Understanding Bond Types
Bonds are IOUs issued by both public and private entities to cover a variety of expenses. For investors, bonds provide a cushion of stability against the unpredictability of stocks and should be a part of almost every portfolio.
In many, but not all, markets, bonds will move in the opposite direction of stocks. If stocks are up, bonds are down and if stocks are down, bonds are up. This is a very broad generalization, but one that helps explain why bonds are a good counter to stocks.
You have a wide variety of bonds to choose from and each type has certain characteristics. Here is an overview of the different bond types:
U.S. Treasury Issues
At the top of the secure list, are U.S. Treasury issues. The “full faith and credit” of the U.S. government backs these debt instruments, which makes them the safest investment on the market.
Corresponding with this safety is a very low return. In certain circumstances, the return may not even keep pace with inflation or barely stay up with it. All interest earned from U.S. Treasury issues is generally exempt from state and local taxes, but not federal income tax.
Here are the different types of U.S. Treasury bonds:
- Treasury Bonds – have a maturity exceeding 10 years and the Treasury issued them in denominations ranging from $1,000 to $1 million. The U.S. Treasury no longer issues Treasury Bonds, however you can still buy them on the secondary market.They pay interest every six months and had original maturities of up to 30 years. Even though you buy them from someone or organization other than the U.S. Government, Treasury Bonds are still backed by the “full faith and credit” of the U.S. government.
- Treasury Notes – have maturities of 2, 3, 5 or 10 years and denominations of $1,000. The U.S. Treasury sells Notes at public auction periodically. You bid for the Note by placing a competitive bid or a non-competitive bid.In the wonderful world of government logic, a noncompetitive bid guarantees you will get the Note. If you issue a competitive bid, you may or may not get the Note. Makes sense, right?
- The interest rate for the Note is set at the auction. A competitive bid states what interest rate you will accept. If that happens to be the rate set at the auction, you get the Note. If not, you don’t get the note.
- A noncompetitive bid states you will accept whatever rate is set at the auction. This guarantees you will get the Note (assuming the auction is not oversubscribed).
- TIPS or Treasury Inflation Protected Securities – are bonds with maturities of 5, 10 and 20 years. They are sold in $1,000 denominations at auction just like Treasury Notes.What makes TIPS different is the inflation adjustment. Every six months the Treasury adjusts the principal by the Consumer Price Index for inflation. The fixed rate of interest is applied to this inflation-adjusted principal.
- In an inflationary environment, every six-month interest payment would be higher than the next. At maturity, the TIP pays the inflation-adjusted principal or the original face value, whichever is greater.
- How could the principal be less than the face value? During a period of deflation, your principal would be reduced and subsequent interest payments less. Under these circumstances, it is possible that the deflation-adjusted principal could be less than the original face value.
- Treasury Bills – are not bonds in the strict sense because their maturities range from 4 to 26 weeks. Along with I, EE/E and H Bonds, T-Bills belong in a cash management category, rather than strictly bonds.
The U.S. Treasury Website has complete information on all of their products.
Agency bonds refer to a group of bonds issued by organizations related to the U.S. government. These agencies typically do not have the explicit backing of the U.S. government behind their bonds, although some do.
Most fall into a category of collateral-backed mortgages or loans, meaning there is some asset, usually real estate tied to the loan. These bonds pay higher rates than strict U.S. Treasury issues for the somewhat, although not much, higher risk. These bonds are typically sold in large denominations to institutional investors. Here are some of the better-known agency bonds:
- Government National Mortgage Association or Ginnie Mae – is owned by the U.S. government. It buys mortgages from lenders and pools them into securities. Its bonds are backed by the full faith and credit of the U.S. Government.
- Federal National Mortgage Association or Fannie Mae buys mortgages on the secondary market and resells them to investors some of the mortgages may be insured by the Federal Housing Authority (FHA). For more information visit their Website.
- Federal Home Mortgage Corporation or Freddie Mac is similar to Freddie Mae, but they don’t contain any mortgages guaranteed by FHA. For more information on Freddie Mac visit their Website.
- Student Loan Marketing Association or Sallie Mae pools student loans instead of mortgages. These are more risky than mortgaged back bonds. For more information visit the Sallie Mae Website.
Local governmental entities like states, counties, townships, cities, utility districts and so on also issue bonds to finance their work.
These municipal bonds, often called munis, fund new roads, schools, sewers and other projects. In some cases, fees collected from the project go to retire the bonds, in other cases tax money is used or a combination of both.
Although not as safe as the U.S. Treasury issues, munis have a good record of security. One of the key features of these bonds is that the income is free from federal income tax.
This tax-free feature, combined with the relative security makes municipal bonds attractive to conservative investors. As an add bonus, in some circumstances, the bonds may be free of state and local tax also.
You buy munis from a broker either at new issue or existing bonds.
Corporations issue bonds to finance large projects that can be paid off over time. Rather than issue new stock or use short-term credit, companies use longer-term bonds to finance new facilities, acquisitions and other needs.
Corporations, even the most credit worthy, do not carry the same degree of safety as governmental issuers; therefore, their bonds pay higher interest rates.
Corporate bonds may offer two features not common in other bonds:
- Convertible Bonds – This feature allows the bond to be converted into common stock under certain conditions. Those conditions are spelled out when the bond is issued.
- Callable Bonds – These bonds may be called or redeemed by the company before maturity. A company would call or redeem the bond if interest rates have fallen significantly since they issued the bond. By calling the high interest bond, the company can refinance the debt at a lower interest rate.
Zero Coupon Bond
Another type of bond is the zero coupon bond. The other bond types above differed by issuer. This bond type is issued by many entities, but because it is so different from traditional bonds, I have set it apart.
Zero coupon bond, as the name suggests, pay no regular interest. Instead, you buy the bond at a deep discount and redeem it at full face value.
For example, you might buy a $1,000 par value zero with 10 years to maturity for $700. In ten years, you would redeem the bond for $1,000.
This broad overview of the different types of bonds was meant to give you just that – an overview. Bonds are important to every portfolio. Understanding what they are and how they work is the first step to letting them work for you.