Agency Bonds

Agency bonds or agency issues are debt securities issued by either Government Sponsored Enterprises (GSEs) or Federal Government agencies which may issue or guarantee these bonds.

GSEs are usually federally-chartered but privately-owned corporations such as FNMA (Federal National Mortgage Association) and FHLMC (Federal Home Loan Mortgage Corporation).

Government agencies include the Small Business Administration, GNMA (Government National Mortgage Association), and the FHA (Federal Housing Authority). A key difference here is that securities issued by GSEs are not direct obligations of the US Government, while those issued or guaranteed by GNMA (Ginnie Mae), the SBA, and the FHA are guaranteed against default just like T-Bills, T-Notes, and T-Bonds.

Agency securities tend to promote a public purpose. For example, FNMA and FHLMC purchase mortgages from lenders, which encourages lenders to make more loans and increase home ownership. Similarly, the Federal Farm Credit Banks provide assistance to the agricultural sector, while the Small Business Administration pro¬vides assistance to small businesses.

Fannie Mae (FNMA) and Freddie Mac (FHLMC) are public companies with common stock, unlike GNMA. While the US Government has provided financial assistance to these entities, it has not guaranteed their debt securities or preferred stock issues, let alone their common stock. So, while investing in Ginnie Mae involves no credit or default risk, this is not the case with Fannie and Freddie.

A minimum investment of $25,000 is required for GNMA mortgage-backed securities. Investors receive monthly interest and principal payments from a pool of mortgages.

When will the mortgages in the pool be paid off ?
 That is an uncertainty. If interest rates drop, the mortgages will be repaid sooner than expected, which we call prepayment risk. If interest rates go the other way, it will take longer than expected for the homeowners to pay off the mortgages, which we call extension risk. GNMA, FNMA, and FHLMC mortgage-backed securities all carry this risk, which we mentioned earlier.

GNMA is backed by the full faith and credit of the US Government. Still, the yields are typically higher than what one would receive on a Treasury security of a similar term due to prepayment and extension risk.

Interest rates on mortgage securities from FNMA and FHLMC are also higher than on Treasury and higher than corporate bonds to reflect the compensation for the uncertainty of their maturity as well as their higher credit risk. While FNMA and FHLMC buy mortgages and issue mortgage-backed securities, GNMA adds her guaranty to mortgage-backed securities that have already been issued. FNMA and FHLMC do guarantee payment to investors, but, again, neither is the federal government, and both charge fees to provide the guarantee.

Sinking Fund

Bonds pay interest-only until the end of the term. Since the issuing corporation must return the principal value of the bond at some point, they usually establish what's known as a sinking fund. With this sinking fund established, the company would be able to return the principal or complete a "call." Having this money set aside can only help the rating by S&P and Moody's, too.

Some bonds especially municipal bonds are es-crowed to maturity, which means the funds needed to retire the bond issue are already parked in a safe, interest-bearing account holding Treasury securities.

Having the debt service covered by a verifiable escrow account tends to make such bond ratings AAA and easy to sell on the secondary market. His rate of default on high-yield corporate bonds has ranged in recent years from about 1% to 13%. On the other hand, the rate of default on U.S. Treasury securities has remained at zero, going all the way back to when Alexander Hamilton first issued them in the late 1700s during the first Washington Administration.

If you buy a bill, note, or bond issued by the United States Treasury, you eliminate default risk. You're going to get your interest and principal for sure. You just aren't going to get rich in the process. In fact, you usually need to be rich already to get excited about U.S. Government debt.

These fixed-income securities are for capital preservation. Working people need to save up for retirement through common stock or equity mutual funds. The less daring will save up by investing through corporate bonds or bond mutual funds. But if one already has millions of dollars, the goal might become preserving that capital as opposed to risking it trying to get bigger returns. If you sell your company for $10 million, for example, you might put $2 million into T-Bonds. If they yield 5%, that's $100,000 in interest income going forward, after all, with no risk to the principal.

U.S. Treasury securities are virtually free of default risk. They carry most of the other risks corporate bondholders face, but default risk is eliminated. Therefore, if an investor compares the yield on, say, a 10-year Treasury note to the yield on a 10-year corporate bond, the higher yield offered on the corporate bond indicates the market's perceived default risk. If the Treasury note yields 3.0% while the 10-year corporate bond yields 4.5%, the risk premium demanded by investors is that difference of 1.50/o. To take on default risk, investors require 1.5 percentage points more in return.

Corporate Bonds

In a notice to investors, the SEC explains that, "Companies use the proceeds from bond sales for a wide variety of purposes, including buying new equipment, investing in research and development, buying back their own stock, paying shareholder dividends, refinancing debt, and financing mergers and acquisitions."

A default on a municipal bond is a rare thing, but corporations can end up unable to pay the interest on their bonds or return the principal at maturity and thereby go into default. 

To protect bondholders from this, Congress passed the Trust Indenture Act of 1939. Under this act if a corporation wants to sell $5,000,000 or more worth of bonds that mature in longer than one year, they must do it under a contract or indenture with a trustee, who will enforce the terms of the indenture to the benefit of the bondholders. In other words, if the issuer defaults, the trustee can move to forcibly sell off the assets of the company, so bondholders can recover some of their money. The trustee is typically a large bank.

A corporate bond pays a fixed rate of interest to the investor, and that bond interest must be paid, unlike a dividend on stock that is paid only if the board of directors declares it from profits. We'll see that a bondholder doesn't suffer as much price volatility as a stock investor. But, unlike the owner of common stock, bondholders don't vote on corporate matters. The only time bondholders get to vote is if the corporation goes into bankruptcy. Creditors are offered various scenarios by the corporation, and the bondholders vote on the terms. In other words, the only time bondholders get to vote is when they wish they didn't.

Since bankruptcy is a concern, corporations often secure bonds by pledging assets like airplanes, government securities, or real estate. These bonds secured by collateral are called secured bonds.

The issuer of a secured bond pledges title of the assets to the trustee, who might end up selling them if the issuer gets behind on its interest payments. Investors who buy bonds attached to specific collateral are secured creditors, the most likely creditors to get paid should the company become insolvent.

Unsecured bonds are like personal loans from the local bank. Secured bonds are like the mortgage loans homeowners take out from the local bank.

In fact, if the collateral used is real estate, we call the secured corporate bond a mortgage bond. Just as a mortgage lender sometimes must foreclose/seize the home, the owners of mortgage bonds could seize the real estate backing the loan should the issuer get behind on their payments.

If the collateral is securities, we call it a collateral trust certificate. And if the collateral is equipment, such as airplanes or railroad cars, we call it an equipment trust certificate. Since secured bonds are usually the safest bonds issued by the company, they offer the lowest coupon payment, too.

Most corporate bonds are backed by a promise known as the "full faith and credit" of the issuer.

That's why we might want to see what S&P and Moody's say about an issuer's full faith and credit. If the credit is AAA, we won't be offered a large coupon payment. But if the issuer is rated right at the cut-off point of BBB (Baa for Moody's), then we demand a higher interest rate in exchange for buying bonds from an issuer just one notch above junk status. Regardless of the rating, if we buy a bond backed by the full faith and credit of an issuer, we are buying a debenture.

Debenture holders are general creditors with claims below those of the secured bondholders. In a bankruptcy, debenture holders must compete with other unsecured creditors of the company, e.g., suppliers with unpaid invoices. Therefore, debentures pay a higher yield than secured bonds, since they carry more risk.

Some bonds are guaranteed bonds, which means a party other than the issuer has promised to pay interest, principal, or both if the issuer of the bonds cannot. Often a parent company will guarantee the bonds issued by one of its smaller subsidiaries to improve the credit rating. A "guaranteed bond" does not imply the investor is guaranteed against loss. Outside of bank products backed by the FDIC, investors should never expect to be guaranteed against all investment risk. Being guaranteed against default is as good as it gets.

Subordinated debentures have a claim below debentures. Since these bonds have more credit/default risk, they pay a higher yield than debentures and secured bonds.

Beneath all creditors, stockholders make their claims on the company's assets. Preferred stockholders get preference, and common stock is always last in line. Common stock represents the lowest claim on a company's assets, which is why it is called the most "junior" security issued by a company.

Fixed-Income Securities "Types and Characteristics"

Insurance-based products provide financial protection. Investments in money market securities provide a rainy-day fund that earns interest and can be tapped in an emergency without having to sell at a loss. To earn higher rates of return, investors purchase longer-term debt securities.

Businesses borrow money short-term by issuing money market securities. To borrow from investors long-term, companies issue fixed-income securities that are usually called bonds. Businesses sell stock to some investors and bonds to others, forming their capital structure.

Equity investors are owners; bond investors are loaners. Loaners are creditors who must be paid their interest and principal on time but don't get a vote in corporate management decisions. Owners don't have to be paid anything, but their potential reward is much bigger than those who buy the company's bonds.

For the issuing company, there are advantages and disadvantages to both types of financing. Equity financing gives the business breathing room since there are no interest payments to meet. But, equity investors take a share of profits, have a voice in corporate matters, and never go away. Debt financing adds the burden of interest payments that could force the company into bankruptcy. However, if the company meets the interest and principal payments, the bondholders are paid off, never making a claim on the company's profits.

Corporate bonds are debt securities representing loans from investors to a corporation. Investors buy the bonds on the primary market, and the corporation pays them interest on the loan until the principal amount is returned with the last interest payment at the end of the term.

The bonds are liquid, meaning the lenders can sell the bonds on the secondary market if they need to convert to cash. But, when they sell the bonds, investors could receive less (or more) than they paid for them.

That is what separates long-term bonds from bank deposits. Even if both T-bonds and bank CDs are guaranteed by the US Government, the T-bond is a security whose market value is subject to fluctuation.

That is also why the yields are typically much higher, as we saw when looking at the yield curve.
A corporation issuing bonds is using leverage.

A company with a leveraged capital structure has financed operations by issuing debt securities or taking out long-term bank loans.

A bond has a specific value known as the par value or principal amount. Since it's printed on the face of the certificate, it is also called the face amount of the bond. Bonds usually have a par value of $1,000 and, occasionally, $5,000. This is the amount an investor will receive with the last interest payment from the issuer. Up to that point, the investor has only been receiving interest payments against the money he loaned to the corporation by purchasing their bond certificates.

The bond certificate has "$1,000" or whatever the par value is printed on the face, along with the interest rate the issuer will pay every year. This interest rate could be referred to as the coupon rate or nominal yield. Whatever it's called, the income that a bondholder receives is a fixed, stated amount. If they buy a 5% bond, investors receive 5% of the par value ($1,000) every year, which is $50 per year per bond. In other words, if he owns $1,000,000 par value of a bond with a 5% nominal yield, the bondholder's interest income is $50,000 a year. Typically, that would be received as two semiannual payments of $25,000.

Types of Maturities
If an issuer issues bonds that all mature on the same date in the future, we call this a term maturity. On the other hand, if the bonds are issued all at once but then mature gradually over time, we call this a serial maturity. Municipal bonds are often issued as serial maturities. In this case, the municipality floats, say, a $50,000,000 issue in which a portion of the bonds will mature each year over, say, 20 years. The longer out the maturity, the higher the yield offered to those investors, and the lower the yield offered on the bonds coming due in just a year or two.

In a balloon maturity, some of the bonds issued come due in the near-term, while most of the principal is paid off all at once, usually at the final maturity date.

Types of Fixed-Income
  • Corporate Bonds 
  • Sinking Fund 
  • Agency Bonds 
  • Municipal Securities  
  • General Obligation Bonds   
  • Revenue Bonds   
  • Callable Bonds   
  • Discount Bonds  
  • Premium Bonds 
Credit Ratings
So, bond prices rise and fall based on interest rate movements. And, their market prices also depend on their perceived credit risk. Nothing worse than lending a corporation money and then finding out they are not going to pay you back. This is known as a "default," and it's the worst thing that can happen to a bond investment.

How likely is it that a bond will go into default? Isn't going to happen on a United States Treasury security. It might happen on some municipal securities. But when you get into the category of corporate bonds, you see it happens more than you'd like.

Luckily, Moody's, S&P, and Fitch all assign bond ratings designed to help investors gauge the likelihood of default. The highest quality issuers have AAA/Aaa (S&P/ Moody's) ratings. The investment grade issues go from AAA/Aaa down to BBB/ Baa. And below that, we're looking at high-yield or junk bonds.

There is also a "D" rating indicating the bond is already in default. Only the savviest and most aggressive bond traders would trade a bond rated that low.

Credit quality is the highest on the AAA/Aaa-rated bonds. As credit quality drops, you take on more default risk, so you expect to be compensated for the added risk through a higher yield. High yield and low quality go hand in hand, just as low yield and high quality do. How does a bond become "high yield" or 'junk"? That means a new issue of low-rated bonds offers high coupon rates to get an investor interested in lending the money, and existing bonds trade at lower and lower prices as people get nervous about a possible default. As the price drops, the yield increases.

When S&P, Moody's, or Fitch downgrade an issuer's credit rating, the market price of those bonds drops, increasing their yield. We saw that with the bonds that financed the ballpark used by the New York Mets.

Certificates of Deposit (CD)

To earn a higher interest rate than what their bank offers on savings or checking accounts, many bank customers put relatively large amounts into certificates of deposit or CDs. These are long-term deposits that pay higher rates of interest if the depositor agrees to leave the funds untouched during a certain time frame.

CDs are typically offered in terms of three or six months, and for as long as one, two, three or five years. Those are typical terms, but savers can find certificates of deposit with terms as short as seven days or as long as 10 years. Obviously, the bank would have to entice someone with a higher rate to get him to agree to leave a large deposit untouched for 10 years. And, a saver, on the other hand, could not expect a high rate of return when locking up funds for a mere seven days. Investors agree not to withdraw funds until the CD matures, which is why CDs usually offer higher yields than a regular savings account. As with any fixed-income investment, rates typically increase with the length of deposit terms.

Deposits in bank CDs are backed by the Federal Deposit Insurance Corporation for up to $250,000 per depositor and ownership category, per insured bank. Bank CDs are insured by the FDIC just like other bank deposits, so this is about as safe as "safe money" gets. As you might imagine, the yields on these government-insured deposits are also modest. Then again, for the liquid part of one's portfolio, bank CDs are often appropriate.

The drawbacks include the fact they are long-term deposits, not as liquid as a savings account or a money market mutual fund. If the individual wants her money out now to cover a roof replacement, she will be penalized and probably lose all or most of the interest she was going to make. Bank CDs are not bonds to be traded on the secondary market. CDs don't do much to protect purchasing power, either, but they are great at maintaining an investor's needs for liquidity and capital preservation. The rates offered on certificates of deposit can change every week.

A $250,000 investment is equally safe in a T-Bill or a bank CD. Above that amount, the T-Bill is safer. And, either way, T-Bills are securities that can be bought and sold any day the securities markets are open, while CDs, on the other hand, are commit¬ments to keep money on deposit for a specified length of time.

Negotiable/Jumbo CDS
Some investors step outside the realm of FDIC insurance and purchase jumbo or negotiable CDs. The denominations here are often several millions of dollars. Therefore, jumbo CDs are usually not insured by the FDIC but are, rather, backed by the issuing bank. That makes their yields higher.

Pulling out of a bank CD usually leads to a forfeiture of interest. On the other hand, with CDs investors have a negotiable security they can sell to someone else. That makes the security liquid, but not immune to investment loss.

Municipal Notes ... it is Tax-Exempt / Tax Free

We'll look at municipal securities in a moment, but for now just know that cities, counties, and school districts can borrow money long-term by issuing bonds, and they can borrow short-term by issuing anticipation notes. For example, property taxes are collected twice a year.

 If the city wants some of that money now, they can issue a tax anticipation note, or TAN. If it's backed by revenues from sewer and water services, for example it's a revenue anticipation note, or RAN.

If the note is backed by both taxes and revenues, they call it a tax and revenue anticipation note, or TRAN.

Through a bond anticipation note or BAN the issuer borrows money now and backs it with part of the money they're going to borrow when they issue more bonds.

The interest paid on these municipal notes is lower than the nominal rates paid on a corporation's commercial paper, but that's okay the interest paid is also tax-exempt at the federal level. So, if an investor or an institution is looking for safety, liquidity, and dependable, tax-exempt interest over the short-term, they purchase these anticipation notes directly or through a tax-exempt money market mutual fund.

Commercial Paper

Commercial paper is typically used by companies as a source of working capital, receivables financing, and other short-term financing needs. To build major items such as an $800 million factory, a company generally issues long-term bonds (funded debt), and pays the lenders back slowly.

But if Microsoft needs a mere $50 million for a few months, they would probably prefer to borrow it short-term at the lowest possible interest rate.

If so, they issue commercial paper with a $50 million face amount, selling it to a money market mutual fund for, say, $49.8 million. Again, the difference between the discounted price and the face amount represents the interest earned by the investor.

Commercial paper is generally issued only by corporations with high credit ratings from S&P, Moody's, or Fitch.

Commercial paper could be described as an unsecured promissory note, as opposed to the BA we just examined, which provides collateral to the lender. Some large corporations issue their commercial paper directly to investors, which may be mutual funds, pension funds, etc.

The industry calls this "directly placed commercial paper." When corporations use commercial paper dealers to sell to the investor, the industry refers to this as "dealer-placed commercial paper."

Bankers' Acceptances ... is it an investment instrument?

A bankers' acceptance is a short-term credit investment created by a non-financial company and guaranteed by a bank as to payment. "BAs" are traded at discounts to face value in the secondary market.

These instruments are commonly used in international transactions, and might associate them with importing and exporting.

As with a T-Bill, bankers' acceptances are so short-term it would make no sense to send interest checks to the buyer. Instead, these short-term debt securities are purchased at a discount from their face value. The difference between what we pay and what we receive is the interest income.

The BA or bankers' acceptance is backed both by a bank's full faith and credit and the goods being purchased by the importer.

Start to Invest in T-Bills (safe Invest)

T-Bills are short-term obligations of the United States Treasury, which means they are as safe as the money in your pocket. But, unlike the money you carry around, T-Bills earn interest. Guaranteed interest.

That's right, the interest and principal are guaranteed, and the U.S. Treasury has never defaulted. So, if you don't need to withdraw a certain amount for several months or longer, you can buy the 3-month or 6-month T-Bill and usually earn higher yields than you'd earn in a savings account. There are no fees to buy T-Bills if you buy them directly through

Bank CDs usually yield about the same as T-Bills, but the bank's FDIC insurance stops at $250,000 per account. T-Bills, on the other hand, are guaranteed no matter how large the denomination. Any given Monday T-Bills are available by auction through the website mentioned above from as small as $100 par value to as large as $5 million. No matter how big the bill, it's guaranteed by the U.S. Treasury, the folks to whom we pay our federal income taxes.

All things you must to know about Annuities investment (Invest Safe)

An annuity is an investment sold by an insurance company that either promises a minimum rate of return to the investor or allows the investor to allocate payments to various funds that invest in the stock and bond markets. These products offer regular payments for the rest of the annuitant's life, but owners of annuities can instead take money out as lump sums or random withdrawals on the back end. Annuities are part of the retirement plans of many individuals, and they can either be part of the safe-money piece or can provide exposure to the stock and bond markets.

The three main types of annuities are fixed, indexed, and variable.

- Fixed annuities
A fixed annuity promises a minimum rate of return to the investor in exchange for one big payment into the contract or several periodic purchase payments. The purchase payments are allocated to the insurance company's general account, so the rate of return is "guaranteed." But, that just means it's backed by the claims-paying ability of the insurance company's general account. So before turning over your money to an insurance company, expecting them to pay it back to you slowly, you might want to check their A.M. Best rating and their history of paying claims.

In a fixed annuity, the insurance/annuity company bears all the investment risk. This product is suitable for someone who wants a safe investment, something that promises to make dependable payments for the rest of his life, no matter how long he ends up living. The fixed annuity offers peace of mind if not a high rate of return.

- Indexed Annuities
A special type of fixed annuity is the equity-indexed annuity or just indexed annuity. With this product, the investor receives a guaranteed minimum rate of return when the stock market has a bad year. But, he/she receives a higher rate of return when an index usually the S&P 500 has a good year.

Do they receive the full upside, as if they owned an S&P 500 index fund? No, and that must be made clear by the sales representative. The contract is also not credited with the dividends associated with the S&P 500, and those dividends can easily be worth 2 or 3% of the index's total return for the year.

Equity indexed annuities have a participation rate. A participation rate of 70% means the contract gets credited with 70% of the increase in the S&P 500. If the index goes up 10%, the contract makes 7% ... unless that amount is higher than the annual cap.

Yes, these contracts also have a cap placed on the maximum increase for any year, regardless of what the stock market does. So, with a participation rate of 70% and a cap of 6%, what happens if the S&P goes up 20%? Although 70% of that is 14%, if you're capped at 6%, then 6% is all the contract value will rise that year. As you can see, indexed annuities are really about the downside protection, which is why a securities license is not required to sell fixed annuities, equity-indexed or otherwise.

- Variable Annuities

Inflation is measured by the Consumer Price Index. Investors adjust the returns on their investments by the CPI to calculate their inflation-adjusted or real rate of return. If an investor receives 4% interest on her bond when the CPI is 2%, her inflation-adjusted return is just 2%. Take the rate of return and then subtract out the CPI to calculate real or inflation-adjusted return. If an investor receives just 1% when the CPI is 2%, his return would be -1% in terms of inflation-adjusted return. He is, in other words, losing purchasing power.

Unlike a fixed annuity, a variable annuity doesn't promise a rate of return. That's why it is called a "variable" annuity the return varies. In exchange for bearing the risks in the stock and bond markets, the variable annuitant gets the opportunity to do much better than he would have in a fixed annuity, protecting his purchasing power from the ravages of inflation.

Could he do worse? Yes, but if he wants a guarantee, he buys a fixed annuity where the insurance company guarantees a certain rate of return. Now he lives with purchasing power risk, because if the annuity promises 2%, that's not going to be sufficient with inflation rising at 4%. If he wants to protect his purchasing power by investing in the stock market, he buys a variable annuity, but now he takes on all the risks involved with that.

Variable annuities use mutual fund-type accounts as their investment options, called sub accounts. In a deferred annuity, the annuitant defers taxation until he takes the money out, which is usually at retirement. The money grows much faster when it's not being taxed for 10, 20, maybe even 30 years, but every dance reaches the point where we must pay the fiddler. It's been a fun dance, for sure, but the reality is we will pay ordinary income tax rates on the earnings we have been shielding from the IRS all these years when we decide to get our own hands on the money.

Features of Annuities
An annuity comes with a mortality guarantee, which means once it goes into the pay out phase, the annuitant will receive monthly payments for as long as he is alive (a mortal). The fixed annuity states what the check will be worth at a minimum, while the variable annuity well, it varies. In the variable annuity, the annuitant will receive a check each month, but it could be meager if the markets aren't doing well.

A fixed annuity is an insurance product providing peace of mind and tax deferral. A variable annuity is a mutual fund investment that grows tax-deferred and offers some peace of mind. But, whether it's fixed or variable, the insurance company offers a death benefit that promises to pay a beneficiary at least the amount of money invested by the annuitant during his life period. In a regular old mutual fund investment, we could put in $80,000 and when we die the investment could be worth $30,000, which is all our heirs would inherit. In a variable annuity, the death benefit would pay out the $80,000.

And, if the value of the investment was more than the $80,000 cost basis, the heirs would receive the $90,000 or whatever the account was worth. Note that in the variable annuity, this death benefit is only in effect while the annuitant is deferring any payments from the contract. As we'll see, once we flip the switch to receive payments in a variable annuity, well, anything can happen.

Insurance companies sell peace of mind. Both the mortality guarantee and the death benefit help a lot of investors sleep better. For maximum peace of mind, individuals should buy a fixed or indexed annuity. For some peace of mind and the chance to invest in the stock and bond markets, individuals should consider a variable annuity.

A variable annuity offers the investment choices from a family of mutual funds (growth, value, high-yield bonds, etc.), the tax deferral from an IRA or 401(k) plan, plus a death benefit similar to a life insurance policy. A fixed annuity—or indexed annuity—offers the tax deferral, the death benefit, and a dependable stream of minimum payments, even if the annuitant lives to 100.

Purchasing Annuities
The categories of fixed, indexed, and variable annuities refer to the way payments are calculated on the way out. In terms of buying annuities the two major types are immediate and deferred. These terms refer to how soon the contract holder wants to begin receiving payments now, or later? These are retirement plans, so we do need to be 591/2 to avoid penalties. Therefore, some customers might want or need to wait 20 or 30 years before receiving payments. If so, they purchase a deferred annuity.

The tax deferral is nice, but if the individual is already, say, 68 years old, he may want to retire now and start receiving payments immediately. As you can probably guess, we call that an immediate annuity while there are immediate variable annuities, it is more common to buy the fixed immediate annuity why? The whole point of buying an immediate annuity is to know that no matter what happens to social security and your 401(k) account there is a solid insurance company contractually obligated to make a payment of at least X amount for as long as you live. An immediate variable annuity would work out well only if the investments did while there is some minimal payment guaranteed, it is meager.

An immediate fixed annuity does not offer a high rate of return, but it does provide peace of mind to investors in retirement. Many financial planners would suggest at least some of their customers' retirement money be in a fixed immediate annuity maybe just enough to provide a monthly payment covering monthly expenses. Figuring withdrawal rates from retirement accounts is tricky, so having a payment of X amount from a solid insurance company could smooth out the bumps.

Customers can buy annuities either with one big payment or several smaller payments. The first method is called "single premium" or "single payment." The second method is called "periodic payment." If an investor has a large amount of money, he can put it in an annuity, where it can grow tax-deferred. If he's putting in a big single purchase payment, he can choose either to wait (defer) or to begin receiving annuity payments immediately. If he's at least 59 1/2 years old, she can begin the pay-out phase immediately. That's called a single-payment immediate annuity. Maybe he's only 42, though, and wants to let the money grow another 20 years before taking it out. That's called a single payment deferred annuity (SPDA).

Many investors put money into the annuity during the accumulation phase (pay-in) gradually, over time. That's called "periodic payment," and if they aren't done paying in yet, you can bet the insurance company isn't going to start paying out. So, if you're talking about a "periodic payment" plan, the only way to do it is through a periodic deferred annuity. There is no such thing as a "Periodic Immediate Annuity".
So there are three methods of purchasing annuities:
  • Single-Payment Deferred Annuity
  • Periodic-Payment Deferred Annuity
  • Single-Payment Immediate Annuity
Again, variable annuities use sub accounts as the investment vehicles in the plan. But, annuities add both features and extra expenses for the investor on top of all the investment-related expenses. Tax deferral is nice. So are the death benefit and the annuity payment that goes on as long as the individual lives. But, that stuff also adds maybe 1.0-1.5% per year in expenses to the investor.

Variable annuities come with a free-look period, which is generally a minimum of 10 business days. If the consumer decides he or she doesn't want to keep the prod¬uct, he or she can cancel without losing any premiums or surrender charges to the company. For fixed annuities, consumers have the same free look period their state re¬quires of insurance policies.

Receiving Payments (Settlement Options)
Some investors make periodic purchase payments into the contract while others make just one big purchase payment. Either way, when the individual gets ready to annuitize the contract, he tells the insurance company which payout option he's choosing. And, he is not able to change this decision he makes the decision and that's that.

If the individual throws the switch to receive payments and chooses life only or straight life he'll typically receive the largest monthly payout. Why? Because the insurance company sets those payments and the insurance company knows better than he does when he's going to die. Not the exact day or the exact method, of course, but they can estimate it with amazing precision. Since the insurance/annuity company is only required to make payments for as long as he lives, the payments are typically the largest for a "life only" or "straight life" annuity settlement option. How does the individual win? By living longer than the actuarial tables predict.

If this option seems too risky, the individual can choose a "unit refund life annuity"
This way he is guaranteed a certain number of payments even if he does get hit by the proverbial bus. If he dies before receiving them, his beneficiary receives the balance of payments.

So, does the annuitant have family or a charity she wants to be sure receives the balance of her payments? If not, why not go with the life only/straight life option—tell the insurance company to pay her as much as possible for as long as she lives.

If she does have family, friends, or a charity she'd like to name as a beneficiary, she can choose a period certain settlement option. In that case, the insurance company must do what the name implies—make payments for a certain period. To either her or the named beneficiaries. For older investors, this option typically leads to a lower monthly payment, since the insurance company will now be on the hook for several years even if the annuitant conveniently expires. If it's a 20-year period certain pay¬out, the payments are made to the beneficiary for the rest of that period, even if the annuitant dies after the first month or two.

The annuitant could also choose life with period certain, and now we'd have an either-or scenario with the insurance company. With this option, the company will make payments for the greater of his life or a certain period, such as 20 years. If he dies after 2 years, the company makes payments to his beneficiary for the rest of the term. And if he lives longer than 20 years, they just keep on making payments until he finally expires.

Finally, the joint with last survivor option typically provides the smallest monthly check because the company is obligated to make payments for as long as either the annuitant or the survivors are alive. The contract can be set up to pay the annuitant while he's alive and then pay the beneficiaries until the last beneficiary expires. Or, it can start paying the annuitant and the beneficiary until both have finally, you know.

Covering two persons' mortality risks (the risk they'll live a long time) is an expensive proposition to the insurance company, so these monthly checks are typically smaller than either period certain or life-only settlement options.

Variable Annuities: Accumulation and Annuity Units
There are only two phases of an annuity, the accumulation period and the annuity period. An individual making periodic payments into the contract, or one who made one big purchase payment and is now deferring the payout phase, is in the accumulation phase, holding accumulation units. When he throws the switch to start receiving payments, the insurance company converts those accumulation units to annuity units.

In a fixed annuity, the annuitant knows the minimum monthly payment he can expect. A variable annuity, on the other hand, pays out the fluctuating value of those annuity units. And, although the value of annuity units fluctuates in a variable annu¬ity during the payout phase, the number of those annuity units is fixed. To calculate the first payment for a variable annuity, the insurance company uses the following:
  • Age of the annuitant
  • Account value
  • Gender
  • Settlement option
Health is not a factor there are no medical exams required when determining the payout. This is also why an annuity cannot suddenly be turned into a life insurance policy, even though it can work in the other direction, as we'll discuss elsewhere.

AIR and Annuity Units
As we said, once the number of annuity units has been determined, the number of annuity units is fixed. So, for example, maybe every month he'll be paid the value of 100 annuity units.
Trouble is, he has no idea how big that monthly check is going to be, since no one knows what 100 annuity units will be worth month-to-month, just like nobody knows what mutual fund shares will be worth month-to-month.

So, how much is an annuity unit worth? All depends on the investment performance of the separate account compared to the expectations of its performance.

Seriously. If the separate account returns are better than the assumed rate, the units increase in value. If the account returns are exactly as expected, the unit value stays the same. And if the account returns are lower than expected, the unit value drops from the month before. It's all based on the Assumed Interest Rate (AIR) the annuitant and annuity company agree to use.

If the AIR is 5%, that means the separate account investments are expected to grow each month at an annualized rate of 5%. If the account gets a 6% annualized rate of return one month, the individual's check gets bigger. If the account gets the anticipated 5% return next month, that's the same as AIR and the check will stay the same. And if the account gets only a 4% return the following month, the check will go down.

The Separate vs. General Account
An insurance company is one of the finest business models ever conceived. See, no one person can take the risk of dying at age 32 and leaving the family with an unpaid mortgage, a stack of bills, and a sudden loss of income, not to mention the maybe $15,000 it takes just for a funeral. But, an insurance company can take the risk that a certain number of individuals will die prematurely by insuring a large number of and then using the laws of probability over large numbers that tell them how many individuals will die each year with only a small margin of error.

Once they've taken the insurance premiums that individuals pay, they then invest what's left after covering expenses and invest it wisely in the real estate, fixed-income, and stock markets. They have just as much data on these markets, so they can use the laws of probability again to figure out that if they take this much risk here, they can count on earning this much return over here within only a small margin of error.

And, most insurance companies are conservative investors. That's what allows them to crunch numbers and know with reasonable certainty they will never have to pay so many death benefits in one year that their investments are totally wiped out. This conservative investment account that guarantees the payout on whole life, term life, and fixed annuities is called the general account. In other words, the general account is for the insurance company's investments. Typically, it is comprised mostly of investment-grade corporate bonds.

Many insurance companies also create an account that is separate from the general account, called the separate account. It's really a mutual fund family that offers tax deferral, but we don't call it a mutual fund, even though it's also covered by and registered under the same Investment Company Act of 1940. The Investment Company Act of 1940 defines a separate account like so:

"Separate account" means an account established and maintained by an insurance company pursuant to the laws of any State or territory of the United States, or of Canada or any province thereof, under which income, gains and losses, whether or not realized, from assets allocated to such account, are, in accordance with the applicable contract, credited to or charged against such account without regard to other income, gains, or losses of the insurance company".

When the purchase payments are invested in the general account, they are guaranteed a certain rate of return. When the purchase payments are invested in the separate account, welcome to the stock and bond markets, where anything can happen.

Financial Statements and Footnotes

Many successful businesses are privately owned. Five Guys and Toys R Us, for example, are well known companies, but we would have to estimate their revenue, expenses and profits since private companies do not report their financial results to the public. By comparison, if we want to know the revenue and net income after tax for Starbucks or Microsoft, we can go to the SEC's EDGAR site and pull up the company's most recent quarterly or annual reports.

It's not that Five Guys and Toys R us do not have income statements, balance sheets, and statements of cash flows. They do not publish their financial statements. Starbucks, Microsoft, and McDonald's, on the other hand, are reporting companies who must disclose all relevant information to the investing public, even to those who will never invest in their stock.

An issuer of securities can only pay the interest on their bonds if they have enough revenue to cover it. The preferred stockholders will only get paid if the profits are dependable, and the common stock will rise over the long term only if the profits at the company rise. The financial statements released by public companies disclose the company's revenue, expenses, and profits, as well as their financial condition and their cash flows.

Each statement tells a different story about the same company.

In a company's quarterly and annual shareholder reports the financial statements are accompanied by footnotes that help clarify the numbers. For example, what does the company mean by "equivalents" in its "cash and equivalents" line item debt securities with six months to maturity? Three months?

When does a company recognize "revenue"? Is it when the company ships pies to a distributor, or only when someone has paid for the product?

Also, unusual revenue events or charges need to be explained so that investors do not get the wrong idea about their long-term impact.

Whenever the numbers in a financial statement require further clarification, the footnotes section is used to provide it. A 10-K or annual shareholder report, for example, presents the consolidated financial statements and then follows up with "notes to consolidated financial statements" that help clarify all the numbers presented from the balance sheet, income statement, and statement of cash flow.

Balance Sheet

When applying for a loan, the lender wants to know two important things: how much money does the borrower make?, and what kind of collateral does he have?

The borrower could submit a statement of cash flow showing all sources of income minus expenses. But the lender would also like to see what kind of assets he is holding minus his liabilities.

The basic formula for the balance sheet is expressed as:

Assets = Liabilities + Stockholders' Equity
Assets — Liabilities = Stockholders' Equity

Assets represent what a company owns. Liabilities represent what a company owes. We take what a company owns, subtract what it owes, and that is the net worth of the company. Another name for net worth is stockholders' equity

Assets are divided into three types.

 The first type is current assets. Current assets represent cash and anything that could be converted to cash in the short-term: cash & equivalents, accounts receivable, and inventory. Cash is cash, and it's a good thing.
 "Equivalents" are money market instruments earning some interest, which is also a good thing. If they mature in the near term, commercial paper, bankers' acceptances, repurchase agreements, and T-Bills are considered "cash equivalents" here on the balance sheet.

 The second type of assets, fixed assets, include office buildings, factories, equipment, furniture, etc. This is the stuff a company uses as opposed to putting directly into its finished products. Fixed assets could all be converted into cash, but this stuff was not purchased to be sold; it was purchased to generate revenue: printing presses, industrial control systems, fleet of delivery vans, etc. A large corporation lists the value of the real estate, as well as the value of the assembly line equipment, as well as the furniture and even the artwork hanging on the walls of the visitor lobby, under fixed assets.

Then there are intangible assets. Intangible assets include patents, trademarks, and goodwill. When a company acquires another company, they usually pay more than just the value of the fixed assets. They're paying for the brand-identity, the customer base, etc. So, that excess paid above the hard, tangible value of assets you can touch and see is called "goodwill."
Then, we would add all three types of assets and call the sum your total assets.

On the other side of the equation we find liabilities, which represent what a company owes. Anything that must be paid in the short term is a current liability. Ac-counts payable, accrued wages, and accrued taxes all represent bills the company must pay currently, which is why they're called current liabilities

Stockholders' Equity/Net Worth
Stockholders' Equity is sometimes called Shareholders' Equity or "net worth." What¬ever we call it, equity equals ownership, and the stockholders own a percentage of the company. What is that ownership worth at the time the balance sheet is printed? That is stockholders' equity.

Companies place the total par value of their preferred stock under this heading. Common stock is assigned a par value of, say, $1, so if a company has 1,000,000 shares of common stock, they would list the par value as $1,000,000 and place it under stockholders' equity.

If investors bought the stock in the IPO at $11, that represents a surplus of $10 above the par value, so the company would list paid-in surplus of $10,000,000, as well. And then any earnings that have been retained are listed as retained earnings.

Defiance between  income statement and  balance sheet

The balance sheet.. is a snapshot of the company's financial strength at the time the report is run. The report could change weekly, even daily.

The income statement, shows the results of the company's operations over previous financial quarters and fiscal years. Once that report is run, it never changes.

The income statement,  can also be referred to as a "statement of earnings" or "statement of operations,"
while the balance sheet is often referred to as the "statement of financial condition."

Statement of Cash Flows

Some subtractions on the income statement do not involve an outlay of cash.
Depreciation and amortization spread an asset's historical cost over an estimated useful life, but no cash is being spent when we record the expense on the income statement.

Therefore, since there's a difference between an accounting entry called "depreciation" and actual cash being spent, analysts ignore intangible expenses like that when focusing on cash flow, which is how much cash is being generated (or consumed) by a company. One way to estimate cash flow is to take the net income from the income statement and then add back two non-cash charges: depreciation and amortization.

Companies that invest in expensive factories, warehouses, and equipment can show quite different figures for net income on the one hand and cash flow from operations on the other. When they add back the depreciation that reduced their net income, their cash flow is a much higher amount.

In the issuer's 10-K, we also find a separate statement of cash flows that shows how much cash has been provided or used by the business over the reporting period. Net income and the cash generated by the business over the period are often quite different numbers. The accrual method of accounting is most widely used, and it involves the company booking revenue/sales before any cash has been exchanged. The statement of cash flows eliminates this sort of distortion, as well as intangible expenses like depreciation/amortization. A good fundamental analyst knows that some companies have been known to book "profits" when they are not generating enough cash to stay afloat.

The statement of cash flows is separated into three distinct ways in which a company can generate (or exhaust) cash: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities. Cash flows from operating activities are what that phrase sounds like: the company provided or exhausted this much cash through their core operations. For example, Starbucks generates most of its cash by operating thousands of successful coffee shops, but it can also generate cash through investing activities and through financing activities.

Cash flow from operations shows us the net income from the income statement, adds back depreciation/amortization, and then records the changes in working capital (from the balance sheet). After dealing with the change in the line items under current assets and current liabilities (working capital), the company can then calculate and re¬port the net cash provided/used by operating activities.

Cash flow from investing activities indicates how much cash was used or generated, usually from investing in capital equipment, and to some extent buying and selling securities, e.g. U.S. Treasuries. Capital equipment ("capex") can be thought of as all the hard, tangible infrastructure that brick-and-mortar companies have to invest in to operate, stay afloat and maybe make a profit (buying a printing press, remodeling existing stores, building new stores, etc.).

If a company is like MSFT or ORCL, they might go on a business buying binge, which is reflected in their cash used for acquisitions. Big increases in this number could indicate that the company is making strategic acquisitions of former competitors, or it could mean that they're generating too much of their returns by buying up smaller fish as opposed to operating successfully.

Cash flow from financing activities is the cash provided/used through any activity involving the shareholders (owners) or bondholders (creditors) of the company. If stock is issued, cash is generated, while if the company engages in share buyback programs, cash is used. If a company issues bonds, cash is generated, while when it finally redeems or calls those bonds, cash is used up.

Also, when the company pays dividends to shareholders, or interest payments to creditors, this is cash that is used by the company. Young, growing companies often issue stock to finance their operations. That may be fine, but new stock issues dilute the value of the existing shareholders' equity. More mature companies, with plenty of cash, often buy back their shares to make each existing share more valuable. Either way, we could track these activities under this section of the statement of cash flows.

The terms "cash flows from investing activities" and "cash flows from financing activities" could be potentially confusing. Remember that if a company buys Government securities or shares of a public company on the open market, we would see that under "cash flows from investing activities." And, if the company invests in a printing press,n that is under cash flows from investing activities, too.

Cash flow from financing activities includes the cash generated by issuing stocks or bonds and the cash used buying back stock and/or retiring bonds.

Income Statement

An income statement show the sales and profits are increasing, decreasing, or flattening. it can also be referred to as a "statement of earnings" or "statement of operations,"it is available to anyone who wants to see it. That includes the company's competitors, which is a reason many companies stay private. For example, if Five Guys is in secret talks to acquire another fast food chain, they would rather keep that quiet as opposed to letting McDonald's see their plans and maybe try to out-bid them.

On the other hand, if McDonald's is planning to open a certain number of restaurants in Africa next year, they would have to let the investment world know about it either on their next scheduled filing or by releasing an 8K.

If you go to your favorite financial website or search for a company's "10¬K" or "annual shareholder report," you can see the financial statements for companies such as Microsoft, Oracle, and Starbucks. For now, though, let's start small.

Let's say there is an 11-year-old in your neighborhood, who launched a lemonade stand for the summer. Her name is Shelly. Each glass of lemonade sells for $1, and the dollars Shelly receives through this summer are called sales or revenue. She sells 10,000 glasses of lemonade, so the revenue is exactly $10,000 over the summer. Revenue is the top line of the income statement.

In some businesses there are returns, refunds, and discounts. Retailers, for example, often report their net revenue or net operating revenue. This is their revenue after all the returns, refunds, and discounts have been accounted for.

The lemonade stand had no discounting or returns, so the revenue is what it is. However, $10,000 in revenue is not the same thing as $10,000 of profit. The lemonade Shelly sold was produced by a combination of the following ingredients: purified water, fresh lemons, lemon juice, sugar, and ice. Those are the goods used to make the product sold, which is why the money spent on them is called the cost of goods sold or cost of revenue. Shelly also has to serve the product in recyclable cups, which cost $1,000, on top of the $2,000 paid for the ingredients. So, now the $10,000 in revenue is down to $7,000 after subtracting the $3,000 for "cost of goods sold."

Like any business, the lemonade stand has operating expenses to cover. Operating expenses are the expenses not directly associated with the production of the company's products: office rent, administrative salaries, office supplies, entertainment costs, travel costs, etc. While Shelly worked the stand herself most of the time, she also hired your sister to come up with some marketing plans. Her $500 of compensation represents an operating expense.

There are other operating expenses, including advertising. Advertising expense was $500 over the summer.

Operating expenses are often referred to as "SG&A' for "selling, general, and administrative" expenses. At a manufacturing company, the labor of the workers on the production floor would generally be part of cost of goods sold, since that labor goes directly into the cost of the finished product. The compensation to the so-called "white-collar workers" out in the cozy offices is part of "selling, general, and administrative" expenses.

If the lemonade stand hires baristas to serve the lemonade, their labor is part of cost of goods sold, while the compensation for her sister's marketing work is an operating expense, not directly related to producing and serving the product.

Shelly also paid the boy next door to build you a stand for $200, and that is a different type of expense. She plans to be in business for the next five years, and she will use that stand each summer. So, she subtracts 1/5 of that $200 on the income statement each year. Instead of subtracting $200 all at once, she only subtracts $40 to depreciate this vital piece of equipment. Even though the business spent the money all up front, next year it will also subtract $40 as a depreciation expense on the income statement. The accountants will do that five times until they have depreciated the cost of the stand to zero.

To depreciate an asset involves spreading its cost over its estimated useful life. A manufacturing company would not expense a $10 million piece of equipment the way they would expense the paper and toner used in the office. The latter are consumed and expenses all at once, while the equipment is slowly written down on the income statement to spread the cost over its estimated useful life.

Tangible assets are depreciated, while intangible assets are written down using amortization. If a company is manufacturing a drug under a patent with a limited life, they amortize the patent over time, as they would depreciate a plastic injection molding machine over several years. In either case, an asset's cost is being spread over its estimated useful life by taking a series of charges on the income statement through these non-cash expenses called either depreciation or amortization.

There are other assets subject to depreciation at the lemonade stand. Shelly had to buy several large coolers, a couple of blenders, a money drawer, a calculator, and a copy of Quick Books TM. These fixed assets all work out to $300, which are depreciated over three years, subtracting another $100 this year.

We have accounted for cost of goods sold, operating expenses, and depreciation.

Now, there are interest payments and taxes to account for before arriving at the company's net income or net loss for the reporting period. Shelly's mom had to spot her some credit to buy her first batch of ingredients and, unfortunately, she charges her interest on the loan. On the plus side, Shelly gets to deduct that interest before figuring taxable income, just as homeowners deduct the interest paid on their mortgages. So, she subtracts the $20 of interest, and the taxable income is $5,840. Taxes work out to $40, and after paying those, the lemonade stand shows a net profit, or net income after tax, of $5,800.

Let's review the lemonade stand's results of operations over the summer:

Sales/Revenue                          $10,000
Cost of Goods Sold               - $3,000
Operating Expenses              - $1,000
Depreciation, Amortization  - $140
OPERATING INCOME        $5,860
Interest Expense                   - $20
PRE-TAX INCOME              $5,840
Taxes                                    - $40
NET INCOME after tax         $5,800

Monetary and Fiscal Policies

Economic policy makers use monetary and fiscal policies to influence the economy. 

Monetary policies are enacted by the Federal Reserve Board and its Federal Open Market Committee. Monetary policies involve setting targets for short-term interest rates to either fight inflation or stimulate a sagging economy.

The Federal Reserve Board (The Fed) requires that its member banks keep a certain percentage of their customer deposits in reserve. This is called the reserve requirement. If the Fed raises the reserve requirement, banks have less money to lend out to people trying to buy homes and start businesses. So, if the economy is overheating, the Federal Reserve Board could raise the reserve requirement to cool things down, and if the economy is sluggish, they could lower the requirement to make more money available to fuel the economy.

However, of the three main tools of monetary policy changing the reserve requirement is the most drastic measure and, therefore, the tool used least often by the Federal Reserve.

In a nutshell that means that if banks can lend out maybe $10 for every $1 they have on reserve, when the Federal Reserve Board changes the amount required to be deposited in reserve by just a little bit, the effects are multiplied throughout the financial system. The multiplier effect is calculated by taking total bank deposits divided by the reserve requirement.

The Fed's Federal Open Market Committee (FOMC) can also use open market operations and either buy or sell US. Treasury securities on the secondary market. If they want to cool things down by raising interest rates, they sell Treasuries on the open market to depress their price and, thereby, increase their yield. If they want to fuel a sluggish economy by lowering interest rates, they buy Treasury securities, thereby driving up their price, which is the same thing as pushing down their yield.

Yields and rates are the same thing. It is the price of debt securities that moves in an inverse relationship to rates/yields. We will look at interest rates and bond prices in more detail up ahead.

When people say the FOMC is raising short-term interest rates by 25 basis points, they're talking about the discount rate, which is the rate the Federal Reserve Board charges banks that borrow directly from the FRB. If banks have to pay more to borrow, they will in turn charge their customers more to borrow from them. So, if the Fed wants to raise interest rates, they just raise the discount rate and let the banking system take it from there.

The Federal Reserve Board does not set tax policy they enact monetary policy. And, typically, they only influence short-term interest rates, although if circumstances require it, they can also influence longer-term rates reflected by Treasury Notes and Treasury Bonds.

The Securities Exchange Act of 1934 covers many aspects of the securities industry. This legislation gave the Federal Reserve Board the power to establish margin requirements under Regulation T and Regulation U. These regulations stipulate how much credit can be extended by broker-dealers and banks in connection with customer margin accounts. So, as with the other tools above, the Federal Reserve Board can make credit more available or less available through margin requirements, depending on the direction of their current monetary policy.

You can think of the Federal Reserve Board/FOMC as a sort of pit crew trying to perform tune-ups on an economy that never pulls over for a pit stop. If the economy starts going too fast, they let some air out of the tires by raising the reserve requirement, raising the discount rate, and selling Treasury securities. If the economy starts to slow down, they pump some air into the tires by lowering the reserve requirement, lowering the discount rate, and buying Treasuries.

Inflation is most likely to occur during the phase of the business cycle called the "peak," a time associated with the phrase "irrational exuberance" during which too many investors and entrepreneurs are convinced that things will keep improving forever.

To fight inflation the Fed slows things down by raising interest rates. Deflation is found during the contraction. To fight deflation the Fed pumps air back into the economy by lowering interest rates.

If the Federal Reserve is fighting inflation, this could be referred to as "tight credit" or a "tight money policy." If the "Fed" is pumping inflation back into the economy, the exam could call this "loose credit" or a "loose-money policy".

Fiscal policy is what the President and Congress do: tax and spend. Keynesian economists recommend that fiscal policy be used to increase aggregate (overall) demand for goods and services.

To stimulate the economy, just cut taxes and increase government spending. Reduced taxes leave more money for Americans to spend and invest, fueling the economy. If the government is spending more on interstate high-way construction, this means a lot more workers are going to be hired for construction crews. Or maybe the federal government orders military transport vehicles from a unit of GM. If so, GM will order a lot more parts from suppliers and hire more workers, who would make and spend more money to push the economy along.

On the other hand, if we need to cool things down, followers of Keynesian economics suggest that the federal government increase taxes and cut spending. Higher taxes leave less money for Americans to spend and invest, and decreased spending puts less government money into companies, who, in turn, spend less money on supplies, equipment, and salaries.

GDP and Business Cycle

People often talk about the economy in terms of whether it is good or bad. But, how do we measure something as big and complex as the American economy? One way is by tracking Gross Domestic Product (GDP). As the name implies, Gross Domestic Product measures the total output of a nation's economy.
It's an estimate of the total value of all goods and services produced and purchased over a three month period. If the GDP number comes in at 3%, that means the economy grew at an annual rate of 3% over the financial quarter. If GDP is 2%, the economy is shrinking at an annual rate of  2%. The GDP numbers that are factored for inflation are called "real GDP."

Gross Domestic Product (GDP) Business Cycle . Measures the value of goods and services produced and provided by workers stationed in the United States over a financial quarter. If GDP is increasing, the economy is growing. If GDP is declining, so is the economy.

The American economy is subject to the business cycle or the boom-and-bust cycle. The four phases of the business cycle are:
  1. Expansion, 
  2. Peak, 
  3. Contraction, 
  4. Trough. 
The period between the peak and the trough is called either a recession or a depression, depending on the severity.
A depression is more prolonged and severe than the more frequently occurring recession. One definition of a recession is two consecutive quarters of inflation-adjusted GDP decline.

As the former head of the San Francisco Federal Reserve Bank explains, "Economists use monthly business cycle peaks and troughs designated by the National Bureau of Economic Research (NBER) to define periods of expansion and contractions".

The NBER website lists the peaks and troughs in economic activity starting with the December 1854 trough. The website also defines a recession as:
A significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.

While there is no standard definition of a depression, economists generally consider a depression to be a more severe and prolonged version of a recession. For example, the Great Depression involved two severe economic downturns. The first lasted from August 1929 all the way through February 1933. After an expansion lasting 21 months, the economy went into a depression again, this time lasting from May 1937 all the way to June 1938.

Stocks of companies operating in certain industries are more dependent on this business cycle than others. These cyclical stocks tend to perform well during an expansion but poorly during a contraction.

Cyclical industries involve expensive purchases and include: heavy equipment, steel, automobiles, durable goods such as refrigerators and dishwashers, travel, and aerospace. Large purchases are what consumers and businesses cut back on first when the economy hits a rough patch. During a robust economy, consumers begin purchasing new cars and refrigerators once again.

Other industries can survive a contraction more easily and are, therefore, called defensive or non-cyclical. These industries include: food, clothing, pharmaceuticals, healthcare, alcohol and tobacco. Food is a defensive industry.

That's not what we mean. We mean supermarkets and food supply companies. Restaurants get clobbered in a recession, as they are one of the first items consumers reduce or eliminate from their budgets. Similarly, clothing is a defensive industry, but we don't mean designer suits, which people cut back on in a recession. We mean the basics, like underwear, socks, gloves, and T-shirts.

If the industry space does better during a recession, it is considered counter-cyclical. Counter-cyclical stocks are negatively correlated to the business cycle. During a contraction, they thrive. During an expansion, they struggle.

There are not many types of business models that improve when consumers have less money to spend, but during a period of high unemployment employment placement agencies typically see an increase in revenue.

Similarly, education and training companies who prepare people for careers in automotive, electronics, or nursing, etc. are also counter cyclical. When people lose a job, they tend to find other careers that they are willing to pay to enter.

While counter cyclical stocks do well during a contraction, they also suffer during expansions. And expansions typically last longer. If unemployment is low, the two types of companies mentioned would see their revenue decrease.

Although we usually associate the term interest-rate sensitive with bonds and preferred stocks, there are also common stocks whose market prices tend to drop when interest rates rise. Companies who pay a generous and relatively fixed dividend tend to experience a decline in market value if interest rates rise. Also, companies who issue a lot of long-term bonds may see their stock price drop when interest rates rise. That's because their cost of borrowing will likely increase in the future and hurt their profits. As we'll see, common stock is all about the expectation of future profits, so companies who do a lot of borrowing get hurt when interest rates increase.

On the other hand, some companies do better when interest rates rise. For example, banks, insurance companies, and certain broker-dealers often earn higher profits when interest rates increase, especially if the yield curve is steep. Broker-dealers make much of their profits by holding customer cash and earning interest on it until the customer buys stock or requests a withdrawal. The steeper the yield curve, the better the profits, as it is for banks and insurance companies.

So, the same economic climate produces winners and losers. During a recession, car makers and high-end retailers may suffer, but Wall-Mart and Priceline might report higher profits as Americans suddenly become cost-conscious. When interest rates rise, utility companies and heavy equipment makers might get hurt while, on the other hand, banks, insurers, payroll and certain broker-dealers might report better results.

If convinced a recession is coming an investor should purchase defensive stocks. People will, after all, keep buying razor blades, groceries, medicine, and liquor regardless of the current economic climate. If an expansion is expected, an investor should purchase cyclical stocks, like automobile and trucking or railroad companies.

How does the investor know when the recessions and recoveries are about to appear?
He doesn't, but the stock market is always about speculation.

Finally GNP (Gross National Product) counts the production of U.S. workers stationed here as well as working overseas for American companies. It does not count the production of, say, Japanese citizens working at a Toyota or Mitsubishi plant in Mississippi.

Gross Domestic Product counts what is produced domestically, by both US. Workers and foreigners working here in the United States.

So, GNP tells us how much American workers are producing wherever they're stationed, while GDP tells us what is produced here in America, whoever is doing that work.

Economic Indicators

People often talk about the economy in terms of whether it is good or bad. But, how do we measure something as big and complex as the American economy?

One way is by tracking Gross Domestic Product (GDP). As the name implies, Gross Domestic Product measures the total output of a nation's economy. It is an estimate of the total value of all goods and services produced and purchased over a three-month period. If the GDP number comes in at 3%, that means the economy grew at an annual rate of 3% over the financial quarter. If GDP is - 2%, the economy is shrinking at an annual rate of - 2%. The GDP numbers that are factored for inflation are called "real GDP."

The Federal Reserve Board monitors many economic indicators to determine whether inflation is threatening the economy, or whether the Fed needs to provide stimulus to a sagging economy. The following employment indicators reveal how many people are working and how much compensation they're receiving. If people are not working, that signals an economic slowdown, and the Fed might lend a hand by lowering interest rates. If too many people are working, that signals inflation, and the Fed might cool things down by raising interest rates.

• Average Weekly New Claims for Unemployment Insurance: if people are showing up for unemployment insurance at a higher rate that is negative. If the number of new claims drops, that means economic activity is picking up positive.

• Unemployment Rate (Non-farm Payroll): also called "payroll employment." Includes full-time and part-time workers, whether they are permanent or temporary employees. Tracks how many people are working in the private sector. Released monthly. Called "non-farm" because it does not measure seasonal agricultural jobs.

• Employment Cost Index (ECI): measures the growth of wages and benefits (compensation). Quarterly figure.

A leading indicator shows up before something happens and is used to predict.
A coincident indicator tells us where we are now,
A lagging indicator gives us data about where we have just been, confirming a trend.

Leading (predict changes in the economy):
•    the average weekly hours worked by manufacturing workers
•    the average number of initial applications for unemployment insurance
•    the amount of manufacturers' new orders for consumer goods and materials
•    the speed of delivery of new merchandise to vendors from suppliers
•    the amount of new orders for capital goods (equipment used to make prod¬ucts) unrelated to defense
•    the amount of new building permits for residential buildings
•    the S&P 500 stock index
•    the inflation-adjusted monetary supply (M2)
•    the spread between long and short interest rates
•    consumer confidence
•    bond yields

Coincident (current state of the economy):

•    the number of employees on non-agricultural payrolls
•    industrial production
•    manufacturing and trade sales
•    personal income levels

Lagging (confirm trends, do not predict):
•    the value of outstanding commercial and industrial loans
•    the change in the Consumer Price Index for services from the previous month
•    the change in labor cost per unit of labor output
•    inventories
•    the ratio of consumer credit outstanding to personal income
•    the average prime rate charged by banks
•    length/duration of unemployment

The table above shows what the main indicators tend to reveal to an economist. For example, if the S&P 500 is up, that means the economy could be headed for an expansion, and when the S&P 500 is down, the economy could be headed for a contraction. The "Fed" typically intervenes to smooth out the rough patches in the economy, so if they see inflationary signals, they start raising interest rates. If they see deflationary signals, they provide economic stimulus by lowering interest rates.