Series 65 Free Practice Questions Quiz 06

Treasury securities
The following are various types of Treasury securities and their characteristics:
• Treasury bills are short-term debt instruments issued by the United States government with a maturity of less than one year.
• Treasury notes are medium-term debt obligations issued by the United States government. Maturity dates range between one and ten years. They are issued at par value with a fixed rate of interest and fall in the fixed income sector of the market.
• Treasury bonds, or T-bonds, bear the longest maturity of any of the Treasury securities. T-bonds are issued at par with fixed interest and maturities of greater than ten years. The fixed interest rate is determined through a competitive bidding process.

FNMA
FNMA stands for Federal National Mortgage Association and is often pronounced “Fannie Mae.” It is a government-sponsored, publicly traded company whose goal it is to make homeownership possible for lower-income families. The FNMA was founded in 1938 to create a secondary mortgage market. FNMA buys and guarantees mortgages that meet its underwriting criteria, thus creating mortgage-backed securities. These mortgage-backed securities are resold and tradable. There is a large market for FNMA mortgage-backed securities, making them very liquid. Their liquidity and relative safety (being a government- backed company) make them highly desirable to multiple classes of investors.

TIPS
Treasury Inflation Protected Securities, or TIPS, are debt securities that are issued by the United States government. TIPS are inflation protected in that they are indexed to the current consumer price index (CPI) to prevent loss of purchasing power due to inflation. The par value of TIPS increases each time the CPI rises, while the fixed interest remains constant. TIPS are considered very safe investments as they are backed by the United States government. TIPS fall in the fixed income sector of the market and are attractive to those saving for retirement as they protect against the loss of purchasing power of today’s dollars.

Government agency bonds
Government agency bonds are not the same as U.S. Treasury or municipal bonds, but pertain to agencies of the federal government. (They also can pertain to quasi-governmental agencies, which are privately operated though either being originally part of the federal government or being sponsored by the federal government.) They are not guaranteed in the same way that Treasury securities are. Actual federal agencies authorized to issue debt securities are the Farm Credit Administration and the Government National Mortgage Association (GNMA, or Ginnie Mae).

Governmentally backed bonds and corporately backed bonds
Governmentally backed bonds are bonds that are secured by a specific government’s ability to tax its constituency. This usually results in a very safe, highly rated investment. If, however, the government or the region is unstable, there is greater risk of default by the government. Corporately backed bonds are secured by a company’s ability to perform well in its sector of the market and show that it is profitable. This results in safe, highly rated debt instruments for well-established, large companies that have historically shown their ability to be profitable and repay their debts.

Coupon bonds
Coupon bonds are debt instruments that are issued at par and pay a fixed rate of interest to the investor. This rate of interest is known as the coupon. A bond issued at a time of high interest rates will be very valuable during times of low interest rates, given that the rate is fixed and the coupon paid is based upon that rate, and coupons paid on new bond issues are based upon the lower rate. Retirees and those investors looking for income often rely on coupon bonds to meet these needs. Highly rated coupon bonds are generally less volatile than stocks and offer annual income. This meets two of the investor’s needs, capital preservation and current income.

Traditional bonds and convertible bonds
Traditional bonds are issued at par value at some fixed rate of interest. The value of the bond may fluctuate during the period between issue and maturity due to changing interest rate environments, but it will be redeemed at par value at the end of the term. Convertible bonds are issued at par value at some fixed rate of interest and provide current income to the holder but may be exchanged at some point for stock in the issuing company and not redeemed at par value. This allows the holder to receive current income similarly to traditional bonds but leaves the option open to participate in gains in the company’s stock price. Investors “pay” for this attractive option, however, by collecting a lower coupon.

Taxation of bonds
Bondholders’ income normally comes from the periodic interest payments of the bond. However, discounts and premiums make things slightly more complicated. For tax purposes, any discount on a bond has to be accreted (increased) on a straight-line basis over the bond’s term; the annual accretion amount is then added to the investor’s reported income on the bond. The opposite occurs for bonds purchased at a premium. Premiums are amortized (decreased), with the annual amortization amount being subtracted from the investor’s reported income.

Bonds
Bonds are debt instruments issued by corporations to raise capital to finance new ventures and current operations within the company. They are issued at par value, typically $1,000 per bond, and have varying terms to maturity. Bonds are typically issued with a fixed rate of interest, or coupon. This coupon is paid in full annually to the holder of the bond. Bonds that are not issued with a coupon are usually issued at a discount to par value and then redeemed at par value. Retirees and those investors looking for current income often rely on coupon bonds to meet these needs. Highly rated coupon bonds are generally less volatile than stocks and offer annual income. This meets two of the investor’s needs, capital preservation and current income.

Relationship between bond valuation and interest rates
The value of a bond fluctuates in relation to the yield it produces. Bond values have an inverse relationship to the yield the bond pays. In a rising interest rate environment, new bonds produce higher yields for the same outlay of principal to the investor. This decreases the demand for existing bonds, and the value falls accordingly. Conversely, in a falling interest rate environment, investors are willing to pay more to receive the higher yields produced by existing bonds. Long-term bonds are more susceptible to this form of interest rate risk than short-term bonds. Short-term bonds may be redeemed at par value and reinvested in a higher-yielding security within a shorter time frame than long-term bonds.