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.

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


Related Articles
  1. Investing Basics

    What are Tranches?

    Tranches often describe specific classes of bonds within a security that hold different degrees of risks and maturities.
  2. Personal Finance

    Why Are Mortgage Rates Increasing?

    Learn how the secondary mortgage market and investor demand affect the cost of home ownership.
  3. Investing

    What Are Tranches?

    “Tranche” is a French word that refers to a slice.
  4. Bonds & Fixed Income

    Profit From Mortgage Debt With MBS

    Mortgage-backed securities can offer monthly income, a fixed interest rate and even government backing.
  5. Bonds & Fixed Income

    All About Zero Coupon Bonds

    Zero-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 ...
  6. Options & Futures

    20 Investments: Zero-Coupon Securities

    What Is It? A zero-coupon security, or "stripped bond", is basically a regular coupon-paying bond without the coupons. The process of "stripping" or "zeroing" a bond is usually done by a brokerage ...
  7. Bonds & Fixed Income

    How Are Zero-Coupon Municipal Bonds Taxed?

    What every investor needs to know about taxes and zero-coupon muni bonds.
  8. Investing Basics

    Understanding Collateralized Mortgage Obligations

    A collateralized mortgage obligation (CMO) is a security consisting of a pool of mortgages organized by maturity and risk.
  9. Insurance

    CDOs and the Mortgage Market

    These structured products contribute to keeping borrowing rates low.
  10. Bonds & Fixed Income

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
RELATED TERMS
  1. Accrual Bond

    A bond that does not pay periodic interest payments. Instead, ...
  2. Active Tranche

    A tranche of a collateralized mortgage obligation (CMO) that ...
  3. Companion Tranche

    A class of tranche found in planned amortization class (PAC) ...
  4. Tranches

    A piece, portion or slice of a deal or structured financing. ...
  5. Collateralized Loan Obligation ...

    A security backed by a pool of debt, often low-rated corporate ...
  6. Coupon Stripping

    The separation of a bond's periodic interest payments from its ...
RELATED FAQS
  1. What is a Z bond in a collateralized mortgage obligation (CMO)?

    Learn about Z-bonds, which are the riskiest level of tranches in collateralized mortgage obligations, and understand how ... Read Answer >>
  2. How does an investor make money on a zero coupon bond?

    Learn about investing in zero-coupon bonds, exactly how they work as an investment vehicle, and their advantages and disadvantages ... Read Answer >>
  3. Who bears the risk of bad debts in securitization?

    Bad debts arise when borrowers default on their loans. This is one of the primary risks associated with securitized assets, ... Read Answer >>
  4. What's the difference between a collateralized mortgage obligation (CMO) and a mortgage-backed ...

    Find out more about collateralized mortgage obligations and mortgage-backed securities and the difference between the two ... Read Answer >>
  5. What is the difference between a collateralized mortgage obligation (CMO) and a collateralized ...

    Both collateralized mortgage obligations (CMOs) and collateralized bond obligations (CBOs) are similar in that investors ... Read Answer >>
  6. What forms of debt security are available for the average investor?

    Discover the various different types of debt securities, issued by government entities or corporations, that are available ... Read Answer >>
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center