security that makes no periodic interest payments but instead is sold at a deep discount from its face value. The buyer of such a bond receives the rate of return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date. For tax purposes, the Internal Revenue Service maintains that the holder of a zero-coupon bond owes income tax on the interest that has accrued each year, even though the bondholder does not actually receive the cash until maturity. The IRS calls this interest imputed interest. Because of this interpretation, many financial advisers recommend that zero-coupon securities be used in Individual Retirement Account or keogh accounts, where they remain tax-sheltered.

There are many kinds of zero-coupon securities. The most commonly known is the zero-coupon bond, which either may be issued at a deep discount by a corporation or government entity or may be created by a brokerage firm when it strips the coupons off a bond and sells the corpus and the coupons separately. This technique is used frequently with Treasury bonds, and the zero-coupon issue is marketed under such names as CATS (Certificate of Accrual on Treasury Securities), tiger(Treasury Investors Growth Receipt) or strip (separate trading of registered interest and principal of securities). Zerocoupon bonds are also issued by municipalities. Buying a municipal zero frees its purchaser of the worry about paying taxes on imputed interest, since the interest is tax-exempt. Zero-coupon certificates of deposit and zero mortgages also exist; they work on the same principle as zero-coupon bonds-the CD holder or mortgage holder receives face value at maturity, and no payments until then. Zero-coupon securities based on Collateralized Mortgage Obligation bonds are called Z-tranche bonds. Some mutual funds buy exclusively zerocoupon securities, offering shareholders a diversified portfolio that will mature in a particular year.

Zero-coupon securities are frequently used to plan for a specific investment goal. For example, parents knowing their child will enter college in 10 years can buy a zero that will mature in 10 years, and thus be assured of having money available for tuition. People planning for retirement in 20 years can buy 20-year zeros, assuring them that they will get the money when they need it.

Because zero-coupon securities bear no interest, they are the most volatile of all fixed-income securities. Since zero-coupon bondholders do not receive interest payments, zeros fall more dramatically than bonds paying out interest on a current basis when interest rates rise. However, when interest rates fall, zero-coupon securities rise more rapidly in value than full-coupon bonds, because the bonds have locked in a particular rate of reinvestment that becomes more attractive the further rates fall. The greater the number of years that a zero-coupon security has until maturity, the less an investor has to pay for it, and the more leverage is at work for him. For instance, a bond maturing in 5 years may double, but one maturing in 25 years may increase in value 10 times, depending on the interest rate of the bond.

weighted cost of the additional capital raised in a given period. Weighted cost of capital, also called composite cost of capital, is the weighted average of costs applicable to the issues of debt and classes of equity that compose the firm's capital structure. Also called marginal cost of capital.

bond with a credit rating of BB or lower by rating agencies. Although commonly used, the term has a pejorative connotation, and issuers and holders prefer the securities be called high-yield bonds. Junk bonds are issued by companies without long track records of sales and earnings, or by those with questionable credit strength. In the 1980s, they were a popular means of financing takeovers. Since they are more volatile and pay higher yields than investment grade bonds, many risk-oriented investors specialize in trading them. Institutions with fiduciary responsibilities are regulated (see prudent-man rule).

category of municipal bond distinguished from public purpose bond in the tax reform act of 1986 because 10% or more of the bond's benefit goes to private activities or 5% of the proceeds (or $5 million if less) are used for loans to parties other than governmental units. Private purpose obligations, which are also called private activity bonds or nonessential function bonds, are taxable unless their use is specifically exempted. Even tax-exempt permitted private activity bonds, if issued after August 7, 1986, are tax preference items, except those issued for 501(c)(3) organizations (hospitals, colleges, universities). Private purpose bonds specifically prohibited from tax-exemption effective August 15, 1986, include those for sports, trade, and convention facilities and large-issue (over $1 million) Industrial Development Bonds. Permitted issues, except those for 501(c)(3) organizations, airports, docks, wharves, and government-owned solid-waste disposal facilities, are subject to volume caps.

bond collateralized by a pledge of mortgages and payable from the issuer's general funds. Because the market value of the collateral must exceed the outstanding bond principal, additional collateral may be required if the market value of the underlying mortgages declines. Unlike mortgage pass-through securities, which convey an ownership interest in a pool of mortgages, ownership of a mortgage-backed bond, and usually servicing rights, are retained by the issuer, although mortgage servicing can be sold, at a price, to a third party. Also, for tax purposes, mortgage-backed bonds are treated as issuer debt rather than as a sale of assets. Mortgagebacked bonds also have a more predictable maturity than pass-through securities, thus giving the bondholder a kind of call protection against early redemption.

dollar denominated bond issued in the United States by foreign banks and corporations. These bonds, the U.S. equivalent of the eurobond, pay semiannual interest, unlike Eurobonds, which pay annual interest, and are registered with the Securities and Exchange Commission. They ordinarily are issued when the domestic market is more favorable to investors than the Euromarket, and offer the foreign investor some degree of protection against fluctuating exchange rates.

long-term, deferred interest Collateralized Mortgage Obligation bond, also called a Z-Bond, that pays no interest until all prior bonds have been retired. An accrual bond is similar to a zero-coupon cdzero-coupon cd bond, except that it has an explicit coupon rate and pays both principal and coupon interests.

U.S. government bond issued in face value denominations ranging from $50 to $10,000. From 1941 to 1979, the government issued Series E Bonds. Starting in 1980, Series EE and HH bonds were issued. Series EE bonds, issued at a discount of half their face value, range from $50 to $10,000; interest bearing Series HH bonds range from $500 to $10,000. Series EE bonds earn interest for 30 years; Series HH bonds earn interest for 20 years. Series EE bonds, if held for five years, pay 90% of the average yield on 5-year Treasury securities based on the previous six months. Series HH bonds are no longer issued. For many years, the government guaranteed a minimum yield on savings bonds. This yield decreased from 7.5% to 6% and then to 4%. The guaranteed minimum feature was dropped in May 1995, and bonds issued on May 1, 1997 or later and held for less than five years are now subject to a 3-month interest penalty. For example, a bond cashed in after 18 months would receive 15 months' worth of interest. Savings bond yields are readjusted every six months, on May 1 and November 1.

Series I bonds provide a return that rises and falls with inflation. I bonds are issued in face amounts from $50 to $10,000. The interest on an I bond is determined by two rates. One, set by the Treasury Department, remains constant for the life of the bond. The second is a variable inflation rate announced each May and November by the Treasury Department to reflect changes in the Consumer Price Index reported by the Department of Labor. I bonds earn interest for 30 years and interest is added monthly and paid when the bond is redeemed.

The interest from savings bonds is exempt from state and local taxes, and no federal tax on EE bonds is due until redemption. Taxpayers meeting income qualifications can buy EE bonds to save for higher education expenses and enjoy total or partial federal tax exemption. This applies to individuals with modified Adjusted Gross Incomes between $61,200 and $76,200 and married couples filing jointly with incomes between $91,850 and $121,850. Income levels are adjusted for inflation annually.

method of evaluating the possibility of default by a bond issuer. Fitch Ratings, Standard & Poor's, and Moody's Investors Service analyze the financial strength of each bond's issuer, whether a corporation or a government body. Their ratings range from AAA (highly unlikely to default) to D (in default). Bonds rated BB or below are not investment grade-in other words, institutions that invest other people's money may not under most state laws buy them.

inflation-indexed savings bond issued by the United States Treasury in eight denominations ranging from $50 to $10,000 with a 30- year maturity. Unlike other inflation-adjusted bonds, but like other savings bonds, the securities, which were introduced in 1998, offer special tax benefits. As long as investors hold their bonds, they may defer paying taxes on their earnings, which are automatically reinvested and added to the principal. Like other Treasury bonds, I-Bonds are exempt from state and local income taxes. If the bond is redeemed to pay for college tuition or other college fees, investors may exclude part or all of the income in calculating their taxes. The payout on the bonds is determined by two rates. Afixed rate, ranging from 3% to 3.5% when the bonds were first introduced, is set by the Treasury Department. The second rate, a rate of inflation, is determined every six months by the Bureau of Labor Statistics to reflect changes in a version of the Consumer Price Index. Some protection against deflation exists in that any decline in the Consumer Price Index could eat into the fixed rate, but not affect the underlying principal.

bonds or notes that guarantee a return that beats inflation if held to maturity. Also applied to shares in mutual funds that hold such securities. Inflation-indexed Treasury securities were introduced in 1997 in 10-year maturities and were subsequently issued as 5-year notes. Similar offerings followed by issuers such as the Tennessee Valley Authority and the Federal Home Loan Bank. In April, 1998, the first 30-year inflation-indexed Treasury bonds were issued. Inflation-indexed Treasuries offer a fixed rate of return, as well as a fluctuating rate of return that matches inflation. The fixed portion is paid out as interest, while the indexed portion is represented by an annual adjustment of principal. For example, a $1,000 inflation-indexed Treasury is issued at auction with a 3.5% interest rate and inflation that year turns out to be 3%. The 3.5% interest on $1,000 would be paid out and, at the end of the year, the inflation rate would adjust the principal, bringing it to $1,030. The following year, the fixed 3.5% interest rate would be applied to the new principal of $1,030 and the principal would again be adjusted according to that year's inflation rate. With low inflation prevailing in the late 90s, anti-inflation securities met a lackluster reception, although longer-term bonds were in somewhat greater demand. Chief drawbacks are the prospect of deflation, a lack of liquidity, and the fact that the inflation adjustment is taxable annually but not paid out until maturity.

agreement by an insurance company to take the place of a defaulted contractor in a development project, and take corrective action, if necessary, to finish the project. The insurance company also may be compelled to pay for damages resulting from default. Surety bonds commonly are required on municipal development projects financed by general obligation bonds or revenue bonds. A surety bond also is required to put a stoppayment order on an official bank check, such as a cashier's check, Also called an indemnity bond.

restatement of a discount yield as its interest-bearing equivalent.

bond denominated in U.S. dollars or other currencies and sold to investors outside the country whose currency is used. The bonds are usually issued by large underwriting groups composed of banks and issuing houses from many countries. An example of a Eurobond transaction might be a dollar-denominated debenture issued by a Belgian corporation through an underwriting group comprised of the overseas affiliate of a New York investment banking house, a bank in Holland, and a consortium of British merchant banks; a portion of the issue is sold to French investors through Swiss investment accounts. The Eurobond market is an important source of capital for multinational companies and foreign governments, including Third World governments.

1. long-term debt instrument issued by the U.S. Treasury department with maturities of 10 years or longer issued in minimum denominations of $1000.
2. bond issued by a corporation and then repurchased. Such a bond is considered as retired when repurchased.

in general terms, any bond issue denominated in Japanese yen. International bankers using the term are usually referring to yen-denominated bonds issued or held outside Japan.

municipal bond issued by a state or local government, or by a development agency, to finance the private industrial projects generating tax revenues and certain public works projects. These bonds are of two types: development bonds financing the renovation or improvement of public facilities, and industrialrevenue bonds, for which a private corporation is responsible for payments to bondholders. Industrial bonds are subject to special IRS rules governing the tax exemption of interest. The tax exemption on many of these bonds, other than bonds financing airports, water treatment plants, and certain other public works related projects, was eliminated by the Tax Reform Act of 1986. Bond ratings on revenue bonds are based on the credit rating of the private corporation backing the lease or rental agreement covering the facilities, because the ultimate source of repayment is the corporation, rather than the bond issuer.

bonds issued by municipal governments, local taxing districts, and state government agencies. These bonds, sometimes referred to collectively as municipal bonds, generally are tax-exempt from federal income taxes on interest earned in the state of origin, although certain classes of bonds issued after August 1986 are subject to federal taxes on interest income. The Tax Reform Act of 1986 placed annual limits on the amount of fully tax-exempt bonds issued by a state or local agency.

Classifications of these bonds include general obligation bonds, revenue bonds, industrial revenue bonds, mortgage revenue bonds.

category of municipal bond as defined in the tax reform act of 1986, which is exempt from federal income taxes as long as it provides no more than 10% benefit to private parties and no more than 5% of the proceeds or $5 million are used for loans to private parties; also called public activity, traditional government purpose, and essential purpose bond. Public purpose bonds include purposes such as roads, libraries, and government buildings.

security represented by an account entry on the records of a private depository or, in the case of U.S. government securities, a Federal Reserve Bank, instead of a paper certificate. Nearly all Treasury securities are issued in book entry form, as are one-third of municipal bonds. Bank entry securities are less vulnerable to theft, can't be counterfeited, and don't require accounting or recording by certificate number. Also, owners don't have to worry about clipping coupons to collect bond interest payments.

covers the employer for all of the employees on a blanket basis, with the maximum limit of coverage applied to any one loss without regard for the number of employees involved. Both commercial and position blanket bonds work the same way if only one employee causes the loss, or if the guilty employee(s) cannot be identified.

a guarantee of the performance of a contractor. In general, contract bonds are used to guarantee that the contractor will perform according to the specifications of the construction contract. If the contractor fails to perform according to contract, the insurance company is responsible to the insured for payment, up to the limit of the bond, which is usually for an amount equal to the cost of the construction project. The insurance company then has recourse against the contractor for reimbursement.

bond that reimburses a business for loss caused by the dishonest act of an employee. Since crime insurance policies exclude coverage of dishonest acts of employees, it is necessary to have a fidelity bond for this protection. Fidelity bonds cover mercantile business and financial institutions.

covers all employees of a business on a blanket basis with the maximum limit of coverage applied separately to each employee guilty of a crime

type of surety bond that is either a fiduciary or a court bond.

1. Fiduciary Bond-guarantees that individuals in a position of trust will safeguard assets belonging to others placed under their control. For example, guardians appointed by a court who are authorized to pay expenses of the minor and administrators of estates who take care of a deceased's assets may require fiduciary bond.
2. Court Bond-guarantees concerning ligation such as: (a) appeal bond, which guarantees that a judgment will be paid if an appeal is lost in a higher court; (b) Plaintiff's Replevin Bond, which guarantees that damages will be paid if the replevin action is wrongfully brought; (c) Removal Bond, which guarantees that damages will be paid if improper removal actions are taken.

insurance coverage against specified losses that occur from the dishonest acts or defalcations of employees. This bond may be applied to persons or positions.

fidelity bond under which an insured employer is reimbursed for loss caused by the dishonest act of two or more employees named or listed in a schedule attached to the bond. The specific amount of coverage is listed beside the name of each employee on the schedule. Coverage is the same as that found under the individual fidelity bond.

formal unconditional promise in writing to pay on demand or at a future date a definite sum of money. The person who signs the note and promises to pay is called the maker of the note. The person to whom payment is to be made is called the payee of the note.

legal instrument used to guarantee the completion of a real-estate development according to specifications. More encompassing than a performance bond, which ensures that one party will perform under a contract on condition that the other party performs. The completion bond assures production of the development without reference to any contract and without the requirement of payment to the contractor.

surety bond given by one party to another, protecting the second party against loss in the event the terms of a contract are not fulfilled. The surety company is primarily liable with the principal (the contractor) for nonperformance. For example, a homeowner having a new kitchen put in may request a performance bond from the home improvement contractor so that the homeowner would receive cash compensation if the kitchen was not done satisfactorily within the agreed upon time.