Fixed-income investments are securities that provide regular interest or dividend payments and, in many cases, a return of principal at maturity. Their primary objective is income with limited, if any, growth potential. As noted in Unit 5, Fixed-Income Investing, the rate of return on a fixed-income investment can be fixed throughout its holding period (e.g., bonds) or can fluctuate with the general movement of interest rates (e.g., Series EE U.S. savings bonds and money market mutual funds).
Most fixed-income investments require a minimum purchase of $1,000 or less. U.S. Treasury securities (See Unit 5) have a minimum purchase of only $100. Treasury bills are issued with maturities of 12 months or less and Treasury notes with maturities of 2, 3, 5, and 10 years. All Treasury securities are backed by the “full faith and credit” of the U.S. government and can be sold prior to maturity in secondary markets. Periodic government Treasury auctions determine the interest rate earned by investors. Generally, the longer the maturity date, the higher the rate of interest a Treasury security (and all bonds) pay, because an investor’s money is “tied up” (subject to interest rate fluctuations and unavailable to invest elsewhere) for a longer period of time.
Interest earned on Treasury securities is exempt from state and local income taxes. Another characteristic is that, like all bonds, Treasuries are subject to interest rate risk (when interest rates rise, bond prices decrease and vice versa). Treasury securities can be purchased from a bank or brokerage firm for a fee or directly from the Federal Reserve System’s “Treasury Direct” program at no charge. For additional information, contact the Bureau of the Public Debt at for the location of the nearest Federal Reserve Bank or the Web site http://www.treasurydirect.gov/indiv/products/products.htm.
Corporate bonds are IOUs issued by for-profit companies and can also be purchased in denominations of $1,000. (In the secondary market, corporate bonds can cost more or less than $1,000). Like Treasury securities, investors deposit a sum of $1,000 or more and receive a fixed amount of interest at regular intervals, generally every 6 months. For example, an investor holding a corporate bond paying 7% interest would receive $70 in two semi-annual payments of $35. Barring any problems with company finances, bond payments continue until bonds are called or principal is returned at maturity (e.g., 30 years). Conservative investors should select “investment grade” bonds issued by corporations rated BBB or higher by a major rating service such as Moody’s or Standard and Poor’s.
Another type of fixed-income investment that can be purchased with a small dollar amount is a zero-coupon bond (a.k.a., zeros). These are bonds issued by certain levels of government (local, state, and federal) or corporations at a deep discount to face value. Unlike other bonds that pay semi-annual interest, zero-coupon bonds don’t pay out anything until maturity, at which time an investor receives the face value, generally $1,000. The table below illustrates the amount of money required initially to purchase a zero-coupon bond that will mature to $1,000 at different yields and maturities:
Table 1. Amounts Required to Purchase a Zero Coupon Bond With $1,000 Face Value
|Years to Maturity||Yield to Maturity|
Note that, the longer the time horizon to maturity and the higher the investment yield, the less an investor needs to deposit up front to guarantee a return of $1,000 at a future date. Brokers often require a transaction with a $5,000 face value, however, so the amounts in the chart would need to be multiplied by five to determine the amount needed to invest initially. For example, a purchase of five 25-year zero-coupon bonds earning 8% would require an up-front deposit of $705 ($141 x 5), which would increase in value to $5,000 in 25 years. A disadvantage of zeros is that the “phantom income” (interest that increases the amount originally invested to full face value) is taxable each year even though this interest is not received until maturity. For this reason, zeros are often recommended for tax-deferred accounts (e.g., IRAs and Keoghs or SEPs for the self-employed).
Series EE and Series I U.S. Savings Bonds (See Unit 5) are also well suited to those with small dollar amounts. Series I bonds are an inflation-adjusted savings bond introduced by the Treasury Department in September 1998. Like inflation-adjusted marketable Treasury securities that were introduced in 1997, the principal amount of Series I Bonds is adjusted semi-annually for inflation. I Bonds are available at most commercial banks and many other financial institutions.
Like Treasury securities, savings bonds are a debt instrument of the U.S. government and income earned is completely exempt from state and local taxes. They can be purchased in denominations ranging from $50 to $5,000 (I bonds issued in paper form) or $10,000 (EE bonds purchased at half their face value for $5,000). Series EE Bonds cost one-half their face value (e.g., $25 for a $50 bond) and I Bonds are sold at par (e.g., $50 for a $50 bond). Many employers also offer savings bond purchase programs via payroll savings, where bonds can be purchased with as little as $5 or $10 per paycheck.
The purchase price of Series EE Bonds is one-half their face value (e.g., $50 for a $100 bond). Series I bonds are sold at face value in the same denominations as Series EE. Effective January 1, 2008, individuals or entities may purchase up to $5,000 worth of each series in paper form (a total of $10,000 in paper bonds) in one calendar year. In addition, individuals can buy up to the same amount of each series in Treasury Direct online accounts or a total of $20,000 (issue price) in single ownership form per calendar year.
Effective May 1, 2005, Series EE bonds pay a fixed rate of interest for the life of the bond based on interest rates in effect at the time of purchase. Bonds must be held one year before being eligible for redemption and those cashed in before 5 years are subject to a 3-month penalty. For example, if an investor redeems a bond after 18 months, they will earn 15 months of interest.
Savings bond rates are announced each May and November for the following 6 months. Thus, the 6-month earning period for rates announced on May 1 is from May through October and, for rates announced on November 1, from November through April. Series EE bonds and I bonds earn interest for 30 years that is exempt from state and local income taxes. Special tax benefits are also available for Series EE bonds and I bonds cashed in for education expenses by qualified taxpayers.