other risks, which can affect the timing of payments, may be
considerable. Also, because valuing the underlying assets is often difficult, there is a risk that an investor
will overpay for a securitization the investor is ill-equipped to value on its own.

Standard categories of securitizations are

mortgage-backed securities (MBS), which are backed by mortgages;

asset-backed securities (ABS), which are mostly backed by consumer debt;

collateralized debt obligations (CDO), which are mostly backed by corporate bonds or other corporate
debt.

Each segment of the market offers unique opportunities and risks, reflecting the nature of the underlying
assets and market conventions that have evolved over time.

"6 
 

The term 6


 is not precisely defined. Generally, it is used to refer to financial instruments
that blend characteristics of debt and equity markets. Convertible bonds are an example. They are debt
instruments that have an imbedded option allowing the holder to exchange them for shares of the issuing
corporation's stock. For this reason, their market prices tend to be influenced by both interest rates as
well as the issuer's stock price. Another example would be a structured note linked to some equity index.
These take many forms. Typical would be a five year note. It is a debt instrument issued by a corporation
or sovereign, but instead of paying interest, it returns the greater of

principal plus the price appreciation on the S&P 500 over the life of the instrument, or
principal.
Other examples of hybrids are preferred stock, trust preferred securities (TruPS) or equity default swaps
(EDS).

Some people extend the definition of hybrid instrument to encompass instruments that straddle other
market sectors. According to this definition, a quanto option or a volatility future would be considered a
hybrid.

You may hear people speaking of "hybrid securities," "hybrid products" or simply "hybrids." All are
synonyms for "hybrid instruments."

A 

A A6  (also called an  6 ) is a type of bond used in some CMOs. It is often the last bond to
mature. It pays no interest while principal is being paid down on earlier bonds. Instead, interest that would
have been paid to the Z bond is instead used to more rapidly pay down principal on the earlier bonds.
Because it accrues interest rather than pay it out, the Z bond is analogous to a zero-coupon bond.

Cash flows for a CMO with three sequential pay bonds followed by a single Z bond are depicted in Exhibit
1. Note that interest payments made by mortgagors during the early years of the CMO are treated as
principal payments to the A, B and C bonds. Principal payments made by mortgagors during the later
years of the CMO are treated as payments of accrued interest to the Z bond.

ëc A 


Exhibit 1

A Z bond pays no interest while principal is being paid


down on earlier bonds.
Z bonds can be incorporated into a variety of CMO structures. Some CMOs have multiple Z bonds that
mature one after another. Multiple Z bonds do not need to be consecutive. A CMO might have an
intermediate Z bond and a long maturity Z bond with intervening sequential pay tranches. A CMO might
consist entirely of Z bonds.

6 

An 6  is a type of transaction or portfolio. Actually, the term is used in two different ways, so it
refers to either of two very different types of transactions or portfolios. People also speak of arbitrage as
an activity the activity of seeking out and implementing either of the two types of arbitrage transactions
or portfolios. An 6  is an individual or institution who engages in such arbitrage.

In finance theory, an arbitrage is a "free lunch" a transaction or portfolio that makes a profit without risk.
Suppose a futures contract trades on two different exchanges. If, at one point in time, the contract is bid
at USD 45.02 on one exchange and offered at USD 45.00 on the other, a trader could purchase the
contract at one price and sell it at the other to make a risk-free profit of a USD 0.02.

Such arbitrage opportunities reflect minor pricing discrepancies between markets or related instruments.
Per-transaction profits tend to be small, and they can be consumed entirely by transaction costs.
Accordingly, most arbitrage is performed by institutions that have very low transaction costs and can
make up for small profit margins by doing a
large volume of transactions.

Formally, theoreticians define an arbitrage as a trading strategy that requires the investment of no capital,
cannot lose money, and has a positive probability of making money.

A market is said to have  6  or be 6  Cif prices in that market offer no arbitrage
opportunities. This is a theoretical condition that is usually assumed for markets in economic and financial
models. The assumption underlies the financial engineering theory of arbitrage-free pricing.

Turning now to the second use of the term arbitrage, it is a usage that is shunned by theoretical purists.
However, it has been in wide use for several decades, so it is fairly standard. According to this usage, an
arbitrage is a leveraged speculative transaction or portfolio.

During the 1980s, junk bond financing funded an overheated mergers and acquisitions market.
Arbitragers of this period were speculators who took leveraged equity positions either in anticipation of a
possible takeover or to put a firm in play. They also engaged in greenmail. Ivan Boesky was a famous
arbitrager from this period who was ultimately convicted of insider trading.

Today, the label arbitrage is often applied to the speculative trading strategies often associated with
hedge funds. These include
statistical arbitrage,
merger arbitrage,
fixed income arbitrage, and
convertible arbitrage.

To distinguish between the two definitions of arbitrage, we might call them "true" arbitrage and
"speculative" arbitrage. They are different, but in a sense they represent, two ends of a spectrum. In
practice, true arbitrage is rare. There is always some risk perhaps due to liquidity, the timing of offsetting
transactions, or perhaps some credit exposure. If these "true" arbitrages become increasingly
complicated or sophisticated, the subtle risks multiply. From there, it is a slippery slope to "speculative"
arbitrage.

The notion of true arbitrage is profoundly important in financial engineering and theoretical finance. In
theory, a market in equilibrium will offer no arbitrage opportunities. Much of the theory of asset valuation
is based on the assumption that prices must be set in a consistent manner that affords no true arbitrage
between them. This is called arbitrage-free pricing.

In practice, people don't write about true arbitrage


or speculative arbitrage. They just write about arbitrage. It is up to the reader to infer from context what
type of arbitrage is being referred to. In a theoretical or financial engineering context, this is usually true
arbitrage. In a trading or portfolio management context, it is usually speculative arbitrage. In a risk
management context, it could be either ask.

People from fields other than finance or economics sometimes confuse the two forms of arbitrage. I once
helped a professor from an unrelated field who was writing a paper that mentioned arbitrage. He had read
about the profound importance of arbitrage in finance theory but thought this was referring to the
speculative arbitrage he had read about in books on hedge funds. Journalists are notorious for confusing
the two. A former colleague, Kin Tam, once commented to me that journalists "write about arbitrage as if
it were something unconscionable."

     3 




The      3 


(BIS) is an international organization which fosters international
monetary and financial cooperation and serves as a bank for central banks. It was originally formed by
the Hague Agreements of 20 January, 1930, with the purpose of facilitating Germany s payment of
reparations following World War I.
Today, the BIS is a focal point for research and cooperation in international banking regulation. It
sponsors the Basel Committee.


   

bankers acceptance (BA) is a money market instrument a short-term discount instrument that usually
arises in the course of international trade. Before we explain BAs, let's introduce some more basic
concepts.

A  is a legally binding order by one party (the ) to a second party (the ) to make
payment to a third party (the ). A simple example is a bank check which is simply an order
directing a bank to pay a third party. The three parties don't have to be distinct. For example, someone
might write himself a check as a simple means of transferring funds from one bank account to another. In
this case, the drawer and payee are the same person. When a draft guarantees payment for goods in
international trade, it is called a 6  .

A draft can require immediate payment by the second party to the third upon presentation of the draft.
This is called a
  . Checks are sight drafts. In trade, drafts often are for deferred payment. An
importer might write a draft promising payment to an exporter for delivery of goods with payment to occur
60 days after the goods are delivered. Such drafts are called 
. They are said to mature on the
payment date. In this example, the importer is both the drawer and the drawee.

In cases where the drawer and drawee of a time draft are distinct parties, the payee may submit the draft
to the drawee for confirmation that the draft is a legitimate order and that the drawee will make payment
on the specified date. Such confirmation is called     the drawee accepts the order to pay as
legitimate. The drawee stamps ACCEPTED on the draft and is thereafter obligated to make the specified
payment when it is due. If the drawee is a bank, the acceptance is called a 6
    (BA).

A bankers acceptance is an obligation of the accepting bank. Depending on the bank's reputation, a
payee may be able to sell the bankers acceptance that is, sell the time draft accepted by the bank. It will
sell for the discounted value of the future payment. In this manner, the bankers acceptance becomes a
discount instrument traded in the money market. Paying discounted value for a time draft is called

   .

In international trade, bankers acceptances arise in various ways. Consider two examples:

An importer plans to purchase goods from an exporter. The exporter will not grant credit, so the
importer turns to its bank. They execute an acceptance agreement, under which the bank will accept
drafts from the importer. In this manner, the bank extends credit to the importer, who agrees to pay the
bank the face value of all drafts prior to their maturity. The importer draws a time draft, listing itself as the
payee. The bank accepts the draft and discounts it paying the importer the discounted value of the draft.
The importer uses the proceeds to pay the exporter. The bank can then hold the bankers acceptance in
its own portfolio or it can sell it at discounted value in the money market.

In an alternative arrangement, the exporter may agree to accept a letter of credit from the importer's
bank. This specifies that the bank will accept time drafts from the exporter if the exporter presents
suitable documentation that the goods were delivered. Under this arrangement, the exporter is the drawer
and payee of the draft. Typically, the bank will not work directly with the exporter but with the exporter's
correspondent bank. The exporter may realize proceeds from the bankers acceptance in several ways.
The bank may discount it for the exporter; the exporter may hold the acceptance to maturity; or it may sell
the acceptance to another party.

Bankers acceptances date back to the 12th century when early forms of the instruments were used to
finance trade. During the 18th and 19th centuries, there was an active market for sterling bankers
acceptances in London. When the United States Federal Reserve (Fed) was formed in 1913, one of its
purposes was to promote a domestic bankers acceptance market to rival London's. This would boost US
trade and enhance the competitive position of US banks. National banks were authorized to accept time
drafts, and the Fed was authorized to purchase certain 6 bankers acceptances. Rules for eligibility
are complex. Generally, they require that a bankers acceptance finance a self-liquidating transaction with
a maturity under six months. Today, the Fed no longer buys bankers acceptances. The practical
significance of eligibility is that there are no reserve requirements if a bank sells an eligible acceptance.
Banks sometimes create ineligible acceptances, but they incur reserve requirements if sold.

Bankers acceptances are quoted in discount form. Maturities are generally between one and six months,
and they trade as bearer instruments. Their credit quality is excellent. Not only are they a primary
obligation of the accepting bank, but they are usually also a contingent obligation of the drawer.

Bankers acceptances trade at a spread over T-bills. The rates at which they trade are called 6

    
(or  
). The Fed publishes BA rates in its weekly H.15 bulletin. Those rates are
a standard index used as an underlier in various interest rate swaps and other derivatives.

    




In fixed income markets, professionals speak of a bond's clean price or dirty price. These are two quoting
conventions that differ in whether or not they include accrued interest in a bond's quoted price.
Exhibit 1 indicates the evolution of the market value of a 3% nominal yield 20-year bond during its first
four years.

ë &'£ Î *  


Exhibit 1

Evolution of the market value of a 3% 20-year bond in the


first four years following issuance.
In the evolution of the market value, we see
two overlapping processes. One is a shark-
tooth pattern that rises and suddenly drops
every six months. This reflects the bond accruing interest and then paying it out in a coupon every six
months. Each coupon is for USD 1.50, and that is the magnitude of each drop in market value. Integrated
with this pattern is a gradual decline in market value over the first two years, followed by a gradual rise.
This reflects, perhaps, evolution in interest rates and/or the credit quality of the issuer.

These two processes can be disaggregated. Consider Exhibit 2. It shows two graphs. The first reflects the
bond's market value with the shark tooth pattern subtracted out. This is called the bond's  .
The shark tooth pattern is shown in the second graph. It is the bond's   
.

£
  7
£ Î  

Î    
$
Exhibit 2
A bond's market value (dirty price) can be disaggregated
into a clean price and accrued interest.

If we add the two graphs of Exhibit 2 together, we get the graph of Exhibit 1. We called the quantity
depicted in Exhibit 1 the bond's market value, but another name for it is the bond's   .
Mathematically:

dirty price = clean price + accrued interest [1]

Traders tend to think of bonds in terms of their clean prices, and that is how they quote bond prices. This
is because clean prices are more stable over time than dirty prices. When clean prices do change, it is for
some economic reason, such as changes in interest rates or changes in the issuer's credit quality. Clean
prices aren't cluttered by the semiannual rise and fall of interest accruing and being paid, as are dirty
prices.

Of course, when a bond is bought or sold in the secondary market, it is the dirty price that is paid. That is
the bond's market value so bonds are quoted as clean prices but transact at dirty prices. For this reason,
the dirty price is sometimes called the    .
Because bonds are quoted as clean prices, dirty prices must be calculated by ascribing a value to
accrued interest and adding it to the clean price. Conceptually, we should add the market value of
accrued interest to the clean price. In most bond markets, coupons don't trade independently, so they
have no observable market values. Accordingly, there are conventions for ascribing value to accrued
interest. Generally, these treat coupons as accruing at simple interest:

[2]

To apply formula [2] correctly, you need to be


aware of some or all of the following dates:

The    is the date on which the coupon will be paid.

The last coupon date is the date on which the previous coupon was paid.

The settlement date is the date on which the traded bond actually exchanges hands and is paid for.

The ex-coupon date (sometimes inappropriately called the ex-dividend date) is the date by which the
trade must occur if the buyer is to receive the upcoming coupon.

To calculate the numerator of [2], you calculate the number of days between the last coupon date and the
settlement date. The manner in which you do so depends on the applicable convention. With an
actual/actual convention, which applies with US Treasury bonds, you simply count the days. With a
30/360 convention, which applies with US corporate bonds, you count the days as if all months had 30
days.

Calculation of the denominator also depends on the applicable convention. With an actual/actual day
count, you count the days between the past and upcoming coupon dates. If a 30/360 basis is used and
coupons are paid semiannually the denominator is simply set equal to 180.

If a bond trades on or after the ex-coupon date, the seller keeps the coupon. However, the buyer will own
the bond during a small fraction of the coupon period. The seller must pay him the interest that accrues
during that brief period. This is sometimes called negative accrued interest, because the interest is
subtracted from the bond price. Formula [2] is not used. The bond's dirty price is set equal to its clean
price minus the quantity

[3]
If you look very closely at the second graph in
Exhibit 2, you will see the effect of negative accrued interest. On each ex-coupon date, the accrued
interest drops to a very slightly negative value before gradually rising again.

Of course, if a bond trade settles exactly on the coupon date, you don't use either formula [2] or [3]. There
is zero accrued interest, and the dirty price equals the clean price.

Clean prices may not be quoted if there is uncertainty as to whether coupons will be paid on schedule. If
a bond is in default, an all inclusive invoice price is quoted, which can be presumed to reflect the market's
assessment of the likelihood that future coupons will actually be paid as scheduled. Such bonds are said
to trade  . Income bonds trade flat. Because they pay no coupons, so do zero-coupon bonds.

 2 
 


Bonds can be issued in three forms, which differ in how they evidence ownership.

6 
are issued as an engraved certificate. The issuer maintains no records of who owns the
bonds. Ownership is transferred by transferring the certificate. Whoever can produce the certificate is
presumed to own the bond. Part of the certificate is a series of coupons, each corresponding to a
scheduled interest payment on the bond. When an interest payment is due, the owner of the bond
physically clips that coupon from the certificate and present it for payment. It is because of these coupons
that a bond's interest payments are called coupons.

The issuer of a bearer bond specifies a     for each coupon. Whether coupons are
physically clipped on that specific date is not so important, but bonds trading for settlement by the coupon
clipping date trade with the coupon. Those trading for settlement after the coupon clipping date trade
without it. Accordingly, the coupon clipping date plays the role of an ex-coupon date.

Bearer bonds pose the risk that certificates might be lost or stolen. They also have a reputation for being
attractive to criminals, who have used them to launder money or otherwise transfer large sums without
leaving a paper trail. For these reasons, bearer bonds are no longer issued in the United States, and they
are becoming less common around the world. Eurobonds are issued in bearer form.

 - 
Exhibit 1
4.25% bearer bond of 1981. The bond's
term was fifty years, and coupons were semiannual. This
specimen has 22 coupons still attached.


6 
are also issued as engraved certificates, but the issuer maintains a record of who
owns each bond. The owner's name and address are printed on the certificate. To transfer ownership, the
current owner endorses (signs) the certificate and presents it to the issuer's transfer agent. The transfer
agent cancels the certificate and issues a new certificate to the new owner. In this way, the issuer always
knows who owns bonds and can credit interest payments without a need for physical coupons. A
drawback of registered bonds is the length of time it takes for the transfer agent to issue a new certificate.
A trade can't settle until the process is complete.

 -
 
Exhibit 2
5% registered bond of
1938. The bond's term was thirty years. This specimen has
been cancelled by the transfer agent by punching holes
along the bottom.

With 6  , ownership of bonds is recorded electronically by a central depository. If a bond is
transferred, the depository changes its records and provides a receipt for the transaction. Generally,
brokers or dealers are listed as owners in place of their clients who are the beneficial owners. The broker
or dealer maintains its own records of beneficial ownership. If it crosses a trade between two of its own
clients, or if it is a counterparty to a client trade, the broker or dealer doesn't even have to inform the
depository of the transaction. Certificates are held by the depository. There is no real need for the
certificates, but a single certificate may be held for an entire bond issuance. Due to its speed and
efficiency, book entry is increasingly becoming the norm for bonds.

6 

A 66  (or 66 ) is a bond whose indenture includes one or more call provisions
providing for the early retirement ("call" or "redemption") of the bond. Call provisions may provide for
optional redemption, extraordinary redemption or sinking fund redemption. When included in a bond's
indenture, extraordinary and sinking fund redemption are "boiler plate" provisions that usually afford the
issuer little opportunity to benefit at investors' expense. Form an investment standpoint, it is optional
redemption that is interesting or a cause for concern. This article focuses exclusively on callable bonds
with optional redemption provisions.
Such callable bonds are especially popular in the United States, where corporate bonds and municipal
bonds are often callable. US Treasuries generally are not callable. Most callable bonds are coupon
bonds. Convertible bonds are often callable. Zero-coupon bonds sometimes are.

A call provision need not be exercised to the bond holder's economic detriment. For example, an issuer
might exercise a call provision to retire a secured bond whose indenture places unwanted restrictions on
the sale of collateral. This might be inconvenient for investors, but it would do them little economic harm.
Such redemptions are rare. Generally, a bond is called when it is economically beneficial for the issuer to
do so and economically detrimental to bond holders. The typical scenario is that interest rates fall, so the
issuer calls the bonds and issue new bonds at the lower interest rates. Such a transaction is called a
 . It benefits the issuer, but investors are forced to surrender their high-coupon bonds and
reinvest in the lower interest rate environment.

In the secondary market, callable bonds don't exhibit the same price sensitivities as non-callable bonds. If
interest rates drop, a non-callable bond's market price will rise. This tendency is muted in a callable bond,
since falling interest rates make it likely that the bond will be called. Once the first call date has passed,
the bond's clean price won't generally rise above the call price. As is apparent in Exhibit 1, callable bonds
tend to have a shorter duration and lower convexity than do comparable non-callable bonds.

Î 3
    6 
Exhibit 1

The price behavior of a callable bond is compared with that of


a similar non-callable bond. As interest rates drop, their prices
diverge, reflecting the fact that the callable bond is likely to be
called.

A callable bond can be thought of a non-callable bond bundled with a short call option on that non-
callable bond:
callable bond = non-callable bond call
[1]
option

The bond holder is short the call option, and the issuer is long the call option. The option has economic
value, so the issuer compensates investors with a higher nominal yield than would be payable on a
comparable non-callable bond. That higher yield is like an option premium the issuer pays the bond
holder for the call option.

The bundled short call option makes callable bonds very difficult to analyze. The yield on a non-callable
bond depends upon interest rates and the issuer's credit quality. The yield on a callable bond depends
upon both of these and the value of the embedded call option. This makes yields on callable and non-
callable bonds not directly comparable. Also, yields on two callable bonds cannot be directly compared
either, since their call features may differ in terms of call protection, call schedules and the degree to
which the call options are in-the-money or out-of-the-money. Further complicating matters, the value of
the call option depends on the volatility of interest rates, which can change unpredictably.

There is also the question of what metric of yield to consider when comparing bonds. Nominal yield and
current yield are problematic with any bond. While yield to maturity is useful for comparing non-callable
bonds, it is somewhat meaningless for callable bonds which may be called long before they mature.
Yield metrics designed specifically for callable bonds such as yield to first call or yield to worst offer an
indicating of value that is crude at best.

Sophisticated analysis of callable bonds requires the use of financial engineering techniques that
simultaneously value the credit risk, interest rate risk and optionality of a callable bond. Few investors
have the resources to perform such analyses, although bond dealers generally do.

     £
 '£*

A      
 (CD) is a money market instrument issued by a depository institution as
evidence of a time deposit. Small denomination certificates of deposit are issued to retail investors. In the
United States, these usually are covered by deposit insurance. This article focuses on large-denomination
certificates of deposit, which are issued to institutional investors for denominations generally exceeding
USD 1.0MM.
A certificate of deposit has a fixed term. At the end of the term, the deposit is returned with interest. The
vast majority of certificates of deposit have terms of under a year, with three months being typical.
Certificates of deposit with terms of a year or more are called £
. Terms of five years are not
unheard of.

Most certificates of deposit credit a fixed rate of interest, but there are also floating-rate certificates of
deposit. A fee must be paid to withdraw funds early. Because most certificates of deposit are negotiable,
investors usually sell an unwanted certificate of deposit rather than pay a fee and withdraw the funds. To
facilitate transferability, most certificates of deposit are issued in bearer form, but some are registered.

Certificates of deposit fall into three general categories:

£ 
 £
are issued within a country by a domestic bank or other depository institution.

 £
are issued within a country by a domestic branch of a foreign depository institution. For
example, a x£ is a CD issued in the United States by a foreign bank.

 £
are issued outside a country
but are denominated in that country's
currency.

Domestic and foreign CDs are subject to the regulations of the country in which they are issued. Euro
CDs are not. For this reason, Euro CDs have historically offered slightly higher yields.

Yields for terms less than a year are quoted as simple interest rates. An actual/360 basis is used almost
everywhere, but certificates of deposit denominated in British pounds are usually quoted on an actual/365
basis. Yields depend primarily on a certificate of deposit's term, the level of interest rates for the currency
it is denominated in, and the credit quality of the issuer.

Depository institutions try to sell their certificates of deposit directly to investors. If their funding needs
exceed their ability to directly market the certificates of deposit, they may also sell them to dealers, who
then resell them. Dealers provide a secondary market in certificates of deposit. Brokers also arrange
transactions. To preserve anonymity, inter-dealer transactions are often brokered.

  ;ë  c6  

A  ;   6   (CMO) is a type of mortgage-backed security (MBS). Unlike a
mortgage pass-through, in which all investors participate proportionately in the net cash flows from the
mortgage collateral, with a CMO, different bond classes are issued, which participate in different
components, called tranches, of the net cash flows. A CMO is any one of those bonds. The tranches are
structured to each have their own risk characteristics and maturity range. In this way, investors can select
a bond offering the characteristics which most closely meet their needs. Collateral for the securitization
may represent a pool of mortgages, but it is often a mortgage pass-through.

Many arrangements are possible. One of the simplest is a


  structure comprising three or
four tranches that mature sequentially. All tranches participate in interest payments from the mortgage
collateral, but initially, only the first tranch receives principal payments. It receives all principal payments
until it is retired. Next, all principal payments are paid to the second tranch until it is retired, and so on.
This process is illustrated for a three-tranch sequential pay structure in Exhibit 1:

 -i3 Î 

Exhibit 1

The segregation of cash flows into three sequential pay


tranches is illustrated. All three participate in interest
payments, but principal payments flow exclusively to the A
bonds until they are retired. After that, all principal
payments flow to the B bonds until they are retired.
Finally, all principal payments flow to the C bonds until
they are retired.
CMOs entail the same prepayment risk as mortgage pass-throughs. The riskiness of a specific bond
depends upon how that tranch is structured and on the underlying collateral. Many different structures are
used in practice, including stable PAC bonds or risky IOs and POs. There are floaters and inverse
floaters. There are also Z-bonds, which are analogous to zero-coupon bonds.

Like mortgage pass-throughs, CMOs typically have minimal credit risk. Either they have a high quality
mortgage pass-through or similar MBS as collateral, or the collateral is bundled with suitable credit
enhancement.

CMOs are issued by various organizations, including Fannie Mae, Freddie Mac, investment banks,
mortgage originators, insurance companies, etc.

  Î

   (CP) is unsecured short-term promissory notes issued primarily by corporations,
although there are also municipal and sovereign issuers. It represents the largest segment of the money
market. The vast majority is issued as discount instruments in bearer form. In the United States, terms
rarely exceed 270 days, since this exempts the paper from registration under the 1933 Act. Terms may
be as long as a year outside the United States, but most commercial paper is issued for terms of about a
month. Yields are quoted on a discount basis. Virtually all countries use an actual/360 basis, but the
United Kingdom uses an actual/365 basis.

The market first developed in the United States during the nineteenth century. America's industrial
revolution was starting, and the fractured, localized banking industry was ill-equipped to meet the liquidity
needs of emerging industrial corporations. If a textile mill was unable to secure loans from local banks, it
might raise the funds by issuing promissory notes in New York, Boston or Philadelphia. Very likely, the
purchaser would be a bank in one of those financial centers, so commercial paper was a vehicle for
raising short-term funds out-of-state in the
absence of cross-state banking.

In the twentieth century, consumer finance


companies turned to commercial paper to finance their lending to purchasers of automobiles, appliances
and other consumer products. General Motors Acceptance Corporation (GMAC) was a pioneer in such
issuances. Today, finance companies issue a significant proportion of commercial paper. They also
introduced 

 26    (ABC paper), which is securitized with loans or other
receivables held in a special purpose vehicle.

It wasn't until the 1980s that commercial paper was first issued outside the United States, reflecting a
global trend towards disintermediation of banks.

Unlike bonds or other forms of long-term indebtedness, a commercial paper issuance is not all brought to
market at once. Instead, an issuer will maintain an ongoing commercial paper program. It advertises the
rates at which it is willing to issue paper for various terms, so buyers can purchase the paper whenever
they have funds to invest. Programs may be promoted by dealers, in which case the paper is called
. Larger issuers, especially finance companies, have the market presence to issue their
paper directly to investors. Their paper is called  .

There is an inactive secondary market for


commercial paper, but dealers will make a
market in paper they issue. Direct issuers will generally honor requests to repay commercial paper early.
Some do so at principal plus accrued interest, although this might invite abuse. Others credit interest
based on the rate the investor would have received if he had purchased the paper with a term equal to his
actual holding period.

Commercial paper entails credit risk, and programs are rated by the major rating agencies. Because
commercial paper is a rolling form of debt, with new issues generally funding the retirement of old issues,
the main risk is that the issuer will not be able to issue new commercial paper. This is called   
.
Many issuers obtain credit enhancements for their programs. These may include a line of credit or other
alternative source of financing. Exhibit 1 summarizes the credit ratings assigned to commercial paper by
Moody's, Standard & Poor's and Fitch.

  Î  



Exhibit 1

Moody's S&P Fitch

A1+ or F1+ or
superior P1
A1 F1
satisfactory P2 A2 F2
adequate P3 A3 F3
speculative NP B or C F4
defaulted NP D F5

Credit ratings applied to commercial paper by the major


rating agencies.

In the United States, commercial paper offers yields above T-bills. This is due both to their credit risk and
the fact that interest from T-bills is not taxed at the state and local level.

Every business day, the Federal Reserve reports the previous day's average rates on commercial paper
for several maturities and types of issuers. These Î 
are a standard index used as an underlier in
various interest rate swaps and other derivatives.
   
3  '3*

Settlement risk has historically been a problem in foreign exchange markets because each currency must
be delivered in its home country. Due to time zone differences, several hours might elapse between a
payment being made in one currency and the offsetting payment being made in another currency.

   
3  (CLS) is a settlement system for foreign exchange trades that eliminates
this problem. The system is run by the 3    , which is a special purpose bank
dedicated to settling foreign exchange trades. The bank and associated companies are owned by (as of
2006) seventy-one of the world's largest financial institutions, each of which owns an equal share in an
overall holding company.

All transactions settle through the CLS Bank during a single 5-hour window each business day. The CLS
Bank is based in New York but maintains accounts in the various countries whose currencies it settles
trades for. To settle a foreign exchange trade through the system, a firm delivers the currency it owes to
the CLS Bank. That payment is not released to the counterparty unless that counterparty deposits the
offsetting payment for the transaction. Payments are netted, so each participant in the system only has to
make one net payment per currency each day.

Direct participation is limited to the financial institutions that are shareholders of the system. They are
called Settlement Members. User Members are institutions that are sponsored by Settlement Members.
They can submit settlement instructions for themselves and their clients, but their transactions flow
through the accounts of their sponsoring Settlement Members. Other parties may not submit settlement
instructions directly to the CLS Bank, but they may indirectly utilize the system as a client of a Settlement
Member or User Member.

   

   encompasses a variety of provisions that may be used to reduce the credit risk of
an obligation. Credit enhancements are often incorporated into OTC derivatives, corporate debt,
securitized debt and other instruments. Techniques of credit enhancement include:

collateralization: One or more parties may agree to post collateral. Collateral levels may be fixed or
vary over time to reflect the market value of different parties' obligations.

third party   


: A parent company or other third party may be contractually bound to
meet the obligations of one party should that party default.

 
 : An insurance policy may provide for compensation in the event that a party
defaults.
letters of credit: A bank may confirm financing.

special purpose vehicle: One party may enter into the deal through its own over-capitalized,
bankruptcy remote subsidiary.

Other techniques may sometimes also be referred to as credit enhancement. These include netting
agreements, credit downgrade triggers, and bundling with credit derivatives.

 


 
 is risk due to uncertainty in a counterparty's (also called an 6 7
or  7
) ability to
meet its obligations. Because there are many types of counterparties²from individuals to sovereign
governments²and many different types of obligations²from auto loans to derivatives transactions²
credit risk takes many forms. Institutions manage it in different ways.

In assessing credit risk from a single counterparty, an institution must consider three issues:

   66 - What is the likelihood that the counterparty will default on its obligation either
over the life of the obligation or over some specified horizon, such as a year? Calculated for a one-year
horizon, this may be called the       .

  
- In the event of a default, how large will the outstanding obligation be when the
default occurs?

  - In the event of a default, what fraction of the exposure may be recovered through
bankruptcy proceedings or some other form of settlement?

When we speak of the    of an obligation, this refers generally to the counterparty's ability to
perform on that obligation. This encompasses both the obligation's default probability and anticipated
recovery rate.

To place credit exposure and credit quality in perspective, recall that every risk comprise two elements:
exposure and uncertainty. For credit risk, credit exposure represents the former, and credit quality
represents the latter.

For loans to individuals or small businesses, credit quality is typically assessed through a process of
 
. Prior to extending credit, a bank or other lender will obtain information about the party
requesting a loan. In the case of a bank issuing credit cards, this might include the party's annual income,
existing debts, whether they rent or own a home, etc. A standard formula is applied to the information to
produce a number, which is called a credit score. Based upon the credit score, the lending institution will
decide whether or not to extend credit. The process is formulaic and highly standardized.
Many forms of credit risk²especially those associated with larger institutional counterparties²are
complicated, unique or are of such a nature that that it is worth assessing them in a less formulaic
manner. The term  

is used to describe any process for assessing the credit quality of a
counterparty. While the term can encompass credit scoring, it is more commonly used to refer to
processes that entail human judgment. One or more people, called  

, will review
information about the counterparty. This might include its balance sheet, income statement, recent trends
in its industry, the current economic environment, etc. They may also assess the exact nature of an
obligation. For example, senior debt generally has higher credit quality than does subordinated debt of
the same issuer. Based upon this analysis, the credit analysts assign the counterparty (or the specific
obligation) a   , which can be used for making credit decisions.

Many banks, investment managers and insurance companies hire their own credit analysts who prepare
credit ratings for internal use. Other firms²including Standard & Poor's, Moody's and Fitch²are in the
business of developing credit ratings for use by investors or other third parties. Institutions that have
publicly traded debt hire one or more of them to prepare credit ratings for their debt. Those credit ratings
are then distributed for little or no charge to investors. Some regulators also develop credit ratings. In the
United States, the National Association of Insurance Commissioners publishes credit ratings that are
used for calculating capital charges for bond portfolios held by insurance companies.

Exhibit 1 indicates the system of credit ratings employed by Standard & Poor's. Other systems are similar.

3 ?Î 7
  

Exhibit 1

 Best credit quality²Extremely reliable with regard to


financial obligations.

 Very good credit quality²Very reliable.

 More susceptible to economic conditions²still good


credit quality.

 Lowest rating in investment grade.

 Caution is necessary²Best sub-investment credit


quality.

 Vulnerable to changes in economic conditions²


Currently showing the ability to meet its financial
obligations.

 Currently vulnerable to nonpayment²Dependent on


favorable economic conditions.

 Highly vulnerable to a payment default.

 Close to or already bankrupt²payment on the


obligation currently continued.

£ Payment default on some financial obligation has


actually occurred.

This is the system of credit ratings Standard & Poor's applies to


bonds. Ratings can be modified with + or ± signs, so a AA± is a
higher rating than is an A+ rating. With such modifications, BBB±
is the lowest investment grade rating. Other credit rating systems
are similar. Source: Standard & Poor's.

The manner in which credit exposure is assessed is highly dependent on the nature of the obligation. If a
bank has loaned money to a firm, the bank might calculate its credit exposure as the outstanding balance
on the loan. Suppose instead that the bank has extended a line of credit to a firm, but none of the line has
yet been drawn down. The immediate credit exposure is zero, but this doesn't reflect the fact that the firm
has the right to draw on the line of credit. Indeed, if the firm gets into financial distress, it can be expected
to draw down on the credit line prior to any bankruptcy. A simple solution is for the bank to consider its
credit exposure to be equal to the total line of credit. However, this may overstates the credit exposure.
Another approach would be to calculate the credit exposure as being some fraction of the total line of
credit, with the fraction determined based upon an analysis of prior experience with similar credits.

Credit risk modeling is a concept that broadly encompasses any algorithm-based methods of assessing
credit risk. The term encompasses credit scoring, but it is more frequently used to describe the use of
asset value models and intensity models in several contexts. These include

supplanting traditional credit analysis;

being used by financial engineers to value credit derivatives; and

being extended as portfolio credit risk measures used to analyze the credit risk of entire portfolios of
obligations to support securitization, risk management or regulatory purposes.

Derivative instruments represent contingent obligations, so they entail credit risk. While it is possible to
measure the mark-to-market credit exposure of derivatives based upon their current market values, this
metric provides an incomplete picture. For example, many derivatives, such as forwards or swaps, have a
market value of zero when they are first entered into. Mark-to-market exposure²which is based only on
current market values²does not capture the potential for market values to increase over time. For that
purpose some probabilistic metric of potential credit exposure must be used.
There are many ways that credit risk can be managed or mitigated. The first line of defense is the use of
credit scoring or credit analysis to avoid extending credit to parties that entail excessive credit risk. Credit
risk limits are widely used. These generally specify the maximum exposure a firm is willing to take to a
counterparty. Industry limits or country limits may also be established to limit the sum credit exposure a
firm is willing to take to counterparties in a particular industry or country. Calculation of exposure under
such limits requires some form of credit risk modeling. Transactions may be structured to include
collateralization or various credit enhancements. Credit risks can be hedged with credit derivatives.
Finally, firms can hold capital against outstanding credit exposures.




A 
 is a bank or other institution that holds securities on behalf of investors. The tasks performed
by a custodian include:

safekeeping of securities
delivering or accepting traded securities
collecting principal, interest, or dividend payments on held securities

Collectively, these services are called 


.

Custodians are typically used by institutional investors who do not wish to leave securities on deposit with
their broker-dealers or investment managers. By separating duties, use of custodians reduces the risk of
fraud. The custodian independently ensures that the investor has unencumbered ownership of the
securities other agents represent to have purchased on their behalf.

If an investor holds foreign securities, their custodian will contract with custodians in foreign countries to
provide local custody services. These foreign custodians are called
6 

.

  

   is assets provided to secure an obligation. Traditionally, banks might require corporate
borrowers to commit company assets as security for loans. Today, this practice is called
 
or 

 26
. Collateral can take many forms: property, inventory, equipment, receivables, oil
reserves, etc.

A more recent development is  ;  


used to secure repo, securities lending
and derivatives transactions. Under such arrangement, a party who owes an obligation to another party
posts collateral typically consisting of cash or securities to secure the obligation. In the event that the
party defaults on the obligation, the secured party may seize the collateral. In this context, collateral is
sometimes called .
An arrangement can be unilateral with just one party posting collateral. With two-sided obligations, such
as a swap or foreign exchange forward, bilateral collateralization may be used. In that situation, both
parties may post collateral for the value of their total obligation to the other. Alternatively, the net
obligation may be collateralized at any point in time, the party who is the net obligator posts collateral for
the value of the net obligation.

In a typical collateral arrangement, the secured obligation is periodically marked-to-market, and the
collateral is adjusted to reflect changes in value. The securing party posts additional collateral when the
market value has risen, or removes collateral when it has fallen. The collateral agreement should specify:

Acceptable collateral: A secured party will usually prefer to receive highly rated collateral such as
Treasuries or agencies. Collateral whose market value is volatile or negatively correlated with the value of
the secured obligation is generally undesirable.

Frequency of margin calls: Because the value of an obligation and the value of posted collateral can
change, a secured party typically wants to mark-to-market frequently, issuing a   to the
securing party for additional collateral when needed.

Haircuts: In determining the amount of collateral that must be posted, haircuts are applied to the
market value of various types of collateral. For example, if a 1% haircut is applied to Treasuries, then
Treasuries are valued at 99% of their market value. A 5% haircut might be applied to certain corporate
bonds, etc.

Threshold level: Only the value of an obligation above a certain threshold level may be collateralized.
For example, if a USD 1MM threshold applies to a USD 5MM obligation, only USD 4MM of the obligation
will actually be collateralized.

Close-out and termination clauses: The parties must agree under what circumstances the obligation
will be terminated. The form of a final settlement in the event of such termination and the role of the
collateral in such settlement is specified.

Valuation: A methodology for marking both the obligation and the collateral to market must be agreed
upon.

Rehypothecation rights: The secured party may wish to have use of posted collateral possibly
lending it to another party or posting it as collateral for its own obligations to another party.
Rehypothecation is not permitted in many jurisdictions.

Legal treatment of collateral varies from one jurisdiction to another. In some jurisdictions, the secured
party takes legal possession of collateral, but is legally bound by how the collateral may be used and the
conditions upon which it must be returned. Such transfer of title provides the secured party a high degree
of assurance that it may seize the collateral in the event of a default. Transfer of title, however, may be
treated as a taxable event in some jurisdictions. In other jurisdictions, the securing party retains
ownership of collateral, but the secured party acquires a perfected interest in it.
§ 

Based on their credit ratings, corporate bonds are arbitrarily divided into  
 6 
and
86 
. The dividing line is the BBB rating, which is the lowest credit rating considered to be
investment grade. Below BBB , bonds are considered junk. Less common, but less disparaging names
for junk bonds are 6  
 ,
    and 2 bonds. Junk bonds
combine features of debt and equity. Legally, they are debt. In the event of bankruptcy, the bond holders
essentially become equity investors. Accordingly, the prices of junk bonds tend to be very sensitive to the
fortunes of the issuer. At lower credit ratings, prices for a firm's debt and equity can be highly correlated.

 

  is a notion whose meaning has evolved as a result of financial innovation during recent
decades. Traditionally, leverage related to the relative proportions of debt and equity funding a venture.
The higher the proportion of debt, the more leverage. A leveraged venture entailed more risk and
potential reward for equity holders.

Consider a stylized example. A corporation is established by ten investors. Each puts up USD 100 in
equity. There is no debt. After one year, the corporation will be liquidated. At that time, if its net assets are
worth USD 900, each equity investor will realize a 10% return. If assets are worth USD 1100, each
investor will realize a 10% return. This is summarized in Exhibit 1.

 -#     
Exhibit 1


 

   
 1000 1000
 
   
 100 100
 6  
 0 0
 
 6  

    7
2 2

   900 1100



  6  

0 0

    

900 1100

   
 90 110

 ;6   


 10% 10%

Without any debt financing, equity investors receive returns in


proportion to the corporation's overall performance.
Now consider the same corporation, but financed differently. The same ten investors each put up USD
100, but only five of them hold equity. The other five hold debt. Debt holders are guaranteed to receive
USD 105. At the end of the year, if the corporation's assets are worth USD 900, there will be USD 375 left
over after paying debt holders. Each equity investor will realize a 25% return. If, on the other hand, the
corporation's assets are worth 1100 at year end, there will be USD 575 left over after paying debt holders.
Each equity investor will realize a 15% return.

 -     
Exhibit 2


 

   
 500 500
 
   
 100 100
 6  
 500 500
 
 6  
 100 100
    7
2 2

   900 1100



  6  

525 525

    

375 575

   
 75 115

 ;6   


 25% 15%

With debt financing, equity investors receive returns out of proportion


to the corporation's overall performance. The returns are "leveraged."

As the examples illustrate, debt financing magnifies the risk as well as the possible reward for equity
holders. Traditionally, the word "leverage" referred to the use of debt financing. In recent decades, that
meaning has shifted to encompass any technique that similarly magnifies risk and reward for an investor.

Consider a call option. It offers a leveraged alternative to taking an outright position in an underlier. Let's
compare the risk-reward characteristics of an outright position vs. a call option position.

Suppose shares of XYZ corporation are trading at USD 100 and currently pay no dividends. An investor
pays USD1000 to buy 10 shares. She holds the position for three months. If, at the end of that period,
XYZ is trading at USD 92, the investor will realize a 8% return. If it is trading at USD 108, the return will
be 8%. See Exhibit 3.

 -#  Î


  
Exhibit 3


 

Î 
 
 100 100
,6 

 
 10 10
i  
 1000 1000
3      
92 108
i      
920 1080

  8% 8%

Direct investment in a company's stock offers returns directly


proportional to the stock's performance.

Now suppose, instead of taking an outright position in XYZ stock, the investor purchases 3-month call
options struck at the money. These are trading at USD 5, so the investor spends USD 1000 to buy 200
options. If, at the end of three months, XYZ is trading at USD 92, the options will expire worthless. The
investor's return will be 100%. If the stock is trading at USD 110, her return will be 60%. See Exhibit 4.

 -  c  



Exhibit 4


 

Î 
     5 5
,6    
 
 200 200
i  
 1000 1000
3       92 108
c        0 8
i       0 1600

  100% 60%

Call options are leverage. They magnify risk and reward compared to
a direct purchase of the underlier.
Today, similar opportunities for leverage abound. Essentially all derivatives including futures, forwards,
swaps, vanilla options and exotics provide leveraged. They offer indirect interest in an underlier for an
initial investment that is less than the value of that underlier. With some derivatives, such as forwards or
swaps, no initial investment is required. Securities lending and repurchase agreements can be used to
leverage a portfolio. In essence, they represent secured borrowing. Short selling offers
leverage proceeds of a short sale are not a loan, but they can be invested just the same. Even traditional
debt-base leverage has evolved, with junk bonds emerging in the 1970s as a legitimate asset class in
their own right.

The widespread proliferation of leverage during the latter half of the 20th century is perhaps the primary
motivation for modern financial risk management.
c 2 3  

c26 
    is any form of direct debt or equity funding of a firm. If the funding is equity,
it appears on the firm's balance sheet as owners equity. If it is debt, it appears on the balance sheet as a
liability. Any asset the firm acquires with the funding also appears on the balance sheet.

c 26 
   , by comparison, is any form of funding that avoids placing owners' equity,
liabilities or assets on a firm's balance sheet. This is generally accomplished by placing those items on
some other entity's balance sheet.

A standard approach is to form a


 
   (SPV) and place assets and liabilities on its
balance sheet. Also called a
 
   (SPE), an SPV is a firm or legal entity established to
perform some narrowly-defined or temporary purpose. The sponsoring firm accomplishes that purpose
without having to carry any of the associated assets or liabilities on its own balance sheet. The purpose is
achieved "off-balance sheet."

Under most accounting regimes, if a sponsoring firm wholly owns an SPV, the SPV's balance sheets is
consolidated into its own. Rather than have the SPV appear on its balance sheet as an asset, the
sponsoring firm has all the SPV's individual assets and liabilities appear on its balance sheet just as if
they were the sponsoring firm's assets and liabilities. This is on-balance sheet financing, which largely
defeats the purpose of the SPV. For this reason, a sponsoring firm typically takes only a partial ownership
position in the SPV. In other arrangements, it takes no ownership interest in the SPV whatsoever.

SPVs are used in a variety of transactions, including securitizations, project finance, and leasing. An SPV
can take various legal forms, including corporations, US-style trusts or partnerships.

Off-balance sheet financing is attractive from a risk management standpoint. When assets and liabilities
are moved from one balance sheet to another, the risks associated with those assets and liabilities go
with them. For example, if a firm transfers credit risky assets to an SPV, the credit risk goes with those
assets.

Off-balance sheet financing also affords considerable flexibility in financing. An SPV doesn't utilize the
sponsoring firm's credit lines or other financing channels. It is presented to financiers as a stand-alone
entity with its own risk-reward characteristics. It can issue its own debt or establish its own lines of credit.
Often, a sponsoring firm overcapitalizes an SPV or supplies it with credit enhancement. In this
circumstance, the SPV may have a higher credit rating than the sponsoring firm, and it will achieve a
lower cost of funding. A BBB-rated firm can achieve AAA-rated financing costs if it arranges that financing
through a sufficiently capitalized SPV.
Off-balance sheet financing is often employed as a means of asset-liability management. Obviously, if
assets and liabilities are never placed on the balance sheet, they don't have to be matched! They do need
to be matched on the SPV's balance sheet, but the SPV can be structured in a way that facilitates this. A


2   is a security issued by a special purpose vehicle. The SPV holds assets and pays the
pass-through's investors whatever net cash flows those assets generate. In this way, the SPV's assets
and liabilities are automatically cash matched, so there is no asset-liability risk. Many securitizations are
structured as pass-throughs. See, for example, the discussion of mortgage pass-throughs.

Off-balance sheet financing has other applications. SPVs can be used in tax avoidance. Banks use off-
balance sheet financing to achieve reductions in their regulatory capital requirements. This is a
compelling reason for many securitizations. It is also the purpose of trust preferred securities.

While SPVs and off-balance sheet financing have many legitimate purposes, they can also be used to
misrepresent a firm's financial condition. Prior to its bankruptcy, Enron created numerous SPVs and used
them to hide billions of dollars in debt. That abuse, as well as other scandals during 2001-2002, prompted
a reexamination of SPVs. Laws, regulations and accounting rules were tightened as a result.

Î
 3  
3  

Certain derivative instruments, such as forwards and options, provide for the purchase or sale of some
underlier. In many cases, parties to such derivatives don't want to physically deliver or receive the
underlier. Instead, they enter into the derivative contract for purely financial reasons.

For example, an airline might enter into an OTC option contract to hedge its cost of jet fuel. It has
established dealers from whom it purchases fuel, so it doesn't want to take actual delivery of fuel under
the option contract. Instead, it negotiates for the option to be cash settled should it exercise the option,
the counterparty will not delver fuel in exchange for payment. It will instead pay the airline the option's
intrinsic value. In this manner, the airline is protected against rising fuel prices but can purchase its fuel
through its usual dealers.

A derivative instrument is 


 
  if the underlier is to be 
   in exchange
for a specified payment. With 

  , the underlier is not physically delivered. Instead, the
derivative settles for an amount of money equal to what the derivative's market value would be at
maturity/expiration if it were a physically settled derivative. In the case of a forward, this equals the
notional amount multiplied by the difference between the market price of the underlier at maturity and the
forward's delivery price. In the case of an option, it is the intrinsic value.

Certain types of derivatives are routinely cash settled because physical delivery would be inconvenient or
impossible. For example, an option on a basket of stocks, such as the S&P 500, will generally be cash
settled because it would be inconvenient and entail considerable transaction costs to deliver all five
hundred stocks that comprise that index. An interest rate cap has has to be cash settled because the
underlier is an interest rate, which cannot be physically delivered.

In commodity and energy markets, people informally distinguish between the 
  and 
 . The physical market encompasses all transactions in which there is physical delivery cash, spot
and physically-settled forward transactions. Paper markets encompass all derivatives transactions that
have cash settlement.

A 2   

In the fixed income markets, there are a variety of instruments that defer the payment of interest. This
article focuses on instruments that have terms greater than a year. See the article     
for the shorter-term forms.

Generally, the instruments are called  2 


6 
(DIBs). They fall into three categories.

 2  6 
are issued at some par value and have a stated nominal yield. Rather than
pay coupons, they accrue them until maturity.

A 2  6 
have a par value that is their maturity value. They are issued at a discount from
that par value. These are also called ;
or 


 (OID) bonds.

£ 2  6 
(or
 2  6 
) pay no coupons for their first few years but then
pay a higher coupon than they otherwise would for the remainder of their term. Usually, they are issued
below par. If the issuer's credit quality doesn't deteriorate and interest rates don't rise, they trade above
par by the time they start paying coupons. They mature for their par value plus the final coupon.

The instruments generally have terms of ten years or more. If they are issued with shorter terms, they
may be called notes instead of bonds. All three structures are illustrated in Exhibit 1.


 
  2  A 2  
£ 2   

Exhibit 1
Cash flows of an accrued-coupon, zero-coupon and deferred-
coupon bond are compared. A par value of USD 100 is
assumed for all three bonds.
While accrued-coupon and zero-coupon
bonds only pay interest at maturity, for accounting and tax purposes, interest is generally recognized as
income when it accrues. Treatment of deferred-coupon bonds depends upon the specific structure and
jurisdiction.
Paradoxically, you will hear of accrued-coupon and zero-coupon bonds being described as either safe,
conservative investments or risky, speculative investments. It all depends on how you intend to use and
account for them. For a buy-and-hold investor who accounts for them at book value, the bonds can be a
safe investment, so long as the issuer is of good credit quality. They guarantee a specific yield until
maturity. Because they don't pay coupons, they pose no reinvestment risk. On the other hand, for
investors who may sell the bonds prior to maturity or account for them at market value, they can be quite
risky. Their duration equals their time to maturity. Many of these bonds have terms of 20 or 30 years. With
durations like that, their market values can be as volatile as those of common stocks. Examples of these
types of bonds are municipal accrued-coupon bonds and Treasury zero-coupon bonds.

Deferred-coupon bonds usually have considerable credit risk. This is because they tend to be issued by
corporations that lack the cash flow to meet near-term coupon payments. Usually, they are junk bonds.
Two variants of deferred-coupon bonds are


26 
, which pay a low coupon for the first few years and a higher coupon after that, and

 22 (PIK) bonds, which are like regular coupon bonds but give the issuer the option of
paying coupons in cash or in more bonds.

Securitizations are often structured with tranches that defer interest. In the context of collateralized
mortgage obligations, these are called Z bonds.