268 Chapter 6 Investments
When a bond is sold, the buyer usually compensates the seller for the interest that was
earned but not paid while the seller owed the bond. In addition, the buyer may pay a
small brokerage commission for handling the transaction, though this commission is often
included in the quoted prices for the bond. We will not discuss this in the text, though it is
reflected in one of the Additional Exercises at the end of this section.Special Types of Bonds
The preceding discussion has presented the basics of bonds in general terms. In a market
as large as the bond market, though, it should not be terribly surprising that there exist
many, many special types of bonds with unique features. It would be impossible to cover
these all here, or even to cover many of them in any depth, but before closing this section
we will mention some common examples.
Savings bonds are one type of bond that may be familiar to many readers. We discussed
these bonds briefly in Chapter 2. Savings bonds are issued by the United States federal gov-
ernment and can be purchased through many banks and other financial institutions. There are
several different types (called series) of savings bonds. The most familiar types of savings
bonds are sold for half of their face value, and are issued with a guaranteed minimum interest
rate. When they are issued, they have a maturity date based on the time it would take to grow
to maturity value at this guaranteed minimum rate. The interest rate that is actually paid on
these bonds, though, is based on an index of market rates for certain government bonds, and
in fact the actual interest rate paid is normally higher (and hence the time to reach maturity is
usually lower) than what is specified when they are purchased. Savings bonds can also be held
beyond their maturity, and continue to earn interest. Interest on savings bonds is not normally
paid prior to maturity, but instead compounds over time. (There are types of savings bonds
that do make semiannual interest payments; while these types of bonds still exist, they are not
available for purchase as of this writing.) Savings bonds cannot be bought and sold. They can,
however, be cashed in for their accumulated value at any time, subject to some limitations.
Inflation-protected securities are bonds, almost always issued by the federal govern-
ment, whose coupon rates (and/or redemption value) vary depending on the inflation rate.
If the rate of inflation increases, so does the bond interest rate. Likewise, if the inflation
rate declines then so do the bond rates. Treasury inflation-protected securities (TIPS) are
a bond of this type sold on the open bond market. Series I savings bonds are a form of
savings bond whose rates vary with the rate of inflation.
Zero coupon bonds are long-term bonds which do not make any interest payments prior
to maturity. These bonds carry the significant disadvantage that IRS regulations require
the bondholder to pay taxes on the interest these bonds earn prior to maturity, even though
the interest is not paid until maturity. For this reason, these bonds are generally unpopular
with individual investors, though they are used in tax-advantaged retirement accounts and
in other accounts where taxes do not have to be paid on an ongoing basis.
Municipal bonds (“munis”) are bonds issued by state and local governments. In many
cases, the interest paid on these bonds is exempt from federal income taxes. Since the income is
tax-free, these bonds often carry much lower interest rates than similar bonds of other issuers.
When evaluating the rate of return earned on bonds such as savings and zero coupon
bonds, where the interest accumulates and/or the rate varies over time, we can use the same
formula we used in Section 6.1 to find rates or return on stocks.Example 6.2.8 Laurie bought a $50 face value savings bond for $25. Sixteen years
later, she cashed the bond in for $79.36. What effective rate of compound interest did
she earn on this bond?i (^) PVFV (^)
1/n
1
i
$79.36____
$25.00
1/16
1
i 0.0748648 7.49%