Chapter 12 Part 7 Flashcards Preview

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Flashcards in Chapter 12 Part 7 Deck (20)
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The Federal Home Loan Mortgage Corporation, nicknamed Freddie Mac, purchases residential

Federal Housing Administration, and Veterans Administration mortgages from savings institutions and resells them by means of mortgage-backed securities. Like Fannie Mae, Freddie Mac's securities arc not guaranteed by the U.S. government


The most common type ofmmtgage-backed security that these government agencies issue is the

pass-through certificate


To create a pass-through certificate, the agency

"purchases a group of mortgages and pools them together. In the simplest scenario, the pool will only contain mortgages with similar interest rates and maturity dates. The agencies then sell interests in this pool to investors as pass-through certificates. Each certificate entitles its owner to a share in the cash generated by the pool of mortgages. Each month the homeowners make their mortgage payments into the pool. After certain administrative charges are deducted, the bulk of these payments is passed through to the investors every month.
The payment includes interest and principal"


Pass-through certificates are fully

negotiable. Investors can sell them to other investors after they are issued


The monthly interest payments that investors receive from agency mortgage-backed securities arc subject to

federal, stale, and local taxes


Mortgage-backed securities often pay

higher yields than treasuries. they can also provide investors with a source of monthly income and are considered relatively safe, conservative invcstn1cnts


As with most agency securities, FNMA and FHLMC certificates are backed by

the agency that issues them and not by the U.S. government. GNMA certificates, however, are directly guaranteed by the federal government.


In addition to the normal risks associated with all debt securities (interest-rate and credit risks), mortgage-backed securities have their own special risk, which is called

prepayment risk. Prepayment risk is similar to call risk in some ways. Many homeowners pay off their mortgages early. These prepayments are put into the mortgage pool and passed on to investors. Since any mortgage can be paid off at any time, the cash flow from a pass-through certificate may be unpredictable. The problem is exacerbated by the fact that many homeowners refinance when interest rates are low. Investors in pass-through certificates may find themselves worrying about how to reinvest large amounts of capital at a time when interest rates are low


Collateralizcd Mortgage Obligations are issued by Freddie Mac and also private companies. They are

bonds backed by pools of mortgages, mortgage pass-lhroughs, or other CMOs


CMOs differ from normal pass-through certificates in that they

divide the principal and interest payments from the underlying mortgages into various classes of bonds called tranches. Each tranche has a different payment schedule and a different rate of interest even though they are all backed by the same pool of mortgages. This gives investors a more predictable cash flow and helps to reduce (though not eliminate) prepayment risk


CMOs are considered to be

corporate securities. These securities are NOT exempt from the Securities Act of 1933. lnterest on CMOs is fully taxable


The local governments that issue municipal bonds include

cities, counties, school districts, and other public authorities, agencies, and commissions. United States territories and possessions also issue municipal bonds. Although the risk of default for a particular issue depends on the issuer, municipal investment-grade bonds are generally considered a rather safe, conservative investment


Since municipal bonds are exempt from

the registration provisions of the Securities Act, there is no prospectus issued. The issuer will provide investors with a similar document called an official statement and include a legal opinion that clarifies the tax status of the municipal bond's interest


The main advantage of municipal bonds is that

their interest is exempt from federal income taxes. Most states also exempt the bonds issued within their state from state and local income taxes. Since municipal bonds allow investors to save money on taxes, they pay lower rates of interest than other bonds of similar credit risk


Bonds issued by a territory or possession of the United States, such as Puerto Rico, the U.S. Virgin Islands, Guam, and American Samoa are

not subject to federal, state, or local income taxes. They are triple-tax-exempt


The more the investor pays in taxes, the greater the advantage of investing in

municipal bonds


Tax-Equivalent Yield

Municipal Yield/100% - Tax Bracket


One of the bonds that your client is considering is a 9% Lemon County bond that is selling at par. Lemon County is located in California where the client lives. The investor is in the 28% tax bracket and would need to earn

12.5% on a fully taxable investment in order to equal the tax-free yield on her municipal bond


net yield

is the income that the investor would keep once the taxman is satisfied. Taxable yield x (100% - tax bracket)


The prices of municipal bonds are expressed in

the same terms as corporate bonds. These securities are quoted as a percentage of their par value. Prices are broken down into eighths of a point

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