Money market securities like municipal notes, T-bills in the secondary market, commercial paper, negotiable CDs, and banker’s acceptance, repurchase agreements, government securities are short- term debt securities with high liquidity. These are low-risk investments that mature in a year or less.

Commercial paper is a short term unsecured promissory notes allowing corporations for financing of accounts receivable and inventories. They are riskier than government securities and CDs. And are sold at a discount of the face value.

Treasury bills (T-bills) are short-term (1 or or less) securities issued by the U.S. government and are considered risk-free. T-bills do not pay interest prior to maturity and are sold at auction at a discount of par (face) value. The difference between the discount price and par value is taxable as interest in the year, the T-bill matures.

Banker's acceptance (BA) is a short-term debt instrument issued by a company and guaranteed by a commercial bank. They are relatively safe investments since the bank and the borrower are liable for the due amount on maturity. BA used in international trade dealings allow international institutions to complete transactions without credit extension.

FIXED INCOME SECURITIES

Fixed-income securities include bonds, notes, debentures, and certificates, are long-term debt securities with a maturity over a year. Corporations must pay interest on debt securities regardless of company’s performance unlike equity securities.

A bond is a loan to an organization sold by the issuer on Interest. Term issue bonds are issued together and have the same maturity date. Serial issue bonds are issued all at once but mature at regular intervals. The coupon rate (or nominal yield) is the stated annual interest rate the corporation pays bondholders until the bond matures. When money is borrowed through bonds, companies make annual or semi-annual interest payments called coupon payments and do not make payments on the principal. The payment at maturity is equal to the face amount (par) plus the last coupon. Bonds don’t grow, they are issued at par and mature at par, between these dates they provide interest income on a semi-annual basis. Bond prices are stated either as a percentage of its par value or in terms of points with each point equaling 1% of the bond’s par value. Bond prices depend on the coupon rate and the prevailing interest rate on the market. There is an inverse relationship with bond prices and interest rates. A bond with a lower price than its par value is selling at a discount. This happens when interest rates have risen above the coupon rate. A bond with a higher price than its par value is selling at a premium. This happens when interest rates have declined below the coupon rate.

The yield is the return (interest) a bondholder receives on his investment. Higher yields result in higher bond prices, lower yields result in lower priced bonds.

The Nominal (stated) yield is a bond’s coupon rate and is only accurate if a bond is bought at par and held to maturity

Nominal Yield = Annual Interest / Par Value

The yield to maturity (YTM), is the difference between the price paid for the bond and the bond’s par value as well as the bond's coupon payments.

The current yield is the investor’s return on a bond at that moment.

Current Yield = Annual Interest / Market Price

The yield to call uses the call date for the number of compounding periods and incorporates any call premium into the future value. A callable bond gives the issuer the right to force the investor to sell the bond back to the issuer prior to maturity. The investor is paid the bond's face value plus a premium to partly compensate the investor for the loss of the future coupon payments on the bond.

The real interest rate is the rate the investor receives considering the inflation.

Real Interest Rate = Nominal Interest Rate - Inflation Rate

Corporate Bonds

Corporations issue bonds when they want to raise capital. New issues must be registered as a security under the Securities Act of 1933 and are subject to the Trust Indenture Act of 1939. Corporate bonds are quoted as a percentage of par and fractions. Companies with leveraged structure can raise capital by selling debt securities. Leverage simply refers to the use of debt. Creditors earn income in the form of interest paid by the corporation during the loan period and have an expectation of repayment of the loan in full. corporations are obligated to pay interest on debt securities regardless of company performance unlike equity securities.

Secured bonds (mortgage bonds, equipment trust certificates and collateral trust bonds) are insured by collateral and allow lower interest rate. If the corporation defaults, the trustee sells the collateral on behalf of bondholder.

Mortgage bonds are liens on land, buildings, or other real property. A first mortgage bondholder has a senior lien and priority over a second mortgage bondholder’s junior lien. The total par value of outstanding mortgage bonds must be less than the property value. Equipment Trust Certificates are secured by an actual piece of equipment such as airplanes or ships. The equipment is worth more than the bond, making it a very safe investment. Collateral Trust Bonds are secured by stocks or bonds of a company other than the issuer. Usually, the company is an affiliate or subsidiary of the issuer.

Unsecured bonds or debentures are riskier and have higher interest rates because there are no assets securing the debt. Subordinated debentures, are more risky and expensive than other unsecured bonds.

CHARACTERISTICS OF COMMON STOCK OWNERSHIP

CASH DIVIDENDS

Cash dividends is money paid to investors out of company's current earnings. This is done with the hope that as earnings grow, the dividends will grow (while still maintaining the same dividend payout policy). Utility stocks tend to have the highest dividend payout ratios. Blue chip stocks (large, well-established companies) provide steady dividend income as well. A company’s dividend is expressed as a dollar amount and as a current yield. The current yield fluctuates as the current market value fluctuates.

Current Yield = Annual Dividend / CMV

STOCK DIVIDENDS

Stock dividends increase the company's outstanding shares and shares an investor owns. Stock dividends are taxable when received. When stock dividends are paid, an investor must adjust the cost basis. This process includes financial reports, current market price, and convertible securities with anti-dilutive provisions.

PROPERTY DIVIDENDS

Property dividends might be taxable. If the property has a value of $10 or more, the company will issue a 1099 Div and subsequently, the property dividend will be taxable.

TAXATION OF QUALIFIED DIVIDENDS

For individuals, the taxation depends on their tax bracket. For corporations who receive dividends from other corporations in which they own stock, the taxation is determined by the percentage of ownership in the dividend-paying company. Max rates for corporations are based on a percentage of ownership and create a percentage of the dividend that will be excluded from taxation. The taxable portion will be taxed at the following corporate tax rates:

• Less than 20% ownership receives a 70% exclusion
• More than 20% ownership receives an 80% exclusion

INITIAL PUBLIC OFFERING

Once the company’s securities are registered, the securities are available for public sale in an initial public offering (IPO). The investment bankers and underwriters purchase the stock from the company and sell them at an increased price (as compensation). The difference in amounts is called the spread.

PRIMARY MARKET

New securities are sold on the primary market since they are issued directly from the company to investment bankers and underwriters.

SECONDARY MARKET

Securities traded between investors are bought and sold on the secondary market, where a broker-dealer assists the buyer and seller in exchanging the stock. Secondary market trades occurs on an organized stock exchange (i.e. New York Stock Exchange) where stocks and bonds are traded in the exchange/auction market or in the OTC market (where unlisted stocks and bonds are bought and sold over the phone and electronically).

OVER-THE-COUNTER (OTC) MARKET

An over-the-counter market is a negotiated market where transactions for unlisted bonds and stocks are conducted over the phone and through computer systems. Market makers establish bid prices and ask prices. Market makers are individuals or institutions that can buy and sell large quantities of a security, and hold large amounts of securities to be sold to the public.

The bid price is the amount of money a market maker is willing to pay to an investor who wants to sell a stock or bond. The ask or offer price is the higher price an investor would have to pay a dealer to purchase a stock or bond. The difference between buying and selling is called the spread. This is the profit that market makers earn. Nearly all bonds are traded in OTC markets, but some are listed on exchanges. OTC stocks are generally low-volume stocks with a high liquidity risk, and are available through the OTCBB (Over-the Counter Bulletin Board) and Pink Sheets.

THE SECURITIES AND EXCHANGE COMMISSION (SEC)

The Securities and Exchange Commission (SEC) is responsible for regulating the trade securities transactions and the operations of national exchanges.

STATE SECURITIES REGULATORS

The entity responsible for administering and enforcing the securities laws in each state is called the administrator. The administrator keeps a record of what is being purchased and sold in their state. The North American Securities Administrators Association (NASAA) is an organization representing the different administrators in each state who updates the Uniform Securities Act, and issues model rules and statements of a policy.

SELF-REGULATING ORGANIZATIONS (SROs)

The securities industry also regulates itself through SROs (i.e. FINRA) each exchange has its own SRO to ensure compliance). FINRA is the world’s largest regulator of security transactions.

Market Capitalization is one way to measure business size, and is the combined market value of all outstanding shares of common stock using the stock price.

Market Capitalization = Number of Outstanding Shares X Market Price Per Share

TYPES OF COMMON STOCK

Blue Chip Stocks have long, consistent records of profits & dividends, and a good business reputation. Blue chips stocks are considered less risky and provide suitable investment opportunities for conservative investors.

Growth Stocks often reinvest earnings in their business rather than pay dividends to their shareholders and have greater potential for growth through increasing stock prices. They are suitable investments for younger or more aggressive investors who are willing to take greater risks with their portfolios.

Income Stocks pay higher dividends than other stocks, and are especially suitable for retired investors with the need for a current income off their investments. The current yield is calculated by dividing the annual dividend by the stock’s market price.

Current Yield = Annual Dividend / Market Price

Defensive Stocks remain profitable during economic downturns and recessions. Companies provide groceries, utilities, pharmaceuticals, household goods and also tobacco, alcohol, discount retailers retain their profitability and share price, in comparison to the rest of the market.

Cyclical Stocks fluctuate with the economy. Companies with cyclical stocks do not remain profitable during an economic downturn (i.e. automobile manufacturers, home builders, and producers of building material).

Emerging Growth Stocks are shares in new companies. Although emerging growth stocks have the most potential for growth, they are extremely volatile and their share price fluctuates.

Penny Stocks are low-priced shares that trade over-the-counter for $5 or less. and are volatile.

MANAGING COMMON STOCK SHARE PRICES

A company splits its stock (stock splits) to make it cheaper and more attractive to investors. In a stock split, the company issues additional shares to each of its current stockholders at a ratio, and the par value and market price are proportionally adjusted downward.

In a reverse stock split, the company decreases the number of outstanding shares by a ratio, and the par value and market price are proportionally adjusted upward.

Buying back stock (stock buybacks) on the open market is one way for a company to increase the share price. By purchasing shares from the open market, the number of publicly-traded shares (or “float”) reduces, meaning that even if the company’s profits remain the same, the earnings per share will increase.

PREFERRED STOCK

Preferred stock is a good option for corporations who have already issued common stock, or do not want to relinquish control of the business to common stock shareholders with voting rights. Preferred stockholders neither have voting or ownership rights in the company, nor high potential for value gain. Although preferred stock pays a fixed income, it still falls into the category of equity. It pays a stated rate of return or percentage based on the par value (face value) of the stock (typically $100 per share). The stated rate of return is the maximum amount that the company is allowed to pay preferred stockholders. Companies facing financial constraints may declare a dividend for preferred stockholders that is less than the stated rate OR no dividend at all. Dividend payments to preferred stockholders have preference over those of common stockholders. No dividends may be paid out to common stockholders until dividends are paid to preferred stockholders first. When companies issue additional shares of common stock to raise capital, the new stock might dilute or decrease the value of the current shareholders’ investments. To prevent dilution, companies provide shareholders with the right to purchase the newly-issued stock before it is offered to the public.

If a company fails to pay the full dividend to a cumulative preferred stockholder, the missed dividends do go into arrears, and all prior, unpaid cumulative preferred dividends are paid to the preferred stockholder before any dividends are paid to common stockholders. If the company fails to pay dividends a certain number of times, the non-cumulative (straight) preferred stockholders may obtain voting rights or convert to common stock.

Participating preferred stock is preferred stock which provides a specific dividend that is paid before any dividends are paid to common stock holders, and takes precedence over common stock in the event of a liquidation.

Callable Preferred Stock allows a company the right to call or buy back stock in the future at a specified price called the call price. The call price is usually higher than the par price.

Convertable Preferred Stock allows the investor to use the par value to convert or buy shares of common stock at an established purchase price called the conversion price. The conversion Ratio is:

Number of Common Shares = Par Value / Conversion Price

Subscription rights work like a coupon that lets current shareholders purchase new stock at a discounted price called the subscription price. Current stockholders may use the subscription rights, let them expire, or sell them to other investors. The process of offering rights to common stockholders is called a rights offering.

A stock warrant is a long-term equity security that allows (but doesn’t obligate) an individual to purchase a company’s stock in the future at a pre-determined price (before expiration). They are issued at a stated price for a stock above the current market value, and it might take a long time before the stock price exceeds the stated price. Sometimes they are issued with bonds, hoping to lure investors to lower-interest-paying bonds with the promise of future common stock at potentially discounted prices. Although they do not pay dividends nor come with voting rights, investors are drawn to them for their leveraging and hedging capabilities.

American Depository Receipts (ADRs) are shares of foreign stock traded in the U.S. They allow U.S. investors to expand their portfolios internationally and trade foreign securities on exchanges or over-the-counter in the U.S. without having to utilize foreign markets. Investors purchase ADRs and receive dividends in U.S. dollars, eliminating the need for currency exchange. However, the investor is exposed to currency exchange risk. ADR holders can exchange the ADR for the actual foreign share certificate.

Convertible Bonds allow the investor to convert the bond (using its par value) into shares of the issuer’s common
stock at a set conversion price. Convertible bonds are characterized by the following:

• Lower yields than other bonds (conversion lowers rates)
• Less subject to interest rates than other bonds (because the bond can trade on the value of the common      stock)
• Not considered as equity until converted
• Anti-dilutive rights (if there is a stock split or stock dividend, the conversion rights are adjusted)
• Investment objectives are income and gains

Use the conversion ratio to calculate the number of common stock shares, a bondholder will receive from one bond:

Number of Common Stock Shares = Par Value of Bond/Conversion Price

Zero-coupon Bonds do not pay interest (no coupon payments) and therefore; have no reinvestment risk. An investor purchases a zero-coupon bond at low price than par value and then redeem it at full par value. Zero-coupon bonds are good for issuers, who are unsure of making interest payments or investors seeking a lump-sum return at a later date (i.e. college education for dependent).

A callable bond can be redeemed prior to its maturity date. Issuers often buy back bonds that have a coupon rate higher than the interest rate at which the company can borrow. Since investors holding bonds with higher interest rates will have trouble reinvesting them for the same rate, issuers will buy back bonds at a set price higher than par (call premium). Bonds with the longest maturities and highest coupon rates are called first.

Callable bonds are characterized by the following:

• Higher coupon rates than other bonds due to the call risk (greater risk, greater return)
• Limited upside potential (when interest rates decline, the probability of the bond being called increases)
• Premium call price
• Call protection: the period during which the bond cannot be called (this period begins with the issue date)
• Pre-refunded and AAA-rated until the call date
• Defeasance is when a borrower sets aside sufficient funds (often in cash and bonds) to cover the debt.

BENEFITS ASSOCIATED WITH BONDS

Bonds are safer investment than stocks. Bond prices remain more stable than stock prices. Even when bond prices change, the bond always hold its par value as long as the investor or the company does not go bankrupt). If the company goes bankrupt, bond-holders have first right of claim before to recover the corporation’s assets before stockholders. Bonds provide guaranteed source of income. Issuers pay interest twice a year and the bond’s par value at maturity. Stocks do not pay dividends, and the share price is not guaranteed (it is determined by the market). However, bonds have limited capital appreciation compared to the stocks. Bonds are an ideal investment for those who need income only for living expenses.

RISKS ASSOCIATED WITH BONDS

If the interest rates increase shortly after the purchase, leaves the investor a bond with a coupon rate below the market interest rate. Additionally, if a bondholder sells a bond before maturity, the bond will be worth less than what the investor paid, causing the investor to lose part of his investment.

Bonds are subject to interest-rate risk. Changes in the interest rates cause their prices to fluctuate. When the interest rate increases, the bond price decreases (and vice versa). Since bonds with longer maturities (i.e. zero-coupon bonds) are exposed to risk for a longer period of time, they are more vulnerable to interest-rate risk than bonds with shorter maturities. Duration measures (in years) a bond’s price sensitivity to interest rates based on the coupon rate and maturity date. Bonds with longer maturity and a lower coupon rate have longer durations. Bonds with longer durations carry more risk and have higher price volatility than bonds with lower durations.

Bonds are also subject to Inflation (Purchasing-Power) Risk). Since bonds are fixed returns over a long period of time, a steady increase in inflation can reduce the return. The real rate of return is used to determine how inflation impacts a bonds return.

Real Rate of Return = Earned Interest Rate – Rate of Inflation

As bond prices rise, interest rates fall, causing the reinvestment of bond income streams that have lower interest rates to become unattractive to investors. This is known as Reinvenstment Risk.

Call risk is the loss of a favorable rate that is caused by an issuer calling in a bond. Bond issuers usually call in a bond because of the high interest rates they are paying once the bond becomes callable.

Interest-rate risk and inflation risk are dependent on the performance of the economy as a whole. Credit (or default) risk, the risk the company may default on its debts, is directly related to the individual performance of the company. Issuers with poor credit risks must pay higher interest rates to persuade investors into purchasing bonds. Bonds with good credit ratings like "AAA' or"Aaa", from rating companies, have lower interest rates and higher market prices. If a bond’s credit rating is lowered, the bond price drops significantly (to reflect the risk of default).

INVESTMENT GRADE VS. SPECULATIVE BONDS

Bonds are rated based on risk of default. Bonds rated Aaa to Baa or AAA to BBB are considered investment grade (suitable to most investors because of the low risk of default). Bonds rated below Baa or BBB are considered to be speculative because there is greater risk of nonpayment. Investors trade these bonds (“high-yield” or “junk bonds”) because the bonds have higher yields and lower purchase prices (which result in higher returns if the companies do not default).

SINKING FUND

To combat the risk of bond investing, corporations and municipalities establish a sinking fund. Sinking fund ensures that the principal can be returned at maturity. A sinking fund is an escrow account that earns small rates of interest invested in safe securities (primarily U.S. Treasuries). Sinking funds are used to invest in U.S. Government securities, call the bonds in, tender the bonds, and open market purchases of the bonds.

ACCRUED INTEREST

Bondholders receive interest payments every six months. If a bondholder sells the bond before receiving the next interest payment, he is still entitled to the interest earned on the bond up to the day the bond was sold. The person who buys the bond adds this amount (the accrued interest) to the price paid for the bond. For corporate and municipal bonds, accrued interest is based on a 30-day month, a 365-day year, and a regular-way settlement of T+3. For U.S. Treasury notes and bonds, accrued interest is based on actual days, a 365-day year, and a regular way settlement of T +1.

TAXATION

Interest on corporate bonds are taxed as ordinary income at the bondholder's marginal rate. Bond interest is taxed the year it is received and must be included in the bondholder’s tax returns. Zero-coupon bonds are slightly different because there are no interest payments. Instead, the cost basis of the bond (the price paid) is accreted (increased) each year for tax purposes. Due to accretion, bondholders are taxed each year on these increases (even though they receive no cash). Regarding these zero-coupon bonds, this is a huge disincentive for high-income investors because they have a high marginal tax rate.

FORMS OF BONDS

Federal and municipal (muni) bonds are bonds issued by the government and its agencies to raise money and finance their operations. The United States Treasury issues both marketable and non-marketable treasury securities. Marketable securities (“treasuries”) are very liquid and are heavily traded on the secondary market. Non-marketable securities are issued to subscribers and cannot be transferred through market sales.

Bearer bonds are owned by a holder (the bearer) rather than a registered owner. In order to receive interest payments on a bearer bond, the bondholder must remove the payment coupons attached to the certificate and provide them to the company. Bearer bonds are no longer used in the United States but common in some foreign countries. They provided an easy way to commit fraud because no proof of ownership was required to collect payment. The IRS had a difficult time ensuring that taxes were properly paid for interest and principal from unregistered bonds.

A registered bond states the bond owner’s name on the face of the bond and is also maintained in the company’s records. There are no coupons attached to registered bonds, but rather the company sends payments directly to the registered bondholder. A “REGISTERED TO PRINCIPAL ONLY” bond is a type of recorded, but not registered bond. It is a combination of a bearer and a registered bond. These bonds require the attached coupons to receive interest payments, but only the registered owner of the bond receives the bond’s principal upon maturity.

Book-entry or journal-entry bonds do not have issued paper certificates. The issuer enters the bondholder’s name and address in its records.

U.S. GOVERNMENT SECURITIES

The United States Government issues bonds and other debt securities through the U.S. Treasury and other agencies. These are the safest debt investment because there is no risk of default. They are backed by the full faith and credit of the United States. The federal government is obligated to pay interest on time and repay the principal at maturity. The major two advantages to investing in U.S. government securities: Federal securities are highly liquid and can be sold easily at any time. And, any interest earned on U.S. government securities is exempt from state and local income taxes (but not federal income taxes).

TREASURY BILLS (T-BILLS)

T-bills are short-term securities with maturities of 1 month, 3 months, 6 months and 12 months (there is no 9-month T-bill). T-bills are issued in book-entry form in denominations of $1,000. They do not pay interest prior to maturity and therefore, bear no reinvestment risk and sold at a discount of par value also called discount securities. T-bills are quoted on a discount yield basis (in basis points), meaning that the price represents the yield a buyer will earn on the T-bill. The bid is a higher quote because the price is lower (bigger discount). The offer is a lower quote because the price is higher (less of a discount). Only T-bills in the secondary market are money market instruments.

TREASURY NOTES (T-NOTES) and TREASURY BONDS (T-BONDS)

T-notes and T-bonds are the most common treasuries and are very similar to corporate bonds. T-notes are available with 2 to 10-year maturities that pay interest semi-annually and return the total principal upon maturity. T-bonds are exactly like T-notes, but with 11 to 30-year maturities. Since T-notes and T-bonds pay interest, they are referred to as interest-bearing securities. Both securities are issued with par values of $1000. They are quoted as a percentage of their par value and in 32nds of a point. The dollar amount of the spread of a note or bond is equal to the difference between the dollar value of the bid and the offer. Holders of T-notes and T-bonds who sell the security before interest is paid are entitled to the accrued interest up to the date of the sell. The buyer needs to include the payment of the accrued interest, in addition to the purchase price. To calculate their accrued interest (A.I.) is as follows:

A.I. = (Actual Days x Annual Income) / 365

Treasury Inflation-Protected Securities (TIPS) have fixed interest rates, but the principal amount is adjusted for inflation by the consumer price index (CPI). TIPS have 5 to 30-year maturities, and at maturity, the bondholder will be paid either the adjusted principal or the original principal (whichever is greater).

Separate Trading of Registered Interest and Principal of Securities (STRIPS) are are fixed-income securities sold at a significant discount to face value and offer no interest payments (zero-coupon) because they mature at par. An investor's return is determined by the difference between the purchase price and the bond's trading value, or face value if held to maturity.

TAXATION OF MARKETABLE SECURITIES

Interest earned on treasuries is exempt from state and local income taxes, but subject to federal income taxes. STRIPS are taxed the same as corporate zero-coupon bonds (accreting the interest every year and paying taxes on it).

NON-MARKETABLE SECURITIES (SAVINGS BONDS)

Savings bonds are non-marketable, meaning they are non-negotiable or can only be sold back to the U.S. government (which is the entity that originally issues types of these securities).

SERIES EE BONDS

EE Bonds are 30-year investments purchased at a 50% discount (or half the par value) in denominations ranging
from $50 to $10,000 ($25 for $50 bonds due to the 50% discount) sold by banks and financial institutions. They can be cashed in after 12 months, but if the bond is less than five years old, there is a penalty of three months interest.

       • EE bonds purchased between May 1, 1997 and May 1, 2005 have an interest rate of 90% of the average 5-yr
         bond yields during the last six months.

       • EE bonds purchased after May 1, 2005 have a fixed interest rate that is reset semi-annually.

HH BONDS

HH bonds are 20-year investments with face values of $500 to $10,000. They pay semi-annual interest at a fixed
rate of 4%. They are no longer issued to the public, and can only be acquired by trading-in EE bonds that are at
least six months old (and they could not have matured more than one year ago either). Investors can defer even
longer on EE bond taxes if they trade them in for HH bonds at maturity.

SERIES I BONDS

I-bonds are 30-year investments. Like EE bonds, they are available in denominations ranging from $50 to $10,000. However, I-bonds are sold at face value. They pay a fixed, guaranteed rate that is reset twice a year, depending on inflation. Due to this, I-bonds have neither default risk nor inflation risk.

TAXATION OF EE, HH, AND I BONDS

Although interests on U.S. savings bonds are exempt from state and local income taxes, they are still subject to
federal taxes. Taxes on accrued interest for EE bonds and I-bonds can be deferred, but only until the bond matures or is cashed in. To defer EE bond taxes even longer, they can be traded in for HH bonds at maturity. If proceeds from I-bonds are used for educational costs the same year as redemption, the proceeds are tax-free.

AGENCY BONDS

MORTGAGE-BACKED SECURITIES (MBS)

An agency bond is issued by a government agency. Unlike U.S. Treasury and Minicipal bonds, these bonds are not fully guaranteed. Many U.S. government agencies issue debt securities to the public to raise money, the most common types are mortgage-backed securities (bonds backed by pools of home mortgage loans). The following three agencies issue mortgage-backed securities:

     1. GOVERNMENTAL NATIONAL MORTGAGE ASSOCIATION (GNMA or “Ginnie Mae”) Unlike most agency
           securities, the GNMA is a direct obligation of the U.S. government.

     2. FEDERAL NATIONAL MORTGAGE ASSOCIATION (FNMA or “Fannie Mae”) These securities are not
          guaranteed by the U.S. government, but are backed by Fannie
          Mae’s ability to borrow from the U.S. Treasury.

     3. FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC or “Freddie Mac”) These securities are not
           guaranteed by the U.S. government.

PASS-THROUGH CERTIFICATES (PTC)

Through a government agency, most mortgage-backed securities issue pass-through certificates (a form of a fixed income security that allows the certificate holder to receive money). Pass-through certificates are negotiable and can be sold to other investors after they are issued.The monthly interest payments that investors receive from mortgage-backed securities are subject to the federal, state, and local income taxes.Mortgage-backed securities have the additional risk of pre-payment, which is the risk that homeowners will pay off their mortgages early.

COLLATERALIZED MORTGAGE OBLIGATIONS (CMOs)

A CMO is a mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment. Organized by maturity and level of risk, a CMO receives cash flow as borrowers repay the mortgages
that act as collateral on these securities. Investors purchase these organized tranches which pay interest regularly as homeowners pay their mortgages. Tranches are portions of debt, and each tranche contains a different risk, reward, and maturity. Repayment of principal occurs one tranche at a time. Early tranches have a risk of prepayment risk.


MUNICIPAL BONDS (MUNIS)

State and local governments use munis to raise money and are safe investments. The interest paid on munis to an investor is tax-free, making munis very desirable to investors in high tax brackets. The federal government does not tax interest on munis, some state and local governments will tax interest on bonds issued by out-of-state governments. Bonds issued in U.S. territories like Puerto Rico, Guam, the U.S. Virgin Islands, or American Samoa, are triple tax-exempt (not subject to federal, state, or local taxes). Under the Securities Act of 1933, munis are exempt from registration.

TYPES OF MUNI BONDS

GENERAL OBLIGATION (GO) BONDS

General obligation bonds are secured by the “full faith and credit” of the issuer. The “full faith and credit” refers to
the state or local government’s ability to tax (or raise taxes) in order to pay bondholders. Only governments that
have the authority to assess and collect taxes can issue general obligation bonds.

General obligation bonds are characterized by the following:

• Issued by cities/counties/states/political subdivisions and their agencies, authorities & commissions
• Tax payers have the right to vote on them
• Subject to statutory debt limits
• Backed by sales taxes, property taxes (limited-tax GO Bonds), income taxes, and fines & fees that are paid into a
   general revenue fund (the source for all debt payments)

REVENUE BONDS

These are backed by revenues that are generated by the proceeds collected from a state improvement (i.e. airport, toll road, utility plant, hospital, university, stadium, etc). Sometimes, not enough revenue (or none at all) is generated to pay back the bonds.
Revenue bonds are characterized by the following:

• No vote is necessary to issue these bonds
• Backed by the revenue generated from a project
• Require a feasibility study (an assessment of the practicality of a proposed project)

INDUSTRIAL REVENUE BONDS (IRBs)

IDRs are issued by a municipality, but backed by a private corporation. IDRs are used to build facilities that are to be leased long-term to the corporation, using the lease payments to pay the interest and principal. Since the bonds are backed by the corporation, investors must rely on credit rating agencies to determine the company’s
“creditworthiness.” IRBs might or might not be taxable.

CREDIT RATINGS

Like corporate bonds, municipal bonds are evaluated by credit agencies (i.e. Moody’s, S&P) to determine likelihood of default and to designate a credit rating. Bad credit ratings results in paying higher interest rates.

MUNICIPAL BOND PRICING

Like corporate bonds, muni bond prices are quoted as a percentage of par value.

MUNICIPAL BOND YIELDS

The yield is the return on the bond. Yields can be used to compare and choose bonds. Since muni bonds are tax-
exempt and corporate bonds are not, the tax-equivalent yield or the net yield must be used to properly compare
them.

                                                     Tax-equivalent Yield = Municipal Yield / (100% - Tax Bracket)

                                                                  Net Yield = Taxable Yield x (100% - Tax Bracket)

MUNICIPAL NOTES (TAX-EXEMPT)

If state and local governments want to raise capital on a short-term basis, they issue municipal notes (muni notes). Just like muni bonds, these muni notes are exempt from federal, state, and local taxes. They are usually issued in anticipation of funds from another source in the near future, and are sometimes referred to as “anticipation notes.”

Investment Companies, Mutual Funds, & Other Pooled Investments


INVESTMENT COMPANIES

The Investment Company Act of 1940 defines “Investment Company” as any company primarily engage in making security investments or a company with at least 40% of their total assets invested in securities.

The three classifications of investment companies are face-amount certificate companies, unit investment trusts,
and management companies.

1. FACE-AMOUNT CERTIFICATES

These are sold at a discount in installments or a lump sum, and are redeemable by the issuer at their face value
sum(s) at maturity or at a lesser surrender value if redeemed early.

2. UNIT INVESTMENT TRUSTS (UITs)

UITs do not have a board of directors and only issue redeemable securities that are sold back to the trust. They are not actively-managed portfolios and have no management fees. Investors own an undivided interest in the securities held by the fund. There are two types of UITs--fixed and non-fixed.

A FIXED UIT is characterized by the following:

• Sold by prospectus in the primary market
• Issued in units of $1,000
• Professionally-selected portfolio of securities (stocks, bonds, etc.)
• Not professionally managed
• Self-liquidating on a specific date or period of time
• Redeemable by the issuer
• Trades in the secondary market after initial offering

A NON-FIXED UIT is when an insurance company registers its separate account (master account) as a UIT to offer
variable products, such as annuities and life. The UIT receives the premium payments in the master account and then redirects the money into a subaccount for the purchase of mutual fund shares. Then, the mutual fund shares are held in the master account. A minimum of two prospectus are needed to offer a variable product (one for the UIT, one for the mutual fund).

3. MANAGEMENT COMPANIES are all other types of investment companies.

Open-end management companies issue redeemable securities that are redeemable within seven calendar days
at net asset value (NAV). Open-end companies can only issue common stock. They also can borrow up to 33 1/3%
of their total assets from a bank (“33 1/3%” is also described as a “coverage ratio of 3:1” or “300% coverage”).

Closed-end management companies issue securities that are traded on the secondary market with other investors. The secondary market price is set by supply and demand, so the CMV (current market value) can be at a premium or discount to the NAV per share. Although closed-end companies can only issue a fixed number of shares, they can issue preferred stock up to 50% of the total assets, and bonds up to 33 1/3% of the total assets.

OPEN-END (MUTUAL FUNDS)
1. Cannot be sold short but sold at premium or discount
2. Do not have preemptive rights, therefore cannot engage in a standby underwriting agreement
3. Cannot be purchased on margin

CLOSED-END (CEFS) AND ETFS
1. Can be sold short
2. May have preemptive rights, and therefore could engage in a standby underwriting agreement
3. can be purchased on margin

MUTUAL FUNDS

A mutual fund is a group of investors with similar investment objectives who has pooled their money together to invest in securities. Mutual funds hire investment advisers to manage the portfolio by the objective set forth by the fund and board of directors. The investment adviser cannot change the objective. As compensation, the adviser charges an annual fee (charged quarterly in advance) as a percentage against the net assets of the fund. The fee is part of the expenses of the fund and is the single largest expense.

INVESTMENT PORTFOLIO

The collection of investments held by an investment company, hedge fund, financial institution or individual. Mutual funds have expansive portfolios containing many different types of stocks and other securities related to the fund’s investment objectives.

UNDIVIDED INTEREST

Mutual fund shares are an undivided interest in the fund’s portfolio, meaning that an individual’s shares in a portion of the fund represent whole ownership. (i.e. one who invests $100 in the fund has the same investment portfolio as an investor with $100,000 in the fund).

BENEFITS OF MUTUAL FUNDS

• Diversification of portfolio
• Professional management of portfolio
• Liquidity
• Ease of purchase and redemption of shares
• Automatic reinvestment of investment income and capital gains (the reinvested dividends and gains are taxable
   that year; the reinvested amounts increase the cost basis of the holdings)
• Simple tax and record keeping (investment adviser is responsible for preparing and sending the 1099-DIV;    under subchapter M of the Internal Revenue Code (IRC), the fund acts as a conduit, so that the tax    consequences realized by the fund pass through to the investor)

NET ASSET VALUE (NAV)

The fund’s net assets divided by the total number of outstanding shares. Mutual fund shares are valued at their NAV. The net assets of a fund are the market value of all securities and cash in the portfolio minus all its debts and other liabilities. If the investor purchases shares at an amount that is not divisible by the fund’s NAV, the investor
will receive fractional shares of the fund (most funds calculate fractional shares to the thousandths decimal place). A mutual fund’s NAV is not changed by mutual fund share purchases or mutual fund share redemption, but the net assets of the fund can change. Dividends and capital gain distributions reduce the NAV of a fund by the amount of the dividend.

SALES CHARGES OF MUTUAL FUNDS

All mutual funds have sales charges (except for no-load funds). If the fund offers breakpoints, rights of accumulation, and reinvestment of dividends & gains at NAV, then the maximum sales charge allowed is 8.5% of the public offering price. If it doesn’t offer all three, then the maximum sales charge is only 7.25%. Most funds have sales charges ranging from 4% to 6%. If the POP and NAV are known, calculate the sales charge by taking the difference, then dividing the sales charge by the POP.

                  Sales Charge Percentage = (Public Offering Price – Net Asset Value) divided by Public Offering Price

FRONT-END LOADS

Front-end load funds have low 12b-1 fees or none at all. The downside is that a portion of the initial investment is not invested in the portfolio. These front-end load funds are more suitable for larger investments because of the lower annual expenses and the ability to reduce the sales charge by meeting breakpoints (which reduce the percentage of the sales charge).

The public offering price (POP) is the NAV plus the sales charge. This equation can also be manipulated to find the sales charge.

EXAMPLE: If the NAV of a fund is $9.25, and the sales charge was $0.75, the POP would be $10.00. The $0.75 goes to the broker-dealer and representative, and the $9.25 goes to the fund. The investment adviser earns money by charging a management fee against the net assets of the fund.

BACK-END LOADS (DEFERRED SALES CHARGES)

These funds allow investors to purchase mutual fund shares at NAV (100% goes to the fund, but one stipulation is
that they may have to pay a sales charge at the time the shares are redeemed). Back-end loads have contingent
deferred sale charges (CDSC), which means the load reduces the longer the investor owns the shares until the
sales charge eventually decreases to zero. Back-end loaded funds usually have higher expense ratios than front-
end funds. They are also more suitable for smaller investment amounts that cannot achieve the break points offered on front-end loaded funds.

NO-LOAD FUNDS

These are mutual funds sold to the public at NAV with no sales charge (front-end or CDSC) attached and no 12-b-1 fee greater than 5%. The NAV and POP are the same for these funds. No-load funds may charge redemption fees. A fund cannot call itself a no-load fund if it has a front-end sales charge, back-end sales charge, or 12b-1 fees that are greater than 0.25%.

EXCHANGE PRIVILEGES

Most funds allow shareholders to exchange shares of the same class in funds from the same company or fund family without being subject to sales charges any back-end load on the old shares or front-end load on the new shares. However, if the sold shares had appreciated in value, the investor would have to recognize a capital gain for tax purposes.

SHARE CLASSES

Many mutual funds offer different classes of shares to investors. The most common classes of mutual fund shares are Class A, Class B, and Class C shares.

Class A shares have front-end load sales charges with small or no 12b-1 fees. This makes ongoing expenses cheaper, but the initial reduction in the investment means less money invested in the portfolio. These shares also receive sales charge breakpoints for higher initial investments. These types of shares are most suitable for large
investors who can achieve breakpoints, and have long investment horizons.

Class B shares usually have a back-end load sales charge with higher 12b-1 fees than Class A shares. The load is a contingent deferred sales charge (it decreases the longer the investor holds the shares). Once the load is at zero,
the shares often convert to Class A shares (this conversion is not taxable). B shares are more suitable for smaller
investors who have long investment horizons and cannot achieve the breakpoints offered under front-end funds.

Class C shares have a level load with a front-end load of 1% and annual 12b-1 fees up to 1% of the funds’ assets.
Some shares have a contingent deferred sales charge if the investor sells the shares in less than 12 to 18 months.
These are more suitable for investors who have intermediate investment horizons.

TYPES OF MUTUAL FUNDS

EXCHANGE TRADED FUNDS (ETFs)

ETFs contain stocks, commodities, and bonds that are sold at the NAV, and are traded in creation units (typically, in blocks of 50,000 shares). Since they are traded on exchanges, ETFs are easily sold and allow investors to trade throughout the day (intra-trade), sell short, and purchase shares on credit (margin). Diversification is achieved immediately with ETFs (even for small investments). They also have low expense ratios, and minimize capital gain taxes by reducing the number of securities sales necessary to maintain a diversified portfolio.

HEDGE FUNDS

These private investments are offered as Regulation D-Exempt transactions to wealthy investors. Investments are
illiquid, as they often require investors keep their money in the fund for at least one year (the lock-up period). They are known as being high risk with high return potential. They also have high management fees and a high participation rate charged by the manager (generally 20% of the portfolio gains). Hedge funds are unsuitable for small investors and those that need liquidity.

OTHER POOLED INVESTMENTS

Real Estate Investment Trusts (REITs) A REIT invests in real estate properties, buildings, and sometimes leases. It sells shares of its portfolio to investors. The shares increase in value from capital appreciation and income from rent. Most REITS are publicly traded, making them a liquid investment in real estate. Ninety percent of the income must be distributed under the Internal Revenue Code. Possible gains exist as a result of advancing market prices. There is no flow through the depreciation on the real estate. You would have to invest in a limited partnership to get that. REITs eliminate or decrease the majority of these risks, and purchasing shares of a REIT is much less expensive than investing in individual properties. REITs are easily-sold and can be used to invest in a broad portfolio of different types of properties or in specialized markets (i.e. office buildings, condos, apartments, retail
centers, hotels, golf courses, factories, industrial sites).

Mortgage REITs provide debt financing for real estate developments, or invest in mortgages by either buying
loans from lenders or purchasing mortgage-backed securities (MBS).

DERIVATIVES AND ALTERNATIVE INVESTMENTS

DERIVATIVES

Derivatives are financial instruments that derive their value from an underlying asset. Derivatives can be used for hedging (strategic investing to reduce risks) and for speculation (conducting a financial transaction with significant risk in hopes of a substantial gain). There are three different types of derivatives: options, futures, and forward contracts. Individual investors and portfolio managers use these instruments to reduce the risk of declines in the stocks they hold.

An Options Contract is an agreement between grantor (who sells the option) and owner or holder ( who buys the option), allowing one party to purchase or sell a security at a set price for a limited time. Options can be used on stocks, bonds, indexes, and even foreign currencies. In regard to stocks, “long positions” are those that are owned, and “short positions” are those that are owed.

However, when discussing options contracts, buying or holding a “call” or “put option” is a long position because the investor owns the right to buy or sell the security to the writing investor at a specified price. Controversially, selling or writing a “call” or “put option” is a short position because the investor owes the holder the right to buy the shares from (or sell the shares to) him at the holder’s discretion. Although long and short positions are used to achieve different results, they are usually established simultaneously to leverage and produce income on a security.

The holder/buyer/owner OWNS (long side) ...

• Paid a premium
• Bought a right
• Maximum loss is the premium paid
• Has a debit in their account
• Goal is to generate a gain

The writer/seller/grantor OWES (short side) ...

• Received a premium
• Sold an obligation
• Maximum gain is the premium
• Has a credit in their account
• Goal is to keep the premium income


Many investors use options to hedge (covered position) or offset their investment risk, while others use options to speculate (uncovered position) on the direction of share prices. A full hedge is the best hedge that offers the most protection. A limited hedge generates income and increases the yield of the portfolio.
When using options contracts to cover or offset a position, one must identify the most appropriate position (hedge) to use. From the two options contracts (call & put) and the two sides (long & short), four positions are made available (long put, short put, long call, short call).

LONG (OWN) POSITION: A stock or bond-risk price declines

      • Long put (full hedge; best hedge--right to sell)
      • Short call (limited hedge that generates income--obligation to sell)
      • Short put (does not hedge a long position)
      • Long call (does not hedge a long position)

SHORT (OWE) POSITION: A stock or bond-risk price rises

      • Long put (does not hedge a short position)
      • Short call (does not hedge a short position)
      • Short put (limited hedge that generates income--obligation to buy)
      • Long call (full hedge; best hedge--right to buy)

THE TWO TYPES OF OPTIONS CONTRACTS (CALLS and PUTS):

CALLS or call option contracts provide the owner the right to buy a stock at a specified price (strike price or exercise price) for a specific amount of time. The grantor or writer of the option has an obligation to sell the security if the owner exercises the option. There are two sides to an option contract--the long side (contains the rights) and the short side (contains obligations).

Options are a zero-sum game (one party will profit in direct proportion to the other party’s loss) and options trade in series. This is where one equity option contract controls 100 shares and then names a specific company, month of expiration, strike price, and type of option. Then, a premium is exchanged to seal the contract.

PUTS or put option contracts provide the owner the right to sell a stock at the strike price for a specific amount of time. The grantor has an obligation to buy the security if the owner exercises the option.

The buyer of a put has a maximum loss of the amount of the premium paid. If the stock is selling higher than the strike price, the option holder would not exercise his option to sell and would only lose the amount of the premium paid. The maximum gain is based on how far the stock price falls below the breakeven point. The breakeven, where the option holder does not gain or lose on the transaction is when the market price of the stock equals the strike price minus the premium.

The seller of a put has a maximum gain of the amount of the premium paid. If the strike price is equal to or less than the stock price, the holder of the option will likely not exercise the option (because the seller was paid a premium not to buy the stock). The maximum loss is based on how far the stock price falls below the breakeven point. The breakeven is the same as the buyer.


BUYING AND SELLING AN OPTION

Buying an option is a gamble on whether or not a stock price will rise or fall. An option owner will exercise an option contract if it will bring in money (intrinsic value--being “in the money”) at the expense of the writer. This doesn’t mean that there is an overall profit on the trade. Contracts will be exercised to lock-in a profit or to reduce loss.

Selling an option is also a gamble on whether or not a stock price will rise or fall. An option will expire if the contract cannot be exercised or if it fails to bring in any money (no intrinsic value--being “out of the money”) at the expense of the writer. If the contract expires, the writer achieves their maximum gain (the premium), and the holder of the contract achieves their maximum loss (the premium).

INTRINSIC VALUE AND TIME VALUE OF AN OPTION

Option premiums can have two types of value: intrinsic value and time value. Option premiums can have two types of value: intrinsic value and time value.

                                                                    Premium = Intrinsic Value + Time Value

INTRINSIC VALUE is what the holder of the contract will receive in (upon the exercise of the contract at the expense of the writer). Intrinsic value is calculated differently for calls and puts.

Intrinsic Value for Calls Options (strike price is used to determine intrinsic value):
• When the current market value is above the strike price, the contract is in the money and will exercise.
• When the current market value is at the strike price, the contract is at the money and will expire.
• When the current market value is below the strike price, the contract is out of the money and will expire.

Intrinsic Value for Puts Options (strike price is used to determine intrinsic value):
• When the current market is above the strike price, the contract is out of the money and will expire.
• When the current market value is at the strike price, the contract is at the money and will expire.
• When the current market value is below the strike price, the contract is in the money and will exercise.

The TIME VALUE of an option is greater for options that are a furthest way from expiration, this value erodes (decays) away over the life of the contract, becoming less and less until at expiration there is no time value left. This decay in value works for the writer and against the holder.

                                                                      Time Value = Premium - Intrinsic Value

Futures are binding contracts that obligate both the buyer and the seller. The buyer must take delivery and the seller must make delivery of the underlying asset (quality and quantity) at a set price and at a specified time and location. Futures contracts are available on commodities and financials. These contracts are used to buy and sell different types of commodities. They are traded on exchanges (with clearinghouses acting as agents between buyers and sellers) and guarantee all trades. Futures can be used by producers, users, and portfolio managers to hedge risk, and can also be used for speculation.

Forwards are like futures, except they are not traded on an exchange. Instead, they are individual customized agreements made between two parties, and are illiquid.

LIMITED PARTNERSHIPS (DIRECT PARTICIPATION PROGRAM or "DPP")

Limited Partnerships are another way to invest in real estate, oil and gas, equipment programs, and historic rehabilitation. Limited Partnerships are characterized by the following:

• Provide limited liability (the most that the limited partner can lose is his original investment and any pre-  arranged recourse financing)
• Are pass-through entities (the income and losses of the partnership pass to the limited partners)
• Are passive (the limited partner must not manage the partnership; if he does, he will lose his LP status and
   become fully-liable for the partnership)
• Democracy (can vote to terminate the partnership, sue the general partner, change general partners or other   major issues, but CANNOT vote regarding daily issues)
• General partners are fully-liable beyond the assets of the partnership
• General partners file the certificate of LP at the state level
• General partners are empowered to manage the partnership, as stated in the partnership agreement
• General partners receive disproportionate sharing

The interest owned by a limited partner is most likely illiquid (difficult or time-consuming to sell). Since income and losses from an LP are passive, the losses can only be used to offset other passive income (NOT earned income). Many investors use LPs as tax write-offs for other passive investment income. They also use LPs to receive tax credits, and for depreciation and depletion allowances.

REAL ESTATE LIMITED PARTNERSHIPS (RELPs)

These limited partnerships can be used to finance new construction, invest in rental and other income properties, or to speculate (purchase raw land in expectation of a dramatic increase in price in a short period of time). The most speculative type of RELP invests in raw land. Raw, undeveloped land lacks income or tax-write offs (depreciation), therefore only providing a return if the land can be resold at a higher price.

The most important consideration when forming LPs is economic viability. Otherwise, the IRS may recapture (disallow previous write-offs), charge back taxes or penalties, and even prosecute for fraud.

INSURANCE PRODUCTS

LIFE INSURANCE

Term insurance is temporary protection because it provides a death benefit only if the insured dies within the allotted policy period. If the insured outlives the policy period, fails to renew the policy, or the policy is canceled or expires, no death benefit is paid. If it is used as a “long-term” life insurance tool, it can be increasingly expensive because each time the term policy is renewed, the age and the risk of the insured increases (which consequently increases the premium).

Whole Life insurance provides death benefits for the entire life of the insured. It also provides living benefits in the form of cash values that accumulate throughout the life of the insured and lasts until death or age 100 and have fixed, level premiums. The insurance company bears all investment risks associated with these policies.

Universal Life insurance is essentially term insurance with cash value where policyowners can adjust the death benefit and the amount and frequency of premium payments to meet their changes in needs. Policyholders can also borrow or withdraw the policy’s cash value. Sales charges and other expenses are deducted from each premium payment, but the rest goes into the insurance company’s general account as an investment for the policyholder (this is called the net premium). Universal Life policies guarantee a cash value equal to a minimum return on the policyholder’s net premiums. If the investments perform better than the guaranteed minimum return, the cash value increases.

Variable Life insurance policies are interest-sensitive, considered to be securities contracts (although they are primarily insurance vehicles), and are usually chosen by applicants who are looking to offset inflation. The cash value and death benefits fluctuate according to the performance of underlying investments. A typical investment account grows through stocks, bonds, money market funds, etc. The policyowner assumes all of the investment risk and the rate of return is not guaranteed (the cash value is equal to the market value of the investments in the separate account).

Most Variable Life policies are sold with a fixed death benefit, but the death benefit still increases or decreases (based on the performance of the investments in the separate account). The death benefit is based on the policy’s Assumed Interest Rate (AIR)—the rate of interest stated in the contract that is used to determine annuity payments (the AIR is not a minimum guaranteed rate of return). If the investments in the separate account perform better than the AIR, the death benefit will increase (and vice versa).

Variable Life policies typically have fixed, level premiums, but many policyholders accumulate enough cash value through the investments to make the policy self-funding. However, if the investments begin to underperform and the cash value falls, the policyholder will have to resume paying the premiums or risk having no cash value and no insurance protection at an age when life insurance coverage is more expensive. Premiums are not tax-deductible, and investments grow tax-deferred. Any capital gains or interest earned are not taxable until the withdrawal.

ANNUITIES

An annuity is a security contract between the insurance company and the contract owner. The contract owner is the “purchaser” (investor) of the annuity. The owner gives the company a specified amount of money, and the company promises to provide an annuitant with income beginning either immediately or in the future. An annuitant can be the owner of the annuity OR it can a beneficiary designated by the owner of the annuity. Most annuities are non-qualified (investments are made with after-tax dollars).

Qualified annuities allow contract owners to invest with pre-tax dollars, but these are mainly for schools and non-profits (to provide a retirement investment for their employees). These are subject to a 10% penalty if withdrawals are made prior to age 59½ without good excuse (i.e. death, disability, qualified medical or education expenses). If a contract owner satisfies one of these exemptions, he must establish a rigid withdrawal schedule with (and approved by) the IRS in order for the withdrawals to be penalty-free. The early withdrawals must continue for five years or until the investor reaches age 59½.

Immediate annuities are purchased with a single, lump-sum payment. The annuitant will begin receiving payments one “period” after the annuity is purchased (i.e. If the payment is monthly or quarterly, then the first annuity payment will be that following month or quarter).

Deferred annuities may be purchased by one single-payment or periodic payments (over a specified time). Most deferred annuities are periodic-payment.

Fixed annuities provide fixed payments of a fixed amount for the fixed period in the contract. The insurance company invests the contract owner’s lump sum or installment payments in its general account and guarantees a minimum rate of return. The two biggest disadvantages of fixed annuities are that they give away any earnings above the minimum rate of return to the insurance company, and that fixed-dollar payments don’t keep pace with inflation.

Variable annuities allow protection against inflation while still receiving the income benefits of annuities. Contract owners make the investment decisions and assume all the risk. They also have control over how payments are invested during the accumulation phase (the period where the investor is contributing to the annuity but not receiving any distributions, allowing cash value to grow). Any capital gains and dividends earned during the accumulation phase are used to purchase more accumulation units and are tax-deferred.

The values in a variable annuity are expressed in UNITS instead of dollars. There are two types of units—accumulation units and annuity units. An accumulation unit represents the measurement of a single unit value of an annuity’s separate account during the accumulation phase (the period in which the contract owner is putting money into the annuity). If investments do well, the units increase in value (and vice versa). Therefore, accumulation units fluctuate in value. The net asset value (NAV) of the accumulation unit is calculated by dividing the total net assets by the total units issued.

An annuity unit is the fixed number of owned shares during the period the annuitant is receiving income from the annuity (annuitization phase). Although the number of these units represented in each payment is fixed, the value of each unit fluctuates to reflect the performance of the separate account’s underlying investments.

The annuitization phase is when the contract owner releases control of the annuity in order to begin receiving payments from the insurance company. These payments are taxed on a “last-in, first-out” (LIFO) basis, meaning that earnings (interest and capital gains) are withdrawn first and taxed as ordinary income. Amounts withdrawn in excess of earnings are tax-free. The owner decides how these payments will be received or to whom they will be given (i.e. monthly payments for life to self or by choosing a beneficiary of the payments). Once this annuitization period starts, the owner can no longer surrender, withdraw, or borrow money from the annuity contract.

At any time during this accumulation period, contract owners may cancel or surrender an annuity in return for its value. They may also withdraw a portion of the annuity (partial surrender) or borrow against the value of the annuity (loan). If the owner dies,the beneficiary receives the annuity value and if he receives more than the owner contributed, the excess amount will be taxed as ordinary income.

Equity-indexed Contracts (EICs) are a combination of fixed and variable annuities. They provide a minimum guaranteed rate of return and offer potential growth. The EIC is linked to the performance of an equity index (i.e. S&P 50). If the index does not perform well, the contract owner receives the minimum rate of return. Conversely, if the index exceeds the minimum return, the owner's earnings increase.
Sales charges may be deducted from the contract owner’s payments, and most companies have a surrender or withdrawal charge when funds are distributed to the annuitant.

Variable Universal Life annuities allow the policyowner to control the investment of cash values and to select the amount and frequency of premium payments. Policyholders can adjust these premium payments and death benefits to meet their needs, and the net premiums are invested in a separate account.

Straight-Life annuities pay the annuitant for life. There are no beneficiaries and the payments stop when the annuitant dies. Since the annuitant bears the risk of dying early, Straight-Life annuities provide the highest possible periodic payout.

Life with Period-Certain annuities pay the annuitant for life, BUT if the annuitant dies before the end of the allotted period, the beneficiary receives the remainder of payments. If the annuitant lives beyond the predetermined period, the beneficiary receives nothing.

Unit Refund Life annuities provide payments for life, BUT if the contract owner dies before receiving a certain number of payments, the beneficiary receives the remainder of payments until the specific number of payments is made (or as a lump-sum).

Joint and Last Survivor annuities vary depending on the number of annuitants. For annuities with two or more annuitants, the annuitants receive payments for life. However, if one person dies, the survivor(s) continue to receive payments. The payments end upon the death of the last survivor.