An Introduction to Bonds

An Introduction to Bonds

Agenda Bond basics Different types of bonds Bond features Yield and tax considerations Bond risks Credit quality Bond investing strategies and client suitability

Defining Characteristics of Bonds Investment securities based on debt (not equity) Fixed rate and term at issue Regular interest payments Less volatile than stocks

How Bonds Compare With Other Investments Annualized Total Return 8.83% Annualized Total Risk* 14.82% Value 9.22% 14.84% Large Cap 9.15% 14.22% Small Cap 11.48% 17.89% Non-U.S. 5.35% 16.31% U.S. Gov t 7.49% 9.85% Munis 5.45% 4.34% Corporate 6.42% 5.36% 2.73% 0.66% 25 Years Ended December 31, 2016 Stocks Bonds Cash Growth *Standard deviation Sources: DST Systems, Inc.; Bloomberg Barclays Capital; the Federal Reserve. For the 25 years ended December 31, 2016. Growth and value stocks represented by a composite of the S&P 500/BARRA Growth and Value indexes and the S&P/Citi Growth and Value indexes. Large-cap stocks represented by the S&P 500 index. Small-cap stocks represented by the S&P SmallCap 600 Index. International stocks represented by the MSCI EAFE Index. U.S. government bonds represented by the Bloomberg Barclays Long-Term Government Bond Index. Municipal bonds represented by the Bloomberg Barclays Municipal Bond Index. Corporate bonds represented by the Bloomberg Barclays Corporate Bond Index. Cash represented by a composite of yields on 3-month Treasury bills, published by the Federal Reserve, and the Bloomberg Barclays 3-Month Treasury Bills Index. All returns are compound annualized returns, and assume reinvestment of all distributions. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. 2017, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. Past performance is not a guarantee of future results.

Bond Market Logistics Bond funds and bond ETFs Primary market vs. secondary market Hold until maturity? Premium and discount pricing Price quotes

Types of Bonds International bonds High Corporate bonds Municipal bonds Risk/Return Potential U.S. government-sponsored enterprise (GSE) bonds U.S. Treasury bonds Low

U.S. Treasury Bonds Low risk Full backing by U.S. government Short- and long-term maturities Bonds, notes, and bills Exempt from state and local taxes

GSEs Terms and structures vary widely Fannie Mae and Ginnie Mae Recent controversy around mortgage GSEs Not backed by full faith and credit of U.S. government May be more risky than government bonds Taxed at federal level and possibly state and local levels as well

Municipal Bonds Tax exempt on federal level May be tax exempt at state and local level too Generally higher risk than U.S. government bonds Different types: General obligation (GO) vs. revenue Private activity COPs, pre-rees, tax increment bonds

Corporate Bonds Investment grade High yield Warrants Generally higher risk than munis or U.S. government bonds Fully taxable on federal, state, and local levels

High-Yield or Junk Bonds Lower quality/higher risk Higher default rate More volatile Rated BB or lower by rating services

Zero Coupon Bonds Issued at a discount All interest paid at maturity Phantom income tax considerations May be best suited to long-term goals

International Bonds Issued outside of the United States Most easily accessed via mutual funds Emerging markets and developed markets Involve special risks May provide additional diversification

Bond Mutual Funds Government, corporate, muni, and international funds Short-, intermediate-, and long-term funds Balanced, asset allocation, and target maturity funds Pros: liquidity, diversification, professional management Cons: Subject to market risk, unlike individual bonds held to maturity

Call Features A called bond = a bond redeemed before maturity Call dates and prices vary from issue to issue Yield to call calculations

Redeemable and Convertible Bonds Redeemable bonds: Can be called (redeemed) by issuer early Convertible bonds: Can be exchanged by investors for shares of the issuer s stock

Bond Insurance Purchased by the bond s issuer Insurer takes over payments if issuer defaults Usually has the effect of boosting credit rating Does not protect against volatility (price swings)

Indexed Bonds Inflation-indexed bonds: Bond interest rate is adjusted for inflation Floating rate securities: Coupon rate rises if interest rates rise or falls if interest rates fall in the overall economy

Tax Treatment Capital gains from any type of bonds are taxable at capital gains rates! Federal Tax State and Local Tax U.S. Treasury Bonds Fully taxable Usually tax exempt Gov t. Agency Bonds Fully taxable May be tax exempt Municipal Bonds Tax exempt May be tax exempt Corporate Bonds Fully taxable Fully taxable

Taxable-Equivalent Yield Tax Free Rate Tax Rate 2% 3% 4% 5% 6% 7% 10% 2.22% 3.33% 4.44% 5.56% 6.67% 7.78% 15% 2.35% 3.53% 4.71% 5.88% 7.06% 8.24% 25% 2.67% 4.00% 5.33% 6.67% 8.00% 9.33% 28% 2.78% 4.17% 5.56% 6.94% 8.33% 9.72% 33% 2.99% 4.48% 5.97% 7.46% 8.96% 10.45% 35% 3.08% 4.62% 6.15% 7.69% 9.23% 10.77% 39.6% 3.31% 4.97% 6.62% 8.28% 9.93% 11.59% Taxable-equivalent yield = Muni bond yield (1 - marginal tax rate)

Measuring Yield Coupon yield Current yield Yield to call Yield to maturity

Bonds and Interest Rates Hypothetical Yield Curve 6% 5% 4% 3% Interest Rates Bond Prices 2% 1% 0% 3 months 6 months 1 year 5 years 10 years Maturity of Bonds of Same Quality 20 years

Bond Risks Credit risk Prepayment risk Inflation risk Interest rate risk

Credit Quality & Ratings Major Bond Rating Systems Ratings S&P Moody s Fitch Prime Grade Excellent Grade High Grade Investment Grade AAA AA A BBB Aaa Aa A Baa AAA AA A BBB Speculative Grade Low Grade Highly Speculativ e Most Speculative Imminent Default BB B CCC CC C Ba B Caa Ca C BB B CCC CC C

Regulatory Considerations Securities and Exchange Commission (SEC) oversight Municipal Securities Rulemaking Board

Bonds in a Portfolio All-Stock Allocation Stock and Bond Allocation 25% bonds 100% stocks 75% stocks Average annual return (25 years): 9.15% Risk level: 14.22% Average annual return (25 years): 8.48% Risk level: 10.74% Sources: DST Systems, Inc.; Bloomberg Barclays. Stocks are represented by the S&P 500 index, bonds by the Bloomberg Barclays U.S. Aggregate Bond Index, for the 25 years ended December 31, 2016. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. 2017, DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions. Past performance is no guarantee of future results.

Individual Bond Strategies Bond Ladder 9 years 6 years 3 years 1 year Bond Barbell 10 years 1 year

Client Suitability: General Rules Know your client Evaluate securities carefully, on a case-by-case basis Factor in tax considerations especially for municipal bonds

Client Suitability: Allocations Investor A: 30 years old, aggressive investor seeking long-term growth bond allocation: 10% to 20% (perhaps with high-yield issues) Investor B: 60 years old, conservative preretiree seeking moderate growth and some asset protection bond allocation: 40% to 60% Investor C: 45 years old, investing for retirement with moderate appetite for risk bond allocation: 20% to 50%

Client Suitability: Tips for Choosing Specific Bonds or Bond Funds Tax-exempt issues best suited to high-income investors Munis inappropriate for tax-deferred accounts such as IRAs Maturity should fit goals High-yield bonds can be equally risky as stocks Consider diversifying with different types or funds

Questions?