There are at least five types of bonds. They each have different sellers, purposes, buyers, and levels of risk vs. return.
- There are five main types of bonds: Treasury, savings, agency, municipal, and corporate.
- Each type of bond has its own sellers, purposes, buyers, and levels of risk vs. return.
- If you want to take advantage of bonds, you can also buy securities that are based on bonds, such as bond mutual funds. These are collections of different types of bonds.
- One of the differences between bonds and bond funds is that individual bonds are less risky than bond mutual funds.
US Treasury Bonds
The most important bonds are the U.S. Treasury bills, notes, and bonds issued by the Treasury Department. They are used to set the rates for all other long-term, fixed-rate bonds. The Treasury sells them at auction to fund the operations of the federal government.
These bonds are also resold on the secondary market. They are the safest, since they are guaranteed by the United States government. That means they also offer the lowest return. They are owned by almost every institutional investor, corporation, and sovereign wealth fund.
Treasury Inflation-Protected Securities are Treasury bonds that protect against inflation.
Savings bonds are also issued by the Treasury Department. These bonds are meant to be purchased by individual investors. They are issued in low enough amounts to make them affordable for individuals. I bonds are like savings bonds, except they are adjusted for inflation every six months.
Quasi-governmental agencies, like Fannie Mae and Freddie Mac, sell bonds that are guaranteed by the federal government.
Municipal bonds are issued by various cities. They are tax-free but have slightly lower interest rates than corporate bonds. They are slightly more risky than bonds issued by the federal government. Cities occasionally do default.
Corporate bonds are issued by all different types of companies. They are riskier than government-backed bonds, so they offer higher rates of return. They are sold by the representative bank.
There are three types of corporate bonds:
- Junk bonds or high-yield bonds are corporate bonds from companies that have a big chance of defaulting. They offer higher interest rates to compensate for the risk.
- Preferred stocks are technically stocks, but they act like bonds. They pay you a fixed dividend at regular intervals. They are slightly safer than stocks in case of a bankruptcy. Holders get paid after bondholders but before common stockholders.
- Certificates of deposit are like bonds issued by your bank. You essentially loan the bank your money for a certain period of time for a guaranteed fixed rate of return.
Types of Bond-Based Securities
You don't have to buy an actual bond to take advantage of its benefits. You can also buy securities that are based on bonds. They include bond mutual funds, which are are collections of different types of bonds.
One of the differences between bonds and bond funds is that individual bonds are less risky than bond mutual funds. Assuming that there are no defaults, the holder of an individual bond gets his principal sum intact upon the instrument’s maturity. With bond funds, the investor risks losing his principal should prices fall.
Bond securities also include bond exchange-traded funds (ETFs). They perform like mutual funds, but they don't actually own the underlying bonds. Instead, ETFs track the performance of different classes of bonds. They pay out based on that performance.
Bond-based derivatives are complicated investments that get their value from the underlying bonds. They include the following:
- Options give a buyer the right, but not the obligation, to trade a bond at a certain price on an agreed-upon future date. The right to buy a bond is called a "call option." and the right to sell it is called the "put option." They are traded on a regulated exchange.
- Futures contracts are like options, except they obligate participants to execute the trade. They are traded on an exchange.
- Forward contracts are like futures contracts, except they are not traded on an exchange. Instead, they are traded over-the-counter either directly between the two parties or through a bank. They are customized to the particular needs of the two parties.
- Mortgage-backed securities are based on bundles of home loans. Like bonds, they offer rates of return based on the value of the underlying assets.
- Collateralized debt obligations (CDOs) are based on auto loans and credit card debt. They also include bundles of corporate bonds.
- Asset-backed commercial paper is a one-year corporate bond package. The value is based on that of underlying commercial assets. These include real estate, corporate fleets, or other business property.
- Interest rate swaps are contracts that allow bondholders to swap their future interest rate payments. They occur between a holder of a fixed-interest bond and one holding a flexible-interest bond. They are traded over-the-counter.
- Total-return swaps are like interest rate swaps, except the payments are based on bonds, a bond index, an equity index, or a bundle of loans.
Frequently Asked Questions (FAQs)
How do bonds work?
Bonds are a loan from an investor to a corporation, government, municipality, or other agency. In exchange for the investment, the entity agrees to repay the investor at a fixed interest rate over a set period of time. Bonds come with a higher guarantee of repayment than a capital investment.
How do you buy bonds?
Depending on the type, you can purchase bonds through brokers, exchange-traded funds, or from the U.S. government at TreasuryDirect. You may need to have at least $1,000, the typical starting face value for most bonds.
What is a coupon rate for bonds?
The coupon rate is just another word for the bond's interest rate.