Fixed Income Types

Investors have many different types of fixed income investments from which to choose. These include:

Certificates of Deposit (CDs)

CDs are time deposits. You agree to place your funds on deposit with a bank for a stated period of time. During the term of the CD, your funds earn interest at either a stated interest rate or at a rate based upon an agreed method of calculation, such as the percentage increase in the stock market. We use them as short-term investments (1-2 years) in tax deferred accounts.

We also may use CDs with rates that have a variable rate (such as Prime Rate) or a contingent rate (linked to stock market). CDs are taxable, although taxes can be deferred in IRAs. (Such deferrals may have a penalty for early withdrawal.) CDs are FDIC insured up to $250,000 per account holder.

Zero Coupon Bonds

Zero coupon bonds, as their name suggests, have no coupon, or periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the principal invested plus the interest earned, compounded semiannually, at a stated yield. Zero coupon bonds are sold at a substantial discount from the face amount.

For example, a bond with a face amount of $20,000, maturing in 20 years with a 5.5% coupon, may be purchased for roughly $6,757. At the end of the 20 years, the investor will receive $20,000. Zero coupon bonds are used when a specific principal amount is needed at maturity.  Zero coupon bonds are issued by the U.S. Treasury, corporations, and state and local government jurisdictions.

Treasury Inflation Protected Securities (TIPS)

The principal amount of TIPS are adjusted for changes in the level of inflation. Every six months the Treasury pays interest based on a fixed rate of interest determined at auction. Semiannual interest payments are determined by multiplying the inflation-adjusted principal amount by one-half the stated rate of interest on each interest payment date. TIPS are issued with 5-year, 10-year, and 20-year maturities.

Treasury Bonds

U.S. Treasury securities—such as bills, notes, and bonds—are debt obligations of the U.S. government. Treasuries are backed by the “full faith and credit” of the government, and therefore are deemed to have no credit risk. Treasury bills are short-term instruments with maturities of no more than one year.

Treasury bills function like zero-coupon bonds, which do not pay periodic interest payments. Investors buy bills at a discount from the par, or face value, and then receive the full amount when the bill matures. Treasury Notes are intermediate- to long-term investments, typically issued in maturities of two, three, five, seven and 10 years. Treasury Bonds cover terms of longer than 10 years and are currently being issued in maturities of 30 years. Treasury notes and bonds pay interest semi-annually.

Agency Bonds

There are two types of Agency bonds:

  • Government Sponsored Enterprises (GSEs): These entities are usually federally-chartered, but they consist of privately-owned corporations such as the Federal Home Loan Banks, Freddie Mac, Fannie Mae and the Federal Farm Credit banks.
  • Federal Government Agencies: These entities may issue or guarantee bonds; they include the Small Business Administration, the Federal Housing Administration, and the Government National Mortgage Association (Ginnie Mae).

Most agency bonds pay a fixed rate of interest or fixed coupon rate semi-annually. The interest from most, but not all, agency bond issues is exempt from state and local taxes.

Municipal (Muni) Bonds

Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities. They are used to build schools, highways, hospitals, sewer systems, and other projects for the public good. Most municipal bonds are free of federal taxes, and they are often exempt from taxes on interest paid to residents of the state of issuance as well.

There are two basic types of municipal bonds:

  • General Obligation Bonds: Principal and interest are secured by the full faith and credit of the issuer and usually supported by either the issuer’s unlimited or limited taxing power. In many cases, general obligation bonds are also voter-approved.
  • Revenue Bonds: Principal and interest are secured by revenues derived from tolls, charges or rents from the facility built with the proceeds of the bond issue. Public projects financed by revenue bonds include toll roads, bridges, airports, water and sewage treatment facilities, hospitals and subsidized housing.

Many of these bonds are issued by special authorities created for that particular purpose. Some private activity municipal bonds are subject to the federal alternative minimum tax.

Tax Bracket 10% 15% 25% 28% 33% 35%

Tax-Exempt Yields (%)

Taxable Yield Equivalents (%)

1.0%

1.11% 1.18% 1.33% 1.39% 1.49% 1.54%

1.5

1.67 1.76 2.00 2.08 2.24 2.31

2.0

2.22 2.35 2.67 2.78 2.99 3.08

2.5

2.78 2.94 3.33 3.47 3.73 3.85

3.0

3.33 3.53 4.00 4.17 4.48 4.62

3.5

3.89 4.12 4.67 4.86 5.22 5.38

4.0

4.44 4.71 5.33 5.56 5.97 6.15

4.5

5.00 5.29 6.00 6.25 6.72 6.92

5.0

5.56 5.88 6.67 6.94 7.46 7.69

5.5

6.11 6.47 7.33 7.64 8.21 8.46

6.0

6.67 7.06 8.00 8.33 8.96 9.23

6.5

7.22 7.65 8.67 9.03 9.70 10.00

7.0

7.78 8.24 9.33 9.72 10.45 10.77

7.5

8.33 8.82 10.00 10.42 11.19 11.54

Taxable Muni Bonds and Build America Bonds

A governmental issuer will sell taxable municipal bonds because the federal government will not subsidize the financing of certain activities that do not provide a significant benefit to the general public. Taxable municipals offer yields more comparable to those of other taxable sectors (such as corporate bonds or bonds issued by U.S. governmental agencies) than to those of tax-exempt municipals.

Build America Bonds (BABs) were created by the American Recovery and Reinvestment Act of 2009 to help state and local governments finance capital projects at a lower cost. (The federal government subsidizes the interest paid in the amount of 35%.) The BABs program expired on December 31, 2010, but many of the bonds are still available on the secondary market.

Corporate Bonds

Corporate bonds are debts issued by industrial, financial and service companies to finance capital investment and operating cash flow. They are typically issued in multiples of $1,000. Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities and purchasing equipment to overall business expansion.

The bonds pay a stated rate of interest, usually semiannually. Unlike stocks, bonds do not give you an ownership interest in the issuing corporation, but bond holders do have seniority over stockholders in the event of a corporate liquidation.

High-Yield Bonds

High-yield bonds are issued by organizations that do not qualify for investment-grade ratings by one of the leading credit rating agencies (Moody’s, Standard & Poor’s, Fitch). These issuers must pay a higher interest rate to attract investors to buy their bonds and to compensate investors for the risks associated with investing in organizations of lower credit quality.

Step-Up Bonds

With step-up bonds, an initial fixed interest rate is paid until a specified date, generally a call date. On a five-year note, for example, the call date may be two years after issuance. If the security is not called on the prescribed date, the interest payment steps up to a specified higher rate that was fixed prior to the issuance of the security. A single security can have more than one step-up period.

CPI-Linked Bonds

With CPI-linked bonds, the principal is periodically adjusted for inflation based on the Consumer Price Index (CPI) or another chosen index.

Other Fixed Income Funds

We may also use the following open end bond funds, or ETFs, as tactical positions for some of our clients:

  • Floating rate bond funds: These are short-term notes consistent with current interest rates.
  • Absolute return (unconstrained) bond funds: These are flexible funds that allow managers to tactically use different fixed income instruments to increase total returns.
  • Emerging market local bond funds: These bonds are delineated in local emerging market currencies. They are used as a hedge against a falling U.S. dollar.