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I just bought 15 of these for $10,677 through my brokerage firm. It says 3.3% interest. I have no idea how this works. But I trust it is gov bond and will pay 3.3%. Can anyone explain how it works? Will it pay interest annually or every 6 months?

This is the bond:

31364DKK1 - FANNIE MAE 0% 04/08/2027

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    Sorry, but I can't help but ask why you would spend over $10k on something if you don't really get how it works? Surely it could have waited a day until you figure out how bonds work? – David Grinberg Dec 20 '16 at 4:48
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    Begin by reading this, all of it, as you probably should have done before you spent the money. fanniemae.com/resources/file/debt/pdf/debt_library.pdf – Eric Lippert Dec 20 '16 at 14:23
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    Is that actually just "over $10k", or is it actually 15 times "over $10k"? Even more frightening if it is actually $160k. – shoover Dec 20 '16 at 20:00
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    @shoover Bonds typically trade at $1000 face value (par value), i.e. what one is due to receive at maturity, so the $10,677 is the discounted price (present value) of the $15,000 (15 x $1000) to be received at maturity. – Chris W. Rea Dec 20 '16 at 22:52
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    @ChrisW.Rea Ah, ok, that's why I'm here, for learning. But I'd rather learn first, before dumping the money into it like OP. ;-) – shoover Dec 20 '16 at 22:54
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Neither. What you appear to have purchased is a zero coupon bond. In under 10 1/2 years, your $10,677 will grow to $15,000. This is a compound 3.3% per year. To be clear, the return comes from the fact that you paid less than the $15000 face value that you will get at maturity, only you do not receive interest along the way.

By the way, no offense intended, but I'm a bit frightened to read," I have no idea how this works", and "I just spent $10,000" in the same sentence. Nothing wrong with the purchase itself, but in the future please do the research first so you know the mechanics of what you're purchasing.

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    @Tony It doesn't really compound at all, as there is no interest. If you invested $10,677 in a compounding product with 3.3% annual interest, that product would also be worth $15k in 2027, so the bond behaves like having 3.3% interest per year. – CodesInChaos Dec 20 '16 at 9:46
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    Is this actually a government bond? I though fanne Mae was a government sponsored enterprise which whilst has received public support during the crisis years will at some point be returned to the private sector. – S Meaden Dec 20 '16 at 13:39
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    @SMeaden: It is not. It took me less than 30 seconds to find "Fannie Mae’s debt securities are unsecured obligations of the corporation only and are not backed by the full faith and credit of the U.S. Government." on their web site. Which is work that the original poster perhaps ought to have done before spending the cash. – Eric Lippert Dec 20 '16 at 14:14
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    @SMeaden Fannie was only ever tenuously 'private sector' in the first place. It was created by an act of Congress (as part of FDR's 'New Deal' during the Great Depression) and its charter explicitly requires it to further the "affordable housing" goals specified by the Department of Housing and Urban Development (HUD) and approved by Congress. It's a weird mix of public/private where its common stock was publically traded for a few decades, but its goals are largely set by the federal government. That said, its bonds aren't "government bonds" in the sense of being backed by the government. – reirab Dec 20 '16 at 23:22
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    @Eric Lippert: From from of your programming blogs : 'Duck typing is so-called because of the principle “if it walks like a duck and quacks like a duck then it is a duck”' So if a bond is bailed out by the government then it is a government bond, ergo Fannie Mae is a government bond. – S Meaden Dec 21 '16 at 1:39
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Since it sounds like you are just starting out in bonds, let me first tell you a little about how bonds work before moving on to answering your actual question.

Whereas stocks represent a portion of ownership of a company, a bond (somewhat simplified) represents a portion of a company or state loan. Effectively, when you buy the bond, you are extending a loan to the entity that issued the bond.

Like stocks, bonds are traded in the public market. Like stocks, bonds can rise and fall in price as investors change their mind about whoever issued the bond. Like stocks, bonds fall in price when they are less favored by the investor collective, and increase in price when they are more favored.

Unlike stocks, how much a bond pays is fixed when the bond is issued. This is known as the "coupon" of the bond, and is often expressed as a percentage of the nominal value of the bond.

The bond also has an end date, known as its maturity or maturation date. At that date, whoever issued the bond will pay, to the current holder, the nominal value of the bond, and the bond ceases to exist. (They are paying off the loan that is represented by the bond, so the bond no longer has any meaningful reason to exist. Were it not to cease to exist, its value would be set to zero, as the money has been paid.)

A third important piece of information for a bond, alluded to above, is the nominal value of the bond. The nominal value of a bond is the amount that will be paid when the bond matures. This, too, is fixed when the bond is issued.

Now, if a bond is disfavored by the investor collective, it will be trading at below par. Another way to say the same thing is that its price is depressed, or lower than the nominal value of the bond. (The opposite is above par.) Slight variation around the nominal value is nothing to be alarmed about, but a bond trading at a price significantly different from its nominal value is a potential red flag.

One reason for a bond trading significantly below par is that the entity that stands behind the bond (in this case, Fannie Mae), is doing poorly financially. In such a situation, there is the risk of a credit event in the bond. "Credit events" are, for example, bankruptcy, debt restructuring, debt forgiveness, and so on. What this means is that if there is a credit event involving the bond, you may not get its full nominal value back at the expected maturity date, either because the nominal value is changed (sometimes down to zero), sometimes because the maturity date is changed (often to a later date), sometimes both.

In this case, the bond you purchased has a 0% coupon rate. In other words, it pays no regular interest. Any return on investment must therefore come only from the difference between purchase value and final value, and considering the time to maturity. Investors like to get a return on their investments, so it is expected to see the current value of the bond to be lower than the nominal value.

You bought the bond for $10,677, while as JoeTaxpayer pointed out, the nominal value is $15,000 to be paid in April 2027. 3.3% per year for 10.5 years corresponds to about 40.6% over those years, and just so it happens, 1.406 * $10,677 = $15,014, working out almost exactly to the difference between its current value and its nominal value. (I very much suspect that a more accurate calculation would yield a result even closer to the nominal value of $15,000.) As you can thus see, the "3.3% interest" is really a 3.3% annual return. Calling it "interest" is likely a simplification to make it more understandable.

The above calculation assumes that you keep the bond to maturity, and that no credit event occurs which involves the bond you purchased. If either of those conditions do not fully hold, then the outcome (in this case) depends solely on the difference between the price you paid for the bond and the price you sell it for, as well as any applicable tax effects.

As Eric Lippert has already pointed out in the comments to JoeTaxpayer's answer, Fannie Mae bonds are corporate bonds not backed by "the full faith and credit of the U.S. government".

Also, even government bonds come with a certain amount of risk. For a recent example, consider the 2011 Greece government debt restructuring where

Private bondholders were required to accept extended maturities, lower interest rates and a 53.5% reduction in the bonds' face value.

Greece, of course, is just one example. There are several more where large countries have needed various forms of debt restructuring in the last few decades alone.

So don't assume that even a bond that is backed by your government is a "safe" investment. History shows that it will be, until it isn't any longer.

Bottom line: Diversification remains your friend.

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    Nicely done. Your writing never disappoints. – JoeTaxpayer♦ Dec 20 '16 at 21:34
  • I've taken the gamble once or twice of buying bonds that were trading at something like 45% below par while paying a reasonably substantial coupon. That said, I did so knowing perfectly well that it was a gamble. Those particular ones have worked out well so far... the particular ones I have now mature around 2019/2020, so it'll be interesting to see if they hold up over the coming three years. – a CVn Dec 20 '16 at 21:45
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    Might be worth fleshing out the "if you sell it" portion - given theoretically the price should increase slowly over time (roughly 3.3% per year, plus/minus risk changes, in theory?) so he may be able to / want to exit earlier than 2027 and still have some gains. – Joe Dec 20 '16 at 23:06
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    +1, though I'd say that, as others have pointed out, the bottom line should read: Knowing what you are doing is your friend. – Stephan Kolassa Dec 21 '16 at 9:27
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I would like to point out one issue that has not been discussed in either JoeTaxpayer's answer or Michael Kjörling's answer.

While a "zero-coupon" bond pays no interest each year/quarter/month (in the sense of sending cash to the investor that the investor can put in the bank or spend -- because there no coupons to redeem), in general, the interest that supposedly accrues each year is taxable income to the investor for that year, unless of course the bond is being held in a tax-deferred account. In particular, taxes on the interest cannot be deferred until the bond is cashed in upon maturity as they can with Series EE US Savings Bonds,* the zero-coupon bond that most people are familiar with. For this reason, most investors prefer to not hold zero-coupon bonds in taxable portfolios.

*It didn't used to be a good idea to defer interest income on EE bonds for children but instead to declare the interest each year and pay the tax on it on behalf of the child at the child's rate. That way, when the bond was cashed in, tax would be due only on interest accrued in the last year. The more recent tax law changes re children's income being taxed not at the kiddie rate but at the parents' rate may have changed all this.

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  • So are you saying on OP's purchase he will have to pay income taxes rather than capital gains? – Brad Thomas Dec 23 '16 at 1:15
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    @BradThomas With a bond, there are no capital gains except in the unlikely event that the bond is sold to someone else for more than its purchase price plus imputed interest up to the date of sale. In the year of sale, imputed interest for that year will be taxed as interest, the excess as capital gains. If the bond is redeemed by returning it FannieMae on the date of maturity and getting cash back, then income tax is due on the imputed interest earned in the year of sale. Income tax on imputed interest during previous years will have been paid with the tax returns of previous years. – Dilip Sarwate Dec 23 '16 at 1:26

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