Investment Securities - Other Types of Bonds
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.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.
Exam Tips and Tricks
Three concepts regarding debt retirement that you will need to know for the exam are redemption, conversion and call provisions.
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.