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Bond Categories

Terminology

Bond

A bond is a contract between a corporation (or government agency) and an investor where the investor loans the corporation (or government agency) a certain amount of money for which the investor receives an agreed upon interest payment.

Diversification

Diversification is the concept of owing stocks in a variety of industry groups rather than merely buying stocks in only one or two industry groups. The reasoning for this is that if one particular industry group performs extremely poorly, then the overall impact on the portfolio is reduced compared to if only stocks in the poorly performing group were held.

Fund

A fund is a managed pool of investments. When investing in a fund, the investor buys a share of the fund. This means that the investor owns a share of the investments that the fund owns.

The Various Categories of Bonds

The Various Categories of Bonds - picture pf a large animated sign with three dimensional letters in light grey large scale font spelling out the word bonds with an up arrow beside the sign

Investors who are new to bonds tend to be familiar with the term 'Treasury bonds' as these bonds are widely covered by the financial press. These are actually numerous different categories of bonds and most of these are not normally mentioned by the financial press.

U.S. Treasury Bonds

Bonds issued by the U.S. Treasury are the safest and the most popular of all the various types of bonds available. While treasury bonds are not guaranteed as such, they come with the full backing of the U.S. Treasury with assurance that their obligation to bondholders will be met. Basically congress has the power to increase taxes etc to meet their obligations and this effectively makes treasury bonds as good as guaranteed.

Treasury bonds come with a variety of maturities ranging from four weeks up to 30 years and they can be sold prior to maturity. An investor can buy newly issued bonds directly form the U.S. Treasury or they can buy used bonds from a bond dealer.

Corporate Bonds

Bonds issued by corporations are riskier than treasury bonds and pay a higher interest rate. Corporate bonds are extremely popular, but unlike treasury bonds there is a risk of default. The risk with corporate bonds is based on the issuing company's financial position, since the company must have sufficient cash flow to make its interest payments. Fortunately for inventors, there are credit agencies which evaluate the credit risk and assign the company with a credit rating.

Corporate bonds which have a low credit rating are referred to as either Junk bonds or High-yield bonds. These bonds pay a higher interest rate but also more likely to default.

Newly issued corporate bonds can be bought though a bond broker. Also corporate bonds can be sold and used corporate bonds can be bought.

Municipal Bonds

Municipal bonds are issued by a state or local government and these bonds are extremely popular with individual investors due to their tax advantages. Municipal bonds are generally exempt from federal taxes which no doubly contribute to their popularity. They do however pay a lower interest rate than treasury bonds and as such investors need to determine whether the tax advantage will provide a higher net return.

Municipal bonds issued by municipalities are considered safe investments. But there are also municipal bonds issued by non-municipalities such as universities, airports and hospitals which are reliant on revenue to meet their bond obligations and this increases the risk of default.

U.S. Savings Bonds

Savings bonds are issued by the U.S. Treasury and are an alternative to a Certificate of Deposit. Savings bonds are essentially the same as treasury bonds with a few exceptions.

Unlike treasury bonds which can be sold, savings bonds cannot be transferred. This is because with savings bonds the investor's name and social security number are included with the bond and they are the only person entitled to the interest and principle upon maturity. Thus savings bonds have no resale value and the returns are purely the interest they earn.

Investing in savings bonds is very simple which makes them attractive to beginner investors. Savings bonds are bought direct from the U.S. Treasury, but unlike bonds they do not make any coupon payments and as such do not provide an income source. Instead, the interest earned is accrued which means it is added to the face value of the savings bond.

Any time after one year the savings bonds can be redeemed and the investor receives their original investment plus the accumulated interest earned. An early redemption penalty applies if a savings bond is redeemed within five years of issue (the investor forfeits the last three months of interest). Savings bonds cannot de redeemed before the minimum term, which is currently one year. The maximum term for which interest is accrued is 30 years.

Currently there two types of savings bonds - I Savings Bonds and EE Savings Bonds. They are basically the same with some minor differences.

  • I Savings bonds can be in either paper form or electronic. The interest rate contains a fixed rate portion and a variable rate portion which is based on the consumer price index (CPI).
  • EE savings bonds are electronic only and have a fixed interest rate.

Agency Bonds

These are bonds issued by federal agencies with the most common agencies issuing bonds being:

  • Federal Home Loan Mortgage Corporation (FHLMC) also referred to as Freddie Mac.
  • Federal National Mortgage Association (FNMA) also referred to as Fannie Mae.
  • Small Business Administration (SBA)

Strictly speaking, only the SBA is a federal agency. The other two are actually government sponsored organizations created by congress and are listed companies.

Agency bonds are considered safe investments as they are backed by the federal government. This implies that should these organizations get in financial difficulties then the federal government will step in to fulfill the issuers' obligations.

Agency bonds can be more complex than treasury bonds are they are mostly purchased by institutions. Retail investors tend not to buy agency bonds directly but tend to prefer using a fund.

International Bonds

Bonds issued buy the governments and corporations of developed foreign countries can help diversify a bond portfolio. The interest rates for bonds are largely determined by the countries inflationary environment. Essentially the higher the inflation rate then the higher the bonds interest rate.

The inflation rate across countries varies considerably as each country deals with its own economic conditions. While the U.S. economy might currently be in a low inflationary environment does not mean that the rest of the world is in a similar position. There are always countries which are currently experiencing low inflation and countries which are battling high inflation.

By including bonds from high interest paying countries, the bond investor can boost their returns and at the same time increase their diversification.

Investing in international bonds involves the currency exchange risk and buying bonds in a foreign currency complicates the investing process. For many bond investors, using a fund simplifies the process as the investor can simply buy fund shares in their home currency.

Emerging Market Bonds

Emerging markets are countries that are not considered to be developed industrialized nations. These economies typically issue bonds in U.S. dollars which is convenient for investors living in the U.S. but inconvenient for investors not living in the U.S.

Bonds issued by emerging markets are frequently government bonds and their interest rates can be high, but they are also come with a much higher risk of default which means investors not receiving their coupon payments and also not receiving their principle at maturity. In addition, emerging market bonds are extremely volatile which can see their value rise and fall dramatically.

Investing in emerging markets is tricky and most bond investors tend to prefer using a fund rather than investing directly.

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