Zero-Coupon Bonds: Zero-coupon bonds are debt securities issued at a deep discount from par, with the difference between the discount and the face value paying out at maturity. These bonds do not make regular interest, or coupon, payments. Corporations, municipalities and the U.S. government all offer zero-coupon bonds.
In the case of corporate and U.S. government zeros, the income received upon redemption, sometimes referred to as phantom income or accreted interest, is taxable each year up to the redemption date, despite the fact that the bondholder does not receive the interest until maturity. Zero coupons are more sensitive to interest rate changes and are thus more volatile than other bonds of similar quality. An investor who needs to sell the bond before maturity risks losing principal if the investor sells the bonds during a time of rising interest rates. Zeros are great investments for people who need the exact redemption value on a certain date and no sooner - which is why zero-coupon bonds are popular college savings tools.
Exam Tips and Tricks
Three concepts regarding debt retirement that you will need to know for the exam are redemption, conversion and call provisions.
CMOs: CMOs, short for collateralized mortgage obligations, are mortgage-backed securities purchased in $1,000 denominations that pool together a large number of private mortgages (usually on single-family residences), mortgage pass-through securities like those issued by Fannie Mae and Ginnie Mae (as discussed above), and other CMOs. All of these mortgage-backed securities are divided into maturity classes called tranches. Each tranche is given its own estimated life, interest rate and payment priority, even though all tranches are backed by the same pool of mortgages.
All tranches receive interest payments according to the tranche-specific rate; however, only the "youngest" tranche receives principal payments - in $1,000 increments - as well. When the principal payments of the youngest tranche are exhausted, the life of that tranche effectively expires, and principal payments begin on the next tranche, with other tranches receiving interest-only payments. This process continues until all tranches have run out of principal payments.
Because changes in interest rates affect the rate of mortgage prepayments, CMO tranches will not strictly adhere to the length of their initial life spans, and so the amount of interest paid and the amount of principal returned over time may vary. In this way, CMOs are complex investment vehicles and should only be used when the client is an experienced investor.
Money Market Instruments
InvestingThe concept of collateralizing and structured financing predates the market for collateralized mortgage obligations and collateralized debt obligations.
InvestingZero-coupon bonds are bonds that do not make any interest payments (which investment professionals often refer to as the "coupon") until maturity. For investors, this means that if you make an ...
Personal FinanceMortgage-backed securities can offer monthly income, a fixed interest rate and even government backing.
InvestingWhat every investor needs to know about taxes and zero-coupon muni bonds.
InvestingA zero-coupon bond or ‘no coupon’ bond is one that does not disburse regular interest payments. Instead, the investor buys the bond at a steep discount price; that is, at a price ...
InvestingA collateralized mortgage obligation (CMO) is a security consisting of a pool of mortgages organized by maturity and risk.
InvestingLearn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
InvestingAn original issue discount is the amount below par at which a bond or other debt instrument is issued.