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Path: senator-bedfellow.mit.edu!dreaderd!not-for-mail Message-ID: <investment-faq/general/part4_1082200966@rtfm.mit.edu> Supersedes: <investment-faq/general/part4_1079601013@rtfm.mit.edu> Expires: 31 May 2004 11:22:46 GMT References: <investment-faq/general/part1_1082200966@rtfm.mit.edu> X-Last-Updated: 2003/03/17 From: noreply@invest-faq.com (Christopher Lott) Newsgroups: misc.invest.misc,misc.invest.stocks,misc.invest.technical,misc.invest.options,misc.answers,news.answers Subject: The Investment FAQ (part 4 of 20) Followup-To: misc.invest.misc Summary: Answers to frequently asked questions about investments. Should be read by anyone who wishes to post to misc.invest.* Organization: The Investment FAQ publicity department Keywords: invest, finance, stock, bond, fund, broker, exchange, money, FAQ URL: http://invest-faq.com/ Approved: news-answers-request@MIT.Edu Originator: faqserv@penguin-lust.MIT.EDU Date: 17 Apr 2004 11:28:31 GMT Lines: 1219 NNTP-Posting-Host: penguin-lust.mit.edu X-Trace: 1082201311 senator-bedfellow.mit.edu 569 18.181.0.29 Xref: senator-bedfellow.mit.edu misc.invest.misc:42148 misc.invest.stocks:840667 misc.invest.technical:101756 misc.invest.options:54791 misc.answers:17215 news.answers:269997 Archive-name: investment-faq/general/part4 Version: $Id: part04,v 1.61 2003/03/17 02:44:30 lott Exp lott $ Compiler: Christopher Lott The Investment FAQ is a collection of frequently asked questions and answers about investments and personal finance. This is a plain-text version of The Investment FAQ, part 4 of 20. The web site always has the latest version, including in-line links. Please browse http://invest-faq.com/ Terms of Use The following terms and conditions apply to the plain-text version of The Investment FAQ that is posted regularly to various newsgroups. Different terms and conditions apply to documents on The Investment FAQ web site. The Investment FAQ is copyright 2003 by Christopher Lott, and is protected by copyright as a collective work and/or compilation, pursuant to U.S. copyright laws, international conventions, and other copyright laws. The contents of The Investment FAQ are intended for personal use, not for sale or other commercial redistribution. The plain-text version of The Investment FAQ may be copied, stored, made available on web sites, or distributed on electronic media provided the following conditions are met: + The URL of The Investment FAQ home page is displayed prominently. + No fees or compensation are charged for this information, excluding charges for the media used to distribute it. + No advertisements appear on the same web page as this material. + Proper attribution is given to the authors of individual articles. + This copyright notice is included intact. Disclaimers Neither the compiler of nor contributors to The Investment FAQ make any express or implied warranties (including, without limitation, any warranty of merchantability or fitness for a particular purpose or use) regarding the information supplied. The Investment FAQ is provided to the user "as is". Neither the compiler nor contributors warrant that The Investment FAQ will be error free. Neither the compiler nor contributors will be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause, in The Investment FAQ or for any damages (whether direct or indirect, consequential, punitive or exemplary) resulting therefrom. Rules, regulations, laws, conditions, rates, and such information discussed in this FAQ all change quite rapidly. Information given here was current at the time of writing but is almost guaranteed to be out of date by the time you read it. Mention of a product does not constitute an endorsement. Answers to questions sometimes rely on information given in other answers. Readers outside the USA can reach US-800 telephone numbers, for a charge, using a service such as MCI's Call USA. All prices are listed in US dollars unless otherwise specified. Please send comments and new submissions to the compiler. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - Municipal Bond Terminology Last-Revised: 7 Nov 1995 Contributed-By: Bill Rini (bill at moneypages.com) These definitions of municipal bond terminology are at best simplifications. They should only be used as a stepping stone, leading to further education about municipal bonds. Act of 1911 and 1915 Used for developments within a particular district and are secured by special assessment taxes set at a fixed dollar amount for the life of the bond. 1911 Act Bonds are secured by individual parcels, while 1915 Act Bonds are secured by all properties within the district. Ad Valorem Tax A tax based on the value of the property Advance Refunding The replacement of debt prior to the original call date via the issuance of refunding bonds. Authority (Lease Revenue) A bond secured by the lease between the authority and another agency. The lease payments from the "city" to the agency are equal to the debt service. Callable Bond A bond that can be redeemed by the issuer prior to its maturity. Usually a premium is paid to the bond owner when the bond is called. Certificate of Participation (COP) Financing whereby an investor purchases a share of the lease revenues of a program rather than the bond being secured by those revenues. Usually issued by authorities through which capital is raised and lease payments are made. The authority usually uses the proceeds to construct a facility that is leased to the municipality, releasing the municipality from restrictions on the amount of debt that they can incur. Crossover Refunded The revenue stream originally pledged to secure the securities being refunded continues to be used to pay debt service on the refunded securities until they mature or are called. At that time, the pledged revenues pay debt service on the refunding securities. Discount Bond A bond that is valued at less than its face amount. Double Barrelled Bonds secured by the pledge of two or more sources of repayment. Face Value The stated principal amount of a bond. General Obligations Voter approved bonds that are backed by the full faith, credit and unlimited taxing power of the issuer. Mello Roo's Bonds used for developments that benefit a particular district (schools, prisons, etc.) and are secured by special taxes based on the assessed value of the properties within the district. Tax assessment is included on the county tax bill. Par Value The face value of a bond, generally $1,000. Premium Bond A bond that is valued at more than its face amount. Principal The amount owed; the face value of a debt. Redevelopment Agency (Tax Allocation) Bonds secured by all of the property taxes on the increase in assessed valuation above the base, on properties in the project. Revenue Bonds Bonds secured by the revenues derived from a particular service provided by the issuer. Sinking Fund A bond with special funds set aside to retire the term bonds of a revenue issue each year according to a set schedule. Usually takes effect 15 years from date of issuance. Bonds are retired through either calls, open market purchases, or tenders. Taxable Equivalent Yield The taxable equivalent yield is equal to the tax free yield divided by the sum of 100 minus the current tax bracket. For example the taxable equivalent yield of a 6.50% tax free bond for someone in the 32% tax bracket would be: 6.5/(100-32) = 0.0955882 or 9.56% YieldA measure of the income generated by a bond. The amount of interest paid on a bond divided by the price. Yield to Maturity The rate of return anticipated on a bond if it is held until the maturity date. This article is copyright 1995 by Bill Rini. For more insights from Bill Rini, visit The Syndicate: http://www.moneypages.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - Relationship of Price and Interest Rate Last-Revised: 28 Oct 1997 Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us), Chris Lott ( contact me ) The basic relationship between the price of a bond and prevailing market interest rates is an inverse relationship. This is actually pretty straightforward. For example, if you have a 6% bond (this means that it pays $60 annually per $1000 of face value) and interest rates jump to 8%, wouldn't you agree that your bond should be worth less now if you were to sell it? If this isn't clear, think about it this way. If the rate of interest being paid on newly issued bonds stands at 8%, a bond buyer would get paid $80 annually for each $1,000 investment in one of those bonds. If that bond buyer instead bought your old 6% bond for the price you originally paid, that bond would yield $20 less per year when compared to bonds on the market. Clearly that's not a very attractive offer for the buyer (although it would be a great deal for you). To quantify the inverse relationship between the price and the interest rate, you really need the concept of the present value of money (also see the article elsewhere in the FAQ on this topic). Computing present value figures helps you answer questions like "what's better, $95 today or $100 one year from now?" The beginnings of it go something like this. Pretend that you have $100. Also pretend that you can invest it in something that will pay a 5% annual return. So, one year from now you have: $100 * (1 + 0.05) = $105 This can be turned around. Let's say that you want to know how much money you need to have today in order to have $200 a year from now, if you can earn 5%: X * (1 + 0.05) = $200 or X = $200/(1 + 0.05) = $190.48 Therefore, we can say that the present value of $200 one year from now, assuming a "discount rate" (this is what the assumed interest rate in a present-value calculation is called) of 5% is $190.48. But what if you wanted to know how much you needed today to have $200 two years from now, again assuming you could earn 5%? Here's the computation. [ X * (1 + 0.05) ] * (1 + 1.05) = $200 X represents the original amount, and the quantity "X * (1 + 0.05)" represents the amount after 1 year. Solving for X we get: X = 200/(1 + 1.05)^2 = $181.41 So, the present value of $200 two years hence, at a discount rate of 5% is $181.41. It should be clear that the present value of $200 N years from now at a discount rate of 5% is: PV = 200/(1 + 0.05)^N And this can be generalized to the present value of an amount C, N years from now, at a discount rate of r: PV = C/(1 + r)^N Now you can combine these. Let's say I promise to pay you $300 a year from today and $500 two years from today. What could I have paid you today that would have made you just as happy as what I promised? Assume you can earn 7% on your money. To solve this, just sum the present value of each payment. This sum is called the "net present value" (NPV) of a series of cash flows. NPV = $300/(1+0.07) + $500/(1+0.07)^2 = $717.09 So, given the 7% discount rate, the payments I scheduled are equivalent to a payment of $717.09 made today. Let's get a little fancier. What if I'm willing to promise to pay you $50 per year for 4 years, starting a year from now, and further promise to pay you $1000 five years from now. What's the most you'd be willing to pay me now to make you that promise. Assume a discount rate of 6%. NPV = $50/(1+0.06) + $50/(1+0.06)^2 + $50/(1+0.06)^3 + $50/(1+0.06)^4 + $1000/(1+0.06)^5 = $920.51 Let's say you want to wait until tomorrow. You have a dream that night that makes you believe that you'll now be able to earn 10% on your money. When I come back to you, you now tell me you'll only pay me NPV = $50/(1 + 0.10) + $50/1.1^2 + $50/1.1^3 + $50/1.1^4 + $1000/1.1^5 = $779.41 My promise is now worth quite a bit less. You should be able to see that if your dream had led you to believe you could earn less on your money, then my promise would have been worth more to you than it did yesterday. At this point, it's probably clear that my "promise" is effectively what a bond is -- I'm agreeing to pay you a fixed amount each year (actually, the bond would pay half that fixed amount twice a year) and then the principal amount at maturity. Given what you think you can earn on your money, the price you should pay for the bond is well-defined. The question is what affects what you think you'll be able to earn on your money? Fed policy might. What you think the chances of inflation are might. Lots of other things might. This is where the fun starts. :-) Also note that you can turn the equation around. Let's say that you have a $1000 bond paying $75 per year. The bond matures in 10 years. Someone is willing to sell it to you for $850. What will I have earned on my investment? The net present value equation always holds, so $850 equals the net present value of the yearly payments and principal payment. Obviously, since we know everything except the discount rate, this equation must define the discount rate that makes it true. The problem is that the rate cannot be simply calculated. You must make a guess, compute the net present value, see how different it is from $850, use that to adjust your guess, and try again until the sides of the equation balance. The discount rate you come up with is called the "internal rate of return" (IRR) and in the bond world is called the "yield to maturity" (YTM). In fact, if you know the initial value of some portfolio, all cash flows into and out of the portfolio, and the final value of the portfolio, you can compute your IRR, thus answering the common misc.invest.* question of "I put $N into a fund on date X, but then added $D on date Y and $F on date W. My account is today worth $B. What's my return?" As a final note, here's a bit of a stumper to spring on someone: Assuming you could earn 5% on your money, would you rather be paid $1000 annually (first payment is today, next is a year from now, etc.) forever (assume you are immortal :-) or $25000 today? Believe it or not, you should take the $25000 today. Here's the analysis why. NPV = $1000 + $1000/1.05 + $1000/1.05^2 ... or NPV = $1000*(1 + 1/1.05 + 1/1.05^2 + ...) A math reference book can tell you (or you might remember or derive it) that the infinite sum: 1 + x + x^2 + x^3 + ... = 1/(1 - x) if |x| < 1 In this case, x = 1/1.05, so NPV = $1000*[1/(1 - 1/1.05)] = $21000 So believe it or not, you'd be better off taking $25000 today then taking $1000 per year forever, given the 5% discount rate assumption. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - Tranches Last-Revised: 22 Oct 1997 Contributed-By: (anonymous), Chris Lott ( contact me ) A 'tranche' (derived from the French for 'slice') is used in finance to define part of an asset that is divided (sliced, hence the term) into smaller pieces. A common example is a mortgage-backed security. One bank may only be interested in the payments at the longer end of the security's maturity, while another investment firm may want only the cash flows due in the near term. An investment bank can split the original asset into 'tranches' where each party (the bank and the investment firm) receive rights to the expected cash payments for particular periods. The two new assets are repriced, and the investment bank usually makes a tidy profit. This can be done with many assets, the goal being better marketablity of typically larger assets. If you want more information on how this is used in specific, I would think there would be data on the debt of less developed countries that has been consolidated, then sold in 'tranches' to investors in the developed worlds. The London Club is a group of commercial creditors which holds claim on the debt of Russia, for example. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - Treasury Debt Instruments Last-Revised: 1 Jan 2002 Contributed-By: Art Kamlet (artkamlet at aol.com), Dave Barrett, Rich Carreiro (rlcarr at animato.arlington.ma.us) The US Treasury Department periodically borrows money and issues IOUs in the form of bills, notes, or bonds ("Treasuries"). The differences are in their maturities and denominations: Bill Note Bond Maturity up to 1 year 1--10 years 10--30/40 years Denomination $1,000 $1,000 $1,000 Minimum purchase $1,000 $1,000 $1,000 Treasuries are auctioned. Short term T-bills are auctioned every Monday. The 4-week bill is auctioned every Tuesday. Longer term bills, notes, and bonds are auctioned at other intervals. T-Notes and Bonds pay a stated interest rate semi-annually, and are redeemed at face value at maturity. Exception: Some 30 year and longer bonds may be called (redeemed) at 25 years. T-bills work a bit differently. They are sold on a "discounted basis." This means you pay, say, $9,700 for a 1-year T-bill. At maturity the Treasury will pay you (via electronic transfer to your designated bank checking account) $10,000. The $300 discount is the "interest." In this example, you receive a return of $300 on a $9,700 investment, which is a simple rate of slightly more than 3%. The best way for an individual to buy or sell Treasury instruments is via the US Treasury's "TreasuryDirect" program, which provides for no-fee/low-fee transactions. Please see the article elsewhere in this FAQ for more information about using the TreasuryDirect program. Of course treasuries can also be bought and sold through a bank or broker, but you will usually have to pay a fee or commission to do this, not to mention maintain an account. Treasuries are negotiable. If you own Treasuries you can sell them at any time and there is a ready market. The sale price depends on market interest rates. Since they are fully negotiable, you may also pledge them as collateral for loans. (Note that if the securities are held by the Treasury as part of their TreasuryDirect service, then they cannot be used as collateral.) Treasury bills, notes, and bonds are the standard for safety. By definition, everything is relative to Treasuries; there is no safer investment in the U.S. They are backed by the "Full Faith and Credit" of the United States. Interest on Treasuries is taxable by the Federal Government in the year paid. States and local municipalities do not tax Treasury interest income. T-bill interest is recognized at maturity, so they offer a way to move income from one year to the next. The US Treasury also issues Zero Coupon Bonds. The ``Separate Trading of Registered Interest and Principal of Securities'' (a.k.a. STRIPS) program was introduced in February 1986. All new T-Bonds and T-notes with maturities greater than 10 years are eligible. As of 1987, the securities clear through the Federal Reserve's books entry system. As of December 1988, 65% of the ZERO-COUPON Treasury market consisted of those created under the STRIPS program. However, the US Treasury did not always issue Zero Coupon Bonds. Between 1982 and 1986, a number of enterprising companies and funds purchased Treasuries, stripped off the ``coupon'' (an anachronism from the days when new bonds had coupons attached to them) and sold the coupons for income and the non-coupon portion (TIGeRs or Strips) as zeroes. Merrill Lynch was the first when it introduced TIGR's and Solomon introduced the CATS. Once the US Treasury started its program, the origination of trademarks and generics ended. There are still TIGRs out there, but no new ones are being issued. Other US Debt obligations that may be worth considering are US Savings Bonds (Series E/EE and H/HH) and bonds from various US Government agencies, including the ones that are known by cutesy names like Freddie Mac, as well as the Mae sisters, Fannie, Ginnie and Sallie. Historically, Treasuries have paid higher interest rates than EE Savings Bonds. Savings Bonds held 5 years pay 85% of 5 year Treasuries. However, in the past few years, the floor on savings bonds (4% under current law) is higher than short-term Treasuries. So for the short term, EE Savings Bonds actually pay higher than treasuries, but are non-negotiable and purchases are limited to $15,000 ($30,000 face) per year. US Government Agency Bonds, in general, pay slightly more interest but are somewhat less predictible than Treasuries. For example, mortgage-backed-bond returns will vary if mortgages are redeemed early. Some agency bonds, technically, are not general obligations of the United States, so may not be purchased by certain institutions and local governments. The "common sense" of many people, however, is that the Congress will never allow any of those bonds to default. In October 2001, the Treasury Department announced that it was suspending issuance of the 30-year bond and had no plans to issue that security ever again. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - Treasury Direct Last-Revised: 2 Oct 2001 Contributed-By: Art Kamlet (artkamlet at aol.com), Bob Johnson, Rich Carreiro (rlcarr at animato.arlington.ma.us) Treasury securities can be purchased directly from the US Treasury using a service named "TreasuryDirect." The minimum purchase for any Treasury security that can be obtained via the TreasuryDirect program is $1,000. There are no fees for accounts below $100,000; accounts in excess of that sum are charged a $25 annual fee. Interest payments can be made directly to an individual's TreasuryDirect account. Further, mature Treasury securities can be used to purchase new ones. Investors can do business with the TreasuryDirect program via the web, phone, or plain old mail. The "Direct To You" services offered by the US Treasury have made transactions in the TreasuryDirect program very attractive for private investors. First, the Treasury can debit a bank account for the amount of the purchase after the instrument's price is set by the auction (the "Pay Direct" service). This means that an investor pays exactly the right amount, unlike the old system in which an investor was forced to send in a check for the full face value and wait for a refund. Second, investors can sell instruments before their maturity dates using the "Sell Direct" service. The Treasury charges $34 for brokering the sale of a Treasury instrument, which reportedly is less than the fee charged by banks and brokerage houses. The instrument is sold using the Federal Reserve Bank of Chicago, which is responsible for getting a fair price. Third, holders of Treasury instruments can reinvest funds from maturing instruments simply by using the telephone or the web along with the information that appears on a notice sent to holders of maturing instruments (the "Reinvest Direct" service). Investors can get more information about the TreasuryDirect program either by calling 800-722-2678 or visiting the web site: http://www.treasurydirect.gov --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - U.S. Savings Bonds Last-Revised: 4 Mar 2003 Contributed-By: Art Kamlet (artkamlet at aol.com), Gordon Hamachi, Rich Carreiro (rlcarr at animato.arlington.ma.us), M. Persina, David Capshaw, Paul Maffia (paulmaf at eskimo.com), J. Zinchuk (jzinchuk at draper.com), Chris Lott ( contact me ) This article describes US Savings Bonds issued by the US Treasury, and discusses how they can be purchased or redeemed. Because the US Treasury changes the rules for these bonds periodically, this article also gives some information about determining the yields of bonds issued over the past 30 years. US Savings bonds are obligations of the US government. Interest paid on these bonds is exempt from state and local income taxes. Savings Bonds are not negotiable instruments, and cannot be transferred to anyone at will. They can be transferred in limited circumstances, and there could be tax consequences at the time of transfer. Two types of US Savings Bonds are offered, namely Series EE Bonds and I Bonds. The I Bond was introduced in 1998 and is indexed for inflation. The Treasury plans to sell both types of bonds on an ongoing basis; there are no plans for one or the other to be phased out. US Savings bonds can be purchased from commercial banks, through an employer via payroll deductions, or (naturally) over the internet. Most commercial banks act as agents for the Treasury; they will let you fill out the purchase forms and forward them to the Treasury. You will receive the bonds in the mail a few weeks later. See the foot of this article for the web site that allows on-line purchases. Savings bonds can be redeemed (cashed in) at many banks or directly with a branch of the Federal Reserve Bank. Using your bank, credit union, or savings and loan is probably the fastest way to cash a bond, but be certain to call ahead to ask (you might need to bring certain documentation). In some cases, the bank may send the bonds to the Fed, which will slow things down. If your bank will not cooperate, contact the appropriate Fed branch to redeem bonds by mail or via the web (see links at the end of this article). Series EE bonds are purchased at half their face value or denomination. So you would purchase a $100 Series EE Bond for $50. I Bonds are purchased at face value or denomination. So you would purchase a $100 I Bond for $100. You can buy up to $15,000 (your cost; actually $30,000 face value) of Series EE Bonds per year. If you buy bonds with a co-owner, the two of you can together buy up to twice that limit, but even so, no more than $30,000 (face amount) in EE bonds purchased in one calendar year may be attributed to one co-owner (so you cannot evade the limits by using many different co-owners). You can buy up to $30,000 of I Bonds per year. The Series EE andI Bond limits are independent of each other, meaning an individual could give Uncle Sam up to $45,000 annually to buy bonds. Series EE Bonds earn market-based rates that change every 6 months. There is no way to predict when a Series EE bond will reach its face value. For example, a Series EE Bond earning an average of 5% would reach face value in 14 1/2 years while a bond earning an average of 6% would reach face value in 12 years. I Bonds are an accrual-type security. In English, this means that interest is added to the bond monthly. The interest is paid when the bond is cashed. An I Bond earns interest for as long as 30 years. The interest accrues on the first day of the month, and is compounded semiannually. The earnings rate of an I Bond is determined by a fixed rate of return plus a semiannual inflation rate. The fixed rate (as the name might imply) remains the same for the life of an I Bond. The semiannual inflation rate (the bonus) is announced each May and November, and is based on the Consumer Price Index (CPI), as calculated by the wizards at the Bureau of Labor Statistics (ooh!). Series EE Bonds and I Bonds issued after 1 February 2003 must be held for at least 12 months before they can be cashed (bonds issued before then could be cashed anytime after 6 months). If an investor cashes an I Bond within the first five years, the investor is penalized by losing three months worth of interest. For example, if you cash an I Bond after exactly twelve months, you will receive just nine months worth of interest. This "feature" of the I Bond is supposed to encourage long-term investment. Series EE Bonds absolutely should be cashed before their final maturity dates for the following reasons. Firstly, if you fail to cash the Series EE bond (or roll it over into an Series HH Bond) before the critical date, you will be losing money because the bond will no longer be earning interest. Secondly, under IRS regulations, tax is due on the interest in the year the bond is cashed or it reaches final maturity. If you hold the bond beyond 12/31 of the final-maturity year, then when you finally get around to cashing it, you will not only owe the tax on the earnings, but interest and penalties besides. Thirdly, once the bond passes its final maturity date (as for example a year later) you cannot roll the proceeds into an HH to further postpone tax on the accumulated interest. Interest on a Series EE/E Bond or I Bond can be deferred until the bond is cashed in, or if you prefer, can be declared on your federal tax return as earned each year. When you cash the bond you will be issued a Form 1099-INT and would normally declare as interest all funds received over what you paid for the bond (and have not yet declared). This is what they mean by deferring taxes. If you with to defer the tax on the interest paid by a Series EE Bond at maturity yet further, you can do so by using the proceeds from cashing in a Series EE Bond to purchase a Series HH Savings bond (prior to 1980, H Bonds). You can purchase Series HH Bonds in multiples of $500 from the proceeds of Series EE Bonds. Series HH Bonds pay interest every 6 months and you will receive a check from the Treasury. When the HH bond matures, you will receive the principal, and a form 1099-INT for that deferred EE interest. At the time of purchase, a bond can be registered to a single person ("single ownership"), registered to two people ("co-ownership"), or can be registered to a primary owner and a beneficiary ("beneficiary"). In the case of co-ownership, either named individual can do whatever they like with the bond without consent for the other person; if one dies, the other becomes the single owner. In the case of beneficiary registration (bond is marked POD for "payable on death"), the primary owner controls the bond, and ownership passes to the beneficiary if the primary owner dies. Ownership of Series EE bonds (but not I-Bonds) can be transferred, for example if a grandparent wants to give a grandchild some money. A transfer in ownership (called a "reissue" by the US Treasury) where a living person who was an owner relinquishes all ownership of a bond is a taxable event. This means that the person giving the bonds (the "principal owner") incurs a tax liability for the accrued interest up to the date of transfer and must pay Uncle Sam. It's essential to keep good records until the time when the beneficiary finally cashes the bonds in. Recall that all interest on the bond is paid when it's cashed in. Because someone paid some tax on that interest already, the person cashing the bond should not pay tax on the full amount. Alternatively, the grandparent could just add the grandchild as a co-owner, which doesn't result in anyone incurring a tax liability at the transfer. Interest from Savings Bonds can excluded if used to pay higher education expenses such as college tuition. Please see the article elsewhere in the FAQ for more details. If your Savings Bonds are lost, stolen, mutilated, or destroyed, give prompt notice of the facts to the Department of the Treasury, Bureau of the Public Dept, Parkersburg, WV 26106-1328, and a list, if possible, of the serial numbers (with prefix and suffix letters), the issue dates (month and year) and the denominations of the bonds. Show all names and addressed that could have appeared on the bonds, along with the owner's Social Security number, and whether the bond numbers and issue dates are known. The more information that you are able to provide, the quicker the Treasury will be able to replace your bonds. Before describing the specific conditions that apply to Series EE bonds issued on various dates, it's important to understand the terminology that is used in these explanations. The following list should help. Warning: this gets complicated quickly, thanks to your friends at the US Treasury. * Issue date: The first day of the month of purchase. Shown on the face of the bond. (The bond face may also show the date on which the Treasury processed an application and printed the bond, but that's not the issue date.) * Nominal original maturity (date): The date at which a Series EE Bond reaches its face value. The applicable rates need only exceed the guaranteed rate (see below) by a small amount for the actual original maturity date to occur earlier than the nominal first date. For Series EE Bonds issued prior to 1 May 1995, the actual first maturity date depends on the minimum guaranteed rate of interest that prevails during its life! This period (date) ranges from 9 yrs 8 months for bonds issued prior to 11/86 to 18 years for those issued since the guaranteed rate was lowered to 4% in 1994. For bonds purchased prior to 1 Dec 1985, the nominal original maturity date will be the stated interest rate on the bond divided into 72. Over the years that date varied from 9 yrs. 6 months to 12 years. that means minimum guaranteed rates of 6 to 7.5%, except for the oldest E bonds whose rates (for those still not having reached final maturity) can be as low as 4%. * Final maturity (date): the date following which the bond no longer earns any interest (see discussion above about cashing bonds before this date). * Guaranteed minimum rate during original maturity: the minimum interest rate that the US treasury will pay you on the bonds, no matter what the market rate may be. This can either be stated as an interest rate (from which the nominal original maturity date can be calculated) or as a nominal original maturity date (from which the minimum guaranteed rate can be calculated). Note that the Treasury states this guaranteed minimum rate as the overall yield from issuance, not as the minimum rate for each six-month period. For example, if a bond paid 8% for some period of time but the overall guaranteed yield is 4%, then depending on interest rates and markets, the bond might pay just 1% for some six-month periods without violating the minimum-rate guarantee. * Crediting of interest: Prior to 1 May 1995, interest was credited monthly, and calculated to the first day of the month you cash it in (up to 30 months, and to the previous 6 month interval after). Bonds issued after 1 May 1995 and all earlier bonds entering any extended maturity period after 1 May 1995 will only earn interest from that point on every six months. For bonds issued after 1 May 1995 or for earlier bonds entering any extended maturity period after that date, you cash them as soon as possible after any 6 month anniversary date, because cashing a bond any time between any two 6th month anniversary dates loses all interest since the last 6 month anniversary date. The following list attempts to clarify the rules that apply to Series E or EE Bonds that were issued in various time periods. Note that the rule changes generally change the game only for bonds that are issued after the rule change. Outstanding Series E Bonds and Savings Notes as well as Series EE Bonds issued in general continue to earn interest unter the terms of their original offerings, even as they enter extension periods. * Series E bonds issued before 1980 These bonds are very similar to EE bonds, except they were purchased at 75% of face value. Everything else stated here about EE bonds applies also to E bonds. * Series EE Savings bonds issued 1 November 1982 -- 31 October 1986 These bonds have a minimum rate of 7.5% through their maturity period of 9 yrs 7 mos. If these bonds entered a period of extended maturity prior to March 1993, they would earn the prevailing market based rates, or a minimum of the 6.0% guaranteed rate until the next extended maturity period begins. If these bonds enter a period of extended maturity after March 1993, they will earn the prevailing market based rates, or at least the minimum 4.0% guaranteed rate for the remainder of their life. * Series EE Savings bonds issued 1 November 1986 -- 28 February 1993 The bonds are subject to the same rules discussed earlier; i.e., they earn the 6% guaranteed rate until they reach face value (which may be before their 12th anniversary depending on prevailing rates), after which they will earn the prevailing market based rates, or at least the minimum 4.0% guaranteed rate for the remainder of their life. * Series EE Savings bonds issued 1 March 1993 -- 30 April 1995 If held at least 5 years, these bonds have a minimum rate of 4%, and this rate is guaranteed through their original maturity of 18 years. These EE bonds will earn a flat 4% through the first 5 years rather than the short-term rate, and the interest will accrue semiannually. Any bond issued before 1 May 1995 will earn a minimum of 4% after it enters its next extended maturity period. * Series EE Savings bonds issued 1 May 1995 -- 30 April 1997 These bonds will earn market-based rates from purchase through original maturity. They will earn the short-term rate for the first five years after purchase and will earn the long-term rate from the fifth through the seventeenth year. The bonds will continue to earn interest after 17 years for a total of 30 years at the rates then in effect for extensions. If the market-based rates are not sufficient for a bond to reach face value in 17 years, the Treasury will make a one-time adjustment to increase it to face value at that time. Therefore, you are guaranteed that a bond will be worth its face value as of 17 years of its purchase date. This equates to a minimum interest rate of 4.1%. If the market-based rates are higher than this, the bond will be worth more than its face value after 17 years. The short-term rate is 85% of the average of six-month Treasury security yields. A new rate is announced and becomes effective each May 1 and November 1. The May 1 rate reflects market yields during the preceding February, March, and April. The November 1 rate reflects market yields during the preceding August, September, and October. The long-term rate is 85% of the average of five-year Treasury security yields. A new rate is announced and becomes effective each May 1 and November 1. The May 1 rate reflects market yields during the preceding November through April and the November 1 rate reflects market yields during the preceding May through October. Effective 1 May 1995: The short-term rate is 5.25% The long-term rate is 6.31% Interest will be added to the value of the bonds every six months. Bonds will increase in value six months after purchase and every six months thereafter. For example, a bond purchased in June will increase in value on December 1 and on each following June 1 and December 1. When investors cash their bonds they will receive the value of the bond as of the last date interest was added. If an investor redeems a savings bond between scheduled interest dates the investor will not receive interest for the partial period. * Series EE Savings bonds issued 1 May 1997 -- present The latest Treasury program made three significant changes to the prior system. First, the market rates on which the savings bond rate are calculated will be long-term rates, rather than a combination of short-term and long-term rates. Second, all bonds will earn 90 percent of the average market rate on 5-year Treasury notes. (This ends the two-tier system that was in place since 1995, as described above.) Finally, interest on savings bonds will accrue monthly, instead of every six months. This will eliminate the problem of an investor losing up to five months interest by redeeming a savings bond at the wrong time. But of course there's a catch. To encourage longer term holdings of savings bonds, a three-month interest penalty is imposed if a savings bond is redeemed within the first five years. Finally, we'll try to summarize the preceding discussion in a table. Nom. orig. Final Guar min rate Interest Issue date maturity maturity orig. maturity credited before Nov ? yrs 40 yrs ?.?% monthly 1965 1 Nov 1982 9 yrs 7 mos 30 yrs 7.5% monthly 31 Oct 1986 1 Nov 1986 12 yrs 30 yrs 6.0% monthly 28 Feb 1993 1 Mar 1993 18 yrs 30 yrs 4.0% monthly 30 Apr 1995 1 May 1995 17 yrs 30 yrs 4.1% biannually 30 Apr 1997 1 May 1997 TBD 30 yrs TBD% monthly For current rates, you may call 1-800-4US-Bonds (1-800-487-2663) within the US. You can call any Federal Reserve Bank to request redemption tables for US Savings Bonds. You may also request the tables from The Bureau of Public Debt, Bonds Div., Parkersburg, WV 26106-1328. Here a few web resources that may help. * The official US Savings Bonds web site offers a huge amount of information, as well as a way to purchase Series EE (denominations 50 to 1000) and I Bonds (denominations 50 to 500) with a visa or master card. This web site can also help you calculate the Current Redemption Value (CRV) of any bond. http://www.savingsbonds.gov * The Treasury's Bureau of the Public Debt maintains another government web site with comprehensive information about savings bonds (includes information about branches of the Federal Reserve Bank): www.publicdebt.treas.gov . * The Savings bond Wizard help you manage your own Savings Bond inventory. It's a PC program, available free of charge: http://www.savingsbonds.gov/sav/savwizar.htm * Another site that offers assistance with savings bond issues: http://www.savingsbonds.com [ Compiler's note: These disgustingly complex regulations come from many of the same people who developed the US Tax Code. See any similarities?? Sheesh! ] --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - U.S. Savings Bonds for Education Last-Revised: 27 Aug 2001 Contributed-By: Jackie Brahney (info at savingsbonds.com) You can use your U.S. Savings Bonds towards your child's education and exclude all the interest earned from your federal income. This is sometimes known as the Tax Free Interest for Education program. Here are some basics on how the Education Savings Bond program works. You can exclude all or a portion of the interest earned from savings bonds from your federal income tax. Qualified higher education expenses, incurred by the taxpayer, the taxpayers spouse or the taxpayer's dependent at a institution or State tuition plans (see below) have to incur in the same calendar year the bonds are cashed in. The following qualifications and exclusions apply. 1. Only Series EE or I Bonds issued in 1990 and later apply; "Older" bonds cannot be exchanged towards newer bonds. 2. When purchasing bonds to be used for education, you do NOT have to declare that at the time of purchase that will be using them for education purposes. 3. You can choose NOT to use the bonds for education if you so choose at a later date. 4. You must be at least 24 years old when you purchase(d) the bonds. 5. When using bonds for a child's education, register the bonds in your name, NOT the child's name. 6. A child CAN NOT be listed as a CO-OWNER on the bond. 7. The child can be a beneficiary on the bond and the education exclusion can still apply. 8. If you are married, a joint return MUST be filed to qualify for the education exclusion. 9. You are required to report both the principal and the interest from the bonds to pay for qualified expenses 10. Use Form 8815 to exclude interest for college tuition. Here are a few frequently asked questions. Does everyone in every income bracket qualify? No. The interest exclusion at the highest level is available to married couples (who file jointly) starting at $83,650 with a modified gross income and is eliminated at $113,650 or more in tax year 2001. For single filers, the exclusion begins to reduce at $55,750 and is eliminated at $70,750 or more in tax year 2001. These income limitations apply to the year you use the bonds, and NOT when you purchase the bonds. What Institutions Qualify for the Exclusion? Post secondary institutions, colleges, universities, and various vocational schools. The schools qualify must participate in federally assisted programs (ex. They offer a guaranteed student loan program). Beauty or secretarial schools and proprietary institutions usually do not apply. What are Qualified Expenses? Tuition and fees, for any course or educational program that involves sports, games or hobbies, lab fees and other required course expenses that relate to an educational degree or certificate-granting program. These expenses must be incurred during the same tax year in which the bonds are cashed in. Note: Room/board expenses, books, and expendable materials (pens, notepads, etc.) do not qualify. A bit of advice: when purchasing bonds that you think will be used for educational purposes, purchase them in small denominations. That way you won't have to cash in more bonds than are necessary to pay the current college tuition expenses. Remember, any excess monies you receive from cashing in some savings bonds that EXCEED the tuition bills may create a taxable event when you file your federal tax return. (Savings Bonds are always exempt from State and Local/City taxes.) Here are some resources on the web that can help. * The Treasury Department's web site: http://www.savingsbonds.gov/sav/savedfaq.htm * The bond experts at SavingsBonds.com: http:/www.savingsbonds.com --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - Value of U.S. Treasury Bills Last-Revised: 24 Oct 1994 Contributed-By: Dave Barrett The current value of a U.S. Treasury Bill can be found using the Wall Street Journal. Look in the WSJ in the issue dated the next business day after the valuation date you want, specifically in the "Money and Investing" section under the headline "Treasury Bonds, Notes, and Bills". There you need to look for the column titled "TREASURY BILLS". Scan down the column for the maturity date of your bill. Then examine the "Bid" and "Days to Mat." values. The necessary formula: Current value = (1 - ("Bid" / 100 * "Days to Mat." / 360)) * Mature Value For example, a 13-week treasury bill purchased at the auction on Monday June 21 appears in the June 22, 1994 WSJ in boldface as maturing on September 22, 1994 with an "Asked" of 4.18 and 91 "Days to Mat.". Its selling price on Wedesday August 31, 1994 appeared in the September 1, 1994 Wall Street Journal as 20 "Days to Mat." with 4.53 "Bid". A $10,000 bill would sell for: (1 - 4.53/100 * 20/360) * $10,000 = $ 9,974.83 minus any brokerage fee. The coupon yield for a U.S. Treasury Bill is listed as "Ask Yld." in the Wall Street Journal under "Treasury Bonds, Notes and Bills". The value is computed using the formula: couponYield = 365 / (360/discount - daysToMaturity/100) Discount is listed under the "Asked" column, and "couponYield" is shown under the "Ask Yld." column. For example, the October 21, 1994 WSJ lists Jan 19, '95 bills as having 87 "Days to Mat.", and an "Asked" discount as 4.98. This gives: 365 / (360/4.98 - 87/100) = 5.11% which is shown under the "Ask Yld." column for the same issue. DaysToMaturity for 13-week, 26-week, and 52-week bills will be 91, 182, and 364, respectively, on the day the bill is issued. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Bonds - Zero-Coupon Last-Revised: 28 Feb 1994 Contributed-By: Art Kamlet (artkamlet at aol.com) Not too many years ago every bond had coupons attached to it. Every so often, usually every 6 months, bond owners would take a scissors to the bond, clip out the coupon, and present the coupon to the bond issuer or to a bank for payment. Those were "bearer bonds" meaning the bearer (the person who had physical possession of the bond) owned it. Today, many bonds are issued as "registered" which means even if you don't get to touch the actual bond at all, it will be registered in your name and interest will be mailed to you every 6 months. It is not too common to see such coupons. Registered bonds will not generally have coupons, but may still pay interest each year. It's sort of like the issuer is clipping the coupons for you and mailing you a check. But if they pay interest periodically, they are still called Coupon Bonds, just as if the coupons were attached. When the bond matures, the issuer redeems the bond and pays you the face amount. You may have paid $1000 for the bond 20 years ago and you have received interest every 6 months for the last 20 years, and you now redeem the matured bond for $1000. A Zero-coupon bond has no coupons and there is no interest paid. But at maturity, the issuer promises to redeem the bond at face value. Obviously, the original cost of a $1000 bond is much less than $1000. The actual price depends on: a) the holding period -- the number of years to maturity, b) the prevailing interest rates, and c) the risk involved (with the bond issuer). Taxes: Even though the bond holder does not receive any interest while holding zeroes, in the US the IRS requires that you "impute" an annual interest income and report this income each year. Usually, the issuer will send you a Form 1099-OID (Original Issue Discount) which lists the imputed interest and which should be reported like any other interest you receive. There is also an IRS publication covering imputed interest on Original Issue Discount instruments. For capital gains purposes, the imputed interest you earned between the time you acquired and the time you sold or redeemed the bond is added to your cost basis. If you held the bond continually from the time it was issued until it matured, you will generally not have any gain or loss. Zeroes tend to be more susceptible to prevailing interest rates, and some people buy zeroes hoping to get capital gains when interest rates drop. There is high leverage. If rates go up, they can always hold them. Zeroes sometimes pay a better rate than coupon bonds (whether registered or not). When a zero is bought for a tax deferred account, such as an IRA, the imputed interest does not have to be reported as income, so the paperwork is lessened. Both corporate and municipalities issue zeroes, and imputed interest on municipals is tax-free in the same way coupon interest on municipals is. (The zero could be subject to AMT). Some marketeers have created their own zeroes, starting with coupon bonds, by clipping all the coupons and selling the bond less the coupons as one product -- very much like a zero -- and the coupons as another product. Even US Treasuries can be split into two products to form a zero US Treasury. There are other products which are combinations of zeroes and regular bonds. For example, a bond may be a zero for the first five years of its life, and pay a stated interest rate thereafter. It will be treated as an OID instrument while it pays no interest. (Note: The "no interest" must be part of the original offering; if a cumulative instrument intends to pay interest but defaults, that does not make this a zero and does not cause imputed interest to be calculated.) Like other bonds, some zeroes might be callable by the issuer (they are redeemed) prior to maturity, at a stated price. --------------------Check http://invest-faq.com/ for updates------------------ Subject: CDs - Basics Last-Revised: 15 Mar 2003 Contributed-By: Chris Lott ( contact me ) A CD in the world of personal finance is not a compact disc but a certificate of deposit. You buy a CD from a bank or savings & loan for some amount of money, and the bank promises to pay you a fixed interest rate on that money for a fixed term. For example, you might buy a 30-month CD paying 3% in the amount of $5,000. A bank may have a minimum amount for issuing CDs like $1,000, but there is usually no requirement to buy a CD with an even amount. Interest earned by a CD may be paid monthly, quarterly, annually, or when the CD matures. Interest paid during the CD's term is paid by check or deposited to another account; it is never added to the amount of the CD (like in a savings account), because the CD amount is fixed. After you have purchased a CD, you can always redeem it before the stated maturity date. However, if you cash out early, the bank will impose a penalty in the amount of 3 or 6-months of interest payments, depending on the term. This "penalty for early withdrawal" is due whether any interest was paid or not. As the name implies, a CD is usually a piece of paper (the certificate) that states the interest rate and term (actually the maturity date). Because CDs are issued by banks, a CD for less than $100,000 is insured by the government (probably the FDIC program), so the investment is essentially risk-free. Some CDs can be bought and sold much like a stock or bond. If you buy a CD through a brokerage house, you may be able to re-sell the CD through them to avoid paying an early withdrawal penalty. These CDs usually have significant minimum investment amounts (like $5,000) and require round numbers (like multiples of 1,000). --------------------Check http://invest-faq.com/ for updates------------------ Subject: CDs - Market Index Linked Last-Revised: 15 Mar 2003 Contributed-By: Chris Lott ( contact me ) A market index linked CD (MILC) is a combination of a CD and a stock-market investment. These instruments seek to add the possibility of great returns to the security of CDs. They do this by pegging the interest rate paid by the CD to the performance of some stock-market index (i.e., they are linked to a market index). The term on these instrument is usually around 5 years. Like a conventional CD, the principal is fully insured by the federal government, so an investor is guaranteed to receive 100% of the original investment if the CD is held to maturity. Early withdrawal is possible, but frequently constrained to certain dates each year. Further, an investor is not guaranteed to receive 100% of the initial investment if withdrawn early. All interest is paid when the CD matures. However, there is no guarantee that any interest will be paid. So there is very little chance an investor will do very well, but there is a reasonable chance of doing better than a conventional fixed-rate CD. These notes have a quirky tax treatment. Although they pay no interest annually, if the CD is held in a regular account, an investor must nonetheless declare income from a market index linked CD every year. So you're probably asking, the thing paid me nothing, what am I declaring!? The amount to declare is based on the amount a comparable, conventional CD of the same term would pay, based on information in the MILC. These declared payments are added to the cost basis of the CD and the whole mess is reconciled when the CD matures. Investors can avoid this hassle by holding this instrument in a tax-deferred account such as an IRA. --------------------Check http://invest-faq.com/ for updates------------------ Subject: Derivatives - Basics Last-Revised: 6 Dec 1996 Contributed-By: Brian Hird, Chris Lott ( contact me ) A derivative is a financial instrument that does not constitute ownership, but a promise to convey ownership. Examples are options and futures. The most simple example is a call option on a stock. In the case of a call option, the risk is that the person who writes the call (sells it and assumes the risk) may not be in business to live up to their promise when the time comes. In standarized options sold through the Options Clearing House, there are supposed to be sufficient safeguards for the small investor against this. Before discussing derivatives, it's important to describe their basis. All derivatives are based on some underlying cash product. These "cash" products are: * Spot Foreign Exchange. This is the buying and selling of foreign currency at the exchange rates that you see quoted on the news. As these rates change relative to your "home currency" (dollars if you are in the US), so you make or lose money. * Commodities. These include grain, pork bellies, coffee beans, orange juice, etc. * Equities (termed "stocks" in the US) * Bonds of various different varieties (e.g., they may be Eurobonds, domestic bonds, fixed interest / floating rate notes, etc.). Bonds are medium to long-term negotiable debt securities issued by governments, government agencies, federal bodies (states), supra-national organisations such as the World Bank, and companies. Negotiable means that they may be freely traded without reference to the issuer of the security. That they are debt securities means that in the event that the company goes bankrupt. bond-holders will be repaid their debt in full before the holders of unsecuritised debt get any of their principal back. * Short term ("money market") negotiable debt securities such as T-Bills (issued by governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are much like bonds, differing mainly in their maturity "Short" term is usually defined as being up to 1 year in maturity. "Medium term" is commonly taken to mean form 1 to 5 years in maturity, and "long term" anything above that. * Over the Counter ("OTC") money market products such as loans / deposits. These products are based upon borrowing or lending. They are known as "over the counter" because each trade is an individual contract between the 2 counterparties making the trade. They are neither negotiable nor securitised. Hence if I lend your company money, I cannot trade that loan contract to someone else without your prior consent. Additionally if you default, I will not get paid until holders of your company's debt securities are repaid in full. I will however, be paid in full before the equity holders see a penny. Derivative products are contracts which have been constructed based on one of the "cash" products described above. Examples of these products include options and futures. Futures are commonly available in the following flavours (defined by the underlying "cash" product): * commodity futures * stock index futures * interest rate futures (including deposit futures, bill futures and government bond futures) For more information on futures, please see the article in this FAQ on futures. In the early 1990s, derivatives and their use by various large institutions became quite a hot topic, especially to regulatory agencies. What really concerns regulators is the fact that big banks swap all kinds of promises all the time, like interest rate swaps, froward currency swaps, options on futures, etc. They try to balance all these promises (hedging), but there is the big danger that one big player will go bankrupt and leave lots of people holding worthless promises. Such a collapse could cascade, as more and more speculators (banks) cannot meet their obligations because they were counting on the defaulted contract to protect them from losses. All of this is done off the books, so there is no total on how much exposure each bank has under a specific scenario. Some of the more complicated derivatives try to simulate a specific event by tracking it with other events (that will usually go in the same or the opposite direction). Examples are buying Japan stocks to protect against a loss in the US. However, if the usual correlation changes, big losses can be the result. The big danger with the big banks is that while they can use derivatives to hedge risk, they can also use them as a way of taking ON risk. Not that risk is bad. Risk is how a bank makes money; for example, issuing loans is a risk. However, banks are forbidden from taking on risk with derivatives. It's just too easy for a bank to hedge bonds with derivatives that don't have the same maturity, same underlying security, etc. so the correlation between the hedge and the risky position is weak. --------------------Check http://invest-faq.com/ for updates------------------ Compilation Copyright (c) 2003 by Christopher Lott.