Fixed Income Securities Professionals

AMIR II Achievement of Market-Friendly Initiatives and Results

March 2006 This document was produced for review by the United States Agency for International Development. It was prepared by Chemonics International Inc.

JORDAN AMIR II Achievement of Market-Friendly Initiatives and Results Contract No. 278-C-00-02-00210-00

The author’s views expressed in this publication do not necessarily reflect the views of the United States Agency for International Development or the United States Government.

Contract No.: 278-C-00-02-00210-00

Contractor Name: Chemonics International, Inc.

USAID Cognizant Technical Office: Office of Economic Opportunities, USAID/Jordan

Date of Report: March 15, 2006

Document Title: Fixed Income Securities Professionals

Final Report

Author’s Name: Dr. Ronald Copley, Copley Investment Management (CIM)

Activity Title and Number: Achievement of Market-Friendly Initiatives and Results Program (AMIR Program)

F/Securities Pricing Workshop, FMD Component, Work Plan No. 650

Fixed Income Securities Professionals

Final Report

March 15, 2006

The opinions expressed herein are those of the author(s) and do not necessarily reflect the opinions of the United States Agency for International Development or the United States Government or Chemonics International or any firms in the AMIR Program consortium or the management of the AMIR Program. Fixed Income Securities Professionals .

Data Page

Name of Component : Financial Markets Development (FMD)

Authors : National Association of Securities Dealers (NASD)

Practice Area : Financial Sector Services

Service Offering : Bank and Other Financial Institution Strengthening

List of Key Words Contained in Report :

• T-bills, Notes, and Bonds • Interest rate risk • Credit/Default risk • Maturity and liquidity risk • Inflation risk • Risk rating agencies • Current yield • Yield to maturity • Yield to call • Duration • Convexity • Bond “priced-to-yield” • Yield curve • Total return • Discount bond • Premium bond • Price convergence • Term structure of interest rates • Risk-free rate • Risk premium • Forward rates • Spread analysis • Diversification

______AMIR Program 1 Fixed Income Securities Professionals .

Abstract

The purpose of this workshop was to explain how government bonds are priced in the primary market at the time of issuance and re-priced in the secondary market when the bond begins trading after the initial offering. The workshop focused on the investor side of the market as opposed to the issuer side.

The development of an efficient government bond market requires that investors possess a basic knowledge of how to price a new bond issue that, in turn, requires investors understand the concept of opportunity cost. If an investor can invest in a competing security of comparable risk, then that investor can efficiently price a new bond issue. The key for investors, then, is to have a fundamental understanding of risk and the return associated with any given level of risk. Because risk is a dynamic concept, investors also need to understand how risk affects the price of the bond after issuance when the bond is trading in the secondary market and how that risk can change through time. Since interest rates as determined in the open market reflect risk, much time was spent on explaining interest rates, how they are determined, and the relationship between interest rates and maturity as reflected in the yield curve.

The above concepts were presented in detail using basic terminology that a person with a general business background could understand. When technical terminology was necessary, I took extra time to explain the term using practical examples to show how the term is used in the investment community. The workshop encouraged participant discussion and divergent opinions on any topic. After I began speaking and listening to comments coming from the audience, I quickly learned that the participants did not need an explanation of introductory concepts such as the definition of a bond and how it is used. As a consequence, I was comfortable focusing my attention on the analysis of how bonds work in a competitive market environment.

______AMIR Program 2 Fixed Income Securities Professionals .

Table of Contents

Executive Summary…………………………………………………………….. 4

Appendix I:

Fixed Income Securities Professionals Agenda ……………...………………… 5

Appendix II:

Fixed Income Securities Professionals Presentation ………………………….. 8

Appendix III:

Fixed Income Securities Professionals Background Reading ……………… 38

______AMIR Program 3 Fixed Income Securities Professionals .

Executive Summary

My responsibility in the workshop was to present a technical analysis of how to price a newly issued bond and re-price it in the secondary market. After discussing the risks of both investing in newly issued bonds (primary market) and seasoned bonds (secondary market), I focused on how to measure the expected return ( ex ante ) and the actual return ( ex post ) and why these two measures may differ. A problem with this type of discussion is that bond terminology is difficult and I made this difficulty well known to all the participants. Even experienced bond people use the same terms to mean different things under different circumstances. I cautioned participants on this seemingly incomprehensible practice.

Certainly, an essential part of any bond workshop is the yield curve: what it is, how it is derived, and how it is used in the market. Consequently, I explained that the yield curve reflects investor expectations about the future course of interest rates that, in turn, drives current bond prices. Inherent to the discussion of interest rates is an analysis of the risks associated with any given bond both at the time of issuance as well as afterwards when the bond is trading in the secondary market. While risk analysis is crucial in determining a bond’s fair price, the investor will never really know the true price of a bond until an actual transaction occurs in the open market. As a consequence, I instructed participants not to lose sight of the fact that bonds trade infrequently relative to stocks so trying to determine the fair market value of a bond ex ante involves a measure of guesswork. This is especially true in the Jordanian market that is still in the developmental stage.

A final part of my presentation involved duration. I explained duration as the management of future asset values relative to future liability values. Matching the duration of a bond to that of a future liability is a conservative investment approach. Likewise, mismatching the duration of an asset to that of a future liability is an aggressive approach with greater risk. In order to better understanding this important relationship, I presented a table showing the impact of matching and mismatching on the investor’s return over various holding periods. For example, funding my 9 year- old child’s freshman year of college (9 years into the future) with a 1-year duration bond would involve reinvesting the proceeds from the maturing bond eight times prior to the time my child enters college. Because future interest rates are unknown, this investment approach is much more risky that an approach of funding the future liability with a 9-year duration bond that involves no reinvestment risk.

______AMIR Program 4 Fixed Income Securities Professionals .

Appendix I: Fixed Income Securities Professionals Agenda

Workshop for Fixed Income Securities Professionals at the Central Bank of Jordan March 7-8, 2006

DAY ONE: Tuesday, March 7, 2006

08:30 Registration

09:00-09:10 Welcoming Remarks and Introduction

Speaker: Mr. Gregory Ambrosio, Residence Advisor, U.S. Treasury

09:10-10:10 Overview of the Types and Features of Fixed Income Securities

- T-bills (money market securities) - Notes and Bonds (government and corporate)

Speaker: Dr. Ronald Copley, AMIR Program Consultant

10:10-10:30 Group Photo and Coffee Break

10:30-11:00 Practical Application Which products do bank treasurers' use when and how?

Speaker: Mr. Robert McDonough, FSVC Volunteer

11:00-12:00 Risks Associated with Investing in Fixed Income Instruments

- Interest rate risk - Credit/Default risk - Maturity and liquidity risks - Inflation risk

Speaker: Dr. Ronald Copley, AMIR Program Consultant

12:00-1:00 Lunch

01:00-03:00 Practical Application How does a bank treasurer measure and incorporate fixed income instrument risk in managing a bank’s portfolio?

Speaker: Mr. Robert McDonough, FSVC Volunteer

03:00-03:30 Coffee Break

______AMIR Program 5 Fixed Income Securities Professionals .

03:30-04:00 A Review of Time Value of Money

- Future value - Present value - Yield concepts (Internal rate of return)

Speaker: Dr. Ronald Copley, AMIR Program Consultant

04:00-05:00 Bond Pricing

- Pricing methods and principles - Conventional yield measures - Total return analysis

Speaker: Dr. Ronald Copley, AMIR Program Consultant

DAY TWO: Wednesday, March 8, 2006

09:00-10:00 Bond Price Volatility

- Price-yield relationships - Measure of bond price volatility

Speaker: Dr. Ronald Copley, AMIR Program Consultant

10:00-10:30 Coffee Break

10:30-11:15 Practical Application Managing Fixed Income securities Risk and Volatility for the Bank proprietary portfolio

- Back testing - Monte Carlo

Speaker: Mr. Robert McDonough, FSVC Volunteer

11:15-12:15 Term Structure of Interest Rates

- Base interest rate - Risk premium - Building a yield curve

Speaker: Dr. Ronald Copley, AMIR Program Consultant

12:15-01:15 Lunch

______AMIR Program 6 Fixed Income Securities Professionals .

01:15-02:15 Practical Application Using the yield curve to price securities for the portfolio. Discussion to include:

- Yield Curve strategy - Yield differential/pickup - Yield spread and strategies

Speaker: Mr. Robert McDonough, FSVC Volunteer

02:15-02:30 Coffee Break

02:30-04:00 Practical Application Liquidity Management:

- Funds Management - Information systems - Scenarios - Diversification - Warning Indicators and Contingency planning

Speaker: Dr. Ronald Copley, AMIR Program Consultant

04:00-04:30 Liquidity rating and reporting

Speaker: Mr. Robert McDonough, FSVC Volunteer

04:30 Distribution of Certificates

______AMIR Program 7 Fixed Income Securities Professionals .

Appendix II: Fixed Income Securities Professionals Presentation

Government Bond Workshop

Ronald E. Copley, Phd, CFA Copley Investment Management Registered Investment Adviser Wilmington, North Carolina [email protected] March 7- 8, 2006

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities:

What is a bond?

______AMIR Program 8 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities:

A bond is a debt security, in which the issuer is obligated to repay the principal and interest (the coupon) until the bond matures. • A government bond - issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are sovereigns bonds. • Bonds - enable the issuer to finance long-term projects with long-term funds (matching principal), and shorter-term projects with shorter-term funds.

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities:

What is the difference between a bond and a bank loan?

______AMIR Program 9 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

A bond is similar to a bank loan: • The issuer is equivalent to the borrower, bond holder to lender, and coupon to interest . • Debt securities maturing less than one year are typically bills, certificates of deposit or commercial paper , and considered money market instruments. • The U.S. Treasury uses the word bond only for issues with maturities longer than ten years, and the word note for issues between one and ten years,

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities:

What is the difference between a bond and a stock?

______AMIR Program 10 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Bonds and stocks are both securities: • Stock holders own a part of the issuing company with the right to dividends. • Bond holders are lenders (creditors) to the issuer for a definite period of time (until the bond matures) with a higher priority of claims against the issuer’s assets than stockholders. • A Consol is a perpetual bond (pays interest forever).

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

How are government bonds classified?

______AMIR Program 11 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Classification of Government Issuers: • Supranational agencies - such as the European Investment Bank or the Asian Development Bank. • National Governments - issue Government bonds in their own currency (risk-free bonds). • Provincial, state or local authorities (municipalities) - in the U.S., municipalities issue municipal bonds that may have the backing of the particular state government.

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Classification of Governmental Issuers (cont.): • Government sponsored entities - in the U.S., Agencies such as the Federal Home Loan Mortgage Corporation (Freddie Mac). • Bunds - issued by the German Finance Agency, denominated in Euros. • Gilts - issued by the UK Debt Management Office denominated in Sterling . • US Treasuries - issued by the Bureau of the Public Debt denominated in US dollars . • Jordanian Treasuries – issued by the Ministry of Finance denominated in Jordanian Dinars .

______AMIR Program 12 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Classification of Governmental Issuers (cont.): • Zero coupon bonds - do not pay interest and trade at a substantial discount from par .The bond holder receives the full principal amount on the maturity date that includes accrued interest. • Strips - the coupon is separated from the final principal payment of the bond and traded independently.

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Classification of Governmental Issuers (cont.): • Inflation linked bonds - the principal amount is indexed to inflation and the interest rate is lower than for fixed rate bonds with a comparable maturity. • As the principal amount grows, the payments increase with inflation-Treasury Inflation- Protected Securities (TIPS ).

______AMIR Program 13 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

How are non-government bonds classified?

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Non-Governmental Issuers: • Companies (corporates) issue Corporate bonds of varying levels of risk to finance purchase of assets. • Special Purpose Vehicles (SPVs) are companies containing assets against which bonds are issued. Such bonds are called asset-backed bonds where the assets may be credit cards or auto loans.

______AMIR Program 14 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

How are bonds issued?

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Underwriting and Auctioning: • The most common process of issuing corporates is through underwriting (risk taking) . One or more banks form a syndicate to purchase the bonds and resell them to their customers. This is similar to how auto dealers operate in the new car market. • US Government bonds are typically auctioned to a network of dealers that resells the bonds to institutional investors who, in turn, may resell them to their customers.

______AMIR Program 15 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

What are the most common features of a bond?

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

The most common features of a bond are: • nominal , principal or face amount - amount over which issuer pays interest, and which has to be repaid at the end. • issue price - price at which investors buy bonds when they are first issued. • maturity date - date on which issuer has to repay the nominal amount. • term - length of time until maturity date is often referred to as term or simply maturity of a bond.

______AMIR Program 16 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Features of bonds (cont.): • coupon rate - interest rate that issuer pays to bond holders either fixed throughout the life or variable with an index such as LIBOR. • coupon dates - dates on which issuer pays the coupon to the bond holders. • callability - some bonds give issuer the right to repay the bond before maturity date on call dates .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

How are the various bond features determined?

______AMIR Program 17 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

An Investment Banker or financial adviser can assist the issuer in determining various bond features, such as the coupon rate: • The coupon rate - rate issuer must pay is influenced by a variety of factors, such as current market interest rates, the length of term and credit worthiness of the issue. • These factors change over time.

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.): Coupon rate depends on: • Quality rating —lower rating means higher coupon due to higher default risk. • Term to maturity —longer maturities mean higher coupon rate due to higher reinvestment risk. • Issuers attempt to reduce coupon rate by attaching various financing features .

______AMIR Program 18 Fixed Income Securities Professionals .

Government Bond Workshop

Overview of the Types and Features of Fixed Income Securities (cont.):

Setting Coupon Rate: • The coupon rate on newly issued bonds is determined by observing the YTM on bonds of similar risk and characteristics trading in the open market. This is similar to conducting an “auction” where bids are based on yields on bonds of comparable risk. • The quality rating of the bond plays an important role in finding comparable bonds.

Government Bond Workshop

Risks Associated with Investing in Fixed Income Instruments:

What risks are associated with investing in fixed income investments?

______AMIR Program 19 Fixed Income Securities Professionals .

Government Bond Workshop

Risks Associated with Investing in Fixed Income Instruments( cont.): • Government bonds are usually referred to as risk- free bonds , because the government can raise taxes or simply print more money to redeem the bond at maturity • In this instance, the term risk-free means free of credit risk or default risk, but not free of interest rate risk.

Government Bond Workshop

Risks Associated with Investing in Fixed Income Instruments( cont.): • Currency risk for foreign investors (for example, non-US investors of US Treasuries would have received lower returns in 2004 because the value of the US dollar declined against most other currencies) • Inflation risk - is that the principal repaid at maturity will have less purchasing power than anticipated if the inflation is higher than expected. TIPS are designed to protect against inflation risk.

______AMIR Program 20 Fixed Income Securities Professionals .

Government Bond Workshop

Risks Associated with Investing in Fixed Income Instruments( cont.): Marketability vs Liquidity: • Marketable-- large trading volume and number of dealers that allow easy transactions. • Liquidity—measure of price stability . • Short-term bonds are more liquid than long-term bonds. • Higher quality bonds are more liquid than lower quality. • T-bills most liquid and marketable.

Government Bond Workshop

Risks Associated with Investing in Fixed Income Instruments( cont.): Interest rate risk —bond prices fall as interest rates increase, and vice versa: • The longer the maturity, the greater the degree of price volatility. • The inverse relationship is caused by new issues coming to market with yields different than older securities.

______AMIR Program 21 Fixed Income Securities Professionals .

Government Bond Workshop

Risks Associated with Investing in Fixed Income Instruments( cont.): • One way to quantify the interest rate risk on a bond is in terms of its duration . Efforts to control this risk are called immunization or hedging strategies. • Bonds prices can be volatile if a credit rating agency like Standard & Poor's or Moody’s upgrades or downgrades the rating of the issuer • Short-term bonds incur reinvestment risk , meaning the investor is forced to reinvest principal in a different investment at an unknown rate.

Government Bond Workshop

Risks Associated with Investing in Fixed Income Instruments( cont.): S&P and Moody’s employs a global rating scale that imposes a consistent discipline on all cross-border analysis: • Debt holders can compare issues of equivalent credit quality. • The credit ratings of non-sovereign borrowers most often are at, or below, the ratings of the relevant sovereign.

______AMIR Program 22 Fixed Income Securities Professionals .

Government Bond Workshop

Investment Grade Bonds (Ratings):

Bond Rating Moody's S&P/ Fitch Grade Risk Aaa AAA Investment Highest Quality Aa AA Investment High Quality A A Investment Strong Baa BBB Investment Medium Grade Ba, B BB, B Non-investment Speculative Caa/Ca/C CCC/CC/C Non-investment Highly Speculative C D Non-investment In default

Government Bond Workshop

Risks Associated with Investing in Fixed Income Instruments( cont.): S&P credit rating: • Opinion of the creditworthiness of an issuer , or • Creditworthiness of a specific issue . • Timeliness of payment and protection to creditor in case of default. • Debt as a percentage of Gross Domestic Product is an important factor for government bonds.

______AMIR Program 23 Fixed Income Securities Professionals .

Government Bond Workshop

A Review of the Time Value of Money:

What is the importance of the time value of money in pricing a bond?

Government Bond Workshop

A Review of the Time Value of Money (cont.): • The current market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield. • The yield represents the current market interest rate of bonds with similar risk characteristics. • Yield and price of a bond are inversely related so that when market interest rates rise, bond prices fall, and vice versa. • Interest rates are generally the major factor affecting the price of all bonds.

______AMIR Program 24 Fixed Income Securities Professionals .

Government Bond Workshop

A Review of the Time Value of Money (cont.): • Taking into account the expected capital gain or loss (the difference between the current price and the maturity value) gives the "yield to maturity”. • The YTM is approximately the current yield plus the capital gain (negative for loss) per year until maturity.

Note : Be careful with the term “yield .” It usually means yield-to-maturity but could also mean current yield .

Government Bond Workshop

A Review of the Time Value of Money (cont.): Example of Yield-to-Maturity (t = 0): Purchase price = 75.28 ($752.60) Par Value = $1,000 Coupon rate = 5 % ($50 per year) Years to maturity = 10 Yield-to-maturity = 8.83% (calculated on an Excel Spreadsheet or Financial Calculator).

______AMIR Program 25 Fixed Income Securities Professionals .

Government Bond Workshop

A Review of the Time Value of Money (cont.): Example of Yield-to-Maturity (t = 1): Interest rates in market = 7% (declined from 8.83%) Current Value of bond = $869.70 (present value of $50 for 9 years + present value of $1,000) Total Return = Coupon rate + Price Appreciation = 5% + ($869.70 - $752.60) / $752.60 = 5% + 16% = 21% (1-year return)

Government Bond Workshop

Bond Pricing:

How are government bonds priced?

______AMIR Program 26 Fixed Income Securities Professionals .

Government Bond Workshop

Bond Pricing: • Bonds may be issued at par (100% of face value equal to a price of 100) • Most government bonds are sold in units of $1000

• All bond prices converge to par at maturity (assuming no default). • The coupon rate divided by the current price of the bond is called the "current yield”.

Government Bond Workshop

Bond Pricing (cont.): Yield measures: Current yield —annual return on amount paid for a bond.

Example 1: Par value of bond = $1,000 Price of bond = $1,000 Coupon rate = 6% Current yield = 6% (= $60/$1,000)

______AMIR Program 27 Fixed Income Securities Professionals .

Government Bond Workshop

Bond Pricing (cont.):

Example 2: Par value of bond = $1,000 Price of bond = $900 Coupon rate = 6% Current yield = 6.67% (= $60/$900)

Government Bond Workshop

Example (calculating current selling price): What is the value of a 20 year, 10%, semiannual pay bond priced to yield 10.6% (coupon rate of newly issued bonds in open market is 10.6%). Converting annual coupons and periods to semiannual gives (10.6 / 2 = 5.3), and (2 x 20 = 40). On a Texas Instruments BA-35 calculator, you would enter: 40 = N, 5.3 = %i, 50 = PMT, 1000 = FV, CPT = PV. Value = $950.57 (current selling price)

______AMIR Program 28 Fixed Income Securities Professionals .

Government Bond Workshop

Example (actual total return, not promised like YTM): Holding Period Return (total): Return (actual) = yield +/- Gain (Loss) = (coupon/purchase price) +/- [(sale price–purchase price)/purchase price] Example: t=0 Purchase Price: $900 Coupon Rate: 6%

t=1 Sell Price: $1,000 (market rates have declined) Holding Period Return = (60/900) + [(1,000-900)/900] = 17.78%

Government Bond Workshop

Bond Pricing (cont.): • The price including accrued interest is known as the " flat " price. • The price excluding accrued interest is known as the " clean " price.

______AMIR Program 29 Fixed Income Securities Professionals .

Government Bond Workshop

Convergence

$1,200

$1,100

$1,000 Price $900

$800 109876543210 Years Until Maturity Bond Purchased at a Discount Bond Purchased at a Premium

Government Bond Workshop

Bond Price Volatility:

What is a good measure of bond price volatility?

______AMIR Program 30 Fixed Income Securities Professionals .

Government Bond Workshop

Bond Price Volatility (cont.): Duration : • Point in time at which interest rate risk offsets reinvestment rate risk. • Investor achieves the same return , no matter what happens to interest rates ( immunization ). • Shorter term bonds generally have lower duration than longer term bonds, which means shorter term bonds are less risky.

Government Bond Workshop

Bond Price Volatility (cont.): Duration and Interest rate risk : • Price risk • Coupon reinvestment risk Price Risk—chance that interest rates will differ from expectations. Because future interest rates are unknown , you incur risk of the unknown. Reinvestment Risk—arises because interest rates at the time you receive coupon payments must be reinvested are unknown.

______AMIR Program 31 Fixed Income Securities Professionals .

Government Bond Workshop

Bond Price Volatility (cont.): The Matching Principle (Immunization) • Higher rates lead to a drop in price but more interest on interest • Lower rates lead to a rise in price but a drop in interest on interest. • Immunization eliminates these two opposing effects and is achieved by setting the duration of the bond equal to the investment horizon. • Immunization is a passive strategy.

Government Bond Workshop

Bond Price Volatility (cont.): Total Return on a 9% $1,000 Bond Due in 10 Years and Held through Various Holding Periods. The following analysis assumes a flat yield curve with parallel shifts immediately following purchase.

______AMIR Program 32 Fixed Income Securities Professionals .

Government Bond Workshop

Income Source Rate Years Held 1 3 5 6.79 9 10 Coupon Income 5% $90 $270 $450 $611 $810 $900 Capital gain or loss 287 234 175 100 39 0 Interest on Interest 1 17 54 105 191 241 $378 $521 $679 $816 $1,040 $1,141 Total Return 37.00% 15.00% 11.00% 9.00% 8.50% 8.20% Coupon Income 9% $90 $270 $450 $611 $810 $900 Capital gain or loss 0 0 0 0 0 0 Interest on Interest 2 32 103 205 387 495 $92 $302 $553 $816 $1,197 $1,395 Total Return 9.00% 9.00% 9.00% 9.00% 9.00% 9.00% Coupon Income 11% $90 $270 $450 $611 $810 $900 Capital gain or loss -112 -95 -75 -56 -18 0 Interest on Interest 2 40 129 261 502 647 $20 $215 $504 $816 $1,294 $1,547 Total Return 2.00% 6.70% 8.50% 9.00% 9.70% 9.80%

Government Bond Workshop

Term Structure of Interest Rates:

What is the “Term Structure of Interest Rates (Yield Curve)”

______AMIR Program 33 Fixed Income Securities Professionals .

Government Bond Workshop

Term Structure of Interest Rates (cont.): Base Interest Rate: Risk free rate and the risk premium—the following equation originally developed by Fisher shows the factors that drive interest rates: i = Rf + risk premium where Rf = real rate + an inflation premium

Government Bond Workshop

Term Structure of Interest Rates (cont.): Real rate: • Reflects productivity of the economy • Must at least equal the rate of increase in the population . Inflation premium : • Driven by monetary policy. • Usually the most important factor driving short-term rates. Risk premium (government bonds) • Business risk (macro) concerned with country’s economic competitiveness in global market.

______AMIR Program 34 Fixed Income Securities Professionals .

Government Bond Workshop

Term Structure of Interest Rates (Yield Curve) cont: The yield curve shows the relationship between yields for different maturities. Three theories generally explain the shape of the yield curve . I. The Pure Expectations Theory – the long rate is the geometric average of the short rates. For example, if the 2-year rate (long rate) is 12 percent and the one- year spot rate (short rate) is 10 percent, then the one- year forward rate one year from now will equal approximately 14 percent. (1+ .12)^2 = [(1+ .10) (1+forward rate)] - 1

Government Bond Workshop

Term Structure of Interest Rates (Yield Curve) cont: II. The Liquidity Premium hypothesis: • Says that investors in longer-term bonds have less liquidity than shorter-term investors and, thus, must be compensated for the higher risk . • The liquidity premium is an increasing function of maturity, although at a decreasing rate. • The liquidity premium hypothesis is sometimes combined with the expectations theory to create a premium over the yield curve indicated by the pure expectations theory:

______AMIR Program 35 Fixed Income Securities Professionals .

Government Bond Workshop

Total Y ield Curve Y ield L iqu idity Pre m iu m

Pure Expectations Yield Curve

M aturity

Government Bond Workshop

Term Structure of Interest Rates (Yield Curve) cont: III. Market Segmentation : the yield curve is determined by the supply and demand for loanable funds within each market segment .

1 2 3 4 Segment Yield

Maturity

______AMIR Program 36 Fixed Income Securities Professionals .

Government Bond Workshop

Term Structure of Interest Rates (Yield Curve) cont: The relationship between yield and maturity for otherwise identical bonds is the yield curve . • The relationship between the spot rate and maturity for identical bonds is the spot rate curve . • The yield curve shows yields based on cash flows from both future coupon payments (including interest on interest) and principal. • The spot rate curve shows yields based only on cash flow from future principal (zero-coupon bonds).

Government Bond Workshop

Term Structure of Interest Rates (Yield Curve) cont: Creating a spot rate curve from coupon paying Treasuries is “bootstrapping .”

8 .5 0 8 .0 0 7 .5 0 7 .0 0

Yield 6 .5 0 6 .0 0 5 .5 0 5 .0 0

5 5 0. 1.5 2.5 3.5 4.5 5.5 6.5 7.5 8. 9.5 Y e a r

Yield C urve S pot Rate C urve

______AMIR Program 37 Fixed Income Securities Professionals .

Appendix III: Fixed Income Securities Professionals Background Reading

Bonds In finance, a bond is a debt security , in which the issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon ). Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer. Bonds are generally issued for a fixed term (the maturity ) longer than one year. A bond is just a loan , but in the form of a security, although terminology used is rather different. The issuer is equivalent to the borrower , the bond holder to the lender and the coupon to the interest . Debt securities with a maturity shorter than one year are typically bills , certificates of deposit or commercial paper , and considered money market instruments. Traditionally, the U.S. Treasury uses the word bond only for their issues with a maturity longer than ten years, and calls issues between one and ten year notes . Elsewhere in the market this distinction has disappeared, and both bonds and notes are used irrespective of the maturity. Market participants use bonds normally for large issues offered to a wide public, and notes rather for smaller issues originally sold to a limited number of investors. There are no clear demarcations. Bonds and stocks are both securities, but the difference is that stock holders own a part of the issuing company (have an equity stake), whereas bond holders are in essence lenders to the issuer. Also bonds have a definite lifespan, their maturity, whereas stocks may be held indefinitely. An exception is a consol bond, which is a perpetuity .

Issuers The range of issuers of bonds is very large. Almost any organization could issue bonds, but the underwriting and legal costs can be prohibitive. Regulations to issue bonds are very strict. Issuers are often classified as follows:

• Supranational agencies , such as the European Investment Bank or the Asian Development Bank issue Supranational bonds .

• National Governments issue Government bonds in their own currency. These are often viewed as risk-free bonds because governments can raise taxes, if needed, to pay off the bonds. They also issue sovereign bonds in foreign currencies .

• Provincial, state or local authorities (municipalities) . In the U.S. they issue what are known as municipal bonds

______AMIR Program 38 Fixed Income Securities Professionals .

• Government sponsored entities in the U.S., such as the Federal Home Loan Mortgage Corporation (Freddie Mac) issue Agency bonds , commonly known as Agencies .

• Companies (corporates) issue Corporate bonds .

• Special purpose vehicles are companies set up for the sole purpose of containing assets against which bonds are issued, often called asset-backed securities .

Issuing bonds Bonds are issued by governments or other public authorities, credit institutions, companies and supranational institutions in the primary markets . The most common process of issuing bonds is through underwriting. One or more banks, forming a syndicate, underwrite the bonds, and sell them on to their customers. Government bonds are typically auctioned. Bonds enable the issuer to finance long-term investments with external funds.

Features of bonds The most important features of a bond are:

• nominal , principal or face amount - the amount over which the issuer pays interest, and which has to be repaid at the end.

• issue price - the price at which investors buy the bonds when they are first issued. The net proceeds that the issuer receives, are calculated as the issue price, less the fees for the underwriters, times the nominal amount.

• maturity date - the date on which the issuer has to repay the nominal amount. After the maturity date the issuer has no more obligations to the bond holders, as long as all payments have been made of course. The length of time until the maturity date is often referred to as the term or simply maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. These are called perpetuities . In early 2005 , a market developed in euro for bonds with a maturity of fifty years. In the market for U.S. Treasury securities, there are three groups of bond maturities:

o short term (Bills): maturities up to one year

o medium term (Notes): maturities between one and ten years

o long term (Bonds): maturities greater than ten years

• coupon - the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index , such as LIBOR , or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued

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which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

• coupon dates - the dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-annual , which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one coupon a year.

• callability - Some bonds give the issuer the right to repay the bond before the maturity date on the call dates . These bonds are referred to as callable bonds . Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium . This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.

• puttability - Some bonds give the bond holder the right to force the issuer to repay the bond before the maturity date on the put dates.

• call dates and put dates - the dates on which callable and puttable bonds can be redeemed early. There are four main categories.

o A Bermudan callable has several call dates, usually coinciding with coupon dates.

o A European callable has only one call date. This is a special case of a Bermudan callable.

o An American callable can be called at any time until the maturity date.

o A Death Put an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option".

• indenture - a document specifying the rights of bond holders. In the U.S. federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. The terms may be changed while the bonds are outstanding, but amendments to the governing document often require approval by a majority vote of the bond holders.

Types of bond

• Fixed rate bonds have a coupon that remains constant throughout the life of the bond.

• Floating rate notes (FRN's) have a coupon that is linked to a money market index , such as LIBOR or EURIBOR, for example three months USD LIBOR +0.20%. The coupon is then reset periodically, normally every three months.

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• Convertible bonds can be converted, on the maturity date, into another kind of security, usually common stock in the company that issued the bonds.

• High yield bonds are bonds that are rated below investment grade by the credit rating agencies . As these bonds are relatively risky, investors expect to earn a higher yield, hence the name high yield bonds. Those market participants that want to emphasize the risky nature of the bonds, also call them junk bonds .

• Zero coupon bonds do not pay any interest. They trade at a substantial discount from par . The bond holder receives the full principal amount on the maturity date. An example of zero coupon bonds are Series E savings bonds issued by the U.S. Government. Zero coupon bonds may be created from fixed rate bonds by financial institutions by "stripping off" the coupons. In other words, the coupons are separated from the final principal payment of the bond and traded independently.

• Inflation linked bonds , in which the principal amount is indexed to inflation. The interest rate is lower than for fixed rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked Gilts in the 1980's . Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. Government.

• Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS), collateralized mortgage obligations (CMO) and collateralized debt obligations (CDO).

• Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As the expectation that you get paid back is lower, the risk is higher. Therefore, subordinated bonds have a lower credit rating then senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches . The senior tranches get paid back first, the subordinated tranches later.

• Perpetual bonds are also often called perpetuities . They have no maturity date. The most famous of these are the UK Consols , which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today.

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Trading and valuing bonds

The interest rate that the issuer of a bond must pay is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer. Since these factors are likely to change over time, the market value of a bond can vary after it is issued. Because of these differences in market value, bonds are priced in terms of percentage of par value. Bonds are not necessarily issued at par (100% of face value, corresponding to a price of 100), but all bond prices converge to par at the moment before they reach maturity. At other times, prices can either rise (bond is priced at greater than 100), which is called trading at a premium, or fall (bond is priced at less than 100), which is called trading at a discount. Most government bonds are denominated in units of $1000, if in the United States , or in units of one hundred pounds, if in the United Kingdom . Hence, a deep discount US bond, selling at a price of 75.26, indicates a selling price of $752.60 per bond sold. (Often, bond prices are quoted in points and thirty seconds of a point, rather than in decimal form.) Some short-term bonds, such as the U.S. T-Bill, are always issued at a discount, and pay par amount at maturity rather than paying coupons. This is called a discount bond. The market price of a bond is the present value of all future interest and principal payments of the bond discounted at the bond's yield, or rate of return. The yield represents the current market interest rate for bonds with similar characteristics. The yield and price of a bond are inversely related so that when market interest rates rise, bond prices generally fall and vice versa. The market price of a bond may include the accrued interest since the last coupon date. (Some bond markets include accrued interest in the trading price and others add it on explicitly after trading.) The price including accrued interest is known as the "flat", "dirty" or "tel quel price ". ( See also Accrual bond .) The price excluding accrued interest is sometimes known as the "clean" price. The interest rate adjusted for the current price of the bond is called the "current yield" or "earnings yield" (this is the nominal yield multiplied by the par value and divided by the price). Taking into account the expected capital gain or loss (the difference between the current price and the redemption value ) gives the "redemption yield": roughly the current yield plus the capital gain (negative for loss) per year until redemption. The relationship between yield and maturity for otherwise identical bonds is called a yield curve .

Investing in bonds

Bonds are bought and traded mostly by institutions like pension funds, insurance companies and banks. Most individuals who want to own bonds do so through mutual funds . Still, in the U.S., nearly ten percent of all bonds outstanding are held directly by households. Bonds are generally viewed as safer investments than stocks , but this perception is only partially correct. Bonds do suffer from less day-to-day volatility than stocks, and

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bonds' interest payments are higher than dividend payments that the same company would generally choose to pay to its stockholders. Bonds are liquid — it is fairly easy to sell one's bond investments, though not nearly as easy as it is to sell stocks — and the certainty of a fixed interest payment twice per year is attractive. Bondholders also enjoy a measure of legal protection: under the law of most countries, if a company goes bankrupt , its bondholders will often receive some money back, whereas the company's stock often ends up valueless. However, bonds can be risky:

• Fixed rate bonds are subject to interest rate risk , meaning they will decrease in value when the generally prevailing interest rate rises. When the market's interest rates rise, then the market price for bonds will fall, reflecting investors' improved ability to get a good interest rate for their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate. This drop in the bond's market price does not affect the interest payments to the bondholder at all, so long-term investors need not worry about price swings in their bonds. However, price changes in a bond immediately affect mutual funds that hold these bonds. Many institutional investors have to "mark to market" their trading books at the end of every day. If the value of the bonds held in a trading portfolio has fallen over the day, the "mark to market" value of the portfolio may also have fallen. This can be damaging for professional investors such as banks, insurance companies, pension funds and asset managers. If there is any chance a holder of individual bonds may need to sell his bonds and "cash out" for some reason, interest rate risk could become a real problem. (Conversely, bonds' market prices would increase if the prevailing interest rate were to drop, as it did from 2001 through 2003.) One way to quantify the interest rate risk on a bond is in terms of its duration . Efforts to control this risk are called immunization or hedging .

• Bonds prices can become volatile if one of the credit rating agencies like Standard & Poor's or Moody's upgrades or downgrades the credit rating of the issuer. A downgrade can cause the market price of the bond to fall. As with interest rate risk, this risk does not affect the bond's interest payments, but puts at risk the market price, which affects mutual funds holding these bonds, and holders of individual bonds who may have to sell them.

• A company's bondholders may lose much or all their money if the company goes bankrupt . Under the laws of the United States and many other countries, bondholders are in line to receive the proceeds of the sale of the assets of a liquidated company ahead of some other creditors. Bank lenders, deposit holders (in the case of a deposit taking institution such as a bank) and trade creditors may take precedence. There is no guarantee of how much money will remain to repay bondholders. As an example, after an accounting scandal and a Chapter 11 bankruptcy at the giant telecommunications company Worldcom , in 2004 its bondholders ended up being paid 35.7 cents on the dollar. In a bankruptcy involving reorganization or recapitalization, as opposed to liquidation, bondholders may end up having the value of their bonds reduced, often through an exchange for a smaller number of newly issued bonds.

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• Some bonds are callable, meaning that even though the company has agreed to make payments plus interest towards the debt for a certain period of time, the company can choose to pay off the bond early. This creates reinvestment risk , meaning the investor is forced to find a new place for his money, and the investor might not be able to find as good a deal, especially because this usually happens when interest rates are falling.

Arguments against bonds

Some theories of economics, notably Islamic economics and green economics , argue that the overall effect of any debt on ecosystems and society is so negative that no bond should have any legal status. These theories are part of a broader category called creditary economics . In these, there is no creditor, only a joint venture partner or investor . Remnants of this same belief still exist even today in Western finance and legal precedents, as seen in usury laws, mortgage laws, and also as seen in perpetual bonds . At the time of issue during the late Middle Ages , many perpetual bonds were sold not as debt instruments but rather as an income stream or annuity instrument. One was buying a future income, not lending money. By this thinking, no interest was paid on perpetual bonds, despite the existence of a yield for such financial instruments. (source: Wikipedia, the free encyclopedia)

Copyright: The license Wikipedia uses grants free access to our content in the same sense as free software is licensed freely. This principle is known as copyleft . That is to say, Wikipedia content can be copied, modified, and redistributed so long as the new version grants the same freedoms to others and acknowledges the authors of the Wikipedia article used (www.wikipedia.org).

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Government Bonds

A government bond is a bond issued by a national government denominated in the country's own currency . Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds .

Risk

Government bonds are usually referred to as risk-free bonds , because the government can raise taxes or simply print more money to redeem the bond at maturity. Some counterexamples do exist where a government has defaulted on its domestic currency debt, such as Russia in 1998 , though this is very rare. As an example, in the US, Treasury securities are denominated in US dollars and are the safest US dollar investments. In this instance, the term risk-free means free of credit risk . However, other risks still exist: such as currency risk for foreign investors (for example non-US investors of US Treasuries would have received lower returns in 2004 because the value of the US dollar declined against most other currencies). Secondly, there is inflation risk - in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation outturn is higher than expected. Many governments issue inflation-indexed bonds , which protect investors against inflation risk.

Issuance

Government bonds are issued through agencies that are part of the government's treasury department, for example

• Bunds are bonds issued by the German Finance Agency , denominated in euros

• Gilts are bonds issued by the UK Debt Management Office and are denominated in sterling

• US Treasuries are issued by the Bureau of the Public Debt

List of government bonds from the main issuers

Government Negociable financial Generic debt at mid- Rating liabilities as % Currency Country Name or 2005 ( US Issuer (S&P /Moody's ) of GDP (end Nickname dollar bn 2003 - source : equivalent) OECD ) Ministry of Yen JGBs AA-/A2 6,666 157.5% Japan Finance (MoF) United US Bureau of the US dollar AAA/Aaa 4,000 62.5% States Treasuries Public Debt AA- with negative Dipartimento del Euro BTPs 1,530 120.9% Italy outlook/Aa2 Tesoro

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Agence France Euro OATs AAA/Aaa 1,300 71.2% France Trésor Finanzagentur Euro Bunds AAA/Aaa 1,020 65.1% Germany GmbH UK Debt Pound United Gilts AAA/Aaa 703 42.0% Management sterling Kingdom Office

Japan (AA-/A2) Issued By: Ministry of Finance (MoF)

• Japanese Government Bonds (JGBs)

o Revenue Bonds/Straight Bonds

o Financing Bills

o Subsidy Bonds

o Subscription Bonds

o Contribution Bonds

o Demand Bonds (kofu kokusai)

Europe

Eurozone

France (AAA/Aaa) Issued By: Agence France Trésor , the French Debt Agency

• OATs

o BTFs - bills

o BTANs - 1 to 6 year notes

o Obligations assimilables du Trésor (OATs) -

o TEC10 OATs - floating rate bonds indexed on constant 10year maturity OAT yields

o OATi - French inflation-indexed bonds

o OAT€i - Eurozone inflation-indexed bonds

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Germany (AAA/Aaa) Issued By: Finanzagentur GmbH , the German Finance Agency

• Bunds

o Bubill - bills

o Bundesschatzanweisungen ( Schätze ) - 2 year notes

o Bundesobligationen ( Bobls ) - 5 year notes

o Bundesanleihen (Bunds) - bonds

Italy (AA- "with negative outlook"/Aa2) Issued By: Dipartimento del Tesoro

• BTPs

o Buoni Ordinari del Tesoro (BOTs ) - bills up to 1 year

o Certificati del Tesoro Zero Coupon (CTZ ) - bills up to 2 year

o Buoni del Tesoro Polianuali (BTPs ) - bonds

o Certificati di Credito del Tesoro (CCTs ) - floating rate notes

o BTP Indicizzato all'Inflazione - inflation linked bonds

United Kingdom (AAA/Aaa) Issued By: UK Debt Management Office

• Gilts

o Conventional Gilts

o Index-linked Gilts

o Double-Dated Gilts

o Undated Gilts

o Gilt Strips

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North America

United States (AAA/Aaa) Issued By: Bureau of the Public Debt

• US Treasuries

o Treasury bill

o Treasury note

o Treasury bond

o TIPS

o Savings bond

(source: Wikipedia, the free encyclopedia)

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Treasury Security

Treasury securities are government bonds issued by the United States Department of the Treasury through the Bureau of the Public Debt . They are the debt financing instruments of the U.S. Federal government, and are often referred to simply as Treasuries . There are four types of treasury securities: Treasury bills, Treasury notes, Treasury bonds, and Savings bonds. All of the Treasury securities (besides savings bonds ) are very liquid and are heavily traded on the secondary market .

Treasury bills

Treasury bills (or T-bills ) mature in one year or less. They are like zero coupon bonds in that they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity . Treasury bills are considered by many the most risk free investment. Treasury Bills are commonly issued with maturity dates of 4 weeks, 91 days (~13 weeks), and 182 days (~26 weeks). Treasury Bills are sold weekly at an auction held on Mondays. Banks and financial institutions, especially primary dealers , are the largest purchasers of T-Bills. They are quoted for purchase and sale in the secondary market on an annualized percentage yield to maturity, or 'basis'.

Treasury notes

Treasury notes (or T-Notes ) mature in one to ten years. They have a coupon payment every six months, and are commonly issued with maturities dates of 2, 3, 5 or 7 years, for denominations from $1,000 to $1,000,000. T-Notes and T-Bonds are quoted on the secondary market at percentage of par in thirty-seconds of a point. Thus, for example, a quote of 95.7 on a note indicates that it is trading at a discount: $952.19 for a $1,000 bond.

The 10-year Treasury note has become the security most frequently quoted when discussing the performance of the U.S. government-bond market and is used to convey the market's take on longer-term macroeconomic expectations. It is also important to the U.S. mortgage market, which uses the yield on the 10-year Treasury note as a benchmark for setting mortgage interest rates.

Treasury bonds

Treasury bonds (or T-Bonds ) mature in ten years or longer. They have coupon payment every six months like T-Notes, and are commonly issued with maturity dates of ten and thirty years. The secondary market is highly liquid, so the yield on the most recent T-Bond offering was commonly used as a proxy for long-term interest rates in general. This role has largely been taken over by the 10-year note, as the size and frequency of long-term bond issues declined significantly in the 1990s and early 2000s .

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The U.S. Federal government stopped issuing the well-known 30-year Treasury bonds (often called long-bonds) on October 31 , 2001 . As the U.S. government used its budget surpluses to pay down the Federal debt in the late 1990s, the 10-year Treasury note began to replace the 30-year Treasury bond as the general, most-followed metric of the U.S. bond market. However, the U.S. Treasury announced in August 2005 that due to a flattening of the yield curve (the difference between short-term bond yields and long-term bond yields is narrowing) and due to demand from pension funds and large, long-term institutional investors , the 30-year Treasury bond will be re- introduced in February 2006 . This will bring the U.S. in line with Japan and other European governments issuing longer-dated maturities amid growing global demand from pension funds (France and the United Kingdom are even offering a 50-year bond).

TIPS

Treasury Inflation-Protected Securities (or TIPS ) are the inflation-indexed bonds issued by the U.S. Treasury. The principal is adjusted to the Consumer Price Index , the commonly used measure of inflation . The coupon rate is constant, but generates a different amount of interest when multiplied by the inflation-adjusted principal, thus protecting the holder against inflation.

The interest payments from these securities are taxed for federal income tax purposes in the year payments are received (payments are semi-annual, or every six months) as one would expect. The inflation adjustment credited to the bonds is also taxable each year, which might not be expected. This tax treatment causes an interesting effect: Even though these bonds are intended to protect the holder from inflation, the cash flows generated by the bonds are actually inversely related to inflation until the bond matures. For example, during a period of no inflation, the cash flows will be exactly the same as for a normal bond, and the holder will receive the coupon payment minus the taxes on the coupon payment. During a period of high inflation, the holder will receive the same cash flow, but will also have to pay additional taxes on the inflation adjusted principal. The details of this tax treatment can have unexpected repercussions.

STRIPS

T-Notes, T-Bonds and TIPS may be "stripped", separating the interest and principal portions of the security; these may then be sold separately (in units of $1000 face value) in the secondary market. Such securities are known as STRIPS ("Separate Trading of Registered Interest and Principal Securities" being a backronym ); the name derives from the notional practice of literally tearing the interest coupons off of (paper) securities.

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Savings bond

Savings bonds are nontransferable treasury securities. Although they cannot be traded on the secondary market, they can be cashed before their maturity date after a required holding period, which is currently twelve months. They are also registered securities , so they can be replaced if lost or destroyed. Savings bonds do not have coupons. Interest is accrued, being paid out only upon the bond's redemption.

The treasury first offered the predecessor to savings bonds, called "baby bonds," in March , 1935 . The bonds were issued in denominations from $25 to $1,000. They were sold at 75 percent of face value, and accrued interest at the rate of 2.9% per year, compounded semiannually when held for their ten-year maturity period. Series A bonds were sold in March , 1935 . Series B bonds were offered in 1936 . Series C bonds were offered in 1937 and 1938 . Series D bonds were sold from 1939 through April , 1941 . The series E bonds started in May , 1941 and played a major role in financing World War II . Series E bonds sold for almost forty years before they were withdrawn from sale on June 30 , 1980 .

Series EE savings bonds were introduced in 1980 to replace the series E bond. They are sold at a discount to their face value. The interest on series EE bonds purchased since 1989 is exempt from federal and state taxes if it is used for education expenses. Since December 11 , 2001 , series EE bonds have been inscribed with the words "Patriot Bonds."

Series HH savings bonds originally sold in denominations from $500 to $10,000. Series E and EE savings bonds were able to be exchanged for them. The Series HH bonds pay interest semianually and mature in ten years. Federal income tax on these bonds can be deferred until the bonds are sold or mature. These bonds have not been available for purchase from the treasury, or via exchange of other bonds, since September 1 , 2004. [1]

Series I Bonds are sold at face value and grow in value with inflation-indexed earnings for up to 30 years. I Bonds gain interest once a month, with interest being compounded twice per year. The composite interest rate has two components (multiplied, not added): a guaranteed fixed rate, which does not change over the 30 year period; and a semiannual inflation rate, which is adjusted twice per year. Even in times of deflation , the composite interest rate is guaranteed never to go below zero, meaning an I Bond's redemption value can never go down.

(source: Wikipedia, the free encyclopedia)

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