Investing in Bonds & Mutual Funds: A Comprehensive Guide to Fixed Income Securities - Prof, Study notes of Financial Management

Download Investing in Bonds & Mutual Funds: A Comprehensive Guide to Fixed Income Securities - Prof and more Study notes Financial Management in PDF only on Docsity! AHRM 2304: Family Financial Management Review Sheet for Exam 4 Chapter 14: Bonds 1. General characteristics of Treasury, municipal and corporate bonds (e.g., risk, tax implications, purchasing) -Corporate Bonds: bonds issued by corporations that allow firms to borrow money for a major source of funding; account for half the bonds outstanding *Secured bond: any bond that is backed by the pledge of collateral (asset that can be sold if a debtor doesn’t pay off his/her debt) *Unsecured bond: debenture (any unsecured long term bond); more risky than secured bonds and have a higher yield; can have a hierarchy of payment (some get paid back first) with unsubordinated and subordinated debentures (low on the list); unsubordinated (“normal”) debentures are less risky than subordinated (or lower list debentures) which have higher risk and higher return -Treasury Bonds: bonds issued by the government (US govt is the largest issuer of debt); risk free, does not issue callable bonds; lower rate of interest; exempt from local and state taxation; can do it through a program called Treasury Direct yourself and avoid fees *bills: maturity of 3, 6, or 12 months *notes: maturity of 2, 3, 5, or 10 years *bonds: maturity of more than 10 years with min donation of $1000 -Agency bonds: issued by government agencies authorized by Congress, NOT directly issued through the treasury; low risk with interest rates slightly higher than Treasury issued; min donation of $25,000 with maturities from 1-40 years *pass through certificate: a certificate that represents a portion of ownership in a pool of federally insured mortgages; issued by GNMA; packages a group of mortgages, guarantees them, and then sells certificates; $25,000 minimum; principal and interest repaid monthly with the amount varying (bad bc people don’t realize there is no payoff at the end) *Treasury inflation-indexed bonds (TIPS): inflation increases the face value of the bond guaranteeing the investor a real return; tax complication because you must pay taxes annually on par value adjustments even though there is no cash received on that money; maturities of 5, 10, or 20 years and a min par value of $1,000 *US Series EE Bonds: savings bonds aimed at the small investor; purchase price is ½ the face value ranging from $50-10,000; bond doubles in value after a specified period but the rate of return varies with the market rate; have guaranteed minimum interest rate based on Treasury securities; high level of liquidity but cashing in before maturity will reduce yield *I bonds: return includes a fixed return and a semiannual inflation rate adjustment so there is better protection; interest is added to the value of the bond and is paid when the bond is cashed in; sold at face value, grow with inflation-indexed earnings for up to 30 years; invest $50-30,000 per year; defer federal taxes for up to 30 years, exempt state and local taxes -Municipal Bonds (Munis): issued by states, counties, cities and other public agencies to fund public projects; over $1 trillion in outstanding value; interest earnings are federal tax exempt; can be exempt from state taxes if you live in the state where bonds issued; capital gains from selling early are taxed; not very liquid due to the lack of a secondary market and need to find a buyer (small issues may be illiquid); serial maturity- a portion of the debt comes due each year for a set number of years, pick the time horizon that matches your need; not risk free- check the bond ratings, although rare issuers can default and rating agencies evaluate bonds; two types- general obligation and revenue 2. What is the difference in revenue and general obligation municipal bonds? -general obligation: backed by the faith and credit of issuer; taxes used to pay back principal and interest; ex school district builds new school and taxes are used to pay back the lenders -revenue: derive funds to pay interest and repay principal from a designated project; ex bond finances a new toll road and revenue from tolls pay back lenders, also used for dorms 3. How are risk and return related for bonds? -rating companies such as Moody’s and Standard & Poor’s judge the future risk potential of a bond including its default risk or the change that it may not be able to meet its obligations of interest or repayment of principal sometime in the future -the poorer the bond rating, the higher the rate of return; ratings go from AAA (safest) to D (extremely risky); an A rating is considered medium grade 4. What factors affect the pricing of bonds? (I.E., selling at par, premium, discount) -par value: the face value of a bond, or the amount that returned to the bondholder at maturity -as the available rate of return increases, the value of a lower rated bond decreases and an investor would pay a discount -as the available rate of return drops, the value of a higher rated bond increases and an investor would pay a premium -an investor would require a rate of return change when: change in the risk associated with the firm issuing the bond or a change in general interest rates in the market -when interest rates rise, bond values drop and when interest rates drop, bond values rise; interest rates affect bond calculation by changing the demand and price for a bond; the call price limits the upward price on a bond with a call provision 5. Advantages and disadvantages of including bonds in a portfolio? -Advantages: *if interest rates drop, bond prices will rise *bonds reduce risk through diversification *bonds produce steady current income *bonds can be a safe investment if held to maturity 2 *the redemption and investment process for buying and selling shares in the fund *services provided investors *performance over the past 10 years or since the fund has been in existence *fund fees and expenses *the fund’s annual turnover ratio 8. What are the steps to choosing/investing in mutual funds? -Step 1- Determine your investment goals: determine your time horizon for each goal; determine your risk tolerance; determine your personal investment preferences; determine your tax planning strategies; determine why you are investing (ex additional income, supplement retirement income, save for a child’s education) -Step 2- Identify funds that meet your objectives: look to third party publications (Morningstar); determine your funds objective (classification); determine the funds investment style (growth, value); read the prospectus; don’t assume the fund’s name reflects its strategy -Step 3-Evaulate the fund: always compare funds with the same objectives; evaluate the fund’s long term performance; look at returns in both up and down markets (decile ranking) 9. Loads/no-loads/low-loads? What is a contingent deferred sales charge? 12b-1 fees? -load funds: sales commissions charged to the investor when purchasing fund shares; sold through brokers, financial advisors (independent, bank, insurance, etc) *Class A: font end sales load *Class B: back end load-commissions charged to the investor when selling the shares; may be a sliding scale, called a contingent deferred sales charge (back end load declines annually such as you pay 5% if you sell the fund in the first year and then 3% if you sell the und in the third year) *Class C: pay coming and going; usually have the highest annual fees -no-load funds: no commission charged -12b-1 fees: fees charged to cover the fund’s cost of advertising and marketing (AVOID) 10. What services are typically offered by mutual fund investment companies? -automatic investment and withdrawal plans -automatic reinvestment of interest, dividends, and capital gains -wiring and funds express option -phone and internet switching -easy establishment of retirement plans -check writing -bookkeeping and help with taxes 11. What are the advantages and disadvantages of mutual fund investments? -advantages *diversification: owning numerous securities reduces risk *professional management: access to the best research to evaluate investment alternatives 5 *minimal transaction costs: low commissions because of volume; may translate into higher returns *liquidity: easy to buy and sell on phone or online *flexibility: over 8,000 funds to choose from, covering many objectives and risk levels *avoidance of bad brokers: avoid potentially bad advice, high sales commissions and churning -disadvantages: *lower than market performance: 84.5% of average annual returns traded on the S&P 500 *costs: sales fee or load can be as high as 8.5% in addition to annual expense ratio at 3%-but both can be controlled with knowledge *Unsystematic risk: not all mutual funds are safe; specialized funds may lack diversification outside a specific industry *Systematic risk: mutual funds do not diversify away systematic risk-even mutual funds will suffer in a crash *capital gains taxes: some mutual funds trade frequently, investors may pay taxes on capital gains-you cannot defer taxes on capital gains within the portfolio Chapter 16: Retirement Planning (refer to the class handout) 12. Why save for retirement? What are the benefits? 13. Terms: -defined benefit: a traditional pension plan in which you receive a promised or “defined” pension payout at retirement; the payout is based on a formula that take into account your age at retirement, salary level, and years of service - defined contribution plan: a pension plan in which you or your employer alone contributes directly to a retirement account set aside specifically for you; in effect a defined-contribution plan can be thought of as a savings account for retirement -vesting: to gain the right retirement contributions made by your employer in your name; in the case of a pension plan, employees become vested when they’ve worked for a specified period of time and thus gained the right to pension benefits; required length of employment to be eligible to receive company paid pension benefits -tax-deferred: -qualified plan: 14. General characteristics/familiarity with different defined contribution plans -defined benefit plans: promised or “defined” payout at retirement; predetermined pension payment on the basis of a formula; usually noncontributory; employer bears investment risk-guaranteed amount regardless of market performance 6 *limitations: lack of portability-pension does not go with you when you leave the company; company may change plan with little notice; few plans adjust future benefits for inflation; some are unfunded plans that lack safety -noncontributory retirement plan: a retirement plan in which the employer provides all the funds and the employee need not contribute -contributory retirement plan: a retirement plan in which the employee, possibly with the help of the employer, provides the funds for the plan 15. General characteristics of defined benefit plans -- pension vs. cash balance plan -funded pension plan: a pension plan in which the employer makes pension contributions directly to a trustee who holds and invests the employees’ retirement funds -unfunded pension plan: a pension fund in which the benefits are paid out of current earnings on a pay as you go basis -cash balance plan: a retirement plan where workers are credited with a percentage of their pay, plus a predetermined rate of interest *pros: account grows at a set rate, regardless of how much actually is earned; retirement benefits are easy to track; benefit younger employees who can start to build benefits faster; portability-if you leave take your cash balance with you) *cons: no choice on investment decisions, earnings are limited to the stated rate; reduced benefits for older workers 16. Why are 401(k) plans so popular? What are the advantages? What is a GIC? -401(k): normally employer-sponsored defined contribution plans; are normally set up as thrift and savings plans in which your employer normally matches a set percentage of your contribution (a do it yourself variation of profit sharing/thrift plan) *they are very tax advantaged: your contributions are excluded from taxation in the current year; your earnings grow tax deferred but at taxed at withdrawal *offer a wide variety of investment choices; invest the max amount in your 401k before any other retirement options -Guaranteed investment contracts (GIC): a contract with an insurance company that guarantees a specified return on all investments in the pension plan (similar to CDs) *relatively conservative investment; issued by insurance companies; generally pay a fixed rate of interest .5-1% above the treasury rates; NOT guaranteed; allow you to keep pace with inflation but not much more 17. Fundamental differences in Traditional and Roth IRA -traditional IRA: personal savings plans, providing tax advantages for retirement savings; contributions grow tax-deferred until withdrawal; allows nonworking spouses to make an IRA contribution provided the working spouse’s “modified” AGI does not exceed $150,000; self-directed, but cannot invest in life insurance or collectibles except gold or silver US coins; distributions prior to age 59.5 are subject to a 10% tax penalty with few exceptions 7 -gifts will transfer wealth prior to death, reducing the taxable value of the estate, the recipient is not taxed either -an individual can give $12,000 ($24,000 per couple) per year tax-free to an unlimited number of people; gifts in excess of the limit are not tax-exempt -the $12,000 amount is indexed to inflation but only in $1,000 increments -the gift and estate tax work together 26. Living will vs. medical power of attorney (medical proxy) vs. advanced medical directive? -living will: states your wishes regarding medical treatment in the event of a terminal illness or injury (useless in a vegetative state) -medical power of attorney (health care proxy): designates someone to make health care decision should you be unable to do so for yourself -advanced medical directive: combines substitute person with the terminal illness; everyone needs one 27. Probate -What is it? The legal procedure that establishes the validity of a will and then distributes the estate’s assets; probate court appoints an executor, generally the one designated in the will; validates the will, allows for challenges to the will, oversees the distribution of assets, and files a report with the court and closes the estate -Why avoid it? Numerous costs and fees-legal fees, executor fees, court fees-that can run to 1-8% of the estate value; can be slow, time consuming process, especially if there are challenges to the will or tax problems; loss of privacy-the property distribution becomes public record -How to avoid it? In other words, what is non-probate property? 1.joint ownership: jointly owned assets transfer to the surviving owner without probate *tenancy by the entirety: married couple only *joint tenancy with the right of survivorship: ownership passes to survivor, bypasses the will *tenancy in common: will controls distribution of deceased’s share, decreased owner’s shares go to estate *community property: state law and will control distribution of the property, surviving spouse receives ½ of all property acquired during the marriage 2. Gifts: do not go through probate; reduce taxable value of estate, allow you to help heirs while you are alive; good way to transfer property that grows in value; disadvantages-you may need the assets or that they are squandered; exception for life insurance policies-3 year rule; unlimited gift tax exclusion on payments made for medical and educational expenses; no limits on gifts to charities 3.Naming beneficiaries in contracts: life insurance not payable to the estate; retirement plan benefits; personal retirement plans; annuities 10 4.Trusts: a legal entity that holds and manages an asset for another person; is created when an individual, a grantor, transfers property to a trustee for the benefit of one or more beneficiaries; the trustee can be an individual, an investment firm, or a bank; any asset can be place in a trust *living trust: takes effect before death *testamentary trust: takes effect upon death 11