Mini-Course Series - Income (Part 3)

MINI-COURSE SERIES

RETIREMENT INCOME Part III

Copyright © 2012 by Institute of Business & Finance. All rights reserved.

RETIREMENT INCOME

1

U.S. TREASURYS Treasury Notes and Bonds Treasury notes and bonds are coupon bonds paying interest semiannually. For example, if the bond’s coupon rate is 10%, a $1,000 investment will pay the investor $50 two times a year (i.e., 5% each coupon payment). The $100 the investor gets each year is a 10% annual return on the investment.

5-Year Treasuries Total Return [1962-2011] Year

Return

Year

Return

Annualized

Return

2011

9.5%

2006

3.1%

5 year

7.3%

2010

7.1%

2005

1.4%

10 year

5.8%

2009

-2.4%

2004

2.3%

15 year

6.3%

2008

13.1%

2003

2.4%

20 year

6.3%

2007

10.1%

2002

12.9%

50 year

7.2%

20-Year Treasuries Total Return [1962-2011] Year

Return

Year

Return

Annualized

Return

2011

28.2%

2006

1.2%

5 year

10.7%

2010

10.1%

2005

7.8%

10 year

8.9%

2009

-14.9%

2004

8.5%

15 year

8.8%

2008

25.9%

2003

1.4%

20 year

8.8%

2007

9.9%

2002

17.8%

50 year

7.6%

Zero Coupons The Treasury itself does not issue any zero coupon bonds; however, there are two types of zero coupon Treasury securities that differ only in how they are created. From an investment perspective, the investor perceives no difference between them. In all cases, the zeros are created by taking a large quantity of a Treasury issue, taking it apart, separating the interest payments from each other and from the principal payment and selling each separately. So, a 2-year T-note could be separated into zeros maturing in six months, one year, one and a half years and two years.

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Zeros created by investment firms with the Treasury are known as STRIPS, an acronym for Separate Trading of Registered Interest and Principal of Securities. While STRIPS are not issued or sold by the Treasury, they are considered an obligation of the Treasury. The other type of Treasury zero (no reinvestment risk) is created by firms buying Treasury coupon bonds and then separate coupon and principal payments themselves. The firms then sell each payment separately as individual zero coupon bonds.

TIPS Treasury Inflation Protection Securities are the Treasury’s marketable (tradable) inflation indexed securities and are designed to protect returns from being eroded away by inflation. For example, if inflation rises 2% a year, the bond’s face value rises 2%. Therefore, the interest will also increase because there is more face value earning interest.

While a TIPS coupon interest rate is fixed at issuance, the principal is adjusted semiannually for inflation. In order to arrive at the interest payment earned the last six months, the inflation-adjusted principal is multiplied by half the fixed interest rate. For example, you own $10,000 face value with a 5% coupon, you earn $500 a year. If inflation rises by 3% the next year, the face value rises to $10,300, the coupon is still fixed at 5%, you earn $515 a year ($10,300 × .05), paid in two semiannual payments of $257.50. You pay taxes on the interest paid every year and taxes on any inflation adjustment to principal (similar to “phantom income”).

The adjustable feature helps to protect the bond’s value from falling as interest rates rise.

While a TIPS coupon is fixed, the amount of interest paid and the principal value will rise as inflation increases. If interest rates are rising because of rising inflation, TIPS tend to not fall in value as much as other bonds. These advantages mean TIPS do not have to offer as much yield as other bonds. In the summer of 2002, a 10-year inflation-indexed bond yielded about 3.5%, while traditional 10-year Treasuries yielded roughly 4.8%. So, if inflation averaged more than 1.3% a year over the next 10 years, the inflation-indexed bonds would outperform their traditional counterparts.

In times of deflation, one could imagine TIPS actually yielding less than fixed-principal bonds (probably not a lot less since you know TIPS will pay full face value at maturity).

However, should inflation again become a problem these securities will become popular since many other inflation hedges, such as gold, do not pay interest.

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Inflation-Protected Bond Funds [through 2011] Year

Return

Year

Return

Year

Return

2011

11%

2006

0%

3 years

9.5%*

2010

6%

2005

2%

5 years

6.7%*

2009

11%

2004

7%

10 years

6.7%*

2008

-4%

2002

15%

15 years

5.3%*

2007

10%

2001

7%

* annualized (note: table shows TIPS with an average maturity of 9.2 years)

INVESTMENT GRADE AND HIGH-YIELD Corporates fall into two broad credit classifications: investment grade and high-yield bonds. The reason for the distinction between investment grade and high-yield bonds is because at one time banks were allowed to invest only in bonds ranked in the top four rating categories. Thus, these bonds became known as investment grade or bank quality.

High-yield bonds were made famous in the 1980s by the marketing prowess of the infamous Michael Milken of the now-defunct firm Drexel Burnham Lambert. Although illegal-trading practices would later land him in jail and leave the firm he worked for insolvent, Milken’s efforts created alternative avenues for young companies to raise muchneeded cash when more traditional methods of borrowing were closed to them.

This sector of the fixed income market offers investors the greatest opportunity for growth if the start-up takes off. It also offers the best chance for the greatest loss if the start-up fails.

Some traders make the distinction between top-tier high-yield bonds and low-grade highyield bonds. In the high-yield’s heyday, folks in the business would say top-tier bonds were junk spelled “junque.” When a company gets into such serious financial trouble that it defaults on the issue and stops paying interest on its bonds, the bonds are said to be trading flat (without interest). These bonds trade at fractions of their face value. The hope is that they will do one or all of the following:  Begin to pay interest again  Pay the past interest in arrears  Pay the principal at maturity

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You will find corporate bonds listed on the NYSE. However, the vast majority of corporate bonds are not traded on the floor but are traded between dealers over-the-counter (OTC)—which would be more appropriate to call OTP for over-the-phone or OL for online. Corporate bonds are assumed to have a $1,000 face value unless otherwise stipulated. A 6% bond with a $1,000 face value would pay $60 a year, so each semiannual interest payment is $30.

The bond’s indenture specifies important facets of the bond issue including coupon, maturity date and seniority—where this debt (bond) ranks in the debt hierarchy on the company’s balance sheet. This is important because you want to know where you stand in the line of creditors looking for their piece of the company’s assets if the company ends up filing Chapter 11. Senior debt holders are second in line, with only banks standing in front of them in the creditor queue, whereas subordinated debt holders are further back in the line. If a bond is subordinated it will say so in the bond’s description, usually abbreviated “sub.”

The bond’s indenture also tells you what, if anything, is backing the bond. Bonds not backed by any collateral and rely solely on the issuer’s name or goodwill to attract investors are called debenture bonds. They are unsecured bonds and rely on the issuer’s ability to make money to pay investors. If the issuer fails there is nothing to secure the bonds.

Many companies cannot issue debenture bonds due to their sketchy credit histories, so they have to post some kind of collateral in order to attract investors. Equipment trust bonds are secured by equipment. For example, a construction company may need to borrow money to buy one a huge crane. If the company was to go bankrupt, the crane would be sold and the proceeds be distributed to the equipment trust bondholders. Equipment trust bonds are often serial bonds; this way the issuer’s debt burden declines as the equipment is depreciated over time. As the value of the equipment erodes, the company owes less money because it has fewer bonds outstanding and so owes less interest than it originally did.

If a company has no hard assets to put up as collateral, and the trustees demand that the bonds be secured, they can specify bonds, stocks and notes to back the issue. These bonds are known as collateral trust bonds. If real estate is pledged, they are mortgage bonds.

The same real estate can be used to back many different loans and bond issues, so you need to check what else it is pledged to and where your issue stands in the claims line.

Guaranteed bonds are backed by some other corporation—(e.g., issuer’s parent company).

Credit derivatives are a noncash way to hedge or bet on a firm’s ability to remain solvent.

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A company can also put aside money on a regular basis in an escrow account that is earmarked to retire portions of the bond on specific dates. These are sinking fund bonds.

Which portion of the issue will be retired via the sinking fund is decided by lottery just before each designated date. Put bonds mean the investor has the option to put the bonds back to the issuer at set intervals. You would be paid a lower yield on these bonds because this is an advantage.

Long-Term Corporate Bond Funds [through 2011] Year

Return

Year

Return

Year

Return

2011

12%

2006

5%

3 years

12.8%*

2010

11%

2005

3%

5 years

6.6%*

2009

17%

2004

8%

10 years

7.2%*

2008

-6%

2003

9%

15 years

6.7%*

2007

4%

2002

11%

*annualized

High-Yield Corporate Bond Funds [through 2011] Year

Return

Year

Return

Year

Return

2011

3%

2006

10%

3 years

19.7%*

2010

14%

2005

3%

5 years

5.3%*

2009

46%

2004

10%

10 years

7.0%*

2008

-26%

2003

25%

15 years

5.3%*

2007

2%

2002

-1%

*annualized

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THINGS TO DO 

Your Practice

Consider TIPS as a substitute for the cash equivalent portion of a client’s portfolio.

Their historical return has been superior and their single-year loss (2008) was likely due to the marketplace adapting to the demand of these government-backed securities. 

The Next Installment

Your next installment, Part IV, covers mortgage-backed securities and CMOs. As you will learn, mortgage-backed securities have risks not associated with traditionally secure fixed-income instruments. You will receive Part IV in a few days. 

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree.

For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

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