the temple of abu simbel egypt - 13oo bc · 2016-06-30 · abu simbel egypt - 13oo bc . r m . s t a...

Chapter

4PRODUCT

KNOWLEDGE

THE TEMPLE OFABU SIMBEL

EGYPT - 13OO BC

R M . S T A R K & C O . , I N C .

BRANCH MANAGER MANUALPRODUCT KNOWLEDGE

4.1

PRODUCT KNOWLEDGE

The information contained in this chapter is designed to enhance the product knowledge of the manager and the broker and is to be used in sales meetings and for training material for new broker trainees.

OPTIONS

ptions give investors the right to buy or sell a stock, futures contract or stock index at a specific price or by a specific date. The owner of the option may or may not exercise the right of purchase or sale. If the right is not exercised or sold, the

option owner forfeits the money paid for the option.

There are two primary types of options:

Calls Puts

A put option gives the buyer the right to sell a specific number of shares of an investment at a predetermined price within a specific time period. In general, put buyers expect that the price of the underlying security will fall during the period of time covered by the option. If the price does fall and the option is exercised, the investor receives the higher than market price for the security.

Conversely, a call option gives the buyer the right to buy a specific number of shares of an investment at a predetermined price within a specific time period. In general, call option buyers expect that the price of the underlying security will rise during the period of time covered by the option. If the price does rise and option is exercised, the investor pays a lower than market price for the security.

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Options are attractive to many investors because they provide an enormous amount of leverage. The investor can control large blocks of stock for a relatively small outlay of cash. As a result, options can be immensely profitable. However, commensurate with their potential for profit, options often entail high risks. In essence, the investor is “betting” that a financial instrument will rise or fall within a rather short period. Therefore, options used in this way are not suitable for every investor.

However, even conservative investors can use options profitably. For example, some investors utilize options to protect or hedge their investments. For example, if investor “H’ owns 100 shares of ABC Corporation, he or she may buy a put option for those 100 shares as “insurance” against a short-term price decline. If the stock does fall and investor must sell for any reason, the put option makes up the difference and protects the investment. Similarly, some investor sell call options to earn incremental income on their investments. If the price of the security does not rise above the strike price of the call option, the call option seller keeps both the security and the option premium. If the security does rise above the strike price, the call option seller keeps the option premium plus any capital appreciation realized on the security up to the strike price.

WHAT IS A LISTED OPTION

Options have been available to investors for may years. However, it wasn’t until the Chicago Board of Options Exchange (CBOE) began trading options in 1973, that options became the viable investment they are today. Since 1973, trading volume in options has exceeded all expectations. As a result, options are now listed on the CBOE and other exchanges, including the New York, American, Philadelphia and Pacific Stock Exchanges.

Listed options generated such great demand because liquid market was provided, standardizing expiration dates and strike prices. Options now trade much like stocks and warrants.

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4.3

TYPE OF OPTIONS

CAPS

Caps are options that give the owner the right to participate up to a predetermined strike price (CAP). A CAP options is automatically exercised if the underlying instrument closes at or above the CAP strike price at any time up to expiration.

CALLS

A call, as explained earlier, give the owner the right to buy a specific number of shares of an underlying security at a stated price on or before a fixed expiration date.

COVERED OPTIONS

Covered options are options in which the seller owns the underlying security.

FOREIGN CURRENCY OPTIONS

Foreign currency options are listed options that trade on a specific standardized foreign currency contract.

IN-THE-MONEY

In-the-money describes a situation in which the strike price is below the market price of the underlying security for a call or above the market price for a put.

OUT-OF-THE-MONEY

Describes a situation in which the strike price is above the market price of an underlying security for a call or below market price for a put.

LEAPS

Leaps (Long-Term Equity Anticipation Securities) are options with expirations of up to two years.

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4.4

PUTS

Puts as explained earlier, give owners the right to sell a specific number of shares of an underlying security at a stated price on or before a fixed expiration date.

UNCOVERED OPTIONS

Uncovered (naked) options are options in which the seller does not own the underlying security.

FEATURES AND INVESTORBENEFITS OF OPTIONSBENEFITS

Choice of expiration periods. Enables investors to plan portfolio decisions and consider time values.

For some options, exercise prices are specified. Investors can know the exact amount that will be available to other investments.

For others, new exercise prices are created above or below the strike price as the underlying security fluctuates. Investors can take advantage of price movements to limit losses or enhance potential profits.

Premium paid to seller immediately. Cash is available for investment or other uses.

Over 1,000 different options are traded. Most popular stocks also have options, providing opportunities for higher returns.

Leverage. Maximizes return on investment with relatively small amount of capital at risk.

Fixed purchase price. Investors know cost of stock if exercised, providing ability to purchase the securities at the exercise price no matter how high market value rises.

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Specific time period for each option contract. Investor has wide choice of expiration dates and can exercise option any time during the period.

Short sales strategy. “Hedge” strategy can limit risk of short sales providing opportunity to profit whether market rises or falls.

Active secondary market. Can buy or sell options without exercising, making money available for other uses.

IMPORTANT FACTS TO REMEMBER

Never put all your clients’ funds into options. As a rule, clients should buy no more than one call for every 100 shares he or she can afford to purchase.

Listed options expire on the Saturday immediately following the third Friday of the expiration month. That third Friday is the last day to trade options expiring in that month.

Investors who sell options are called “Writers”. Writers of covered options (calls) are generally conservative investors seeking extra income. On the other hand, writers of uncovered options are usually speculators willing to take high risks to earn substantial returns on their investments.

Option writers who have written listed covered calls on the CBOE are not affected by cash dividends, therefore increasing the writers return. In unlisted options, the dividends belong to the owner of the call and therefore reduces the exercise price.

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Returns from writing options vary greatly. However, in a neutral market the combination of dividends and premium income can generate a generous annual return.

Most option premiums from unexercised calls should be treated as short-term capital gains. However, gains from leaps may qualify for long-term capital gains.

Writers of calls can enter into a closing purchase transaction at any time before exercise and/or expiration. Any gain or loss realized will be treated as short-term capital gain or loss (leaps may have long-term gains/losses). The buyer of a call may also enter a closing sale transaction at any time prior to expiration, providing a capital gain or loss.

Option Clearing Corporation (OCC)is a corporation owned jointly by all the exchanges trading listed options. On the basis of compared trades submitted by various exchanges, the OCC issues the option to the buyer and holds the writer to his or her obligation. The OCC is therefore the issuer of all listed options and a holder must exercise against the OCC, not the original writer. The OCC maintains a system for collecting the remitting funds in settlement of option trades and it holds collateral deposited by option writers to guarantee their performance.

Spreading is a system of strategies calling for the simultaneous purchase and sale of options of the same class in order to establish hedged positions.

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4.7

LISTED EQUITIES

quities comprise one of the most popular and most widely traded investments in the world. Virtually all investors who have long term financial goals should consider equities as the core holdings of their investment portfolios. In fact, whether

they seek to build wealth, preserve capital, plan for retirement or fund an education for children or grandchildren, equity investments are most likely to product the greatest long term investment rewards.

From a historical perspective, common stocks (the most dominant form of equity participation) have outperformed all other types of financial instruments. For over 70 years, the stock market has grown at an average of more than 10% per year, compounded annually. This compare to approximately 4.6% for long term government bonds, 3.6% for treasury instruments and 3.1% for inflation over the same period. Source: Ibbotson Associates, Chicago, IL

Of course 60 years is an unrealistic time frame for investors trying to achieve specific objectives. When viewed from a more realistic perspective, stocks continue to outperform other investments. For example, in the decade of the 80’s, a $10,000 investment in the stocks of the Standard and Poors (S & P) 500 index, with dividends reinvested, returned approximately $50,000, a 40% gain.

Stocks also outperform other investments when returns are measured in five year intervals. During 46-48 five-year periods between 1938 and 1980, common stocks were profitable investments. Common stocks had better returns than other investments for 38 of those five-year periods. By comparison, corporate bonds led in only three periods, government bonds led three times and treasury bills led only four times.

Clearly, equities have played a significant role in helping investors achieve their most important long term financial goals. Whether your clients seek growth, income or preservation of capital, participation in the growth of corporations in the United States and around the world should be a key component of their long-term investment portfolios.

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4.8

TYPES OF EQUITIES

COMMON STOCK

Common stock is the most popular form of equity participation in the United States due to the fact that investors share in the potential growth of a corporation’s assets, earnings and profits through dividends and capital appreciation. Yet shareholders’ liability is limited. There are over 3,000 common stocks listed on the major U.S. exchanges, representing many trillions of market capitalization.

Common stock is a unit of equity ownership in a corporation. Owners of this kind of stock exercise control over corporate affairs and enjoy any capital appreciation. They are paid dividends only after preferred stock. Their interest in the assets, in the event of liquidation, is junior to all others.

Common stocks are often divided into separate categories each with its own characteristics:

BLUE CHIP: Stocks are issued by America’s largest and most well-capitalized corporations. Blue chip stocks have a history of profit, growth and dividend payment, as well as quality management, products and services. Blue chip stocks are usually high priced and low yielding. The term “Blue Chip” comes from the game of poker, in which the

SMALL CAPITALIZATION: Stocks are issued by smaller companies and often are characterized by superior growth potential and commensurate levels of risk.

GROWTH STOCKS: Growth stocks describe the stocks of companies experiencing consistent and sustained earnings growth over time.

PREFERRED STOCK: Preferred stock is a different class of equity and comes in various types. For example, “Straight Preferred” usually offer little equity participation in the underlying company but provide a fixed dividend yield. Therefore, straight preferred stock appeals to investors who seek dividend income and relative price stability.

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CONVERTIBLE PREFERRED: Convertible preferred stock enable investors to exchange their shares for a fixed number of common shares. Therefore, investors can enjoy the safety and yields of preferred stocks as well as the potential for capital appreciation, as the underlying common stock increases in value.

DISCOUNT PREFERRED: Discount preferred stock are preferred stocks selling below their par value, usually because the stock was issued at a time when interest rates were lower than currently prevailing rates. The price of the preferred stock is discounted to compensate for the lower dividend. As a result these securities often provide actual current yields that are quite competitive with new issues.

WARRANTS: Warrants are securities that entitle the holder to buy the underlying stock at a fixed price under predetermined terms. Corporations issue warrants encouraging greater investor participation in their securities.

The price of the warrant usually reflects the price of the common stock. Warrants have a fixed life span. However, warrants have the potential for large percentage gains, should the underlying common stock rise significantly prior to the warrant’s expiration. If the underlying security fails to sell at or above the warrant’s strike price during that time, the warrant will expire worthless.

A warrant is also an inducement attached to new securities in distribution giving purchasers a long-term (usually a five to ten years) privilege of subscribing to one or more shares of stock reserved for them by the corporation from its un-issued or treasury stock reserve.

RIGHTS: A right is a privilege granted to owners of certain stocks to purchase newly issued securities in proportion to their holdings, usually in values below the current market price. Rights have a market of their own and are actively traded. They differ from warrants in that they must be exercised within a relatively short period of time.

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FREATURES AND INVESTOR BENEFITS OF LISTED EQUITIES

Dividend income. Value of investment should grow as the company grows.

Active secondary market. Securities can be sold quickly and easily, providing access to capital for other uses.

Cumulative (preferred stock only). If dividends are missed they accrue and must be paid in full before dividends may be paid for any other class of equity.

Opportunities for dividend increases. Helps income oriented investors keep pace with inflation.

Marginable. Considered good collateral for margin or bank loans.

Listed options often available. Provides greater flexibility in investment strategy and the ability to boost returns.

Wide range of issues. Provides ability to diversify to manage risks, also provides opportunity to tailor a portfolio to specific needs.

Ownership in company. Ability to share growth of the company without incurring any of the company’s liabilities.


The most important reason for owning stocks is the potential for capital appreciation and dividend income which can help investors protect and increase the purchasing power of their assets over time and best inflation.

Dividends are usually paid four times per year. You can find the exact dividend payment dates for specific stocks in the “Standard and Poor’s Stock Guide” and the “Standard and Poor’s Dividend Records”.

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“Ex-Dividend” describes the period between the announcement of a dividend and its payment to shareholders. Investors who purchase on or after the ex-dividend date are not entitled to the last dividend. Stocks usually are ex-dividend on the fourth business day preceding the record date.

Corporations purchase preferred stocks because 70% of the dividends of “new money preferred stocks” (those issued after October 1, 1942) is not taxable to the corporation increasing the effective after-tax yield.

Many companies offer dividend reinvestment allowing for portfolio growth without paying additional commission to purchase more shares.

Warrants provide leverage because a small rise in the underlying stock price can produce a proportionally larger rise in the warrant’s price.

Like bonds, preferred stocks are evaluated (rated by Standard and Poor’s, Moody’s and other rating services). It should be noted that preferred stocks receiving the highest ratings generally are safest. But, their yields are correspondingly lower than more speculative issues.

Several factors drive the price of a preferred. Preferred stocks are bought and sold as yield or income vehicles. Therefore, prices tend to reflect the interest rate environment as well as changes in the credit rating or perceived credit quality of the issuer.

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4.12

PREFERRED STOCK

referred stock is a class of stock which pays a fixed dividend on a quarterly basis. This dividend must be paid before any dividends are paid to the common stock holders. It is also usually a

“cumulative” dividend, which means that should they be in arrears, the issuer must pay all past missed and current preferred dividends before any common stock dividends are paid.

Preferred stocks are issued by major banks, utilities, industrial corporations and various foreign entities to raise capital. Because they pay a fixed dividend, they are interest rate sensitive, performing more like a bond than a stock. For investors, they are an affordable, liquid investment with most recent issues having a $25 par value. Due to the relative safety and higher yields, preferreds are an attractive supplement to more traditional fixed-income securities.

There are more than 1,000 outstanding issues of preferred stock worth approximately $130 billion, of which approximately 75% of the issues are listed on major exchanges.

INVESTOR PROFILE

Preferred stocks offer investors dividend safety, investment grade quality and a relatively high return on their investments. Typical preferred investors include:

1 Individuals looking for more yield.

2 Individuals looking to diversify their retirement accounts.

3 Retired investors seeking higher quarterly interest income.

PERPETUAL PREFERREDS

Unlike bonds, a perpetual preferred has a fixed quarterly dividend but has no set maturity date. Most new issues can be called in five (5) years. Perpetual preferreds are the simplest forms of preferreds.

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Benefits include safety of dividends (cumulative), dividend payments adjust using the highest of three treasury yields and establishes minimum and maximum dividend levels.

ADJUSTABLE-RATE PREFERREDS (ARPs)

Adjustable-rate preferreds (ARPs) feature dividend resets each quarter based on a formula tied to a U. S. treasury benchmark yield. The benchmark is usually defined as the three month bill rate, the ten year constant maturity or either the twenty year or thirty year constant. The reset formula is a fixed number of basis points above or below the highest constant, or a percentage of it. Most ARPs are perpetual. All have collars which limit the minimum and maximum that the dividend can be reset. Dividends are generally cumulative and most have call provisions.

Benefits include safety of dividends (cumulative), dividend payments adjust using the highest of three treasury yields and establishes minimum and maximum dividend levels.

AMERICAN DEPOSITORY SHARES (ADRs)

American Depository Shares are issued by foreign entities seeking access to U.S. capital markets. They are issued in U.S. dollars so there is no currency risk. ADRs are attractive to many types of investors because of their relatively high current yield and quality ratings. Unlike most other preferreds, many issues have non-cumulative dividends.

Some ADR dividends are subject to withholding tax that qualified individuals receive back in the form of a tax credit. Because of the withholding tax, some ADRs are not suitable for IRA or pension accounts. However, many issues pay full dividends in cash and can be used by IRA, pension accounts and non-resident aliens.

The benefits include issued in U.S. dollars (no currency risk) and relatively high yields.

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CHARACTERISTICS AND BENEFITS OF PREFERRED STOCK

Relative safety. As with common stock, the price of preferreds can fluctuate daily. Most preferred dividends are cumulative, if dividend is omitted, the company must pay preferred dividend before paying common stock.

Diversity. Preferreds are offered by major banks, utilities, industrial corporations and foreign entities. The fit a wide array of investor needs and investment goals.

Liquidity. Approximately 75% of outstanding preferred issues are listed on a major exchange. They are easy to buy, sell and follow.

MONTHLY DIVIDEND PACKAGE

By purchasing three different issues with consecutive quarterly dividend payable dates, the investor can attain a monthly income package. For example:

CYCLE 1: Dividend pays on: January – April – July – October.

CYCLE 2: Dividend pays on: February – May – August November.

CYCLE 3: Dividend pays on: March – June – September – December.

SWAP COMMON FOR PREFERRED

Since some preferreds can yield as much as 200 basis points more than stocks of the same company, clients needing more income might consider swapping out of their common stock and buying preferreds.

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4.15

OVER-THE-COUNTER (OTC) EQUITIES

ike other forms of equities, Over-The-Counter (OTC) stocks represent ownership interests in the companies that issue them. While many OTC stocks tend to be issued by companies with smaller market capitalizations than their exchange listed

counterparts. Many of today’s well known companies are participants in the Over-The-Counter marketplace.

The term Over-The-Counter (OTC) dates back to the mid 19th century when securities were traded over the counters of private banks. As such, the OTC is one of the oldest and largest securities marketplaces in the world.

Investors will find federal, state and municipal securities, many bank and insurance company stocks, industrial and utility issues in the OTC market. Many of the largest and most seasoned corporations, some of the smallest, new and unseasoned companies as well as investment company shares are traded on the OTC, in addition, there is an active OTC market in many listed securities.

PURPOSE OF THE OVER-THE-COUNTER MARKET

The OTC market meets two important needs of the government, industry and the individual investor:

1 Generates working capital for government and industry as well as potential capital appreciation and income for investors.

2 Provides an orderly secondary negotiated market for the exchange of securities already in the public hands.

Today the OTC is a vast network of computer cables and telephone lines. With the touch of a button, brokers are in touch with market makers all over the world and can make transactions in a matter of seconds. In the OTC, stocks have sponsorship and an attendant merchandising service, enabling the public to gain all the benefits of equity and debt investments.

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NASDAQ

The “National Association of Securities Dealers Automated Quotations” system (NASDAQ) is a sophisticated nationwide electronics system that allows a dealer to make immediate changes in his or her quote on a stock at any time during the trading day. Corporations must meet the following minimum qualifications for listing on NASDAQ:

1 300 or more stockholders.

2 100,000 shares publicly held.

3 Assets of $4 million (as of the date of this writing).

4 Shareholders’ equity of $500,000.

5 Two or more market makers.

The computerized quotations network by which NASD members can communicate bids and offers are through the following levels:

LEVEL 1: Provides only the arithmetic means of the bids and offers entered by members.

LEVEL 2: Provides the individual bids and offers next to the name of the member entering the information.

LEVEL 3: Available to NASD members to enter bids and offers and receive level 2 service.

The NASDQ OTC price index is a computer-oriented, broad-based indicator of activity in the unlisted securities market which is updated every five minutes.

FEATURES AND INVESTOR BENEFITS OF OTC EQUITIES

Potential for capital appreciation. The underlying value of the investment can grow as company grows, enabling the investor to build wealth and combat inflation.

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Active secondary market. Can be easily sold at any time if investor wants to take profits, stop losses or if money is needed for other uses.

Limited liability. Provides the ability to maintain equity without incurring corporate liabilities.

Can be used for loan collateral. Many OTC stocks can be margined and are suitable collateral at banks.

Potential for regular income. Many OTC stocks pay dividends.


OTC securities offer the same possible capital appreciation and growth potential as listed securities. Investors can invest in some of the oldest and most established companies in the U.S. for long-term growth and/or invest in relatively new companies which may offer quicker returns. Indeed, the IBMs of tomorrow are possibly now trading on the OTC.

It is legally possible to short OTC stock providing the proper approval is received.

Margin requirements on OTC securities are the same as most listed securities.

Subject quote is when the price and/or size cannot be quoted as firm.

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4.18

FIXED INCOME

ixed income securities represent the debt of the federal government and its agencies, local governments and corporations.Structurally, debt securities are senior to all other financial

obligations. Consequently, the principal and interest of fixed income securities must be paid in full before other classes of obligations in the event of financial problems.

Fixed income securities offer a relatively safe and predictable income flow, typically over a predetermined period of time. The coupon (the amount of interest the issuer has agreed to pay annually) is set at issuance and will remain the same until maturity, thus the term “fixed income”. Investors may choose from a variety of maturities (from one day to 40 years) to best suit their investment needs.

The large variety of fixed income securities available, and the huge size of the marketplace, makes this way of raising capital one of the most popular worldwide. Consequently, the vast amount of outstanding government, agency, municipal and corporate debt provides a large secondary market which offers a high degree of liquidity for investors.

BOND RATINGS

Since safety is one of the most important aspects of fixed income investment, a rating system has been established to evaluate the relative credit worthiness of these securities.

The two most recognized independent rating agencies are “Standard and Poor’s” and “Moody’s” rating services. The rating agencies help investors make an informed decision based on their professional evaluation of the credit quality of a security and the issuer’s ability to make payments of interest and principal. Their rating symbols, and a brief explanation of what they mean are shown in the chart on the next page.

Once a rating is assigned, it is periodically reviewed and may be raised or lowered based on the issuer’s merits. It is important to understand what goes into a securities’ rating, so that your client’s needs are met with the appropriate mix of fixed income rated securities.

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MOODY’S S & P DESCRIPTION TYPEAa AAA Strongest capacity to pay interest Investment

And repay principal. GradeAa AA Very strong capacity to pay Investment

Interest and repay principal. GradeA A Strong capacity to pay interest Investment

And repay principal. GradeBaa BBB Adequate capacity to pay interest Investment

And repay principal. GradeBa BB Lowest degree of speculation with Speculative

Respect to capacity to pay interest GradeAnd repay principal.

B B Greater vulnerability to default SpeculativeBut currently has the capacity GradeTo meet interest and principalPayments.

Caa CCC Currently vulnerable to default SpeculativeDependent on favorable Gradeconditions.

Ca CC Highly speculative SpeculativeGrade

C C/C Highest degree of speculation, no SpeculativeInterest is paid Grade

– D In payment default. SpeculativeGrade

Standard & Poor’s attaches a plus or minus sign to ratings to indicate that acredit is considered to be in the upper or lower segment of the rating category. Moody’s breaks down their ratings by using numerical modifies, 1, 2, and 3. Notethat both rating services may not respond immediately to current news.

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The better the issuer’s ability to repay interest and principal (as determined by its rating), the lower the amount of interest an investor will receive. Conversely, a lower rated bond will pay higher rate of interest to compensate an investor for the additional risk.

The chart on the next page places the fixed income products in their position in the typical risk/reward order, based both on ratings and their perception in the market place.

MARKET RISK

All fixed income securities are subject to standard fixed income market risks. If a security is sold prior to maturity, the price it will sell for in the marketplace is dependent upon the current interest rate environment. Therefore, if the current environment is one of lower interest rates, the price of the security will rise above the purchase price. If interest rates are higher, the price of the security will decline, as shown in the diagram shown below.

Bond prices rise because the market is willing to pay more for a higher coupon.

When interest rates drop.

Bond prices fall becausethe market will pay less for a lower coupon.

When interest rates rise.

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LOWER RISK / REWARD SPECTRUM HIGHER

AAA AA A BBB BB & BELOW

TREASURIES/AGENCIES

ZEROS

CORPORATE BONDS

MUNICIPAL BONDS

PREFERREDS

CMO’s

HIGHYIELD

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Fixed income securities come in three forms:

1 Registered.

2 Coupon (bearer).

3 Book entry.

Registered bonds - are bonds that are issued in certificate form. These certificates can be held by the investor or held in safekeeping in a brokerage account with interest being paid, typically semi-annually, directly to the investor.

Coupon bonds - are bonds that were issued before 1982. These bonds are certificates with coupons physically attached. Investors are required to clip coupons semi-annually and deposit them at their bank in order to receive their interest payments. Typically, interest is paid semi-annually.

Book entry bonds – are bonds that are the wave of the future in the fixed income market. Rather than individual certificates, there is a single certificate representing the entire issue. This certificate is deposited with a clearing house. The clearing house dispenses funds in a timely fashion to investment firms who subsequently credit their individual client accounts. In lieu of a certificate, investors have the original confirmation of their purchase and a record of holdings on their brokerage firm statement. The benefits to investors are the reduction or elimination of problems stemming from missed call notices and lost income due to late redemptions, as well as the loss, theft or damage of certificates.

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HIGH-YIELD BONDS

igh-yield bonds are corporate bonds whose credit ratings are below BAA3/BBB by Moodys and Standard and Poors. High-yield bonds are typically issued by emerging mid-cap corporations to finance growth. Maturities usually range

between 7 to 10 years and interest is paid semi-annually.

The most attractive aspect of investing in high-yield bonds is the high interest income. The coupon on a high-yield bond is typically between 200 and 500 basis points (2% to 5%) higher than on a like maturity investment grade corporate bond. Also, high-yield bonds provide an alternate vehicle to stocks with which aggressive investors can capitalize on emerging growth industries such as cellular telephones and cable television.

The high-yield bond market, which had receded after the 1987 crash, is once again rapidly growing. Today there are approximately over $250 billion of securities outstanding. High-yield mutual funds are the biggest holders of bonds, followed by pension funds and insurance companies. Individual investors, as a group, hold only 5% to 10% of the outstanding issues at any given time.

INVESTOR PROFILE

High-yield bonds, because of their inherent risk and attractive returns are most appropriate for very aggressive fixed income investors. Equity investors are also attracted to high-yield bonds because of their potential principal appreciation. Typical high-yield investors are very sophisticated, high net worth individuals, mutual funds, pension funds, insurance companies and money managers.

High-yield bonds offer these investors an opportunity to receive high current income whiled seasoning their existing portfolios by providing diversification.

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INVESTOR RISKS

Credit risk is particularly critical in evaluating high-yield bonds as it represents the underlying financial strength of an issuer based on its ability to make timely payments of interest and principal. The primary means of assessing an issuer’s ability to pay is the interest coverage ration. This ratio compares the amount of cash flow a company generates to its total interest expense. When an issuer can no longer meet its fixed financial obligations, that issuer is placed in default.

STRUCTURE

PLAIN VANILLA BONDS

Plain vanilla bonds are straight forward annual cash interest paying bonds. Typically they have a call schedule and change of control provision. The change of control provision is prevalent in high-yields. It means that if the company’s management is taken over and effects a change of control, the bondholder has the option to elect to put the bonds to the company at a predetermined price, typically at par.

ZERO COUPON BONDS

Zero coupon bonds are deferred coupon bonds that pay only at maturity. This vehicle is becoming increasingly uncommon in the high-yield market as a straight zero. The high-yield market’s adaptation of this product is called the “Hybrid Zero Coupon” bond.

HYBRID ZERO COUPON BONDS

Hybrid zero coupon bonds are the high-yield markets answer to zero coupon bonds. These bonds are issued at a deep discount as zeros, for a determined amount of time, at which point a call option is initiated or the bond will convert into an interest bearing bond at a predetermined rate. Most zeros also have an IPO call provision allowing the company to call a predetermined percentage of the issue at a set premium rate to the accredited value of the bond. The yields on these bonds are generally higher than those found on “plain vanilla” bonds due to the lower subordination of these vehicles.

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PAY IN KIND BONDS (PIK)

PIKs are bonds in which the company has the option to pay the coupons in more bonds or cash. These bonds trade flat (without accrued interest) and go ex-dividend similarly to a preferred stock.

DEFAULT BONDS

Default bonds are bonds in arrears on payment of interest or principal. These bonds trade flat and obviously are the most speculative high-yield bonds.

CHARACTERISTICS AND BENEFITS OF HIGH-YIELD BONDS

High returns – Because of the complexity and risk associated with these securities, they are priced at significantly higher yields than other fixed income securities.

Liquidity – While there are over $250 billion in outstanding high-yield securities, not all of these are liquid.

Current average rates – BB rated high-yield bonds are currently offering 8% to 9% coupons, while B rated issues are yielding 9% to 11%.

CORPORATE BONDS

orporate bonds are a senior debt obligation issued by corporations. The senior nature of the debt requires that the principal and interest be paid off before other classes of securities, should problems arise in the company. Interest is

generally paid semi-annually. Maturities vary from just a few months to as long as forty years. The principal amount is usually $1,000.

Corporate bonds offer clients a higher yield than government bonds and more relative safety than stocks. There is also a huge variety of corporate issuers to choose from many of whose names are easily recognizable by investors.

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U.S. corporate bonds represent one of the largest capital markets in the world, with well over $ one trillion outstanding. Fortune 500 issuers regularly turn to this market to raise capital.

STRUCTURE

SECONDARY MARKET DISCOUNT BONDS

Secondary market discount bonds are bonds trading at a price lower than par ($1,000). The coupon interest is taxed at the client’s prevailing tax rate. The difference between what is paid (below par) and what is received at maturity (par) is also taxed at prevailing capital gain rates. However, the tax even takes place in the year the bond matures. Therefore, deep discounts have attractive yields while deferring taxes to future years.

ORIGINAL ISSUE DISCOUNT BONDS (OID)

OIDs are bonds that are issued at a 25% (.0025) discount of par ($1,000) times (x) the number of years to maturity. For example, a 10 year bond issued below 97 ½ would be considered an OID and a 20 year bond would have to be issued below 95 and a 30 year bond below 92 ½.

TENNESSEE VALLEY AUTHORITY (TVA)

A TVA is a quasi-governmental agency that is rated AAA. TVAs are exempt from state and local income tax.

YANKEE BONDS

Yankee bonds are U.S. dollar denominated bonds issued by foreign governments or corporations. Interest and principal are payable in U.S. dollars. These issues are generally of excellent quality and trade actively on the OTC secondary market.

MEDIUM-TERM NOTES

These are highly rated corporate debt securities with maturities ranging from 9 months to 10 years. They are designed to be custom tailored both in terms of denominations and maturity dates. Most notes are non-

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callable. The denominations can be as small as $5,000 or as large as the investor desires. Interest is paid semi-annually.

TRIPLE A GUARANTEED SECONDARY SECURITIES (TAGS)

TAGs allow bonds or notes with low ratings to be insured and resold with a AAA rating. The insurer, “Financial Security Assurance (FSA Inc.)” is an AAA rated company that was formed to provide financial guarantees on corporate, as well as other bonds. For example, a block of utility first mortgage bonds rated BAAA.BBB+ can be insured and resold as AAA/AAA.

CUSHON BONDS

Cushion bonds are bonds that trade at a higher price than its next call or refunding price. Although, it appears to be a long-term investment, the short call date makes early retirement a strong possibility. The high coupon and refunding provision can minimize the volatility of the issue, due to the existing relationship with the short-term market. In comparison, a lower coupon with a long maturity subjects the principal to wider price fluctuations. Paying a premium can be viewed as advantageous if the coupon the bond carries makes up for the loss in principal if the bonds are called.

INVESTOR PROFILES

Corporate bonds are for clients who are seeking higher fixed income yields, while maintaining a relative degree of safety and liquidity. The higher yields are especially attractive when corporate bonds are placed in:

1 Retirement accounts.

2 Supplement retirement plans.

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MONTHLY INCOME PLAN

A monthly income plan is simply six corporate bonds with different interest payment dates (January/July, February/August, etc.), generating a check a month.

ROLLOVER PLAN

Divide the amount to be invested into five equal parts and distribute it among five consecutive maturities. For example, $100,000 divided by 5 = $20,000. $20,000 would then be invested in bonds maturing in 2006, 2007, 2008, 2009, 2010,.

By spending the investment out over five years, you and your client diminish the need to attempt to forecast when interest rates might decline or rise. If after a year, rates are higher, the first $20,000 that matures could be invested at a higher rate of return. If rates decline, only 20% of the portfolio has to be invested at lower rates, while the balance benefits by increasing in value. Under both scenarios, you take advantage of the market; the market doesn’t take advantage of you.

Benefits include:

1 Relative safety of principal (if held to maturity).

2 Relatively high rate of return.

3 Liquidity.

4 Minimizes exposure to interest rate swings.

BARBELL STRATEGY

This strategy involves purchasing some bonds with a short maturity and some with a long maturity. The client should benefit from short-term rates, while the longer maturity could position the client for potential price appreciation. If rates remain high, the client’s short-term instruments will mature, enabling the client to reinvest at higher rates. If rates decline, the longer maturity should respond and increase in value. In both scenarios, your client’s portfolios effectively keep pace with the market.

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The combinations of maturities that can be purchased are numerous. You can use 2 and 30 year maturities, 5 and 20 year maturities, or any maturities in between. Various coupons can be combined as well.

KEY CHARACTERISTICS AND BENEFITS

Relative safety. – Corporate bonds are secured by the issuing corporation whose credit-worthiness is evaluated by the rating agencies.

Diversity. – Corporate bonds are issued by a wide variety of well known companies in a large variety of maturities and structures, including floating rate, variable discount rate and puts.

Liquidity. – With over $2 million in outstanding issues, corporates represent one of the most active and most liquid secondary markets.

TAX-EXEMPT MUNICIPAL BONDS

unicipal bonds are debt obligations issued by states, cities and various other municipal or governmental entities. They are used to raise funds to build schools, libraries, water and sewer

systems or to finance infrastructure improvements such as bridges, roads and tunnels.

The most attractive feature for investors of municipal bonds is the tax-exempt income. Municipal bonds offer interest payments which are exempt from federal income taxes and generally exempt from the taxes of the state or city in which they are issued. The tax-exemption is especially favorable for an investor living in an area with high state taxes. Additionally, tax-exempt municipal bonds can offer a high degree of safety.

The tax-exempt municipal market is both vast and diverse with a total of over $1 trillion of securities outstanding and over 50,000 issuers. Retail households own the lion’s share of this market with a total of over 50%. Tax-exempt mutual funds and money market funds combined own a 25& share of the outstanding municipal bonds. Together these two groups

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comprised mostly of mom and pop investors, are the largest single holders of municipal debt and represent over 75% of the total market share.

STRUCTURE

GENERAL OBLIGATION BONDS (GO)

General obligation bonds are backed by a pledge of the issuer’s full faith, credit and taxing power for the prompt payment of principal and interest.

Benefits:

1 Security of the municipal government’s full taxing power.

2 High degree of safety.

3 Liquidity, general obligation bonds are in high demand by high net worth individuals.

REVENUE BONDS

Revenue bonds are payable from the receipts of a revenue producing enterprise. State agencies and authorities, such as water, sewer, gas or electric systems, toll bridges or airports. All these are income producing facilities. The yields offered on revenue bonds are generally higher than those found on general obligation bonds due to increased risk.

Benefits:

1 Specific revenues pledged as security.

2 Higher tax-free yields.

3 Active secondary market.

ZERO-COUPON BONDS

Zero-coupon bonds are somewhat like a series EE savings bond. It is sold at a deep discount to its par value. It does not pay periodic interest, instead, the tax-free interest automatically compounds semi-annually at a

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predetermined rate until maturity when the principal and accrued interest is returned to the investor. Municipal zeros are a good way to save for retirement or for children’s and grandchildren’s education.

Benefits:

1 Smaller initial investment.

2 Interest is automatically reinvested at the original rate.

3 Ability to lock in a yield until maturity at the time of purchase.

4 Growth potential due to compounded semi-annual interest.

5 Tool for future financial planning needs.

6 No capital gains tax on appreciation to maturity value if purchased in the new issue market.

PREMIUM BONDS

Premium bonds are municipal bonds whose coupon rate is higher than prevailing interest rates and therefore sells at a price higher than it’s face value. They generally offer yields higher than the yields available on comparable bonds that are trading at par or at a discount. The premium price is returned to the investor in the form of higher coupon payments. Premium bonds are a good defensive investment because they are less volatile in changing interest rate environments.

Benefits:

1 High current tax-exempt income.

2 Higher yield to maturity (or call date) that offered by par or discounted bonds.

3 Minimized price volatility.

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INSURED BONDS

Some investors prefer the additional safety of an insured municipal bond. Currently there are five municipal insurers who will, for a fee changed to the issuer, insure the prompt payment of principal and interest when due on a bond issue. When such insurance has been obtained, the bonds are rated AAA from both of the credit rating agencies.

The municipal insurers are:

1 MBIA.

2 FGIC.

3 AMBAC.

4 FSA.

5 CAPITAL GUARANTY.

Benefits:

1 Added security.

2 Active secondary market.

3 Marketability.

PRE-REFUNDED BONDS

Pre-refunded bonds are municipal bonds that have been refinanced by the proceeds of a new bond issue. The proceeds of the new issue are put into escrow to retire the original issue, generally at the first optional call date. The second or newer issue remains outstanding in the market until their stated maturity. Most pre-refunded bonds are said to be backed by the U.S. Government because the proceeds in the escrow account are typically invested in U.S. Treasury or federal agency securities.

Benefits:

1 Increased security.

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2 Higher current tax-exempt income.

3 Minimized price volatility in a changing interest rate environment.

INVESTOR PROFILE

While owners of tax-exempt municipal bonds are generally high net worth individuals, many other investors can benefit from tax-free income:

1 Individuals looking for yields exceeding those found on taxable investments.

2 Investors looking for principal preservation.

3 Anyone seeking to lower their exposure to federal and state income taxes.

INVESTMENT STRATEGIES

LADDERED PLAN

Individual accounts can benefit from structuring their tax-exempt municipal bond portfolio in the form of a ladder or rollover plan. A ladder is created by purchasing equal amounts of bonds in a series of maturities over a period of time. For example, one through five years or five years through twenty years. The investments can be made in different issues in consecutive maturities. For example, every two years of five years, etc. With this type of structure, funds become available on a specified schedule to meet the individual investment needs of your clients.

Benefits:

1 Diversification.

2 Relative safety of principal.

3 Liquidity.

4 Reduced exposure to interest rate volatility.

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Remember that a laddered portfolio can help cushion a portfolio against interest rate swings. Should interest rates rise, funds that will be due on the schedule can be reinvested at the higher rate. Also, with funds spread out over a range of maturities, price volatility on the long end will be minimized. If interest rates fall, only the portion of the funds that are maturing on the schedule will have to be invested at the lower interest rate.

MUNICIPAL RETIREMENT ACCOUNT

A municipal retirement account or MIRA is an account made up of tax-exempt zero coupon bonds. It is ideal for supplementing traditional IRA funds without all of the limitations.

By setting up an MRA, clients can invest as much money as they wish at any time and there’s no limit to the contribution amount. What’s more, the tax-exempt zeros can be purchased so that they mature at a time that will coincide with retirement. Because an MRA is not a qualified retirement plan, there are no penalties for early withdrawal. Should your client need the funds prior to maturity, they can sell the bonds at the current market value, which of course may be more or less than original cost.

Setting up an MRA with tax-exempt zero-coupon bonds will require a smaller initial investment than a full coupon bond purchase and the money will grow over time tax-free until maturity when your clients collect principal and accrued interest.

GIFTING

Clients can also use zero-coupon municipals to help in estate planning. By gifting less than $10,000 current value, a client can give $25,000 future value of zero coupons which will mature in 15-20 years. Clients can gift to their heirs for various purposes, including education, retirement and simply for wealth building. Because the money was gifted, heirs will avoid inheritance taxes in the future.

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TAXABLE EQUIVALENT YIELD

Taxable or tax-exempt, which investment will offer the higher return? Many investors may believe that taxable investment, which usually has a higher nominal yield, offers the greater return. However, after federal income taxes (in some cases state income taxes) are taken into account, taxable securities may actually have a lower return than that offered by tax-exempt municipal bond investments.

The taxable equivalent yield calculation should be a critical part of every sales presentation on municipal bonds. Finding the taxable equivalent yield on a given tax-exempt bond will help you determine what yield you would need to obtain on a taxable investment in order to match the tax-free return offered by the municipal bond.

The following chart is for illustrative purposes only and does not apply past or future performance of any investment:

Federally =Tax-freeyield

3 %

4 %

5 %

6 %

Taxable equivalent yield by tax bracket

28 % 31 % 36 % 39.6 %

4.17 % 4.35 % 4.69 % 4.97 %

5.56 % 5.80 % 6.25 % 6.62 %

6.94 % 7.25 % 7.81 % 8.28 %

8.33 % 8.70 % 9.38 % 9.93 %

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Tax-exempt income. Income on municipal bonds is exempt from federal and in most cases, state income tax.

High degree of safety. The default rate is less than 1% for the outstanding universe of municipal bonds.

Diversity. Over $1 trillion of municipal bonds are currently outstanding. There is an issuer, coupon, maturity and rating to suit the specific investment needs of virtually every investor.

Liquidity. Because the demand for municipal bonds is so vast, there is an active secondary market for most issues. The price the investor receives, though, will be determined by the prevailing interest rate environment.

U.S. TREASURY AND FEDERAL AGENCY SECURITIES

nited States treasury securities are direct obligations of the United States government and are viewed as the safest and most liquid investments in the world. The issues are initially sold to

investor through auctions held by the Treasury through the facilities of the Federal Reserve Bank. Used to finance our nation’s debt, these securities come to market on a regularly scheduled basis as established by the U.S. Treasury’s division for the management of the public debt. Only three basic types of treasury securities are brought to market:

1 Treasury bills.

2 Treasury notes.

3 Treasury bonds.

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Treasury bills, notes and bonds carry the full faith and credit of the U.S. Government which makes them the safest of all investments.

Federal agency securities were created by Congress in an attempt to aid various segments of the U.S. economy. While GNMA (Government National Mortgage Association) is an agency of the Federal Government and direct obligations, FNMA (Federal National Mortgage Association) and FHLMC (Federal Home Loan Mortgage Corporation) are government sponsored corporations and carry only a moral obligation of the U.S. Government. Instead, the securities bear the direct guarantee of each respective agency. Since these agencies are not directly government guaranteed, they generally offer a higher yield than treasury securities.

The market for U.S. treasury and federal agency securities is the larges over-the-counter market in the financial world. On any given day, several hundred billion dollars of these issues change hands.

STRUCTURE

TREASURY BILLS

Treasury Bills are offered in three basic maturities:

1 Three months.

2 Six months.

3 One year.

The two shorter maturities are usually auctioned on Monday and are settled and paid for on Thursday. One-year treasury bills are offered once a month. The minimum order for treasury bills is $10,000 with multiples of $1,000 form only and since treasury bills do not have a coupon, they trade on a discounted yield basis. Not only are treasury bills bought and sold on a discounted basis, but they are also quoted in newspapers on a discounted yield. With the investor always paying less than par for treasury bills, the yield to maturity will be higher than the discount yield.

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The investor should always compare the equivalent yield of the treasury bill to the yield of other investments of similar maturity, such as CDs, commercial paper or any other security maturing in less than one year.

TREASURY NOTES AND TREASURY BONDS

Treasury notes (ten years or less) and bonds (longer than ten years) come to market less frequently than treasury bills, but they are very popular investments and meet the needs of those buyers who want to purchase longer maturing treasury issues. These issues pay a fixed rate of interest twice a year and the principal is returned to the investor at maturity at par. Two and three year treasury notes are denominated and traded in lots of $5,000, while longer maturing notes and all treasury bonds are bought in lots of $1,000. Like treasury bills, notes and bonds come in book-entry form. Occasionally, older issues may be registered and shipped to the buyer.

ZERO-COUPON BONDS

Zero-coupon (stripped) treasuries are products created by various dealers. The Treasury Department does not auction zero-coupon issues.

FEDERAL AGENCY BONDS

Federal agency bonds are scheduled by each respective issuer of agency paper. In general, the minimum size of any of these issues is $10,000 with multiples of $5,000. Principal is returned at maturity and interest is paid semi-annually.

INVESTMENT PROFILE

U.S. treasury and federal agency securities have very practical appeal for every investor. The conservative investor appreciates the safety and liquidity they offer. The more risk oriented investor values basic safety and liquidity for a portion of his or her portfolio, also, as well as the vast maturity range.

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an interest in these types of securities. In addition, local corporations, municipalities, school boards, pension funds, banks, savings and loans, colleges, hospitals, foundations and insurance companies all invest in U.S. treasury and federal agency securities.


ROLLOVER PLAN

Divide the amount to be invested into five equal parts and distribute it among five consecutive maturities. For example, $100,000, divided by 5 = $20,000. $20,000 would then be invested in bonds maturing in 2007, 2008, 2009, 2010, and 2011.

By spreading the investment out over five years you and your client diminish the need to attempt to forecast when interest rates might decline or rise. If after a year, rates are higher, the first $20,000 that matures could be reinvested at a higher rate of return. If rates decline, only 20% of the portfolio has to be invested at lower rates while the balance benefits by increasing in value. Under both scenarios, you take advantage of the market, the market doesn’t take advantage of you.

Several benefits of a rollover plan are:

1 Relative safety of principal (if held to maturity).

2 Relatively high rate of return.

3 Liquidity.

4 Minimizes exposure to interest rate swings.

MONTHLY INCOME PLAN

Structuring a portfolio to provide monthly income from treasures and/or federal agencies can be done by purchasing six issues with varying bi-monthly dividend payments to cover every month of the year (January/July, February/August, March/September, etc.).

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BARBELL PLAN

Structuring a portfolio with equal weighted amounts in very short and very long maturities. The short maturities provide stability while long maturities add additional yield.

SWAPPING

Clients can get additional yield by selling shorter maturities and replacing them with longer maturities which typically yield more.


Safety. These issues offer the highest degree of safety and liquidity of any investment.

Diversity. Maturities vary from one week to 30 years.

Liquidity. The largest and most active capital market in the world.

Predictability. Because they are usually non-callable, they offer dependable, predictable income and return of principal at maturity. In the past several years, agencies have begun to issue callable bonds as another financing tool.

Tax-exemption. Exempt from state and local taxes.

AGENCY PASS-THROUGH SECURITIES

ending institutions seeking to raise additional capital to continue originating mortgages sell existing mortgage loans to various government issuing agencies. The agencies then pool the

mortgage loans with similar characteristics, typically 30 year, fixed-=rate loans to create agency pass-through certificates.

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Congress chartered three institutions to increase liquidity in the secondary mortgage markets and thus increase the supply of capital available for residential housing loans. Most agency pass-through certificates are guaranteed by, and derive their names from the organizations listed below.

GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (GNMA)

GNMA guarantees the timely payment of principal interest on all of its pass-through and its guarantee is backed by the full faith and credit of the U.S. Government. Investors in GNMA pass-through certificates are therefore assured of receiving timely payments each month even if any of the underlying mortgage loans default.

FEDERAL NATIONAL MORTGAGE ASSOICATION (FNMA)

FNMA guarantees timely payment of both principal and interest on its mortgage securities, even if any of the underlying mortgage loans default. Note that this guarantee is not backed by the full faith and credit of the United States.

FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC)

FHLMC guarantees timely payment of principal and interest on the FHLMC gold pass-through certificates. Non-gold FHLMCs however, are only guaranteed for the timely payment of interest and the eventual payment of principal, even if any of the underlying loans default. Note that this guarantee is not backed by the full faith and credit of the United States.

The securities issued by these organizations differ slightly in payment delay, guarantees and pool composition. However, many agree that agency pass-through certificates can be considered to be of higher credit quality than corporate AAA rated bonds.

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STRUCTURE

Agency pass-through certificates differ from other fixed-income securities in that they are self amortizing. In other words, while principal is returned to fixed-income investors at maturity, the agency pass-through investor receives payments of principal and interest monthly. Therefore, each monthly payment to the investor is composed of scheduled principal and interest plus an unscheduled principal (resulting from a homeowner prepaying a mortgage).

Every month homeowners make payments of interest and scheduled (and unscheduled) payments of principal to the mortgage lender. The mortgage lender typically securitizes the mortgages through Ginnie Mae, Freddie Mac or Fannie Mae. The mortgage lender collects the homeowner’s monthly principal and interest payments and distributes the cash flows to the pass-through certificates holders on a pro-rata basis.

INVESTOR PROFILE

Agency pass-through securities are for clients who seek an investment with the safety a government or government-sponsored agency, but provide higher yield and monthly cash flow. These features appeal to many individual investors who are:

1 Planning for retirement.

2 In need of more monthly income.

3 Seeking higher yields.

4 Looking for safety of GNMA, FNMA AND FHLMC.


BUY AND HOLD

Agency pass-through certificates are best suited for those clients who anticipate holding the investment to maturity. Mortgage-backed securities, in general, are not meant as trading vehicles. The are buy and hold investments.

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INVESTOR RISKS

The key to investor risk is that homeowners have the right to pay more than the scheduled monthly payments or to prepay their mortgage loans in full at any time. They also have the right to hold their mortgage for the entire agreed upon term of the loan.

These features separate a mortgage pass-through security from the rest of the non-callable fixed-income market. The homeowner’s option to prepay, or hold the loan to term, lends uncertainty to the timing and amount of cash flows due to the investor. Therefore, there are two unique risks associated with an investment in agency pass-through securities.

PREPAYMENT RISKS

Like all securities that are collateralized by residential mortgage loans, early payment of principal by the homeowners can reduce the average life of agency pass-through securities. The early return of principal is identified as prepayment risk.

Prepayment typically occur in an environment in which interest rates are declining. Homeowners take advantage of the opportunity to refinance their loans at the new lower level and pass principal through to holders of mortgage-backed securities. In many instances, prepayment risk can produce reinvestment risk.

Reinvestment risk occurs when client funds, which are returned because of early principal payments, must be reinvested at the new lower market interest rates.

EXTENSION RISK

The opposite pr prepayment risk is extension risk. Extension risk occurs when principal is returned at a slower than anticipated rate and the average life and expected maturity of the mortgage-backed security can actually lengthen, sometimes significantly.

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It’s important to look at the interest rate analysis provided in mortgage-backed security offerings to determine how much extension risk or prepayment risk a certain issue may have.


High degree of safety. GNMA pass-through certificates are guaranteed by the U.S. Government, while FNMA and FHLMC pass-throughs are guaranteed by the respective government sponsored agencies.

Diversity. The mortgage pass-through markets currently include 15 year and 30 year securities with a wide range of coupons, as well as adjustable-rate mortgages (ARMs) and balloon payment mortgages with 5 and 7 year maturities.

Liquidity. There is an active and liquid market in mortgage pass-through securities. The major coupon categories of GNMA, FNMA and FHLMC are nearly as liquid as treasuries.

Monthly income. Investors receive a monthly payment of interest, scheduled principal and prepayments.

ZERO-COUPON BONDS

nlike regular coupon bonds, which pay interest semi-annually prior to the payment of the principal amount at maturity, zeros pay accrued interest and principal at maturity. In other words,

zeros generate no coupon payments throughout the life of the security.

Zeros are sold at a discount to the face value of the bond and as the maturity date approaches, the price of the zero moves towards par. The return on the investment is derived solely from the price increase between the time of purchase and the maturity date (or sale date if sold prior to maturity). There is no reinvestment of coupon income to be considered

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in that they do not generate coupon payments and are sold at a discount to their face value.

Zero-coupon bonds are issued by the U.S. Government, as well as municipal and corporate issuers. U.S. savings bonds (Series EE) are the most common example of zeros. The zero-coupon market is immense, with at least $200 Billion (face amount) outstanding. Many investors are aware of government guaranteed zeros which have been used extensively to fund IRAs.

STRUCTURE

STRIPS

U.S. treasury notes and bonds are separated into their component interest and principal cash flows. Because these cash flows consist of either interest or principal payment on U.S. government securities they are government guaranteed.

CATS

CATS (Certificates of Accrual on Treasury Securities), represent ownership in cash flows of U.S. Treasury securities, held in trust. CATs offer higher yields than other strips due to their lower liquidity.

REFCORPS

REFCORPs are government backed zeros created by the Resolution Funding Corporations to provide funding for the RTC in the rescuing of S & Ls.

FICO

The Financing Corporation (FICC) are moral obligations of the U.S. Government that were issued to help recapitalize FSLIC (Federal Savings and Loan Insurance Corporation). This security offers the highest yield in the government zero market.

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GTC

GTC (Government Trust Certificates) represent financing and securitization of loans made by the U.S. Government to foreign nations through the Department of Defense.

ISRAEL AID

Aid to Israel bonds are issued by the Agency for International Development which is U.S. Government guaranteed.

INVESTOR PROFILE

Individuals looking to build wealth for specific purposes on predetermined dates in the future. These needs may include:

1 Education.

2 Retirement planning.

3 Special occasions such as weddings, bar mitzvahs, etc.

4 Big ticket items such as second homes, boats, etc.


LOOKING IN CURRENT YIELDS

For accounts that believe interest rates will decline in the future, buying zero-coupon bonds in longer maturities, with higher yields, is appropriate. In addition to buying longer maturities clients can swap existing intermediate maturities for longer maturities.

10 YEAR EXTENSION SWAP

SELL $50,000 11/15/2006 YTM $66,763 BUY $105,000 11/15/2016 YTM $31,790

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BENEFIT

Zeros with longer maturities trade at a deeper discount which allows investors to increase face value over shorter maturities. In a declining rate environment, extending maturities of current zero-coupon bond holdings provides for greater total returns.

LADDERED PORTFOLIO

For accounts that believe interest rates are headed higher, laddering zero-coupon bonds in a short-term portfolio offers good current market returns, while allowing clients frequent reinvestment of maturing funds at increasingly higher yields.

LADDERED PORTFOLIO EXAMPLE

$ 25,000 11/15/2006 @ 99.071 3.00 YTM

$ 25,000 11/15/2007 @ 95.548 3.50 YTM

$ 25,000 11/15/2008 @ 91.559 3.85 YTM

$ 25,000 11/15/2009 @ 86.714 4.35 YTM

$ 25,000 11/15/2010 @ 82.017 4.65 YTM

Benefits:

1 Reinvest maturing funds at higher rates.

2 Minimal price volatility because of short maturity.

3 Maximum liquidity.

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Relative safety. The majority of zero-coupons have either a government or quasi-government guarantee for the payment of interest and principal.

Diversity. The existence of U.S. Government agency and corporate zeros allow clients to choose from a number of different products. Also, zeros range in maturity from six months to forty years. This diversity allows investors to use zeros for a wide variety of financial needs.

Liquidity. The vast size of the government guaranteed zero market makes it among the most liquid.

CMOs

ollateralized Mortgage Obligations (CMOs) are a series of bonds of varying maturities backed by home mortgages. What is mean by “series” is that the single pool of mortgages can be divided

into several smaller offerings, each tailor made to meet various investor’s needs. As the underlying mortgages get paid off, the CMOs are paid off in order of maturity.

These mortgages are packaged by various securities firms, typically in concert with government, or government-sponsored agencies including the Government National Mortgage Association (GNMA or FANNIE MAE), which guarantee the newly created mortgage pools.

CMOs offer the safety of government or agency guarantees but with more yield than treasury bonds. CMOs afford investors the flexibility of choosing a maturity range that best suits their needs and a choice of monthly interest only payments, or monthly principal and interest payments.

The CMO market began in June of 1983 with a $1 billion Freddie Mac issue.

C

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STRUCTURE

COLLATERALIZED MORTGAGE OBLIGATIONS (CMOs)

Every month homeowners make payments of interest and scheduled (and unscheduled) payments of principal to the mortgage lender. The mortgage lender typically securitizes the mortgage through Ginnie Mae, Freddie Mac or Fannie Mae and deposits them with a trustee band. Principal and interest is directed by the trustee bank in sequence. As you can see in the chart on the following page, the variety of classes of the CMO are paid in the predetermined order of maturity.

MORTGAGE COLLATERALIZED BONDS (MCB)

MCBs are a CMO class varying only in the way they pay principal which is illustrated below. Excess monthly principal is deposited into the redemption fund. Based on the availability of funds, investors can ask the trustee to redeem (put) their bonds early. Funds in excess of the put requests are used by the issuer to redeem bonds in $1,000 denominations, using a lottery system. MCBs may be called by the issuer if the outstanding principal balances fall below certain levels (typically 10% of the original issuance).

REDEMPTION FUND

INVESTOR PUT

LOTTERY CALL

ISSUER CALL

CMOs

R. M. STARK & CO., INC.CONTINUING EDUCATION PROGRAM

L LHOME MORTGAGE TRUSTEE

OWNER LENDER BANK

0CMOs

2000 2005 2010 2015 2020 2025 2030PRINCIPAL PAID IN ORDER OF MATURITY

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INVESTOR PROFILE

CMOs and MCBs are for clients who seek an investment with the safety of a government or government-sponsored agency, but provide a higher yield and monthly cash flow. These features appeal to many individual investors who are:

1 Planning for retirement.

2 In need of more monthly income.

3 Seeking higher yields.

4 Looking for the safety of GNMA, FNMA and FHLC.


BUY AND HOLD

CMOs and MCBs are best suited for those clients who anticipate holding the investment to maturity. Mortgage-backed securities, in general are not meant as trading vehicles. They are buy and hold investments.

INVESTOR RISKS

The key to investor risk is that homeowners have the right to pay more than the scheduled monthly payments or to prepay their mortgage loans in full at any time. They also have the right to hold their mortgage for the entire agreed upon term of the loan.

These features separate a CMO/MCB from the rest of the non-callable fixed-income market. The homeowner’s option to prepay, or hold the loan to term, lends uncertainty to the timing and amount of cash flows due to the investor. Therefore, there are two unique risks associated with an investment in CMOs and MCBs.

PREPAYMENT RISKS

Like all securities that are collateralized by residential mortgage loans, early payment of principal by the homeowners can reduce the average life of

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CMOs and MCBs. The early return of principal is identified as “prepayment risk”.

Prepayments typically occur in an environment in which interest rates are declining. Homeowners take advantage of the opportunity to refinance their loans at new lower levels and pass principal through to holders of mortgage-backed securities. In many instances, prepayment risk can produce reinvestment risk.

Reinvestment risk occurs when client funds, which are returned because of early principal payments, must be reinvested at the new lower market interest rates.

EXTENSION RISK

The opposite of prepayment risk is extension risk. Extension risk occurs when principal is returned at a slower-than-anticipated rate and the average life and expected maturity of the mortgage-backed security can actually lengthen, sometimes significantly. It’s important to look at the interest rate analysis provided in mortgage-backed security offerings to determine how much extension risk or prepayment risk a certain issue may have.

CHARACTERISTICS AND BENEFITS

High degree of safety. CMOs and MCBs are typically backed by GNMA or FNMA or FHLMC guarantees.

Diversity. CMOs and MCBs are available in a variety of maturity ranges and coupon rates.

Liquidity. CMOs and MCBs are very liquid due to size of the market and the quality of their guarantees.

Monthly income. Depending on the particular issue, MCBs and CMOs provide investors with monthly income in the form of interest payments only or payments consisting of both principal and interest.

Redemption options. MCBs offer investors certain “put” features based on the principal pay-down from the underlying mortgages.

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ADDITIONAL FACTS AND FIGURES

The Mortgage-Backed Securities (MBS) market has been in existence since the 1970s and is one of the largest publicly traded markets in the world.

Agency MBS issuance broke a record with volumes of $1.1 trillion in 2001, an increase of more than 125 percent from the $483.4 billion that was issued in 2000. A record $2.8 trillion in outstanding issuance of Agency MBS was reached in 2001.

Mortgage related security issuance (including agency and private label MBS/CMO issues), reached a record $1.67 trillion in 2001.

Issuance more than tripled in the Agency CMO market in 2001, reaching $362 billion versus only $100 billion that was issued in 2000.

Currently, there is a record $1.3 trillion of agency and private label CMO issues outstanding. A record $800 billion in outstanding issuance of agency CMOs was reached in 2001.

U.S. MORTGAGE MARKET THE BASIC BUILDING BLOCK

Home mortgages are the basic building blocks from which CMOs are created. The structure of mortgage market, along with its safeguards, is fundamental to CMOs.

U.S. home mortgages are the basic building block from which CMOs are created. A firm understanding of the enormity and structure of the home mortgage market, along with the effectiveness of the comprehensive safeguards, employed by lenders, is a fundamental starting point for gaining an appreciation of CMOs.

Collateralized Mortgage Obligations (CMOs) offer a unique opportunity for monthly income, relative safety and attractive yield advantages compared to other similar quality investments. The Federal Home Loan Mortgage Corporation (FHLMC), more commonly known as

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“Freddie Mac”, first introduced CMOs in 1983. The Tax Reform Act of 1986 authorized the establishment of Real Estate Mortgage Investment Conduits (REMICs), creating certain tax and accounting advantages for issuers and for certain large institutional and foreign investors. For investment purposes, REMIC securities are indistinguishable from CMOs. The CMO market has grown to over $1 trillion in size since its inception in 1983 and today accounts for an ever increasing and important segment of the overall mortgage market.

One of the first types of mortgage-backed securities created was the mortgage pass-through security. These securities are now also used as collateral for CMO issues. To create these pass-through securities, similar home mortgages meeting the standard criteria of the issuing government agency are grouped together in to “pools”. Investors are then able to purchase an interest in these pass-through securities. As the mortgage holders make monthly payments of principal and interest, the pass-through security holder is entitled to a pro rate portion of the payments received. The mutual advantage of this process is that it makes funds available for home mortgages at attractive rates, while at the same time creating high quality securities for investors. Mortgage pass-through securities are considered to have an investment horizon of approximately 10 to 12 years on average, even though the mortgages are typically 30 year loans. This shortened horizon occurs because most mortgage loans are paid off early due to, among other things, homeowners moving, prepayments and in the event of lower interest rates, refinancing. In an effort to attract clients with investment objectives shorter or longer than the typical pass-through security, the CMO was created. This was achieved by using pools of mortgage pass-throughs as collateral, which produces monthly cash flow of principal and interest, and then redirecting the cash flow to create short, intermediate and long term bonds.

The Federal Home Mortgage Corporation (FHLMC) more commonly known as “Freddie Mac”, the Federal National Mortgage Association (FNMA), as well as the Government National Mortgage Association (GNMA), more commonly known as “Ginnie Mae”, are the largest issuers of CMOs. While FHLMC and FNMA dominate the new issue market, many private issuers also regularly bring CMOs to market, known as “Private Label” or “Whole Loan” CMOs.

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STRUCTURE

A typical collateral group is structured into 10 to 20 different classes or tranches. Each class can have a different coupon, expected average life and cash flow schedule. This unique structure enables the issuer to transform a pool of 30 year mortgage pass-through securities into a series of bonds each designed to meet the needs of a different investor group.

The issuer predetermines the order in which the classes will be retired. Each month as the cash flow from the underlying collateral is received, the trustee will disburse the interest and principal to the classes based on a predetermined set of rules. Thereby, principal and interest will be directed to some classes while others will receive interest only for some period. After the shortest maturity class has been fully retired, the principal will then be directed to the next class in line. This type of structure allows investors in the longer term classes to enjoy steady interest income for several years as the early classes absorb the prepayments.

It is important to note that the yield and average life of each class will vary depending on the actual prepayment experience.

The illustrations on the following three pages depict the most basic CMO structure and the sequential pay. However, most issues have more classes with different cash flow allocations.

BENEFITS OF CMOs

CMOs offer excellent credit quality. FHLMC and FNMA long-term debt has been rated Aaa by Moody’s and AAA by Standard and Poor’s. CMOs, although not explicitly rated by the rating agencies, are senior to this long-term debt and thus have an implied AAA rating.

CMOs are available in a variety of average lives and with varying sensitivity to changes in prepayment speeds, allowing investors to choose the class that best meets their investment objectives. The deliver monthly cash flow of either interest only and ultimately principal, or interest and principal until the bond is retired.. Accrual bonds are an exception. Accrual bonds offer monthly compounding of interest until a conversion date, at which time monthly cash flow is paid to the investor.

CMOsPART TWO


EXHIBIT 1

75mm 7%COLLATERAL

Principa Interest

C 7% 25MM

16-30 YEARS

A 7% 25MM

2-5 YEARS

B 7% 25MM

6-15 YEARS

CMOsPART TWO


EXHIBIT 2

75mm 7%COLLATERAL

Principa Interest

B 7% 25MM6-15 YEARS

A 7% 25MM2-5 YEARS

C 7% 25MM

16-30 YEARS

CMOsPART TWO


EXHIBIT 3

75mm 7%COLLATERAL

InterestPrincipa

B 7% 25MM6-15 YEARS

A 7% 25MM2-5 YEARS

C 7% 25MM16-30 YEARS

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MINIMUM INVESTMENT AND TRANSACTION COSTS AND LIQUIDITY

Most CMO tranches sold to individual investors are available in $1,000 denominations. Mortgage securities dealers execute CMO transactions over-the-counter. Transactions are done at a net cost which includes the dealer spread or profit on the trade. Spreads on CMOs are generally wider than on treasuries or agency debentures because the treasury market is generally broader and more liquid. Although there is an active secondary market for CMOs, the degree of liquidity can vary widely. The unique characteristics of individual CMO tranches place limitations on the potential liquidity of the product. Accordingly, if these investments are sold in the secondary market prior to maturity or a call date, they may be worth less than their original cost.

TAX CONSIDERATIONS

When comparing Treasury yields to CMO yields, investors should be aware that interest income on CMOs are subject to federal, state and local income tax, while treasury securities are exempt from state and local income taxes. CMO payments that represent the return of principal are not taxable. However, similar to corporate bonds and other taxable fixed income investments, CMOs purchased at a discount to par may be subject to original issue discount (OID) tax. Investors should have a comprehensive understanding of all tax related matters associated with CMO investing and should contact their tax advisor, if applicable, prior to any CMO investment.

TRANCHE TYPES

Tranche – French word for “slice”.A class of investment interest in a CMO.

The CMO structure offers issuers a flexible tool with which to design tranches to meet investor needs and respond to market conditions.

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Certain CMO tranche types are defined according to generalcharacteristics, however, investors should carefully evaluate how the security is likely to perform under a range of economic assumptions.

SEQUENTIAL PAY TRANCHES

1 Most basic class within a CMO structure. Also called “Plain Vanilla” or “Clean Pay” classes.

2 Principal is retired sequentially, that is one class begins to receive principal payments from the underlying securities only after the principal on any previous class has completely paid off. See the three example charts after page 4.52.

3 While the first class principal is paying down, the other class holders still receive monthly interest payments at the coupon rate on their principal.

4 If prepayments are faster than the prepayment speed assumed when the security is purchased (at pricing), the principal is retired earlier than expected, thereby shortening the average life of each class. Likewise, the opposite would be true.

5 Average life represents the average amount of time that each principal dollar is expected to be outstanding.

6 Changes in the average life of the class may affect the yield-to-maturity of the bond.

PLANNED AMORTIZATION CLASS (PAC)

1 PACs are designed to produce more stable cash flow by redirecting prepayments from the underlying securities to other classed called “support” or “companion classes”.

2 PAC investors are scheduled to receive fixed principal payments, known as the “PAC Schedule”, over a predetermined period time, referred to as the “PAC Window”, through a range of prepayment scenarios, known

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as the “PAC Band:. The schedule will be met only if the underlying mortgages prepay at a rate within the range assumed for the structuring of the PAC for the life of the security.

3 If prepayments are slow, a PAC tranche receives a greater share of principal to prevent its average life from lengthening, while an accompanying support tranche receives less (thereby extending its life). Similarly, if prepayments are fast, the support tranche receives the excess principal and experiences a shortening of average life in order to protect the PAC.

4 PAC bonds are protected only within predefined “prepayment speed assumptions (PSA) bands.

5 There are limits on how much protection a support tranche can provide to a PAC. At the slow extreme of prepayment experience, all principal can be directed to the PAC and at the fast extreme, all principal can be directed to the support tranche. Once a support tranche is paid off (should that occur before the PAC0, the PAC is subject to unprotected variation in average life, like a “sequential pay” tranche.

6 PACs offer investors the benefit of greater average life protection at the expense of reduced yield. Many institutions require average life stability for business purposes, but still find the yield of PACs attractive relative to other high quality investment alternatives. An individual investor may also at times desire this average life stability.

CMO ISSUERS

The “Federal Home Loan Mortgage Corporation (FHLMC)”, the “Federal National Mortgage Association (FNMA)” as well as the “Government National Mortgage Association (GNMA)” are the largest issuers of CMOs. While FHLMC and FNMA dominate the new issue market, many private issuers also regularly bring CMOs to market. The latter are known as “Whole Loan CMOs”.

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FREDDIE MAC AND FANNIE MAE

Two U.S. Government sponsored enterprises (commonly referred to as “GSEs” or “Agencies”), Freddie Mac and Fannie Mae, have evolved into essentially the same federal mandate.

Freddie Mac and Fannie Mae are GSEs. GSEs are privately owned but federally chartered companies created by congress. While they enjoy certain competitive advantages, as a result of their government charter, in order to ensure success in their performance of a critical mission on behalf of the American people, their debt obligations are not U.S. Government guaranteed.

FEDERAL HOME LOAN MORTGAGE CORPORATION (FHLMC).

(EST. 1970) (www.freddiemac.com)

Freddie Mac also supports the secondary market for mortgages along with Fannie Mae. Although the original charters for Freddie Mac and Fannie Mae provided for different roles, they have evolved to a similar function and now compete against one another. As a result, the Federal Government also regulates Freddie Mac through the “Office of Federal Housing and Enterprise Oversight”.

Freddie Mac and Fannie Mae strive to maintain AAA credit quality. The agencies themselves are AAA rated. They strive to attain a market perception of credit risk on par with the U.S. Government, as faith in their guarantee is essential to success full issuance of MBS. With the aid of competitive advantages they receive by charter, they have historically been able to maintain a high lever of profitability. As long as the agencies are conservatively managed (which the W.S. Government implicitly assures through regulation and oversight), they have the capacity to maintain top quality credit ratings.

.All Agencies carry credit ratings of Moody’s Aaa and Standard and Poor’s AAA. These are the highest ratings awarded by the two main credit rating organizations

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GINNIE MAE(www.giniemae.gov)

The “Government National Mortgage Association (GNMA or Ginnie Mae)” was created by Congress under the “Housing and Urban Development Act of 1968”. GNMA’s purpose is to provide home ownership for low to moderate income families. As a wholly owned U.S. Government Corporation, GNMA is backed by the full faith and credit of the U.S. Government.

GNMA is a wholly owned U.S. Government Corporation as opposed to a Government Sponsored Enterprise “GSE”. The credit quality of GNMA is identical to that of the U.S. Treasury. GNMA MBS can be an alternative for investors who only accept U.S. Government risk.

WHOLE LOANS CMOs

AAA rated Whole Loan CMOs are collateralized by individual mortgages that are typically too large (Congress sets the maximum loan size that may be included in the FNMA and FHLMC mortgage securitization program.As of January 1, 2002, it is presently set at $300.700) and perhaps of differing underlying credit quality to qualify to become collateral in an agency mortgage-backed security, or otherwise will not qualify for the “Agency Securitization Program”. Unlike agency issued CMOs. where the collateral is made up of pass-through securities, the whole loan CMO is collateralized directly with the mortgages themselves.

CREDIT RATINGS

Whole loan CMOs are available with a broad range of credit ratings.Whole loans that are rated AAA by at least two rating agencies are considered the highest quality.

To obtain the AAA rating, underwriters use any of the following methods to enhance the credit:

1 Senior/subordinate structure.

2 Insurance.

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3 L.O.C. (Letter Of Credit).

Almost all Whole Loan CMO issuance presently utilize the senior/subordinate credit enhancement.

In this structure, a subordinate class is created to be the first to receive any principal losses due to defaults that would occur if a property is liquidated at a price below the loan value. The typical average loan is 75% of the property value although that can vary in Whole Loan CMOs. The size of the subordinate piece required in order for the senior piece to receive a AAA rating is typically between 3% and 7% of the total structure.

DENOMINATIONS

While Whole Loan CMOs are usually issued in $1,000 denominations, just as Agency CMOs, they are sometimes issued in $25,000 denominations.

COMPENSATING INTEREST

When mortgages are prepaid early in the month, the mortgage holder is required to pay interest only up to the date of the repayment. For the bondholder receiving monthly income, this may create a shortfall in the interest portion of their check for that particular month. Agency issuers will always compensate the bondholder for this shortfall in interest, called “compensating interest”. But only up to a limited amount. AAA rated Whole Loan CMOs may be an attractive alternative for investors looking to maximize their yield without substantially increasing their exposure to credit risk.

“Product suitability must be determined for each individual investor”.

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LOTTERY BONDS

“Retail Classes” or “Lottery Bonds” were created to address some of the concerns individual investors have expressed about CMOs. Principal on a tranche designated as a Retail Class is always returned to investors in multiples of $1,000. This results in several advantages, including:

1 Principal returned will always be in increments allowing for reinvestment. This way there is less chance that the individual will spend principal without realizing it.

2 Factor is always 1.0.

3 Limited estate feature is available, see below.

ESTATE FEATURE

Principal available for payment on the tranche is directed first to “deceased owners” whose estates have requested redemption, then to other investors who have submitted a request to receive principal. If any principal remains, investors are chosen at random to receive payments in multiples of $1,000.

The mechanics of the principal process are as follows:

1 First $100,000 is allocated to the ”deceased owners”. In the event that there is not enough principal to satisfy all requests, they are honored in the order in which they were received.

2 Next $10,000 is allocated to each “living owner” who has requested principal payment. In the even there is not enough principal to satisfy all requests, a lottery is held to determine which investors receive principal.

3 Step 1 and then step 2 are repeated until either the principal runs out or all requests have been fulfilled.

4 Any remaining principal is distributed to investors chosen through a lottery.

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The easiest way to understand how a Lottery Bond works is to go through an example Suppose a $10,000,000 tranche is sold to 50 individuals, each of whom invest $200,000. In month 50, the principal payment window opens with $2000,000 available for payment. During the previous 49 months, two 200,000 holders have passed away and an additional five have requested principal payments for other reasons (none of these requests can be honored until the payment window opens). The allocation process proceeds as follows:

ALLOCATION $2,000,000 PRINCIPAL REMAINING

$ 100,000 to each of 2 $ 1,800,000 deceased owners.

$ 10,000 to each of 5 requesting $ 1,750,000 living owners.

$ 100,000 to each of 2 $ 1,550,000 deceased owners.

$ 10,000 to each of 5 requesting $ 600,000 living owners (repeat until allrequests are honored).

600 blocks of $1,000 to the $ 0 remaining 40 individuals byrandom lot (any individualmay receive full, partial or no repayment at all).

As a result of this method of principal distribution, the weighted average life of the investment will vary from one holder to the next. The average life displayed in a yield table represents the average life of the tranches as a whole. The average life experienced by any individual investor may be considerably longer or shorter.

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GUARANTEED MATURITY SECURITIES

Freddie Mac Guaranteed Securities (GMS) are structured mortgage-backed securities with a shortened stated final maturity. Freddie Mac GMS are backed by either Gold PCs or Hybrid ARMs and have been issued with final dates of 5 to 15 years. Shorter or longer finals are also possible.

The GMS feature is available on a variety of bond types including Pac, TAC, Scheduled, Support and Sequential tranches. At the guaranteed final date, the investor is paid any outstanding principal on the bond plus 30 days of accrued interest.

These securities offer the investor high credit quality, a competitive yield and limited extension risk. Additionally, GMS appeal to investors with maturity restrictions that preclude them from buying mortgage-backed securities or CMOs, which typically have 30 year stated maturity dates.

INVESTOR BENEFITS

Extension protection – With shorter stated final maturities than many other mortgage securities, GMS offers investors protection to mitigate extension risk.

Enhanced yields – Investors of GMS receive the benefits of higher yielding mortgage-backed securities.

Superior credit quality – GMS carry the Freddie Mac guarantee of scheduled payment of principal and timely interest.

Sound alternative – GMS are an excellent alternative to 15 year mortgage-backed securities and comparable mortgage-backed CMOs, agency debt, balloon mortgages or corporate bonds.

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MYTHS AND CONCERNS vs. FACTS

MYTH: CMOs are too complicated for the average investor to understand.

FACT: Some CMOs may be quite complicated, but most are no difficult to understand than a home mortgage. Most investors have first hand knowledge about how home mortgages work and what causes them to prepay. In fact, your client is probably much more familiar with a mortgage than a corporate balance sheet, and yet, is able to get comfortable with the idea of owning corporate debt or equity. Don’t sell your clients short and deprive them of all that CMOs have to offer.

MYTH: CMOs take too long to explain to a potential investor.

FACT: Once you have mastered the fundamentals of how CMOs function you will probably find it takes no longer to explain a CMO to a client than it does to explain almost any other fixed income investment. For many investors, a CMO may be suitable investment vehicle. Also, once a client understands how CMOs work, they won’t require a full explanation for subsequent discussions.

MYTH: Because principal returns at unexpected times and in small amounts, investors may spend principal without being aware of it.

FACT: This can happen with many CMOs, however, a lottery CMO bond will eliminate this concern. Whenever there is a principal payment on a lottery CMO bond, it is always in increments of $1,000. This way, if a client is getting a

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monthly interest payment of $350 and suddenly receives $1,350 or $2,350 they can easily surmise that the excess is principal being returned. In addition, the principal payment will always be large enough to reinvest upon receipt.

CONCERN Investors have to pay accrued interest even on new issue CMOs.

FACT: This is really just a timing issue. CMOs are created using pools of pass-through securities which were in existence before the issue date of the CMO. Therefore, on the original settlement date of the CMO, the underlying pass-throughs are trading with accrued interest which must be paid by the purchasers of the CMO. But, because interest was accruing before the issue date, investors will also receive a full on month interest payment on the following payment date even though they have owned the CMO for less than one month.

CONCERN: There may be delay periods in interest payments received.

FACT: All CMOs pay on a delay basis. The interest is calculated from the first to the 30th of the month and paid on a specific payment date. This delay is needed so the loan-servicing agent can collect all the principal and interest payments from homeowners and determine if any return of principal is due the CMO holder. All yields quote on CMOs reflect the delay in payments.

Freddie Mac pays on the 15th of the month, Fannie Mae pays on the 25th of the month and most Ginnie Mae’s pay on the 20th of the month.

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CONCERN: What if a client needs to sell prior to maturity?

FACT: CMOs are designed as a buy and hold investment. But having said that, CMOs trade on a mature market with hundreds of broker-dealer participants. The secondary market in CMOs compares very favorable with other negotiated bond markets.

CONCERN: How to explain the implied AAA rating to you client.

FACT: Freddie Mac and Fannie Mae long-term debt has been rated Aaa by Moody’s and AAA by Standard and Poor’s. CMOs although not explicitly rated by the rating agencies are senior to this long-term debt and therefore have an implied AAA rating.

GLOSSARY

Accrual Bond – See “Z” class.

Adjustable-Rate Mortgage (ARM) – A mortgage loan with an interest rate and payments that change periodically over the life of the loan.

Average Life – Mortgage-backed securities return principal to the investor over a period of time rather than on one specific maturity date. The return date. The return of principal is therefore referred to as the average life which is the weighted average time to receipt of principal. In most cases, the average life, approximately 50% of the principal will have been returned.

Call Risk – The possibility that pre-payments will increase above an anticipated rate, causing earlier then expected return of principal, usually during a time of falling interest rates.

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Cap – The maximum rate of interest payable on an adjustable rate security or mortgage loan.

Class – Another term for a “tranche” as it relates to a CMO.

Clean Pay – Sequential pay tranches are also referred to as clean pay (see sequential).

CMO (Collateralized Mortgage Obligation) – A multiple-class mortgage-backed security. The REMIC is synonymous with CMO and, today, all CMOs are issued in the form of REMICs, however, the terms are often used interchangeably.

CMT (Constant Maturity Treasury) – An index published by the Federal Reserve Board calculated from the average yield of a range of treasury securities adjusted to constant maturities of various time periods. For example, six months, one year, ten years, etc.

COFI (Cost of Funds Index) – An index of the weighted average interest rate paid by savings institution, for sources of funds, usually by members of the 11th Federal Home Loan Bank District.

Collateral – Property acceptable as security for a loan or other obligation.

Companion Class – A CMO class that absorbs the prepayment variability removed from reduced volatility class such as PACs and TACs.

Compensating Interest – Any interest shortfall in any given month due to the prepayments of mortgages early in the month that is made up by the issuer.

CPR (Constant Prepayment Rate) – A prepayment measure calculated by assuming that a constant portion of the outstanding mortgage loans will prepay each month (also see PSA).

Credit Risk – The possibility that there may be a default by the issuer or other party in its financial obligations to the investor.

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Current Face Value – The current amount of principal outstanding on a security, which is calculated by multiplying the original face value by the most recent factor.

Current Pay Class – A term used for any CMO class that is currently paying principal and/or interest.

Default – Failure to perform an obligation (in the case of a note or mortgage loan, usually by non-payment of principal and interest installments).

Effective range – The range of upper and lower constant prepayment speeds at which a PAC schedule will hold. The effective range can change over time depending on the prepayment experience of the securities backing the CMO and can widen or narrow in relation to the original stated PAC band. (See PAC Schedule and PAC Bond).

Effective Yield – The annual return on an investment that is calculated by dividing the coupon interest rate by the amount invested expressed as a percent of par.

Extension Risk – The possibility that prepayments will be slower than an anticipated rate causing later-than-expected return of principal. This usually occurs during times of rising interest rates.

Factor – The decimal value, calculated monthly, that represents the proportion of the original principal amount outstanding at a given time.

Final Distribution Date or Maturity Date – The latest possible date on which a C<O class will receive payment. The actual final payment of any class will likely occur earlier, and could occur much earlier, than the final distribution date or maturity. A projected final maturity is calculated based on an assumed pre-payment rate to determine the final maturity of each class.

Fixed Rate Class – A mortgage loan with an interest rate and payments that do not change over the life of the loan. Also, a REMIC class with an interest rate that does not change over the life of the class.

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Floating Rate Class (Floater) – A CMO class that pays interest at a rate that adjusts periodically by a predetermined amount above a specific index.

Floor – The minimum rate of interest payable on an adjustable rate class or mortgage.

Guaranteed Maturity Security (GMS) – Securities issued by Freddie Mac with a short final maturity which is usually significantly shorter than the WAM of the collateral underlying the bonds.

Index – A published interest rate used to determine the interest rate payable on an adjustable rate mortgage or class.

Inverse Floating Rate Class (Inverse Floater) – a CMO class that pays an interest rate that adjusts periodically in the opposite direction of a specific index. Inverse floater adjustments may also be based on a multiple of the index.

“IO” (Interest Only) Class – A CMO class that pays the investor some or all of the interest payments on the underlying securities and little or no principal. IO classes usually have either a nominal or notional principal balance. A nominal principal balance represents the actual but relatively small amount of principal that will be paid to the class. A notional principal balance is the amount used as a reference to calculate the amount of interest due on an IO class not entitled to receive any principal. Declining interest rates have an adverse effect on IOs.

Libor (London Interbank Offered Rate) – The interest rate charged among banks for short term Eurodollar loans. A common index for adjustable rate mortgages and securities.

Lottery Bonds – Bonds designed with features generally considered desirable to individual investors. These features include a limited death put, principal payments returned in increments of $1,000, the factor remains at 1.0, option to elect to participate in early redemption of principal in early redemption of principal (by random lottery).

Maturity Date – See Final Distribution Date.

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Option Risk – The possibility that a borrower may prepay a mortgage in a time frame that adversely affects the investor’s yield.

Original Face Value – The original principal amount of a security on its issue date.

PAC (Planned Amortization Class) – A CMO class designed to pay investors scheduled payments over a range of constant prepayment speeds.

PAC II – Similar to a PAC bond, but protected over a narrower range of prepayment speeds.

PAC Band or Range – A range of constant prepayment speeds defined by a minimum and maximum under which the PACs scheduled repayment will remain unchanged. There can be multiple levels of PACs in a CMO, each having successively narrower PAC bands. The widest band of PACs is, PAC I and the next are PAC II.

PAC Schedule – The planned monthly principal balances of a PAC class in which the underlying securities prepay at a constant prepayment rate within the same PAC bond.

PAC Window – The time period during which a PAC class is scheduled to receive principal payments.

Payment Date – The date on which payments from a security to an investor is made. For additional information see Freddie Mac, Fannie Mae and Ginnie Mae.

Plain Vanilla – See Sequential Class.

“PO” (Principal Only) – A CMO class that does not bear interest and is entitled to receive only payments of principal. Rising interest rates will have an adverse affect on POs.

Pool – A group of mortgages backing an individual MBS issue.

Prepayment – The unscheduled payment of all or part of the outstanding principal of a mortgage loan, including payments by the

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borrower as well as liquidations from foreclosures, condemnations or casualty.

Prepayment Risk – The possibility that the mortgages underlying the security are repaid faster or more slowly than expected.

Principal – The remaining balance of a security or loan, exclusive of accrued interest.

Private Label – A mortgage security not issued or guaranteed by a U.S. government agency (such as Ginnie Mae) or U.S. government sponsored enterprise like (Fannie Mae or Freddie Mac).

Prospectus and Prospectus Supplement – The legal documents that outline all details of an investment.

Prepayment Speed Assumptions (PSA) – A measure of the rate of prepayment of mortgage loans. This model represents an assumed rate of prepayment each month of the then-outstanding principal balance of a pool of new mortgage loans. A 100 percent PSA assumes prepayment rates of 0.2 percent per annum of the then unpaid principal balance of mortgage loans in the first month after originations and an increase of an additional 0.2 percent per annum in each month thereafter (for example, 0.4 percent per annum in the second month) until the 30th month. Beginning in the 30th month and in each month thereafter, 100 percent. PSA assumes a constant annual prepayment rate CPR) of 6 percent. Multiples are calculated from this prepayment rate, for example, 150 percent PSA assumes annual prepayment rates will be 0.3 percent in month one, 0.6 percent in month two, reaching 9 percent in month 30 and remaining constant at 9 percent thereafter) A zero percent PSA assumes no prepayments.

Record Date – The date used to determine the owner of a security for purposes of distributing the next scheduled payment.

Retail Class – See Lottery Bonds.

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REMIC (Real Estate Mortgage Investment Conduit) – A multiple class mortgage cash flow security. Also referred to as a Collateralized Mortgage Obligation (CMO).

Scheduled Bonds – Similar to PAC II, but generally have a smaller range of protection for scheduled payments.

Scenario Analysis – An examination of expected investment performance over a variety of assumed interest rate changes.

Secondary Mortgage Market – The market in which existing mortgages or mortgage securities are bought and sold.

Sequential Class – A CMO class that receives principal payments in a prescribed sequence.

Settlement Date – The date of the delivery of and payment for a security.

Super Floater – A floating rate class that pays a rate of interest that resets periodically as multiples of the benchmark index.

Support Class – A CMO class that absorbs the prepayment variability removed from reduced volatility classes such as PACs and TACs.

Targeted Amortizations Class (TAC) – A CMO class designed to provide investors with a payment schedule that will hold at a single, constant prepayment speed. Prepayments in excess of the predefined prepayment speed are allocated to companion classes and do not affect the TAC class. If prepayments fall below the predefined speed, however, the TAC class will have slower principal repayment and its average life will extend.

Tranche – French world for “slice”. A class of investment interest in a CMO.

Weighted Average Coupon (WAC) – The weighted average of the interest rates on the mortgage loans underlying the MBs that back the CMO or the weighted average of the WACs of the individual MBS pools backing the CMO.

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Weighted Average Life (WAL) – The average amount of time that will elapse from the date of a security’s issuance until each dollar of principal is repaid to the investor. The weighted average life of each class of a CMO is only an assumption. The average amount of time that each dollar of principal is actually outstanding influenced by, among other factors, the rate at which principal, both scheduled and unscheduled, is paid on the mortgage loans underlying the MBS that back the CMO,

WAM (Weighted Average Maturity) - The weighted average of the remaining terms to maturity (expressed in months) of the mortgage loans underlying the MBS or the weighted average of the remaining terms to maturity of the individual MBS pools backing the CMO.

Window – The period of time from receipt of first principal payment to the last.

Whole Loan – A CMO whose collateral has not been securitized by Ginnie Mae, Freddie Mac or Fannie Mae. Therefore, they are issued by private entities and obtain their AAA rating based on the strength of the collateral and subordinate structures of the deal.

Yield – The rate of return on an investment over a given time, expressed as annual percentage rate. Yield is affected by price paid for the investment as well as the timing of principal repayments.

Yield To Maturity (YTM) – The annual percentage rate of return on an investment, assuming it is held to maturity.

Z Class – A CMO class that pays no cash flow to the investor until certain other classes are paid off or some other specified event occurs. The interest earned but not paid increases the principal balance of the class. Once the previous classes have paid off or the specified even occurs, the Z class becomes an interest paying amortizing class.

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CDs

ach CD is insured by BIF (Bank Insurance Fund), SAF (Savings Association Insurance Fund) or FDIC (Federal Deposit Insurance Corporation), up to $100,000 of principal and

interest per account. Similarly, pension and profit sharing plans are covered up to $100,000 per participant in accordance with the vesting provisions of the plan. In more than 50 years, not BIF, SAIF insured depositors have ever lost money within the limits of the insurance protection (state insured financial institutions excluded).

Zero-Coupon CDs have an interest accrual feature allowing for semi-annual reinvestment and compounding of interest at the same rate. Issued at a discount and maturing at $1,000 par value, zero-coupon CDs are excellent investments for accounts that are sheltered from current taxes, such as retirement plans.

INVESTOR PROFILE

CDs are most suitable for investors who want current income and preservation of capital. In addition, investors use CDs as a place to hold their assets while they wait for other investment opportunities.

FEATURES AND BENEFITS OF CDs

BIF, SAIF and FDIC insurance – Insurance provides a high degree of safety and peace of mind.

Fixed maturity date – Investor knows when principal will come due facilitating advance planning.

Fixed rate of return – Investor knows when interest is due.

Wide range of maturities – Investor can select maturities to meet specific goals. “laddering” several maturities can provide diversification and protect against interest rate fluctuations.

No early call features – Investor is assured of steady income, even if interest rates drop.

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Affordability - $1,000 denominations make CDs a available to a wide range of investors.

Liquidity – Active secondary market provides immediate access to underlying value for other uses.

Death benefit clause – If investor dies, CD can be redeemed at face value plus accrued interest, providing immediate access to funds and facilitating estate settlement.


Bankruptcy is a last resort of regulatory authorities. In such a case a receiver is appointed and insured deposits are paid and settled as soon as possible. Although no time frame is specified, it is anticipated that settlement would occur in approximately one week, because regulators realize that prompt payments alleviate concern.

Some institutions are federal chartered and some are state chartered. It makes no difference for insurances purposes. Instead, type of charter affects only the reporting system, the reserve requirements and the states in which an institution may market its CDs. All CD products are protected by federal insurance.

Insurance coverage is $100,000 per owner per account. A married couple can structure up to three accounts in a way that will provide $300,000 of insurance coverage.

What if your client wants a monthly income and the only CDs available are those paying interest semi-annually? A possible solution might be if

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your client has $50,000 and CDs are yielding 8% it is easy to calculate that annual interest will be $4,000k or $2,000 semi-annually. Therefore, suggest that you client buy $48,000 of the CD and invest the remaining $2,000 in a money market fund. Each month pay out one-sixth of the semi-annual amount, which is $333 per month. This technique will create a monthly cash flow and at maturity (after six months) the account will include the $48,000 principal plus accrued interest of $1,920, for six months for a total of $49,920.

One reason why a client would benefit by purchasing a CD through you, rather than from a local bank, is that many investors, especially the elderly, invest in short-term instruments to avoid interest-rate risk. The death benefit provision of a CD allows the investor’s estate to redeem the CD at par plus accrued interest. This provision applies to a joint account if either party dies. Of course, if the CD is bid above par, simply sell in the secondary market.

UNIT TRUSTS

unit investment trust is a fixed portfolio of securities professionally selected to meet state investment objectives. You may choose a unit trust comprised of municipal bonds,

corporate bonds, U.S. treasury bonds, government agency securities, foreign securities or a combination of them. You invest by purchasing units representing an ownership interest in the trust’s securities. Your units entitle you to a proportionate share of the value of the securities (which will fluctuate) and of any income produced. Your capital is returned to you as securities mature, redeemed or sold.

When you invest in unit trusts you have a team of professionals serving you, including investment experts (although the trusts are not actively

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managed) as well as a pricing agent, a bank trustee and an independent accounting firm. Each portfolio is selected by a group of professional securities analysts and buyers who are focused on obtaining both quality and value for investors.

Most fixed income portfolios invest in investment grade bonds rated “A”or better, or in “AAA” insured bonds. All unit trusts are priced daily by an independent evaluator to reflect current market conditions, thus, assuring clients an updated price when they buy or sell units. The bank trustee collects interest, dividends and principal payments, makes distributions to investors and handles investors record keeping (including providing year-end reports for tax purposes). Each unit trust’s financial statements are audited by a major independent certified public accounting firm.

The total market for unit trusts is approximately over $100 billion. The vast majority of individuals are attracted to unit trusts for monthly income, diversification and relative liquidity.

INVESTOR PROFILE

Unit trusts should be of interest to any investor, large or small, who lacks the time, expertise or capital to diversify and structure an individual investment portfolio. Also, for individuals who are:

1 Seeking monthly income.

2 Building wealth for the future.

3 Seeking a diversified portfolio.


The nature of unit trusts allows clients to choose their investment strategy based on the specific fund chosen.

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STURCTURE

CORPORATE UNIT TRUSTS

These trust consist of diversified portfolios of long-term corporate bonds. There are three types:

1 Uninsured series – These portfolios consists of bonds rated “A” or better.

2 Insured series – These portfolios consists of corporate bonds for which insurance has been purchased, which give the units an “AAA” rating. The sponsor has purchased portfolio insurance which guarantees payment of interest and principal.

3 Intermediate series – These trusts are comprised of portfolios of corporate bonds with 10 to 10 years average lives.

TAX-EXEMPT UNIT TRUSTS

National series – These trusts offer long-term portfolios of tax-exempt bonds from numerous states. The income is free of federal income tax on a proportionate basis for residents of specific states as reported to unit holders by trustee banks.

State series – These trusts offer long-term portfolios of specific state series, for example, New York, Pennsylvania, California and numerous others. The income from these trusts is federal, state and local tax-exempt for residents of the issuing states. Among each national and states series, you often have a choice of:

1 Insured series – The insurance guarantees the prompt payment of interest and principal when due. The units are rated “AAA”.

2 Uninsured series – These trusts consist of portfolios of “A” rated or better tax-free bonds.

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3 Intermediate series – These trusts consist of portfolios of tax-exempt bonds with average lives of 10-12 years.

GOVERNMENT UNIT TRUSTS

GINNIE MAE SERIES

These trusts consist of portfolios of Government National Mortgage Association (GNMA) pools of FHA and VA mortgages that are guaranteed by the “full faith and credit” of the U.S. Government. While all unit trusts make monthly interest payments, Ginnie Mae pools also generate monthly principal payments as homeowners pay their mortgages.

TREASURY SERIES

These trusts are available in various maturities, short, intermediate (generally 5 to 7 years) and long-term (25 to 30 years). All pay monthly interest checks and are rated “AAA” and the income is exempt from state and local taxes (exempt in Tennessee).

TREASURY LADDER SERIES

These trusts consist of portfolios of U.S. Treasury notes with “laddered maturities”. Generally, trusts consist of 5 different bonds with approximately 20% of the portfolio maturing annually for 5 years. This strategy helps to overcome interest rate moves. If rates are coming down, as a bond matures the remainder of the portfolio is still earning the former high rates. The income from these trusts is exempt from state and local taxes (except in Tennessee).

EQUITY UNIT TRUSTS

Government Securities Equity Trusts (G/SET) – These trusts offer a combination of 10-12 year U.S. treasury zero coupon bonds plus shares of a specific mutual fund. The zeros guarantee a pre-determined minimum maturity value. The mutual fund shares offer potential growth. It is a hedged approach for conservative accounts or reluctant equity buyers. They are particularly well suited for retirement accounts and college education accounts.

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Utility Trusts – These trusts offer diversified portfolios of utility securities with a definite life. At some pre-determined point, the portfolio is liquidated and unit holders receive a distribution of their principal. These trusts have two objectives, growth of capital and growth of income. The monthly income distribution increases if dividends increase in the underlying portfolio.

Index Trusts – This strategy allows a client to invest a portion of their portfolio in various index trusts. Trusts have been created using the following indexes:

1 S & P 500.

2 S & P 400.

3 Dow Jones Industrial Average (DJIA).

4 Dow Dividend Strategy.

5 DJIA and Treasury Series (1/2 DJIA and treasuries to guarantee a specific minimum value at maturity),

Concept Series – These trusts consist of portfolios from specific sectors, including healthcare, infrastructure ecology, telecommunications, natural gas, environmental and others. Portfolios are chosen and held for 5 years. Units are usually liquid and can be sold at any time for a capital gain or a capital loss.

KEY CHARACTERISTICS ANDBENEFITS OF UNIT TRUSTS

Selection and professional supervision. Unit trusts offer professional securities, selection. Although trusts are not actively managed, the sponsors regularly review the portfolios and may sell or replace securities, in limited circumstances, in the best interest of the unit holder.

Diversity. Risk is reduced because unit trusts hold securities from a variety of different issuers.

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Liquidity. Trusts can be redeemed at any time. The price the investor receives is based on the net asset value (NAV) of the securities in the portfolio as determined by an independent evaluator at more or less than original cost.

Monthly income. Most unit trust offer holders the option of monthly, quarterly, and sometimes semi-annual dividend payments.

Reinvestment. Trust distributions can be reinvested with no additional sales charge, which keeps capital continuously working and gives the added benefit of compounding.

MUTUAL FUNDS

utual funds are investment companies that pool money from investors and, depending upon the investment objective of the specific fund, invest the proceeds in a diversified portfolio of

financial instruments such as stocks, bonds and money market instruments. With more than $1.3 trillion in assets (as of January 1992), mutual funds are among the most popular investments in America. In fact, more mutual funds exist than there are stocks on the New York Stock Exchange. Consequently, a mutual fund is available to satisfy virtually any investor’s needs or goals.

Mutual funds are designed to make investing easy and affordable. Whether clients are investing for retirement, their children’s education or any other financial goal. Mutual funds can provide valuable benefits that may not be available to those directly in stocks, bonds and other financial instruments.

Mutual funds also provide the benefits of diversification and spreading risk both among different securities as well as across different markets. In fact, many investors can achieve a comprehensive investment program by investing in a strategic combination of mutual funds. For example, the right combination of funds can provide geographic diversity, like global

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funds vs. domestic funds. Different investment styles like growth vs. capitalization stocks vs. small capitalization stocks.

A MUTUAL FUND FOR EVERY NEED

A wide range of mutual funds are available which enable the individual investor to participate in financial markets in the U.S. and around the world.

GROWTH FUNDS

Growth funds seek to increase the value of an investment over time. These funds typically invest in the stocks U.S. corporations.

ASSET ALLOCATION FUNDS

Asset allocation funds seek a combination of growth and income. Accordingly, they may invest in a diversified portfolio of stocks and bonds and other securities.

GLOBAL EQUITY FUNDS

These mutual funds invest primarily in common stocks and bonds of companies around the world, including the U.S.

INCOME FUNDS

Income funds aim to produce a steady stream of current income primarily through fixed-income investments such as U.S. government securities, corporate bonds and mortgage-backed securities.

TAX-EXEMPT INCOME FUNDS

These funds invest primarily in municipal bonds issued by state and local governments and seek to generate income that is free from federal income taxes and some cases, state and local taxes as well.

MONEY MARKET FUNDS

These mutual funds seek high current income consistent with liquidity and preservation of capital.

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OPEN-END FUNDS

Open-end mutual funds capitalize through the continuous offering of shares which they stand prepared to redeem at any time at a net asset value (NAV). Shares may only be purchased from and sold back to the fund itself.

CLOSED-END FUNDS

Closed-end mutual funds typically capitalize in a one time public offering of shares. The majority trade on the New York Stock Exchange and therefore their price trades according to market forces rather than to their underlying net asset value (NAV). The NAV is very similar to shareholder’s equity (assets minus liabilities), except that the assets are normally priced at their current market value instead of at the lower of original cost or current market price.

CLOSED-END VS. OPEN-END MUTUAL FUNDS

The three main differences between closed-end and open-end funds are their:

1 Capitalization.

2 Pricing.

3 Liquidity

Closed-end funds have a fixed capitalization. The price is determined by supply and demand of the market place. Whereas open-end funds always stand ready to offer or redeem shares at their NAV, except if the fund is approaching it’s announced open-ending date, liquidation or possible acquisition.

Although closed-end funds do not provide the ability to redeem shares at the NAV as an open-end fund does, the advantages for closed-end funds are that they can:

1 Maintain a fully invested philosophy because they do not have to maintain liquidity within the fund of redemptions.

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2 Invest in potentially more profitable private placements and venture capital opportunities that the liquidity required for open-end funds do not allow.

3 Invest in less liquid publicly traded securities.

Also, a common problem that open-end managers observe is that investors tend to purchase and redeem shares at the most inopportune time, such as, purchasing at market tops and selling at market bottoms. This can interfere with a consistent investment philosophy.

FEATURES AND INVESTOR BENEFITS OF MUTUAL FUNDS

Professional management. Continuous approach to meet the stated objectives of the fund in all types of markets may provide the potential for superior performance.

Diversification. Limits risk while providing a reward commensurate with the stated objective of the fund.

Liquidity. Mutual fund shares can be sold at net asset value (NAV) on any business day to provide funds to meet unexpected emergencies.

Flexibility. The movement of dollars within a fund group provides the ability to alter an investment program at little or no change.

Profit potential. The value of the investment can grow as the manager successfully chooses the equity and debt positions than comprise the portfolio.

Automatic reinvestment of dividends and capital gains. Profit potential may be maximized over a period of time through the automatic reinvestment of distributions. This flow of funds provides a dollar cost averaging approach to the overall investment.

Withdrawal plans. A preplanned approach to meet income needs.

Affordability. Low initial and subsequent investment minimums make mutual funds affordable for most investors.

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MUTUAL FUND SWITCHES

Mutual funds are usually designed to be long-term investment vehicles (one year or longer, according to the NASD). Regulatory standards prohibit short-term, in-and-out trading or switching between different fund families which result, or could result, in additional commission charges. Regulators view seriously the switching of clients between mutual funds under different management but with similar investment objectives.

The firm’s policies are designed to discourage short-term trading of mutual funds, which apply to all mutual funds with a front-end or rear-end sales charge) contingent deferred sales charge), as well as closed-end companies. While changed objectives, fund performance or individual client needs may indicate a switch to be in the best interest of that client, these transactions require careful examination and prior approval by the Branch Manager and/or the Compliance Department.

EXCHANGE PRIVILEGES

Families of funds generally allow clients to switch funds within the family without paying a new commission, although some funds may charge a modest service charge. The use of these exchange privileges are not considered improper switching, provided they coincide with the customer’s investment objectives.

If a fund shareholder desires to change from one mutual fund with a sales charge to another mutual fund with a sales charge within a family of funds, the exchange privilege must be used. An exchange privilege is not available during the initial public offering phase even for funds with the same family. The broker should advise the client to wait until after the initial public offering is completed and then use the exchange privilege.

SWITCH LETTERS

A shareholder desiring to change from one mutual fund with a sales charge to another mutual fund with a sales charge, where a free exchange privilege is not available, is required to sign a “switch letter”. Approval

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BREAKPOINTS

Brokers are prohibited from selling mutual fund shares in dollar amounts just below the point at which the sales charge is reduced. Clients must be advised, if they are close to a breakpoint, that they can receive a reduced sales charge by either purchasing some additional shares or:

1 Signing a “Letter Of Intent (LOI), which allows the customer to make additional purchases of the same fund for a period of thirteen months.

2 Signing a “Rights Of Accumulation (ROA), which allows the client to group related accounts together in order to reach a break pint and receiving a reduced sales charge.

These alternatives entitle clients to obtain reduced sales charges with additional purchases of the same fund over an extended period of time.

MUTUAL FUND ORDERS

Trading hours for mutual funds are between 9:30 AM and 4 PM E.S.T., Monday through Friday when the New York Stock Exchange is open. All mutual fund orders placed before 4PM will be entered the same day. Orders placed at 4PM or after will be entered the next business day. Under no circumstance will a mutual fund order be placed after the market is closed. Also, the order system is programmed not to accept mutual fund orders after 4 PM.

If an error has occurred, such as buying or selling an incorrect quantity or incorrect fund, a full description of the error, signed by the broker and the manager should be faxed to the Compliance Department requesting the error to be corrected. The error will then be corrected directly with the mutual fund family at the closing price on the day the original order was entered.

CLASS A, CLASS B AND CLASS C SHARES

It is imperative that prior to soliciting or purchasing a mutual fund for a customer, the broker and the customer review all essential factors that will

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determine which type of fund would most appropriately fit in the customer’s objectives and be in the client’s best financial interest.

Class A shares: Shares subject to a front-end sales charge.

Class B shares: Shares subject to an asset-based sales charge and a declining contingent deferred sales charge.

Class C shares: Shares subject to an asset-based sales charge and a 12 month contingent deferred sales charge.


Few individuals have the time, resources or knowledge required to invest profitably in today’s financial market place. Mutual fund managers are full-time investment professionals who continually apply a disciplined approach to the pursuit of stated investment goals.

When helping to choose a mutual fund for your client, you must first assess your client’s current needs, future objectives and tolerance for risk. Based on those parameters, you can provide recommendations of funds with the appropriate investment objectives. You can also provide past records of how well these funds have performed in both rising and falling markets. Although future performance cannot be projected from past performance, it is still an important consideration when choosing a mutual fund.

Mutual funds are very liquid investments. Clients can sell all or part of their funds on any trading day and receive the closing price for that day.

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RETIREMENT PLANS

financially secure retirement is a financial goal that most investors share. In fact retirement has long been a cherished part of the American dream. Whatever your client’s financial

goals are, a well coordinated and structured investment plan can help them achieve them.

However, the nature of retirement planning has changed dramatically in recent years because of a number of significant economic and demographic trends. Perhaps most importantly, Americans are living longer than ever before. Consequently, they must plan for a longer period of retirement than their parents and grandparents did. Inflation, escalating health care expenses and other factors are making retirement planning more important and more challenging for today’s retirees. Traditional sources of retirement income such as social security and company pensions are no longer enough for most people. Increasingly, retirees must rely on their own investments to ensure that their income grows with inflation and that their assets last as long as they do.

Retirement plans are those in which an individual or a business makes current tax deductible contributions to a trust or custodial account that is maintained for the future benefit of the individual or employee. There are restrictions on when amounts can be withdrawn without penalty. Both “qualified: and non-qualified” retirement plans allow for tax deductible contributions and/or tax-deferred growth on the earnings in the plans. A retirement plan is considered “qualified” when it meets the requirement of the internal revenue code, enabling assets to accumulate on a tax-deferred basis. Certain individuals may make tax deductible contributions to IRAs. In the case of company sponsored plans, contributions are tax deductible for the employer and are not taxable to the employee until the benefits are received during retirement. In some cases, such as when an employee leaves the company, accumulated assets may be paid to the employee before retirement. Under this scenario, the employee may be able to “roll over” the proceeds into another qualified retirement plan or a IRA within a specific period in order to avoid current taxation.

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Qualified retirement plans usually allow favorable tax treatment like forward income averaging on “lump sum distributions”. Profit sharing plans, money purchase plans and 401Ks are types of qualified plans. There are two types of qualified retirement plans:

Defined contribution plans: Do not stipulate the ultimate benefit for the individual but define the amount of money that is being contributed over time on behalf of the employee.

Defined benefit plans: Require that the retirement benefit be clearly determinable contributions to a defined benefit (DB) plan are based on a computation of what is needed over time to produce a defined persuasion in the future to the participant.Actuarial assumptions and computations are required.

Other plans such as IRAs, SEPs, SARE SEPs and 403b plans are not considered qualified plans, but, nevertheless are given similar treatment. These retirement plans do allow for tax deductible contributions and the earnings are tax deferred. In the case of IRAs, contributions are tax deductible at certain income levels.

The federal government provides tax advantages for retirement plans because they recognize that people must begin early when saving for the future. Otherwise, the entire burden of retirement benefits would be on the federal government or with the individual and/or his or her family. Clearly, one of the most beneficial services a broker can provide his or her clients is in helping in the creation and maintenance of a comprehensive program designed to achieve a secure and prosperous retirement.

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TYPES OF RETIREMENT PLANS

CONVENTIONAL AND ROTH IRA ACCOUNTS

Many individuals can receive the benefits of tax-deferred compounding of their assets through an IRA, regardless of whether their contributions are tax deductible under current law

SIMPLIFIED EMPLOYEE PENSION PLAN (SEP)

Small business owners, self-employed individuals, partnerships and independent contractors should consider the SEP. A low cost employer sponsored retirement plan which does not require IRS form 5500 filing.

SALARY REDUCTION SIMPLIFIED EMPLOYEE PENSION PLAN (SARSEP)

Available to certain employers with 25 or fewer eligible employees (50% of whom must participate). A “SARSEP” plans have virtually no administrative costs or government reporting requirements. Employees may contribute up to the same limits imposed by more complicated 401K plans. Employee contributions are also permitted.

PROFIT SHARING PLANS

This is a plan for sharing employer profits with employees. Contributions are discretionary. With a discretionary profit sharing plan, the employer determines the year of the contribution as well as the amount.

MONEY PURCHASE PENSION

The plan has contributions that are fixed and are not based on the employer profits. For example, if the plan requires that contributions be 10% of the participants’ compensation, the plan is a money purchase plan.With this type of plan the employer is committed to making contributions each year even if the business has no profits.

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401K PLANS

401K plans are qualified retirement plans that enable employees to make tax deferred contributions through convenient payroll deductions. Employers have the option making matching and/or profit-sharing contributions to the plan.

403B PLANS

Available exclusively to employees of certain tax exempt organizations or public educational institutions. 403B plans provide an opportunity for employees to invest on a tax deferred basis through payroll deductions. Investment choices include annuities or mutual funds.

FEATURES AND BENEFITS OF QUALIFIED RETIREMENT PLANS

SPPONSORING COMPANIES

Contributions are tax deductible to the employer. A large part of the plan’s cost is paid by dollars that would otherwise go to taxes.

Employee morale improves. By demonstrating concern for its employees the company can reduce turnover and attract new employees.

Wide variety of plans available. A broad array of qualified retirement plans is available to meet the specific needs of companies, business owners, self-employed professionals and individuals.

FOR EMPLOYEES AND INDIVIDUALS

Contributions and earnings are tax deferred for the employee. No taxes are paid on earnings while the assets are held in the account. When the money is paid out at retirement, it is likely that the individual will be in a lower tax bracket than presently.

Future security. Knowing that assets are set aside for the future provides peace of mind.

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Wide range of investment alternatives. Virtually every type of investment (except municipal bonds and other tax advantage instruments) may be purchased for a retirement plan.

Compounding. Because no money must be withdrawn to pay taxes on earnings, those earnings compound at a much faster rate than taxable earnings.


When an employee exits a qualified retirement plan, the employee has 60 days in which to roll over the contents before incurring a tax liability.

The difference between a “Defined Contribution Plan” and a “Defined Benefit Plan” is:

1 Defined contribution plans do not stipulate ultimate benefit, but do stipulate the actual amount of money that is to be contributed for a given period on behalf of the employee.

2 Defined benefit plans require that the ultimate benefit to the employee be determinable. The employer’s contributions to the defined plan are based on actual assumptions and computations.

GLOSSARY OF TERMS

Conduit IRA – A temporary holding tank for money distributed from a qualified plan. The funds may be from a lump sum distribution or a termination distribution from a qualified plan. The funds are then held tax free until rolled into a new employer’s qualified plan.

Defined Benefit - A qualified retirement plan that designates a specific benefit to be paid to the participant upon retirement. The amount of the

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benefit is established in the terms of the contributions necessary for the benefit to be paid at retirement.

Defined Contribution – A qualified retirement plan that specifies the amount of contributions to be made. The amount of benefits remains uncertain and will depend upon the earnings of the plan and the level of contributions.

401 K – A qualified profit sharing plan permits employee contribution through a salary reduction agreement. The employer can elect to match employee contributions or make regular profit sharing contributions.

403 B - A qualified retirement plan available to non-profit organizations which permits employee contributions based on a fixed percentage of salary by means of salary reductions. Investments are legally limited to mutual funds or annuities.

Money Purchase – A qualified plan under which an employer must contribute a fixed percentage of compensation or earned income each year for each participant covered under the plan. The contribution must be made regardless of profitability.

Profit Sharing Plan – A qualified plan under which an employer’s contributions are discretionary and are made out of current or accumulated profits or earnings.

Plan Administrator – The person responsible for preparing a plan’s annual reports, providing required information to employees, and determining benefit eligibility and other administrative duties necessary to the plans’ operation.

Rollover – A tax free movement of cash or other assets from one retirement plan to the participant or to another plan. An IRA account owner may shift assets from his or her present IRA to another. Certain payouts from a pension plan may also be rolled over to an IRA or to another employer’s plan.

Transfer – The movement of a retirement plan from one institution directly into the same type of plan at another institution. A transfer is

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distinguished from a rollover in that a distribution is not made to the participant as in the case of a rollover. A transfer can take place as often as a participant desires.

SYNDICATE

yndicate describes a group of investment bankers who purchase securities from the issuer and then re-offer them to the public at a fixed price. The syndicate is usually organized along historical or

social lines, with one member acting as syndicate manager who insures the successful offering of a corporation’s securities.

FEATURES AND INVESTOR BENEFITS OF SYNDICATE OFFERINGS

Scheduled on a calendar basis. Investors know when offerings will be available.

Net basis. The commission is included in the offering price. The issuer pays the commission, saving the client money.

Increase in liquidity. Investors can establish sizeable positions without affecting the market price.


One reason why it is often difficult to receive a large allocation is that approximately 30% is allocated to retail investors with the balance being allocated to institutions and to more than 5,000 financial advisors.

If a member firm is part of an underwriting group, its brokers may not trade that security until the syndicate has been terminated. The lead

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manager of the syndicate decides when the syndicate is terminated. In addition, placement on offerings is extremely important to the success of the transaction.

If you do sell stock purchased within ten (10) business days of the offering, all sales at or below the original offering price will result in a loss to the financial advisor of the syndicate buy-side commission. If a new issue settles via physical delivery, the financial advisor will be subject to loss of the buy-side commission as long as the syndicate delivery penalty is in effect.

An offering may be reduced in size requiring reallocation of shares. Keep in mind that tickets are actually expression of interest for an allocation. For example, we may have over-allocated in anticipation of a light response, only to learn that the offering is over-subscribed.

An announcement of the price of an offering is usually made after the close of the market on the day of the offering. The issue must be declared effective by the Securities Exchange Commission before confirmations can be mailed to clients.

Your order ticket is considered an indication of interest only until the offering is declared effective by the SEC and released by syndicate. Once the ticket is processed by the home office, it is considered an order. The syndicate department does not know how many shares it has until the offering is released. Your client is not to be guaranteed of ownership until the effective date and confirmation from the Syndicate/Compliance Department has been given. Do not request payment from your customer until the issue has been deemed effective and you received confirmation that your client’s indication of interest has become an order.

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”Green Shoe” is a term that describes an over-allotment of the initial offering by the syndicate manager. The “Green Shoe” or over-allotment option is an option granted to the underwriters on the same terms and conditions as the public offering. It is limited to a maximum of 15% of the shares offered to the public and when exercised, does not represent additional shares available to retail clients. This creates a stronger stabilizing effort to absorb any immediate after-market selling.

MARGIN

argin accounts enable investors to buy certain securities on credit. Essentially, the client pays only a portion of the purchase price and borrows the remainder from the brokerage

firm. The client pays interest on the money that is borrowed. Unlike most loans, the client is not required to repay the borrowed money on any specific due date. Instead, the client is simply required to maintain a certain amount of collateral to back up the loan and to continue to meet the interest payments on the borrowed funds. On rare occasions the member firm may deem it necessary to call the full amount of the loan.

By purchasing securities with borrowed money, investors are able to “leverage” their investments. They are able to buy far more of an investment than they otherwise would have with cash alone. If the securities appreciate in value, the investor receives all of the profit less only the interest paid on their margin loan and the margin debt. If the investment declines in value, the investor participates fully in the loss because the full amount of the loan, plus interest, must be repaid.

To open a margin account, a client must sign a margin agreement and deposit money and/or marginable securities. Clients may purchase a wide range of securities on margin, including almost all listed stocks and many

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FEATURES AND INVESTOR BENEFITS OF MARGIN ACCOUNTS

Ability to borrow money when purchasing securities. Investor may buy more securities with the same amount of money, providing greater opportunities for more income, more long term growth or more trading profits.

Ability to withdraw funds from the account. Owner can convert some of the securities to cash without selling them, making cash available for virtually any purpose.

Loan amount does not fluctuate. Investor is entitled to 100% of proceeds less margin debt and accrued interest.

No set repayment date. Investor is not required to repay the money by any set due date.

Interest is normally tax deductible. Reduces income taxes.

Interest on the loan is established at a rate that is usually 1 ½% above the bank call loan rate (lower rates may be available as margin debt grows). Lower interest costs than many other loans and may provide more supendable dollars.

Interest charged only for exact number of days of the loan on the remaining loan balance. Lower effective interest rate than many forms of loans.

Monthly statements show status of loan in margin account.Investor know exact amount of loan and interest charges.


Margin accounts are simple to open. If you determine that your client’s financial resources and threshold of risks are suitable, the client signs a client margin agreement.

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Securities must remain in street name. In order to use securities as collateral when necessary, the broker dealer needs access to those securities. In that sense, it is somewhat similar to taking certificates to the bank when you want to use your stocks and bonds as collateral for a bank loan. Those securities are earmarked for that particular client.

The Federal Reserve of the United States has designated which securities may be bought on margin and which may not. Basically, almost any listed security may be purchased on credit. In addition, clients may buy corporate bonds, municipal bonds and government bonds on margin.

Margin requirements are presently 50%. A client must deposit 50% of the purchase price and may borrow the remaining 50%. The amount of money that a client must deposit is called the “margin”. The amount that the client borrows is called the “debit balance”. Margin requirements are different for each class of security, such as corporate bonds, municipal bonds, government bonds, NYSE securities and OTC securities.

Interest rates on margin accounts fluctuate with the general level of interest rates. The interest rate is normally based on the “broker call”loan rate which is what the broker dealer must pay to banks when they borrow money. If the “call loan rate” goes up or down, margin loan interest will go up or down accordingly.

All margin accounts do not pay exactly the same interest rate. Lower interest rates are sometime provided to accounts with a larger debit in the margin account.

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There are two kinds of margin calls. The “Fed Call” or “Reg-T Call”and the “House Call” or “Maintenance Call”.

A “Fed Call” is generated when the initial margin requirement is not met. With most equity purchases, the initial margin requirement is 50%. This can be covered two ways:

1 The deposit of cash.

2 The deposit of fully paid marginable securities.

A “House call” is generated anytime the underlying security falls below the predetermined house requirement. For most equity issues, R. M. Stark’s requirement is 35%. House calls are met three ways:

1 The deposit of cash.

2 The deposit of fully paid marginable securities.

3 The liquidation of the appropriate amount of securities.

The best ways to avo8id margin calls are:

1 Clients should attempt to buy higher quality securities which are not subject to sharp declines in value.

2 Clients should diversify their investments into a variety of stocks representing different industries. If one group of stocks is weak, another group of stocks may be strong.

3 Clients should not always borrow the maximum amount of money. They should buy on credit only when they see unusual values in stocks or bonds.

Margin accounts can increase the income of a portfolio. Assume investor “A” has bought 30 corporate bonds at par with a 10% current return. Also, assume that the minimum interest rate on a debit balance is currently 8 ¾%. In this case, investor “A” has the following rate of

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return:

Investor A

Our of pocket investment: $30,000 30 bonds for cash.

Interest income. $ 3,000 10% of face value.

Rate of return. 10% $3,000 divided by $30,000

Assume investor “B” buys the identical corporate bonds with a 10% current return. However, investor “B” purchases 100 such bonds on margin. Investor “B” has the following rate of return:

Investor B

Our of pocket investment: $ 30,000 Amount borrowed $ 70,000

Face value of bonds bought $100,000

Gross income less charges $ 6,125 for interest$70,000 x 8 ¾%)

________

Rate of return on outof pocket investment ($3,875 divided by 30,000) 12.9% vs. 10% with same layout of money. Dollars invested.

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ANNUITIES

n annuity is a contract between an insurance company and an individual that provides a number of valuable investment benefits. Most valuable is the tax-deferred status of most

annuities. Because all annuity earnings are tax-deferred, they compound at a faster rate than comparable taxable investments. In addition, many annuities contain special features that make them excellent retirement planning vehicles.

Unlike life insurance contracts, annuities are designed to protect the policyholder while he or she is still alive, rather than his or her dependents. However, many annuities also allow for a complete pass through of funds to beneficiaries.

Annuities fall into two general categories “immediate” and “deferred”. An immediate annuity is purchased with a single payment and starts paying an income immediately following the purchase. In contrast, a deferred annuity guarantees future income which will begin on a specific future date which the policyholder chooses. During the interim period interest accumulates without current taxation. Investors may fund a deferred annuity either with a lump sum payment or in installments.

Annuities are suitable for investors who want retirement income, capital growth and the benefits of tax-deferred compounding of interest. While many annuities are purchased by investors who are retired or planning for retirement, many younger investors use them as a savings vehicle for their children’s education and as a way to participate in the market without paying current taxes on reinvested shares.

TYPES OF ANNUITIES

FIXED ANNUITIES

Fixed annuities typically provide a guaranteed interest rate that is locked in for a specific period. These annuities provide safety of principal as the investment is backed by the issuing insurance company. Many fixed

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annuities provide attractive retirement features, such as a guaranteed income for life, other income payment options, access to principal and certain death benefits.

VARIABLE ANNUITIES

Variable annuities generally provide the long-term growth and income benefits of a diverse family of mutual funds as well as the advantages of tax-deferred compounding. In addition, many variable annuities offer certain guarantees of safety for both principal and income.

FEATURES AND INVESTOR BENEFITS OF FIXED ANNUITIES

Principal rate guaranteed. Investor has access to 100% of principal at any time, providing peace of mind.

Interest rate guaranteed. Investor is assured of a steady and known interest rate for a specific period of time.

Interest is tax-deferred. No taxes are paid until distributions are made, providing the growth benefits of compounding.

Lifetime income is guaranteed (optional). If chosen, investors cannot outlive their principal under this payout option.

Easy access to principal. All or part of the principal is available for emergencies or other uses.

Liquidity. Many fixed annuities permit withdrawal of earnings annually.

No sales charges on certain annuities. 100% of client’s money goes to work immediately.

FEATURES AND INVESTOR BENEFITS OF VARIABLE ANNUITIES

Growth and/or income. Depending upon the underlying mutual fund choices, money may be invested for growth, income or both.

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Professional management. The underlying mutual fund investments are professionally managed helping investors participate in timely market opportunities.

Diversification. Spreading investments among a number of different securities and mutual funds can help reduce risk.

Flexibility. Most variable annuities provide a wide choice of stock, bond and money market funds.

Tax-deferred compounding. Earnings compound at a faster rate than comparable taxable investments.

Death benefit. Heirs are guaranteed the return of principal or prevailing market value, whichever is greater, less any withdrawals.

Liquidity. Many annuities permit withdrawal of earnings annually.

Tax-free transfers among investment options. As objectives or situations change, investors can switch among funds at no cost or tax consequences.

Dollar cost averaging. Investing funds at regular intervals can help minimize the risk of market fluctuations.

No sales charge on certain annuities. 100% of client’s money goes to work immediately.


Most investors are concerned with retirement income and/or accumulating wealth. Besides the ingestible assets they use to purchase stocks and other investments, they often have a sizable “nest egg” invested in so-called “low risk” vehicles, such as CDs and bank accounts. Fixed annuities give you access to that nest egg because principal, interest, liquidity, renewal and purchase options are all guaranteed by the issuer. The contracts specify that the investor will never get back less than his or her original investment. Variable annuities give you the opportunity for

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tax-deferred equity participation with principal guaranteed at death. In addition, research shows that clients who buy annuities tend to buy other products as well and are a good source of referrals.

You as the broker need an insurance license. Annuities are contracts between an insurance company and an individual and are therefore considered insurance products for which you need a license to sell.

The ideal prospect for annuities is anyone interested in earning retirement income, deferring taxes or accumulating wealth over the long term. More specifically, investors age 45 to 70 who are conservative and in high tax brackets are attracted to annuities.

Several income options available from annuities include:

1 Payments for a designated period – The insurance company guarantees to make annuity payments only for the number of years selected by the client (one to thirty years), If the annuitant dies before the required number of payments are made, the insurance company continues to make payments to a named beneficiary for the duration of the period.

2 Installment refund – This option provides lifetime income with an additional guarantee which states that if the annuitant does not collect the entire amount applied to the option, the payments will continue to beneficiary until an aggregate amount is paid that is equal to the original investment amount.

3 Joint and last survivor annuity – A monthly income is guaranteed for the lives to two individuals. Upon the death

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of one individual the other receives income until his or her death.

4 Lifetime income – A monthly income paid for the life of the annuitant without provision for a beneficiary. Income benefits cease if the annuitant dies prematurely.

Annuity contracts have two distinct stages. First, in the accumulation stage, money compounds on a tax-deferred basis. Then, during the income stage, money is paid out based on the distribution option that has been selected. The client may choose not to implement this stage if income is not needed and funds will continue to grow on a tax-deferred basis.

Money is available prior to annuity payments. This is called a partial withdrawal and your client may request money at any time. However, some insurance companies may impose a charge and may place some restraints on the frequency of partial withdrawals. Current federal tax law treats partial surrenders as taxable withdrawals of interest first. The IRS imposes a 1-% tax penalty on any interest withdrawn or surrendered before age 59 ½.

If death occurs during the accumulation stage, the beneficiary receives the full value. If death occurs during the income stage, it depends on the payment option selected. If your client dies before any payments are made, the beneficiary receives 100% of the total annuity purchase payments. This money becomes available upon receipt of a validated death certificate and would bypass probate enabling the beneficiary to get the money immediately and save 6% to 9% in probate costs.

Clients will continue to collect interest as payments are made. Certain minimum guarantees are provided in the contract for the entire payment period.

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Terminal funding is an investment vehicle used to purchase annuities from proceeds existing from qualified pension and profit sharing plans.

One question often asked is “aren’t municipal bonds better investments for clients who want tax advantaged income?”Deferred annuities and municipal bonds are very different investments. Municipal bonds pay current income. Annuities accumulate money on a tax-deferred basis for the future. The two products can compliment each other.

State premium taxes are excise or use taxes charged by some states on the premiums collected by the insurance company from the residents of that state. Some insurance companies will pay the premium tax if the annuity premium is more than a certain dollar amount.

The 1035A section of the ITS tax code states that an annuity will maintain its tax-deferred status if liquidated and the funds are used to purchase another annuity. The funds must be assigned directly to the new insurance company.

Full or partial surrenders are usually processed within seven business days from receipt of the written request.

RATE GUARANTEE

Fixed (Book Value) Annuity – Rate guaranteed for a number of years. Usually has a bailout option. The holder may terminate the contract with

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no surrender chares if the renewal rate is more than 1% below the initial rate.

Variable Annuity – None, unless a fixed rate account is offered within the variable series.

CD Annuity – Rate guaranteed for one year.

Market Value Adjustment (MVA) Annuity – Rate guaranteed for a specified number of years (usually 3 to 10 years).

RATE RENEWALS

Fixed (Book Value) Annuity – New rate is set annually after initial rate guarantee expires.

Variable Annuity – N/A.

CD Annuity – New money rate thereafter.

MVA Annuity – Varies, usually exchanged for a new contract when guarantee period ends.

PRINCIPAL GUARANTEE

Fixed (BV) Annuity – Principal guaranteed at all times. Contract has a stated value of initial deposit plus accumulated interest.

Variable Annuity – Principal subject to fluctuation of sub-account performance. Contract guaranteed against loss of principal upon death of annuitant.

CD Annuity – Principal guaranteed at all times.

MVA Annuity – Principal guaranteed at maturity but is subject to market adjustment if withdrawn early.

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LIQUIDITY

Fixed (BV) Annuity – Usually allows access to either annual interest or 10% of annuity value with no surrender penalty. Full liquidity available at all times but subject to declining surrender penalties.

Variable Annuity – Usually allows access to either annual interest of 10% of annuity value with no surrender penalty. Full liquidity available at all times but subject to declining surrender penalties.

CD Annuity – Partial liquidity is available for a limited time only (30 days from anniversary date). Full liquidity is available on anniversary date with no surrender charges.

MVA Annuity – Option to gain access to previous years’ earnings at no surrender penalty. Full liquidity is available at all times but is subject to surrender charges and market value adjustment. Principal will be worth more or less than original investment depending on level of interest rates.

SURRENDER CHARGES

Fixed (BV) Annuities – Typically charged for 5 to 7 years, 0% thereafter.

Variable Annuity – Typically charged for 5 to 7 years. 0% thereafter.

CD Annuity – Typically charged for 5 years for redemptions between anniversary dates.

MVA Annuity – Typically charged for 5 to 7 years, 0% thereafter. In addition, a market value adjustment is applied depending on current interest rates.

MVA Annuity – Swap to take advantage of positive market value adjustment (surrender charges may apply).

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RISING RATE ENVIRONMENT

Fixed (BV) Annuity – Consider a one-year rate guarantee.

Variable Annuity – Consider a money market account with plan to move or dollar cost average into managed sub-accounts when outlook improves.

CD Annuity – Continue one-year renewal during interim.

MVA Annuity – Hold contract to maturity to avoid a negative MVA, withdraw annual interest and reinvest at a higher rate.

529 PLANS

n recent years, Section 529 plans have become a popular tool for investors to set money aside for future college expenses. What many don’t realize is that Section 529 plans can also serve as an effective

wealth transfer tool.

Paying for a child’s or grandchild’s college education is an expensive proposition, even for many high-net-worth Americans. Today’s elite institutions promise graduates a rewarding future, but at a cost that more often than not extends well into six figures. Enter the 529 plan, a tax-advantaged investment vehicle generally available to families regardless of their income level. For affluent parents and grandparents, a 529 plan offers a variety of potential benefits, including some that go beyond the scope of college planning. A 529 plan may in fact play an integral role in an estate plan.

Named for the section of the Internal Revenue Code that authorized them, 529 plans allow investment earnings to grow sheltered from federal income taxes, and withdrawals used to pay for qualified education

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expenses are tax free. But for parents or grandparents concerned about estate taxes, 529 plans may be even more valuable, supporting a long-term gifting strategy while still providing significant control over assets that have been removed from a taxable estate.

THE 529 PLAN – PRIMARY PURPOSE

First and foremost, a 529 plan is a college savings tool. Before recommending a 529 plan to your client, be sure to explain the role of the 529 plan in an estate plan, it’s important that the client understands a few basics. There are two types of 529 plans:

1 Prepaid tuition plans, which allows the customer to lock in tomorrow’s tuition at today’s rates.

2 A college savings plan which allow the client to choose from a menu of investments and offer more return potential, as well as risk.

Both of the above plans are generally sponsored by a state government (although tax law permits certain educational institutions to sponsor prepaid tuition plans) and administered by one or more investment companies.

With a 529 college savings plan, the underlying investment options are typically mutual fund portfolios. Many plans offer age-based asset allocation portfolios that become more conservative as the beneficiary grows older. Others let account owners choose from individual investment options to create a customized portfolio.

Originally, 529 plans offered the benefit of tax-deferral. Taxes on earnings weren’t due until withdrawal and then only at the beneficiary’s rate. But thanks to tax legislation passed in 2001, qualified withdrawals are federally tax free. Keep in mind that currently that tax-free status is currently scheduled to expire in 2011.

Eligibility to contribute to a 529 plan is not limited by age or income. In addition, total plan contribution limits often exceed $200.000.Withdrawals can be used to pay for undergraduate or graduate school expenses.

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Withdrawals for purposes not related to paying qualified education expenses are subject to ordinary income taxes and a 10% penalty tax.

ESTATE PLANNING

The IRS clearly had college planning in mind when it drafted Section 529 of the Internal Revenue Code. However, it also left the door open to use 529 plans as estate planning tools. That’s because a contribution to a 529 plan is considered a completed gift from the donor to the beneficiary named on the account, even though the account owner, not the beneficiary, maintains control over the money while it’s in the account. Tax rules permit clients to give $11,000 (indexed to inflation) to as many individuals as you choose each year, free from federal gift taxes. Couples can give $22,000 without incurring taxes. As a result, one method of reducing a taxable estate is for the donor to make scheduled gifts up to the tax-free limits each year. For example, giving $11,000 to each grandchild on an annual basis.

That’s where 529 plans come in, the first $11,000 contributed each year per beneficiary won’t come back to bite the donor, as long as the donor hasn’t made any additional taxable gifts to the beneficiary in that year. The donor can also accelerate the gifting schedule by electing to make a lump-sum contribution of $55,000 to a 529 plan in the first year of a five-year period ($22,000 for a couple). Of course, the donor would not be able to make additional taxable gifts to that beneficiary during the five year period. And, if the donor uses the five-year averaging election and dies before the five years are up, a prorated portion of the contribution may be considered party of the donor’s taxable estate.

But the wealth transfer potential can be substantial. An individual who has five grandchildren could immediately remove up to $275,000 from his or her taxable estate by contributing the money to five separate 529 plan accounts. Five years later, he or she could do it again.

MAKING THE RIGHT DECISION

If your client is considering a 529 plan, other important facts must also be considered. There are often important differences between the plans offered by each state. For example, lifetime contribution limits can vary

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widely from state to state. The limits are often based on average college costs within the sponsoring state. In calculating those averages, some states assume that not just undergraduate expenses are incurred, but graduate expenses as well.

Also, some plans offer relatively few investment options, while others may give you a wide range of investment choices managed by specially selected sub-advisors. Help your client evaluate the performance of the investment options offered by specific plans. Compare the fees and expenses each plan charges too. Keep in mind that some states offer in-state residents a tax deduction when they make a 529 plan contribution.

THE DONOR IS IN CONTROL

It’s worth emphasizing to your clients, although the assets contributed to a 529 plan are no longer considered part of the donor’s taxable estate, the donor still exercises control over the money. The donor decides how it will be invested, within the confines of the plan’s available investment options. And when it will be withdrawn. The donor also has the right to change beneficiaries, in the event that the original beneficiary decides not to attend college, and doing so generally won’t trigger tax consequences if the donor chooses a beneficiary who is a member of the original beneficiary’s family. As spelled out in Section 529, qualified family members include the beneficiary’s brothers or sisters, mother or father, sons-or daughters, and nieces or nephews, among others. If there isn’t another suitable beneficiary, the donor also has the option of closing the account taking the money back, although earnings will be subject to income taxes, as well as a 10% penalty. When choosing a 529 plan, your client needs to look beyond estate planning considerations. There are dozens of plans available and their features and rules can vary greatly. Even after helping your client choose a plan, suggest that he or she also consult with an estate planning attorney or tax professional before making a decision.

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State-sponsored Section 529 college savings plans have the potential to double as high-powered estate planning tools. Any assets contributed to a 529 plan account are removed from the donor’ taxable estate and pass into the plan free of federal gift taxes, up to a annual limit of $11,000 ($22,000 per couple).

The IRS will allow you to make five years’ worth of tax-free gifts in one year, but only once every five years. That means the donor can contribute up to $55,000 at once, $110,000 per couple, helping to finance a beneficiary’s education while simultaneously minimizing potential estate tax obligations.

Although the assets gifted to a 529 plan are removed from your estate, you retain control over investment. Withdrawal and beneficiary decisions.

529 plan contributions and investment earnings can currently be withdrawn tax free as long as the money is used for qualified education expenses. If the donor makes withdrawals for non-education purposes, the donor must pay ordinary income taxes and a 10% penalty.

Help your client choose wisely before selecting a 529 plan. For example, compare fees, investment options and lifetime contribution limits.

The internet carries an abundance of information regarding 529 plans. Information can be found on most mutual fund websites, all 50 of the state’s websites and many federal websites. To find additional resources, go on any search engine and use the search words: “529 college plans”.

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