Table of Contents

Types of Bonds ............................................................................................................................................ 3 What Are Municipal Bonds? ..................................................................................................................... 3 Zero Coupon Municipal Bonds ...................................................................................................................... 3 Introduction .............................................................................................................................................. 3 A New Kind of Bond in the Municipal Bond Market ................................................................................. 4 What is the Build America Bonds Program? ......................................................................................... 4 How do Build America Bonds work? ..................................................................................................... 5 What Kinds of Investors Buy Build America Bonds? ............................................................................. 5 What Individual Investors Should Know ............................................................................................... 5 What Else Do We Need to Know? ......................................................................................................... 6 What Are the Risks to Individual Investors of Build America Bonds? ................................................... 6 BABs as Model for Certain Qualified Tax Credit Bonds ........................................................................ 7 State Taxation of Municipal Bonds for Corporations ............................................................................... 7 Notes: .................................................................................................................................................... 7 What Are U.S. Treasury Securities? ........................................................................................................ 10 The U.S. Treasury Market and Inflation-Protected Securities ................................................................ 11 Agency Bonds .......................................................................................................................................... 11 The GSE Debt Market: An Overview ....................................................................................................... 14 GSE Issuers and Their Financing Needs............................................................................................... 14 The Credit Quality of GSEs .................................................................................................................. 14 The Growing Use of Regular Issuance Programs & Auctions.............................................................. 15 Other Agency Issuers .......................................................................................................................... 16 What Are Corporate Bonds? ................................................................................................................... 17 What Are High-Yield Bonds? ................................................................................................................... 17 Fixed-Rate Capital Securities....................................................................................................................... 17 An Innovative Alternative for the Income-Oriented Investor................................................................. 18 Certificates of Deposit................................................................................................................................. 18 The Building Blocks of a Portfolio ........................................................................................................... 19 What are Certificates of Deposit? ........................................................................................................... 19

What are the Features of CDs? ............................................................................................................... 20 Interest Features ..................................................................................................................................... 20 Fixed Rate............................................................................................................................................ 20 Variable Rate ....................................................................................................................................... 20 Contingent Rate .................................................................................................................................. 21 Zero Coupon........................................................................................................................................ 21 Redemption Features.............................................................................................................................. 21 Call Features........................................................................................................................................ 21 Early Withdrawal................................................................................................................................. 22 Liquidity............................................................................................................................................... 23 Early Withdrawal................................................................................................................................. 23 Information About Your Broker .......................................................................................................... 23 Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs) ............................. 24 Securitization: An Overview .................................................................................................................... 25 Fixed Income Exchange-Traded Funds........................................................................................................ 26 Similarities to Bonds ........................................................................................................................... 26 Differences between ETFs and Bonds ................................................................................................. 26 Differences between ETFs and Open-end Fixed Income Mutual Funds ............................................. 27 Callable Securities - An Introduction .......................................................................................................... 28 Three forms of embedded options ..................................................................................................... 28 Importance of lockout periods............................................................................................................ 28 Premiums and Discounts .................................................................................................................... 28 Risks of Investing in Callable Securities............................................................................................... 29 Investment Strategies Using Callable Securities ................................................................................. 29 Bond and Bond Funds ................................................................................................................................. 31 What You Should Know Before Deciding ............................................................................................ 31 Risks of Bond Investing ....................................................................................................................... 31 Diversifying Risk by Building a Portfolio.............................................................................................. 31 Bond Funds: Convenient, Affordable way to Invest in a Diversified Portfolio of BondsWith some Differences .......................................................................................................................................... 32 Types of bond funds............................................................................................................................ 32

Types of Bonds
What Are Municipal Bonds?
Municipal bonds are debt obligations issued by states, cities, counties and other governmental entities, which use the money to build schools, highways, hospitals, sewer systems, and many other projects for the public good. When you purchase a municipal bond, you are lending money to a state or local government entity, which in turn promises to pay you a specified amount of interest (usually paid semiannually) and return the principal to you on a specific maturity date. Not all municipal bonds offer income exempt from both federal and state taxes. There is an entirely separate market of municipal issues that are taxable at the federal level, but still offer a stateand often localtax exemption on interest paid to residents of the state of issuance. Most of this municipal bond information refers to munis which are free of federal taxes. See Taxable Municipal Bonds for more about taxable municipal issues.

Zero Coupon Municipal Bonds

Introduction
Types of Zero Coupon Bonds The three largest categories of zero coupon securities available are zero coupon Treasury bonds, zero coupon corporate bonds and zero coupon municipal bonds, which are issued by the U.S. Treasury, corporations, and state and local government jurisdictions, respectively. Generally, zero coupon Treasury bonds are considered the safest zero coupon bonds because they are backed by the full faith and credit of the U.S. government. Zero coupon corporate bonds and municipal bonds offer a potentially higher rate of return commensurate with additional credit risk, which will vary based on the issuing entity. Zero coupon municipal bonds are the only zero coupon securities that pay interest that is exempt from federal income tax and, in many cases, state and local taxes. This section will discuss zero coupon municipal bonds. Size of the Municipal Zero Coupon Market Zero coupon bonds were introduced to the fixed-income market in 1982. The municipal zero coupon market is substantially larger today than it was in 1982, when there were 58 new offerings totaling $2.2 billion in issuance.

In 2009, there were 380 new issues totaling $17.2 billion. More than 164.4 billion of zero coupon municipal bonds have been issued in the past ten years.* To understand how zero coupon municipal bonds work, it is important first to become acquainted with the principal characteristics of both municipal bonds and the zero coupon structure. * Source: Thomson Reuters

A New Kind of Bond in the Municipal Bond Market

What is the Build America Bonds Program?

The new Build America Bond Program allows state and local governments to issue taxable bonds in 2009 and 2010 for government capital projects and receive a direct federal subsidy payment from the US Treasury for a portion of their borrowing costs. Unlike municipal bonds which are usually tax exempt, Build America Bonds (BABs) are a new type of bond that pays interest which can be taxed; issuers can choose whether they offer a tax credit for the buyer or a direct payment from the federal government equal to 35 percent of the interest costs. Because of strains in the municipal market due to the economic downturn, these new BABs have been popular with issuers and institutional investors alike. Build America Bonds are intended to help state and local governments finance capital projects at a lower cost because the federal government is subsidizing the interest paid in the amount of 35 percent, stimulate the economy and create jobs. Government capital projects refer to creating public infrastructure such as public schools, roads, transportation infrastructure such as rail, bridges and ports, public buildings, etc. BABs are only for governmental activity not private activity bonds, that is, the proceeds of such bonds cannot be used by for-profit or not-for-profit organizations. BAB issuers can offer higher interest rate payments than typically they would be able to afford because of the federal government subsidy. This helps state and local government issuers potentially issue bonds that are more attractive to investors which would normally be interested in the corporate bond markets. The BABs program expired at the end of 2010. However, President Obamas fiscal 2012 budget, which he released on February 14, 2011, proposes to permanently reinstate the Build America Bonds (BABs) program with lower, revenue neutral, 28 percent subsidy rate. The BABs program, which were created by the American Recovery and Reinvestment Act of 2009 and expired on December 31, 2010, originally provided a 35 percent federal reimbursement of interest costs, but they could only be used for general obligation (GO) infrastructure projects. The presidents proposal would allow 501(c)(3) nonprofit issuers to sell BABs and expands their use to current refunding and short-term working capital. The House and Senate will consider the proposal and it is unclear whether BABs will be included in any budget to which Congress agrees.

How do Build America Bonds work?

Build America Bonds (Direct Payment) are bonds in which the U.S. Treasury Department pays state or local government issuers a payment equal to 35 percent of the coupon interest payments on such bonds. Proceeds of these bonds can be used for expenditures, debt service reserve funds and costs of issuing the bonds but not to refinance capital expenditures, so-called refunding issues. The 35 percent U.S. Federal interest subsidy is deeper than the corresponding 25 percent Federal interest subsidy on Build America Bonds (Tax Credit). Fixed-rate and variable-rate bonds can be issued under this program.

What Kinds of Investors Buy Build America Bonds?

Build America Bonds may attract additional bond investors including foreign investors such as foreign banks and pension funds that might have previously been interested only in Treasury, agency or corporate bonds. Pricing is likely to be somewhere between a comparable corporate bond and the tax-equivalent yield of a municipal bond. Most BABs are issued for debt of twenty years and longer. An investor will be purchasing a taxable bond whose interest rates are partially subsidized by the U.S. Government. This can help diversify a portfolio with bonds that have the security of 35 percent of the interest being paid by the federal government; are issued for long term; could provide yield benefit over other bonds in some cases; and in general are considered more secure than conventional municipal bonds with lower default rates than comparable corporate bonds. Some investors may also choose to invest in BABs because they are financing public infrastructure such as roads, bridges and schools. Institutional investors, such as pension plans, money managers and mutual funds, are purchasing BABs due to their long term nature and for situations where they do not need tax-exempt income.

What Individual Investors Should Know

Individual investors who might be considering these bonds should understand that BABs are new and complex instruments, are not conventional municipal bonds and are not as liquid as municipal bonds. These bonds might be considered for part of an individual investor's buy and hold strategy if they hold bonds for maturities of 20 years and longer. (Longer term bonds have to pay more interest because their longer term brings more risk to investors.) Like traditional municipal bonds, interest payments to investors in BABs are exempt from local taxes in the state of issue; unlike conventional municipal bonds, however, interest on BABs may be subject to federal taxes. Individual investors should consult their financial or investment advisers for more

information to determine whether these investments are appropriate for their particular circumstances.

What Else Do We Need to Know?

Build America Bonds can be issued in 2009 and 2010, i.e. the bonds must be sold in the next two years.There is no cap on the number of BABs that can be sold and there is no cap on the amount the US Treasury will pay in subsidies. There are some issues that are still to be worked out including how to price these bonds daily over time; how to use taxable conventions in a state and local municipal tax exempt bond framework and whether BABs will be sold after 2010.

What Are the Risks to Individual Investors of Build America Bonds?

Liquidity risk As a new kind of bond offering, the market of buyers and sellers for BABs is also new. There is a risk that not enough interested buyers will be available to permit an investor to sell at or near the current market price. Interest rate risk The risk that interest rates might change affects BABs. For example, if interest rates rise, BAB market prices might fall. Call risk Some (mostly larger) BAB issues have conformed to the convention in the corporate bond market of either requiring what is called a make-whole call premium or not having an option of being redeemable. Some have been issued with provisions that allow state and local governments to "call" the bonds back and refinance if the federal government stops paying subsidy on the interest. Investors should understand what call provisions exist on the BAB issue they are considering. Note that there is only call risk for the investor if the BAB being considered has a call provision. Credit risk This is the risk that an issuer will default or be unable to make payments. The credit of the bond is backed by the municipality issuing the bond, not the federal government. The issuer of the bond must remain solvent in order to pay investors. Federal subsidy risk There is the risk that the federal government would eliminate or reduce the subsidies for BABs in the future. Some BABs have been issued with provisions that allow state and local governments to "call" the bonds back and refinance them if the federal government stops paying subsidy on the interest.

BABs as Model for Certain Qualified Tax Credit Bonds

Due to the success of Build America Bonds, the program's features have been passed on to more municipal issuers. Certain types of tax credit bonds issued after March 18, 2010, are now eligible to receive direct subsidy payments from the U.S. Treasury to help with a portion of their borrowing costs. Issuers of four types of credit bonds-issuers of qualified school construction bonds, qualified zone academy bonds, new clean renewable energy bonds and qualified energy conservation bonds-can opt to receive direct subsidies instead of offering tax credits to investors. Eligible issuers of school construction bonds and zone academy bonds can receive payments equal to the lesser of the actual interest rate of the bonds or the tax credit rate for municipal taxcredit bonds, which the Treasury sets daily. Eligible issuers of energy bonds can elect to receive direct payments equal to 70 percent of the amount of interest that would have been payable under the tax-credit option. Turning tax credit bonds into BAB-style bonds is intended to make them more attractive to issuers, helping state For the latest SIFMA research and statistics on Build America Bonds click link below.
SIFMA Fact Sheet About Build America Bonds

State Taxation of Municipal Bonds for Corporations

Notes:

Bonds are designated "X" if taxable. All others are exempt or excluded from tax, or no income taxes are levied by those states. In certain cases, these designations pertain only to general obligation bonds, or to bonds in general. For example, a state may not generally exempt bonds, but some bonds may be specifically exempted by the laws authorizing their issuance.
1. Income earned from a bond issued by another state is taxable only if such other state imposes a tax on Utah bonds. 2. Interest from some obligations is exempt from tax. 3. Taxable only if long form is used. 4. Some bonds may be exempt by state law. 5. Pro-rata adjustment is allowed. 6. Interest on some obligations is exempt by law. 7. Taxable only for gross income tax purposes. 8. Interest on U.S. obligations and obligations of all states would not be taxable if the investment allocation percentage is zero. Otherwise, the interest is taxable at the investment allocation percentage.

State Alabama Alaska (no tax) Arizona Arkansas

States Own Bonds Other States Bonds X

X X X X X X X5 X X X X X X X X6 X6 X7 X6 X X X

California Franchise X California Income Colorado Connecticut Delaware District of Columbia Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts X

X X X

Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada (no tax) New Hampshire New Jersey New Mexico New York (8) North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont X X X X6 X X X6 X

X X X X X X

X X X X X

X X

X X X X

X X

Virginia Washington (no tax) West Virginia Wisconsin Wyoming (no tax) X5 X6

X X

Source: Reproduced with permission from State Tax Guide, published and copyrighted by Commerce Clearing House, Inc., 4025 W. Peterson Ave., Chicago, Illinois 60646. Reflects law through 01/01/10.

What Are U.S. Treasury Securities?

U.S. Treasury securitiessuch as bills, notes and bondsare debt obligations of the U.S. government. When you buy a U.S. Treasury security, you are lending money to the federal government for a specified period of time. Because these debt obligations are backed by the full faith and credit of the government, and thus by its ability to raise tax revenues and print currency, U.S. Treasury securities or "Treasuries" are generally considered the safest of all investments. They are viewed in the market as having virtually no credit risk, meaning that it is highly probable your interest and principal will be paid fully and on time. Because of this unique degree of safety, interest rates are generally lower for this class of secruities than for other widely traded debt, riskier debt securities such as corporate bonds. A good rule of thumb to follow is that safer investments offer lower returns. Conversely, the higher the risk, the higher the return. The amount of marketable U.S. Treasury securities is huge, with $7.3 trillion in outstanding bills, notes and bonds as of December 31, 2009*. The Treasury market is one of the world's most liquid debt markets, meaning it is one where pricing, executing and settling a trade is very efficient and thus inexpensive due, in part, to very tight bid/ask spreads. The average daily trading volume in U.S. Treasuries was $409.8 billion in 2009** and these securities trade virtually 24 hours a day with the U.S. primary dealers making live and continuous markets in these securities each business day via trading desks in cities across the globe like Tokyo, London, and New York. In 2009, the U.S. Federal Reserve estimated that 10.2% of bills, notes and bonds were held by individuals, 11.7% by banks and mutual funds, 6.6% by public and private pension funds, 47.7% by foreign investors, 6.8% by state and local governments and 16.9% by other investors.

The focus of this section is on marketable U.S. Treasury securities, those that are of most interest to individual investors because they trade on the open market. There are other classes of Treasury debtnon-marketable securitiesthat are not transferable but can be purchased from and redeemed by the government. U.S. Savings Bonds fall into this category, and, even though they are non-marketable, are discussed here because they are designed for individual investors. * Source: U.S. Treasury ** As reported by the primary dealers to the Federal Reserve Bank of New York. Specific statistics can be found at http://www.newyorkfed.org/markets/gsds/search.cfm.

The U.S. Treasury Market and Inflation-Protected Securities

The United States Department of the Treasury currently offers a special kind of security, called a Treasury Inflation-Protected Security (TIPS)*, whose principal amount is adjusted for inflation. The Treasury Department issues TIPS because it believes their issuance will reduce interest costs to the Treasury over the long term and will increase the different types of investors that buy their debt instruments.

Agency Bonds
Agency bonds are issued by two types of entities1) Government Sponsored Enterprises (GSEs), usually federally-chartered but privately-owned corporations; and 2) Federal Government agencies which may issue or guarantee these bondsto finance activities related to public purposes, such as increasing home ownership or providing agricultural assistance. Agency bonds are issued in a variety of structures, coupon rates and maturities. Each GSE and Federal agency issues its own bonds, with sizes and terms appropriate to the needs and purposes of the financing. There are usually minimums to invest in agency bonds $10,000 for the first investment and increments of $5,000 for additional investments. Investing in Ginnie Mae Federal Agency bonds requires a $25,000 minimum investment. The degree to which an agency bond issuer is considered independent from the federal government impacts the level of its default risk. The interest from most but not all agency bond issues is exempt from state and local taxes; some of the biggest issuers such as GSE entities Freddie Mac and Fannie Mae are fully taxable. In general the agency bond market is considered a liquid market, in which investments can quickly and easily be bought and sold. However, as explained below, some agency bond issues have features that make the bond issues more "structured" and complex, which can reduce liquidity of these investments for investors and make them unsuitable for individual investors. Agency Bonds issued by GSEsBonds issued by GSEs such as the Federal Home Loan Mortgage Association (Freddie Mac), the Federal Home Loan Mortgage Association (Fannie Mae) and the Federal Home Loan Banks provide credit for the housing sector. Federal Agricultural Mortgage Corporation (Farmer Mac); the Farm Credit Banks and the Farm Credit System Financial Assistance Corporation do the same for the farming sector. The bulk of all

agency bond debtGSEs and Federal Government agenciesis issued by the Federal Home Loan Banks, Freddie Mac, Fannie Mae and the Federal Farm Credit banks. GSEs are not backed by the full faith and credit of the U.S. government, unlike U.S. Treasury bonds. These bonds have credit risk and default risk and the yield on these bonds is typically slightly higher than on U.S. Treasury bonds. Some GSEs such as Fannie Mae and Freddie Mac are publicly traded companies that register their stock with the SEC and provide publicly available documents such as annual reports on the SEC website. Agency Bonds issued by Federal Government agenciesBonds issued or guaranteed by Federal Government agencies such as the Small Business Administration, the Federal Housing Administration and the Government National Mortgage Association (Ginnie Mae) are backed by the full faith and credit of the U.S. government, just like U.S. Treasury bonds.* Full faith and credit means that the U.S. government is committed to pay interest and principal back to the investor at maturity. Because different bonds have different structures, bonds issued by federal government agencies may have call risk. In addition, agency bonds issued by Federal Government agencies are less liquid than Treasury bonds and therefore this type of agency bond may provide a slightly higher rate of interest than Treasury bonds. *A significant exception to this full faith and credit guarantee for Federal Government agency bonds are those issued by the Tennessee Valley Authority (TVA). Its bonds are secured by the power revenue generated by the Authority. Types of Structures of Agency Bonds As noted above, most agency bonds pay a fixed rate of interest or fixed coupon rate semiannually. Most agency bonds are non-callable or bullet bonds. Like all bonds, agency bonds are sensitive to changes in interest rateswhen interest rates increase, agency bond prices fall and vice versa. However, in addition to fixed rate coupon and non callable agency bonds, agencies do structure their bond issues to meet different investor needs. Variable or floating coupon rate agency bonds: so-called "floating rate" or "floaters" are agency bonds that have interest rates that adjust periodically. Adjustments are usually linked to an index such as U.S. Treasury bond yields or LIBOR according to a predetermined formula (with limits on how much the interest or coupon rate can change). No-coupon agency bond notes or "discos": no-coupon discount notes are issued by agencies to meet short-term financing needs and are issued at a discount to par value. Investors who sell such discos prior to maturity may lose money. Callable agency bonds with "step up" coupon rates: callable agency bonds that have a pre set coupon rate "step up" that provides for increases in interest rates or coupon rate as the bonds approach maturity to minimize the interest rate risk for investors over time. Step ups are often

called by issuers at a time of declining interest rates. Declining interest rates may accelerate the redemption of a callable bond, causing the investor's principal to be returned sooner than expected. As a consequence, an investor might have to reinvest principal at a lower rate of interest. The interest from most but not all agency bond issues is exempt from state and local taxes and it is important for investors to understand the tax consequences of agency bonds; some of the biggest agency bond issuers such as GSE entities Freddie Mac and Fannie Mae are fully taxable for example. Capital gains or losses when selling agency bonds are taxed at the same rates as stocks. Consult your financial advisor before determining whether agency bonds are a suitable investment for you. Buying and Selling Agency Bonds Agency securities are generally bought and sold through brokers and are likely to include fees or transaction costs. The agency bond market in which individuals might participate is considered relatively liquid. However, not all kinds of agency bond issues are considered liquid, including some of which may be structured for a particular issuer or class of investors and may not be suitable for individual investors. Investment dollar minimums may make buying and selling individual bonds less suitable to many individual investors than buying an agency bond fund or U.S. Treasuries directly. Investors should take into account that the tax status of various agency bond issues varies depending on the agency issuer. As with any investment, it is important to understand the work of the agency or enterprise that is issuing the bonds and know the credit rating of the issue. This allows an investor to know the basis on which a bond is being issued. Go to the Government/Federal Agency Market-at-a-Glance page to see Agency bond price information. You can find helpful information in The GSE Debt Market: An Overview. For additional investor resources on bond issuance programs see the following:

For more information and documentation for investors on Federal Farm Credit Banks Funding Corporation bond issuance programs, click here. For more information and documentation for investors on Federal Home Loan Banks Office of Finance (FHLB) bond issuance programs, click here. For more information and documentation for investors on Federal Home Loan Mortgage Corporation (FHLNC, also known as Freddie Mac) bond issuance programs, click here. For more information and documentation for investors on Federal National Mortgage Association (FNMA, also known as Fannie Mae) bond issuance programs, click here. For more information and documentation for investors on Government National Mortgage Association (GNMA, also known as Ginnie Mae) bond issuance programs, click here. For more information and documentation for investors on Tennessee Valley Authority (TVA) bond issuance programs, click here.

The GSE Debt Market: An Overview

GSE Issuers and Their Financing Needs

Government-sponsored enterprises (GSEs) are financing entities created by Congress to fund loans to certain groups of borrowers such as homeowners, farmers and students. Through the creation of GSEs, the government has sought to address various public policy concerns regarding the ability of members of these groups to borrow sufficient funds at affordable rates. GSEs are also sometimes referred to as federal agencies or federally sponsored agencies. The reader should note, however, that there are organizational differences among the GSEs although all are established with a public purpose: Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) are privately owned corporations, while the Federal Home Loan Banks and the Federal Farm Credit Banks are systems comprising regional banks. All GSE debt is not guaranteed by the federal government, whereas government agencies such as Government National Mortgage Association (Ginnie Mae) are divisions of the government whose securities are backed by the full faith and credit of the United States. To conduct their lending business, GSEs have significant funding requirements. While many are stockholder-owned companies that can raise equity capital, most GSEs rely primarily on debt financing to fund their day-to-day operations. Among the most active issuers of debt securities are:

Federal Home Loan Banks Freddie Mac Fannie Mae Federal Farm Credit Banks and Tennessee Valley Authority (TVA).

Supranational and international institutions, such as the World Bank, also issue debt securities. See complete descriptions of each GSE. Buyers of GSE-issued debt securities include domestic and international banks, pension funds, mutual funds, hedge funds, insurance companies, foundations, other corporations, state and local governments, foreign central banks, institutional investors and individual investors.
The Credit Quality of GSEs

In general, debt securities issued by GSEs are considered to be of high credit quality. The senior debt of the GSEs is rated AAA/Aaa, while the subordinated debt of Fannie Mae and Freddie Mac is currently rated AA-/Aa-. Some GSEs have explicit, though limited, lines of credit from the U.S. Treasury. As a group, GSEs benefit from a perceived tie to the federal government as institutions established under federal legislation. In September 2008, the Federal Housing Finance Agency became the conservator of the housing GSEs. In connection with the

conservatorship, Treasury has now committed to provide necessary funding to correct any deficiencies in their net worth. However, debt securities issued by GSEs are solely the obligation of their issuer and, unless explicitly stated, do not carry any guarantee by the federal government. They are considered to carry greater credit risk than securities issued by the U.S. Treasury and certain government agencies (e.g., Ginnie Mae) whose securities have the full-faith-and-credit guarantee of the U.S. government. For this reason, GSE debt obligations often carry a yield premium over Treasury securities with comparable maturities. The premium varies with market volatility, and the structure, maturity, and general supply and demand for the particular security.
The Growing Use of Regular Issuance Programs & Auctions

The GSEs utilize a variety of issuance formats for their securities. Most long-term debt is issued in public monthly security sales through designated dealer groups using both syndicate and auction pricing methodologies. Currently, the majority of GSE term debt is issued through various programmatic issuance formats, as outlined in greater detail below. All the GSEs have created issuance programs that incorporate funding calendars for large-size issues. Due to differences in the GSEs organizational and corporate structures, the separate funding calendars will vary as to specified issuance details. In 1997, the Federal Home Loan Banks Office of Finance began using auctions in its issuance of short-term discount notes. Since then Freddie Mac and Fannie Mae have also incorporated auction formats in their programmatic short-term funding. Additionally, all the GSEs post daily rates for discount notes. Currently, most of the non-callable term debt that is issued is in the form of conventional notes having maturities of one, two, three, five, ten and thirty years. However, many GSEs have incorporated floating-rate and callable securities into their issuance programs and regularly issue these structures as well. Today, GSEs increasingly choose to raise funds through a variety of formal debt issuance programs.

Freddie Mac Reference Notes, Reference Bonds and Reference Bills; Fannie Mae Benchmark Notes, Benchmark Bonds and Benchmark Bills; Federal Home Loan Bank TAP Issues; and Federal Farm Credit Bank Designated Bonds and Calendar Bond Program

have all been developed to brand these particular securities with certain attributes of liquidity and pricing transparency. The selective application of auction methodology in debt issuance by the GSEs in the last few years has introduced greater regularity and transparency to the securities pricing process and made possible for the first time a true when issued (WI) market in those short- and long-term issues which are scheduled to be auctioned.

Working through the Securities Industry and Financial Markets Association, the dealers and issuers have helped establish commonly used trading guidelines that govern WI trading in GSE auctioned issues of term debt with a maturity of two years and longer. (See Practice Guidelines for When-Issued Trading in GSE Auctioned Securities.) Additionally, advances in technology have enhanced the market for customized interest rate swaps, options and futures, and allowed the GSEs to issue a variety of structured products that can be highly tailored to simultaneously meet the very specific needs of issuers and investors. For instance, the GSEs have various medium-term-note (MTN) programs that allow them to come to market on a continuous basis with different debt offerings. As a result, GSEs have gained the flexibility to structure the size and terms of their debt issues to meet the requirements of a particular investor or class of investors. Under these programs, issuers may choose a variety of maturities with either callable or fixed maturities as well as floating interest rates, interest rates linked to one or more market indices, different interest payment dates and other key features. The same flexibility can be achieved through individually negotiated security offerings. The variety of issued securities enable GSEs to lower their cost of funding by targeting an issue to a particular investor need, since investors are typically willing to pay a premium to obtain a desired cash flow or implement a particular market view. Issuers also use the structures to obtain options from investors in a cost-effective manner. For example, an investor will demand a yield premium for allowing the issuer the option to call a bond or note, but if interest rates decline the issuer might ultimately save money by exercising the call option. In connection with these structures, issuers often enter into customized options and/or swap agreements with a third party. The third party may be an investment bank, a subsidiary of an investment bank, a swap dealer or another entity. Under these agreements, the issuer receives a cash flow needed to fulfill the terms of the security offering while agreeing to pay its counterparty a rate that might better match the incoming cash flow on its assets. The GSE issuer assumes all counterparty credit risk; a default by the issuers counterparty on an option or swap agreement does not change the issuers obligations to investors in the related security.
Other Agency Issuers

Resolution Funding Corporation (REFCORP) Tennessee Valley Authority (TVA) Federal Farm Credit System Financing Corporation (FICO) The Private Export Funding Corporation (PEFCO) Government Trust Certificates (GTC) The U.S. Agency for International Development (AID) The Financial Assistance Corporation (FAC) The General Services Administration (GSA)

The Small Business Administration The U.S. Postal Service

You can find out more about Agency Bonds here.

What Are Corporate Bonds?

Corporate bonds (also called corporates) are debt obligations, or IOUs, issued by private and public corporations. They are typically issued in multiples of $1,000 and/or $5,000. Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding their business. When you buy a bond, you are lending money to the corporation that issued it. The corporation promises to return your money (also called principal) on a specified maturity date. Until that time, it also pays you a stated rate of interest, usually semiannually. The interest payments you receive from corporate bonds are taxable. Unlike stocks, bonds do not give you an ownership interest in the issuing corporation.

What Are High-Yield Bonds?

All bonds are debt securities issued by organizations to raise capital for various purposes. When you buy a bond, you lend your money to the entity that issues it. In return for the loan of your funds, the issuer agrees to pay you interest and ultimately to return the face value (principal) when the bond matures or is called, at a specified date in the future known as the maturity date or call date. High-yield bonds are issued by organizations that do not qualify for investment-grade ratings by one of the leading credit rating agenciesMoodys Investors Service, Standard & Poors Ratings Services and Fitch Ratings. Credit rating agencies evaluate issuers and assign ratings based on their opinions of the issuers ability to pay interest and principal as scheduled. Those issuers with a greater risk of defaultnot paying interest or principal in a timely mannerare rated below investment grade. These issuers must pay a higher interest rate to attract investors to buy their bonds and to compensate them for the risks associated with investing in organizations of lower credit quality. Organizations that issue high-yield debt include many different types of U.S. corporations, certain U.S. banks, various foreign governments and a few foreign corporations.1
1

High-yield bonds issued by foreign governments and foreign corporations will not be addressed within the scope of this booklet, which will primarily focus on high-yield bonds issued by U.S. corporations.

Fixed-Rate Capital Securities

An Innovative Alternative for the Income-Oriented Investor

Fixed-rate capital securities were developed in the early 1990s to meet the needs of incomeoriented investors while creating a cost-efficient source of capital for issuers. From the investors perspective, fixed-rate capital securities combine features of corporate debt securities and preferred stock to offer the benefits of:

attractive yields, fixed monthly, quarterly or semiannual income, investment time frames that are generally predictable (i.e., 20-49 years, although there are some perpetual), liquidity and investment-grade credit quality (in most cases).

Like corporate debt securities, fixed-rate capital securities generally:

rank senior to common and preferred shares in the issuers capital structure and most have a stated maturity date.

Like preferred stock, fixed-rate capital securities generally:

have a $25 liquidation value (although some are now being issued with a $1,000 liquidation value), trade on a major securities exchange (for retail-targeted offerings) and are priced at a flat rate that includes accrued income, where applicable.

Unlike preferred stock, however, they offer no tax benefits to corporate investors. Fixed-rate capital securities also carry certain risks, including call risk, the possibility of deferred payments and, in some cases, extension risk, in addition to other risks commonly associated with fixed-income securities, which are explained in more detail later in this brochure. Because of their typically attractive yields and investment-grade credit ratings, fixed-rate capital securities can help investors achieve enhanced returns without sacrificing credit quality. As part of a diversified portfolio, they may be suitable for both individual and institutional investors. Prior to investment, however, all investors are advised to understand thoroughly the characteristics of the security they are purchasing and the various factors that may affect its value.

Certificates of Deposit
This brochure provides you with basic information about investing in certificates of deposit (CDs) issued by banks, savings associations and other depository institutions* whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC).

The Building Blocks of a Portfolio

Before choosing any investment, you should put together a financial plan: outline your goals, clarify your tolerance for risk, and set savings targets that make sense given your income and living expenses. A successful investment strategy requires a long-term perspective and staying on course even when the financial markets are declining. When developing and implementing your strategy, consider choosing an investment professional who can help you make the right financial decisions. The basic building blocks of any portfolio are stocks, bonds or notes, mutual funds, and interest-earning cash deposits. Typically, your investment plan should include a healthy mix of all four. Deciding how much money you should allocate to each type of investment depends on your age and goals, and the amount of risk that you can accept. The important principle to remember is diversification dont put your entire savings into just on basket or one type of investment. Depending on the features, CDs may be an appropriate investment for your portfolio. CDs are available from several sources, including the bank in which you deposit your money, securities brokers and other financial institutions. Institutions sometimes referred to as deposit brokers.

What are Certificates of Deposit?

CDs are time deposits you agree to place your funds on deposit with the bank for a stated period of time. During the term of the CD your funds earn interest at a stated interest rate or based upon an agreed method of calculating the rate, such as the percentage increase in the stock market.

Because you agree with the bank to keep your funds on deposit for a period of time, CDs may offer you a higher rate of interest than other types of deposit accounts that allow you more immediate access to your funds, such as checking and savings accounts. Generally, the longer you are willing to let the bank keep your funds, the higher the rate you will receive on your CD. Most banks are members of the FDIC, a government agency that insures bank deposits. You are eligible for $100,000 of deposit insurance for all the deposits you own at one bank in each recognized ownership capacity. For example, all the deposits (CDs, checking accounts, etc.) you own at one bank in your own name are insured up to a total of $100,000. You are eligible for an additional $100,000 for all deposits you own at one bank in joint accounts and another $100,000 for Individual Retirement Accounts. The FDICs brochure Your Insured Deposit explains deposit insurance coverage in more detail. You can obtain the publication from the FDIC and from most banks and securities brokers. You can contact the FDIC by mail (550 17th Street, N.W., Washington, DC 20429), by phone (800-276-6003) or by e-mail. You can also visit the FDIC web site.

What are the Features of CDs?

All CDs do not have the same features. Banks are free to offer CDs with different maturities (i.e., three months, one year, five years), methods of determining interest and payment features. Banks are not required to permit you to withdraw your funds prior to the CDs maturity, even if you were to pay a penalty. If early withdrawal is permitted, there are no strict guidelines governing the penalty that a bank may impose. When selecting a CD you should carefully review its terms and conditions. The Federal Truth in Savings Act requires all FDIC-insured depository institutions and deposit brokers to disclose certain information to you when advertising the rate on a CD. The information must include the Annual Percentage Yield or APY (the rate that reflects the amount of interest you will earn on your deposit), the maturity, the minimum required deposit and whether there is a penalty for early withdrawal. Other significant features, such as the right of the institution to redeem or call the CD, must also be disclosed. The Federal Reserve Boards brochure, Making Sense of Savings, explains the APY and other disclosure requirements. You can obtain the brochure from the Board by writing to: Publications Services, MS-127, Board of Governors of the Federal Reserve System, Washington, DC 20551 (or calling 202-452-3244) or on the web site of the Federal Consumer Information Center.

Interest Features
Fixed Rate

Many CDs pay interest at a fixed rate for the term of the CD. The interest may be compounded or simple. Interest may be paid to you periodically during the term of the CD or at maturity. Variable Rate

CDs may offer rates that change periodically during the CDs term. With such CDs you need to understand how the interest rate is calculated and how often the rate can be re-set. CDs that re-set the rate periodically are referred to as floating rate CDs because the rate floats during the term of the CD. These CDs may re-set the rate at pre-determined intervals against any number of common financial references Treasury securities, the prime rate or some other index. If these indices decline, so will the rate on the CD. The APY will reflect the rate in effect at the time you purchase the CD. CDs that change to a pre-determined rate at pre-determined times are referred to as step rate CDs. These CDs will have an interest rate that is fixed for a period of time and then step up or step down to another fixed rate. The steps may occur more than once before the CD matures. The APY on step rate

CDs will reflect the total interest to be paid during the life of the CD, so it will be less than the highest step rate, but more than the lowest step rate. Contingent Rate

The rate on some CDs is determined by the outcome of some event or the performance of a financial index. For example, many banks offer CDs that pay interest linked to the performance of the stock market. You receive the percentage increase in the value of the stock market over a period of time. If the value of the stock market does not increase, you may receive no interest. In many cases, a contingent rate CD will have an APY of 0%. This reflects the fact that the CD has no stated interest rate and the interest rate cannot be determined at the time you purchase the CD. Zero Coupon

Zero coupon CDs are sold at a discount to their face amount and pay the entire face amount at maturity. For example, you may pay $900 for a $1,000 CD and receive the full $1,000 at maturity. At maturity, you will have received $100 in interest.

Redemption Features
Call Features Some CDs allow the bank to redeem or call the CD at its sole discretion. These CDs are termed callable CDs. On pre-determined dates, the bank can choose to give you your money back (including accrued interest) and cancel the CD. A call provision does not give you the right to redeem the CD. Call features are typically incorporated in CDs with longer terms and the call feature may be combined with other features, such as a step rate. Typically, the bank will call your CD when interest rates have declined below the rate on your CD because the bank can attract deposits at a lower rate. If your CD is called you may not be able to reinvest your money at the same rate as the CD that was called. This risk is termed reinvestment risk. Callable CDs are sometimes referred to in terms of their maturity and the period during which they cannot be called. For example, 15 year, non-call one means the CD matures in 15 years, but may be called at pre-determined dates or, in some cases, at any time after the first year. Banks and deposit brokers must inform you that a CD is callable. However, the APY on a callable CD is not required to reflect the call feature. This will be significant if the CD has step rates because the CD could be called before the CD steps to a more favorable rate. In that case you will receive less than the advertised APY. You should be sure you understand both the APY you will receive on the CD if it is held to maturity and the APY you will receive on the CD if it is called.

Early Withdrawal As stated Earlier, banks are not required to permit early withdrawal. You should determine whether early withdrawal is permitted and, if so, the amount of the penalty that the bank will impose if you withdraw your funds. If you think you may need your money before the CD matures, you should decide if the penalty is a reasonable amount to pay for the opportunity to get your money early. If not, you should place your money in a shorter term CD or keep it in a different type of account. Though not required to do so, banks may permit early withdrawal without penalty in certain circumstances, such as your death or incapacity. Is The Interest On My CD Taxable? Yes. You may be able to defer taxes on your CD interest by holding it in an IRA or other retirement account. You may owe taxes when your funds are distributed from those accounts. You may be required to pay taxes annually on zero-coupon CDs and some contingent interest CDs if you hold the CD outside a retirement account even though these CDs do not pay interest annually. This tax consequence referred to as Original Issue Discount may be significant to you. If you have questions about the tax consequences of a particular CD, you should consult your tax adviser. What Are Brokered CDs? Brokered CDs are CDs issued by banks that are made available to the customers of a deposit broker. Most, though not all, deposit brokers are securities brokers registered with the Securities and Exchange Commission. Other deposit brokers are subject to regulation by different regulatory bodies or may not be subject to regulation at all. This description of brokered CDs is based upon standard practices in the securities industry. You should compare these practices to the practices of any deposit broker offering you a CD. Brokered CDs are obligations of the bank, not the broker. Brokered CDs generally have the features of CDs available directly from banks and are eligible for the same deposit insurance as CDs purchased directly from banks. Generally, the CD is sold to you without a fee because the broker receives its compensation from the bank. You have a right to know the amount of the fee paid to the broker by the bank. Brokers may provide certain services to you that would normally be provided by the bank. The broker will hold your CD as your custodian and keep a record of your holdings. The broker will include your CD holdings in the periodic account statements you receive concerning the assets you have with the broker. Tax information concerning the amount of interest you should include in y our income for tax purposes will also be provided by the broker. Unlike banks, securities brokers are required to provide you with an estimated market value of your CD on your periodic account statement. This is an estimate of the amount you might receive if you were

able to sell your CD prior to its maturity. You may not be able to sell your CD for the amount listed on the statement. Also, the amount on the statement does not affect your deposit insurance, which is based on the outstanding principal amount of your CD, not the estimated market value. When you hold your CD through a broker you have certain rights, including the right to dismiss the broker as your agent and move the CD to an account at another broker or establish the CD directly with the bank. Once you establish the CD directly with the bank your broker has no further obligation with respect to the CD. Within a few days of your CD purchase, a securities broker will provide you with a trade confirmation that sets forth the terms of your CD. In addition, the broker will send you a CD disclosure document describing your rights with respect to the CD, the availability of deposit insurance coverage and other important considerations. The disclosure document will usually be sent with the trade confirmation, but is also available upon request. You should review these documents carefully and ask your broker if you do not understand the terms and conditions of your CD or if the terms and conditions are different than you were told when you placed your order. Liquidity Though not obligated to do so, some securities brokers may be willing to purchase, or arrange for the purchase of, your CD prior to maturity. The broker may refer to this activity as a secondary market. This is not early withdrawal. The price you receive for your CD will reflect a number of factors, including then-prevailing interest rates, the time remaining until the CD matures, the features of the CD and compensation to the broker for arranging the sale of the CD. Depending on market conditions, you may receive more or less than you paid for your CD. The broker is free to discontinue offering you this service at any time. Early Withdrawal

Banks usually limit early withdrawal of CDs offered through brokers. You may not be permitted to withdraw your funds even if you are willing to pay a penalty. Banks generally permit early withdrawal of brokered CDs without penalty upon the death or adjudication of incompetence of the depositor. Information About Your Broker You can find out if your broker is a registered or licensed securities broker by contacting your state securities regulator or the Public Disclosure Program of the National Association of Securities Dealers. Call 800-289-9999 or log on to www.nasdr.com and click on Know Your Broker to verify a brokers license or registration and obtain a background report on the broker detailing any existing legal or regulatory problems. What Questions Should I Ask Before Buying a CD? 1. Does the CD meet your investment objectives? 2. What are its terms, i.e., APY, maturity, early withdrawal, call features, etc.?

3. What are the terms offered on other available CDs? 4. Is the interest paid to you periodically throughout the term of the CD, or at maturity? 5. Will you need your funds before the CD matures? 6. Are your total deposits at the bank within the FDICs $100,000 limit? 7. If the CD is callable, what is the first date the bank can call it and how frequently after that can it be called? 8. Do you understand the tax consequences associated with the CD? 9. If purchasing a CD from a broker, are you familiar with the brokers reputation and comfortable with your salespersons advice? 10. Have you asked for copies of the disclosure materials available from the bank or the broker? November 2001 The Securities Industry and Financial Markets Association is the trade association representing the largest securities markets in the world, the $33 trillion debt markets. Its membership includes securities firms and banks that underwrite, trade and sell debt securities. The Association acts as an advocate for industry positions and informs and educates the public about the role of the bond markets and the global economy. The Association publishes newsletters and education materials, presents seminars and conferences and published bond markets-related statistics. These efforts are aimed at increasing the level of professionalism in the industry and raising public awareness of the importance of the bond markets. More information about the Association is available on its website. The Securities Industry and Financial Markets Association also brings together the shared interests of nearly 700 securities firms to accomplish common goals. SIFMA member firms (including investment banks, broker-dealers, and mutual fund companies) are active in all U.S. and foreign markets and in all phases of corporate and public finance. The U.S. securities industry manages the accounts of nearly 80 million investors directly and indirectly through corporate, thrift, and pension plans, and generates $358 billion of revenue. Securities firms employ approximately 760,000 individuals in the United States. (More information about SIFMA is available on its website). *For purposes of this brochure, all FDIC-insured institutions are referred to as banks.

Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs)

Securitization: An Overview
Securitization* is the process of creating securities by pooling together various cash-flow producing financial assets. These securities are then sold to investors. Securitization, in its most basic form, is a method of financing assets. Any asset may be securitized as long as it is cash-flow producing. The terms asset-backed security (ABS) and mortgage-backed security (MBS) are reflective of the underlying assets in the security. Securitization provides funding and liquidity for a wide range of consumer and business credit needs. These include securitizations of residential and commercial mortgages, automobile loans, student loans, credit card financing, equipment loans and leases, business trade receivables, and the issuance of asset-backed commercial paper, among others. Securitization transactions can take a variety of forms, but most share several common characteristics. Securitizations typically rely on cashflows generated by one or more underlying financial assets (such as mortgage loans), which serve as the principal source of payment to investors, rather than on the general credit or claims-paying ability of an operating entity. Securitization allows the entity that originates or holds the assets to fund those assets efficiently, since cashflows generated by the securitized assets can be structured, or tranched, in a way that can achieve targeted credit, maturity or other characteristics desired by investors. *Terms that appear in italics are defined in the glossary found at the end of this guide.

Fixed Income Exchange-Traded Funds

Fixed income exchange-traded funds (ETFs), whose shares are traded on major stock exchanges, are a special type of mutual fund designed to track the performance of a specific bond market index. A bond market index is a statistical composite, created and maintained by a financial institution or financial information service, that tracks the performance of the overall bond market or of a specific sector (government, corporate, or mortgage-backed), maturity range or credit quality within the larger market. Different ETFs offer investors the opportunity to achieve broad or targeted bond market exposure. Like bond market indices, ETFs are also created and managed by financial firms, but not necessarily by the same institutions that create and manage the index on which they are based. Common brand names for ETFs include iShares, SPDRs (short for Standard& Poors Depository Receipts, also known as spiders), Diamonds and Vipers. ETFs based on equity indices are more common, but some of these brands include fixed income ETFs as well. Each has different firms as sponsors and administrators. Unlike most bonds, ETFs generally trade on organized exchanges like the New York Stock Exchange or the American Stock Exchange.
Similarities to Bonds

Prices of fixed income ETF shares are affected by the same factors that influence bond prices:

changes in interest rates (rising interest rates mean declining bond prices and vice versa) changes in yield spreads (the difference in yield between a U.S. Treasury security and another type of bond with comparable maturity) changes in the yield curve (the relationship among yields of bonds with different maturities)

Differences between ETFs and Bonds

Fixed Income ETFs usually distribute monthly dividends which can include both interest income on the underlying bonds and capital gains (if any). Most bonds pay interest semi-annually. Unlike bonds, ETFs have no maturity date. Although bonds in the fund mature eventually, the proceeds are reinvested in new bonds rather than returned to investors. The only way for an ETF investor to get his or her principal back is to sell the shares. The price received may be more or less than what was paid, depending on the direction of interest rates and other bond market conditions in the interim. ETFs trade on stock exchanges, whereas bonds are generally bought and sold through dealer firms. Trading on a stock exchange means that investors can execute trades just as they would with any listed stock. Also, price quotes and trading history for ETFs are available in the same manner as for listed stocks. Furthermore, individual investors can execute trading strategies in ETFs that may be cumbersome using bonds themselves. For example, ETFs can generally be sold short just as any

listed stock, and for most fixed-income ETFs, there are actively traded options chains available to individual investors. Short sales and options on individual bonds generally are not available to individual investors.
Differences between ETFs and Open-end Fixed Income Mutual Funds

Fixed income ETF shares are bought and sold on a stock exchange, while open-end mutual fund shares are bought and sold directly through the fund sponsor. ETF shares are priced continuously throughout the day, and traditional open-end mutual fund shares are priced once daily. ETF shares can be bought or sold at any time during the day. Open-end fund shares can only be bought or sold at the end of the trading day. ETF investors pay a brokerage commission on the trade, while traditional open end mutual fund investors may have to pay a sales charge or other fees to enter or exit the fund. Many open-end mutual funds are actively managed, meaning the portfolio manager makes investment decisions in an effort to enhance performance relative to the market as a whole. As a result, open-end funds tend to impose relatively higher management fees than passively managed (indexed) funds. ETFs are always indexed and tend to have management fees and expense ratios significantly lower than actively managed funds and in some cases lower than other index funds.

Callable Securities - An Introduction

A callable municipal, corporate, federal agency or government security gives the issuer of the bond the right to redeem it at predetermined prices at specified times prior to maturity. Take, for example, a U.S. agency 10-year note noncallable for 3 years, maturing in 10 years, which can be called or redeemed by the agency issuer at the end of the third year after issuanceknown as a 10nc3. The three-year noncallable period is known as the lockout period. Yields on callable bonds tend to be higher than yields on noncallable, bullet maturity bonds because the investor must be rewarded for taking the risk the issuer will call the bond if interest rates decline, forcing the investor to reinvest the proceeds at lower yields. With a callable security, the investors compensation for selling the option is reflected in a higher yield and lower price as compared to a similar bullet security with the same maturity. In an example from 1997, A U.S. agency 10nc3 was offered at a yield of 6.856 percent while a 10-year bullet with the same coupon carried a yield of 6.236 percent. The difference in dollar price between these two securities would represent the value of the call option. The investor has to determine the value of the option and the level of compensation required for the associated risks in a callable security.
Three forms of embedded options

The type of embedded option in a callable security affects the options value.

American options are continuously callable at any time after the lockout period expires. Bermudian options give the issuer the right to call the bond on specified dates after the lockout period that typically coincide with coupon dates. European options have a one-time call feature coinciding with the expiration of the lockout period.1

Importance of lockout periods

Coupled with the time to maturity, the lockout period also affects the options value. For example, the embedded option in a 10-year noncallable for six months (10nc6M) can be likened to a 6-month European option on a 9.5-year security. The embedded option in a 10nc3 European callable is the same as a 3-year option on a 7-year security. The uncertainty or risk associated with 7-year rates three years from now is higher than the uncertainty of 9.5 year rates 6 months from now, so the first option should have a higher value.
Premiums and Discounts

Prices on callable bonds depend on the markets expectation of interest rates at the time the call feature on a bond becomes active in relation to the coupon rate on the callable bond. If the market expects interest rates at the time the option becomes active to be such that the issuer will

exercise its option and call the bond, the option is said to be in the money, which can cause the security to trade at a premium to par, or a price higher than the bonds face value. Discount callables, priced below face value, or par, with a coupon below the going market rate, have embedded options that are out of the money. This means that the market expects interest rates at the time the bond becomes callable will be such that the issuer will not exercise its option.
Risks of Investing in Callable Securities

Premium callables trade at yield to callmeaning that the price of the bond is calculated with the assumption that the bond will be calledand carry extension risk. If interest rates rise before the end of the lockout period, the bonds embedded option becomes worth less, as the security is less likely to be called. Discount callables trade like bulletsnon-callable bondsto maturity and carry compression risk. If interest rates fall, they become more likely to be called. Callable securities that are at the moneywhere interest rates are very close to the point where the option will be exercisedhave the most sensitivity to changes in market rates and implied volatility. Unlike a noncallable bond, a callable securitys duration, or sensitivity to interest rate changes, decreases when rates fall and increases when rates rise. The spread or difference in yield over comparable noncallable securities compensates callable investors for this negative convexity. In addition to interest rate risk, the value of the options embedded in callables is sensitive to changes in the slope of the yield curve.2 The value of the options is a function of forward rates,3 which are dependent on the spot4 level of rates and spot yield spreads.5 Volatility risk in callables takes two forms. The first is realized volatility: large swings in rates can necessitate frequent rehedging, with its associated costs, as well as underperformance. Implied volatility, or the market forecast of future rate uncertainty, is the second. When a position is unwound or sold, the value of the callable security will depend on the new level of implied volatility. If implied volatility is higher, callable security prices will be depressed.
Investment Strategies Using Callable Securities

Many investors use callable securities within a total return strategywith a focus on capital gains as well as incomeas opposed to a buy and hold strategy focused on income and preservation of principal. Owners of callable securities are expressing the implicit view that yields will remain relatively stable, enabling the investor to capture the yield spread over noncallable securities of similar duration. They must also have views on the likely range of rates over the investment period and the markets perception of future rate uncertainty at the horizon date for reasons explained in Risks of Investing in Callable Securities above. If an investor has the view that rates may well be volatile in either direction over the near term but are likely to remain in a definable range over the next year, an investment in callable securities can significantly enhance returns.

Premium callables would generally be used when the bullish investor believes that rates are unlikely to fall very far. Discount callables would generally be chosen when the investor believes volatility will be low but prefers more protection in an environment of rising interest rates. Lehman Brothers Callable Securities - An Introduction
1. Note that the names used to describe the types of options do not necessarily relate to where securities with these features are sold or traded. 2. The yield curve is the collection of interest rates at a variety of maturities. In most cases, the longer the maturity on a bond, the higher its yield. A steeply sloped yield curve indicates a relatively big difference between yields on bonds with shorter and longer maturities. 3. Forward rates are the markets projection about the level of interest rates at some point in the future. 4. Spot rates refers to the current level of interest rates. 5. Yield spreads in this case refers to the difference between the interest rates of bonds of two different maturities, or two points on the yield curve.

Bond and Bond Funds

What You Should Know Before Deciding

When you invest in a bond, you buy the debt of its issuer, which might be the U.S. government or an affiliated entity, a state or city government or borrowing authority, or a corporation. Every bond has certain characteristics:

A definite maturity date when the bond issuer promises to repay the bondholder who owns the security at the time. A promise to pay taxable or tax-exempt interest at a stated coupon rate in defined intervals over the life of a bond. A yield, or return on investment, which is a function of the bonds coupon rate and the price the investor pays, which may be more or less than the bonds face value depending on a variety of factors. A credit rating indicates the likelihood that the issuer will be able to repay its debt.

Risks of Bond Investing

While generally considered safer and more stable than stocks, bonds have certain risks:

Interest rate risk: when interest rates rise, bond prices fall. If you need money and have to sell your bond before maturity in a higher rate environment, you will probably get less than you paid for it. Interest rate risk declines as the maturity date gets closer. Credit risk: if the issuer runs into financial difficulty or declares bankruptcy, it could default on its obligation to pay the bondholders. Liquidity risk: if the bond issuers credit rating falls or prevailing interest rates are much higher than the coupon rate, it may be hard for an investor who wants to sell before maturity to find a buyer. Bonds are generally more liquid during the initial period after issuance as that is when the largest volume of trading in that bond generally occurs. Call risk or reinvestment risk: If a bond is callable, the issuer can redeem it prior to maturity, on defined dates for defined prices. Bonds are usually called when interest rates are falling, leaving the investor to reinvest the proceeds at lower rates.

Diversifying Risk by Building a Portfolio

Bond investors can diversify risk by purchasing bonds from different issuers with different maturities. Treasury securities are available in $1,000 increments, but the minimum purchase for municipal and corporate bonds can be $5,000 or more. The cost of buying a bond includes a commission or a markup on the price, depending on whether you are buying from a firm acting as an agent who is getting the bond from someone else, or as principal, meaning the firm owns the bond it is selling.

Executing an effective diversification strategy requires a significant minimum investment to start. While there is no absolute requirement, a rule of thumb says it often takes at least $10,000 or more to build a fully diversified bond portfolio.
Bond Funds: Convenient, Affordable way to Invest in a Diversified Portfolio of BondsWith some Differences

Bond fundsincluding mutual funds (open-end and closed-end, actively managed and indexed), exchange-traded funds and unit investment trustsoffer a convenient and affordable way to invest in a diversified portfolio of bonds, but a bond fund investment can differ from a bond investment in ways that are important to understand. When you buy a bond fund, you buy shares in a portfolio of bonds that is created or managed to pursue a specific investment objective such as current income, current tax-exempt income, total return, or to match the performance of a market index. The portfolio might invest in a particular type of bond (government, municipal, mortgage or high-yield) or a particular maturity range (short-term: three years or less; intermediate term: three to 10 years; or long-term: usually 10 years or longer). Many bond funds make monthly or quarterly dividend payments, as opposed to the semiannual payment schedule common to most bonds. Their price is based on their Net Asset Value (NAV), or the total market value of the portfolio divided by the total number of fund shares outstanding. A funds NAV changes daily with market conditions and in some cases with cash inflows and outflows to and from the fund portfolio.
Types of bond funds

Bond mutual funds can be actively managed or indexed, open-end, closed end or exchange traded funds. For more details, see the comparison table.

Actively managed bond funds, as their names suggest, have managers who buy and sell bonds in pursuit of their investment objective. They sometimes sell bonds at a profit, creating a capital gain, or at a loss if they need cash to pay shareholders who want to sell their shares. Index bond funds are not actively managed but constructed to match the composition of a given bond index, such as the Lehman 10-year Bond Index. When the index changes, the portfolio changes automatically. Sponsors of open-end bond funds (usually a mutual fund company) offer new shares and redeem existing shares continuously, requiring their managers to invest cash coming into the fund and liquidate positions when they need cash to meet redemptions. Investors in open end funds have the choice to collect their interest income and capital gains or reinvest them automatically in new funds shares. Closed-end bond funds have a fixed number of shares that trade on exchanges similar to stocks at a price that may be above or below net asset value depending on supply and demand. Closedend bond funds can be indexed or actively managed. To buy or sell shares in a closed end fund, you have to go through a broker and pay a commission.

Exchange traded funds (ETFs) represent shares in a basket of bonds that mirrors an index, but the number of shares is not fixed. ETFs trade on an exchange, with shares bought and sold through brokers who charge commissions. Unit investment trusts are a portfolio of bonds held in a trust that sells a fixed number of shares. On the trusts maturity date, the portfolio is liquidated and the proceeds returned to unit holders on a pro rata basis. UITs are usually created by brokerage firms that maintain a limited secondary market for the units. Unit holders who want to sell before maturity may have to accept less than they paid.