Types of Bonds
Welcome to the second part of The Bond Series where we will discuss the types of bonds. If you missed it, the first part can be found here.
As we discussed in Part 1, bonds are issued by many different entities. This includes the U.S. government, cities, corporations, and international bodies. Some bonds, such as mortgage-backed securities, can be issued by financial institutions. Thousands of bonds are issued each year, and even though bonds may share the same issuer, each bond is unique.
So let’s dive in the various types of bonds!
U.S. Treasury Securities
One of the most famous types of bonds is the U.S. Treasury securities (“Treasuries”). These are issued by the federal government and are considered by experts as the safest investment. Why? Because all Treasury securities are backed by the “full faith and credit” of the U.S. government. Unless you expect the government to fail in the near future, this is a pretty safe bet.
But what about the recession or a market crash? It doesn’t matter the case, be it a recession, inflation, or war. The U.S. government is going to take care of its bondholders.
Treasuries are also liquid. A group of more than 20 primary dealers are required to buy large quantities of Treasuries every time there is an auction and stand ready to trade them in the secondary market.
There are other features of Treasuries that are appealing to the individual investor to include;
- they can be bought in denominations of $100, making them affordable
- the buying process is convenient
You can buy Treasuries through brokerage firms and banks. Or even easier, just follow the instructions on the TreasuryDirect® website to buy directly.
Three Varieties of Treasuries
There are three varieties of treasuries. Each is unique and can satisfy your goals as an investor.
These are short-term securities that are non-interest bearing (zero-coupon) with maturities of only a few days (these are referred to as cash management bills). They securities are offered at 4 weeks, 13 weeks, 26 weeks, and 52 weeks. These are often to referred to as T-bills.
You buy them at a discount to face value (par) and are paid the face value when they mature. Interest income is subject to federal income tax, but exempt from state and local income taxes.
These are fixed-principal securities issued with maturities of two, three, five, seven and 10 years. These are often referred to as T-Notes. The interest is paid semiannually, with the principal paid when the note matures.
Just like T-Bills, interest income is subject to federal income tax, but exempt from state and local income taxes.
These are long-term, fixed-principal securities issued with a 30-year maturity. These are often referred to as T-Bonds. Outstanding fixed-principal bonds have terms from 10 to 30 years. The interest is paid on a semiannual basis with the principal paid when the bond matures.
Just like the others, interest income is subject to federal income tax, but exempt from state and local income taxes.
U.S. Savings Bonds
One of the few well known types of bonds is the U.S. Savings bond. These are issued by the federal government and backed by the “full faith and credit” guarantee.
But unlike Treasuries, savings bonds are even more affordable. They can be purchased for as low as $25. This allows newer investors who very little to invest get some skin in the game. Exactly like Treasuries, the interest earned on your savings bonds is subject to federal income tax, but not state or local income taxes.
Savings bonds can be purchased from the U.S. Department of the Treasury, at banks and credit unions. Your employer might offer them through payroll deduction. But unlike most other Treasuries, savings bonds cannot be bought and sold in the secondary market. In fact, only the person/s who have registered a savings bond can receive payment for it.
As of January 1, 2012, paper savings bonds are no longer sold at financial institutions but will remain available through TreasuryDirect®. It is a secure, web-based system operated by Public Debt.
Two Types of U.S Savings Bonds
Savings bonds now come in two versions, the Series EE and the Series I.
Both are accrual securities. What does that mean? It means the interest you earn accrues monthly at a variable rate and the interest is compounded semiannually. You receive your interest income when you redeem the bonds.
You can purchase savings bonds electronically through the TreasuryDirect Website. The portal allows you to buy, track, change registration and redeem your bond/s electronically via a secure online account. A program called SmartExchangeSM allows TreasuryDirect account owners to convert their paper savings bonds to electronic securities in a special Conversion Linked Account via their online account.
Whether you buy savings bonds electronically or in paper form, most savings bonds are sold at face value. What does that mean? It means that if you buy a $100 bond, it costs you $100, on which you earn interest.
One of the lesser known types of bonds is the Mortgage-backed securities, also known as MBS. These are bonds secured by home and other real estate loans. A number of these loans, usually with similar characteristics, are pooled together to create the loan. For instance, a bank offering home mortgages might round up $10 million worth of such mortgages. That pool is then sold to a federal government agency like Ginnie Mae or to a government sponsored-enterprise (GSE) such as Fannie Mae or Freddie Mac. They also, can be sold to a securities firm to be used as the collateral for a new MBS.
The majority of MBSs are issued or guaranteed by an agency of the U.S. government such as Ginnie Mae or Fannie Mae. The issuing organization pays interest and principal payments on their mortgage-backed securities. While Ginnie Mae’s guarantee is backed by the “full faith and credit” of the U.S. government, those issued by GSEs are not.
A third group of MBSs is issued by private firms. These “private label” MBS are issued by subsidiaries of investment banks, financial institutions, and homebuilders. However, their credit-worthiness and rating may be much lower than that of government agencies and GSEs.
Because of the general complexity of MBS, and the difficulty that can accompany assessing the creditworthiness of an issuer, use extreme caution when investing. The reward might not be worth the risk.
Most MBS bondholders receive monthly interest payments. Not semiannually like a traditional fixed-income bond. But, there’s a good reason. Homeowners, whose mortgages make up the underlying collateral for the MBS, pay their mortgages monthly, not twice a year. These mortgage payments are how MBS investors are paid in the end.
One importance to note is how investors receive their proceeds. Let’s compare it to a Treasury bond. The Treasury bond pays you interest only. In addition, at the end of the bond’s maturity, you get a lump-sum principal amount.
But a MBS pays you interest and principal. Your cash flow from the MBS at the beginning is mostly from interest. However, gradually more and more of your proceeds come from principal. Since you have been receiving payments of both interest and principal, you don’t get a lump-sum principal payment when it matures. Why? Because, you’ve been getting it in portions every month.
One of the few types of bonds investors might get confused for stocks are Corporate bonds. Companies issue corporate bonds (or corporates) to raise money for capital costs, operations and acquisitions. Corporates are issued by all types of businesses, and are segmented into major industry groups. The money earned from future operations usually backs the bond as collateral. In some cases, the company’s physical assets may be used as collateral for bonds.
Corporate bondholders receive the equivalent of an IOU from the issuer of the bond. But unlike equity stockholders, the bondholder doesn’t receive any ownership rights in the corporation. However, there is a perk to this. In the event that the corporation falls into bankruptcy and is liquidated, bondholders are more likely than stockholders to receive some of their investment back.
There are many types of corporate bonds and investors have a wide-range of choices to include;
- bond structures
- coupon rates
- maturity dates
- credit quality
- and more!
Corporate bonds are issued with maturities ranging from one to 30 years. For short-term debt that matures in 270 days or less, it is known as “commercial paper.” Bondholders receive regular and predetermined interest payments (the “coupon”) when the bond is issued. Interest payments are subject to federal and state income taxes. In regards to capital gains and losses, the sale of corporate bonds are taxed at the same short- and long-term rates (for bonds held for less, or for more, than one year) that apply when an investor sells stock.
Corporate bonds tend to be categorized as either investment grade or non-investment grade. Non-investment grade bonds are also referred to as “high yield” bonds because they pay higher yields than Treasuries and investment-grade corporate bonds. However, higher yield equals more risk. Hence why they are referred to as “junk bonds.”
Most corporate bonds trade in the over-the-counter (OTC) market. The OTC market for corporates is decentralized, with bond dealers and brokers trading online or over the phone.
TIPS and STRIPS
The U.S. Department of the Treasury offers bonds that help protect investors against inflation. They’re called Treasury Inflation Protected Securities, or TIPS for short. Familiar to most types of bonds, they are issued with maturities of five, 10 and 30 years.
What is the advantage? TIPS are unique because they shelter you from inflation risk. How does that occur? Because their principal is adjusted semiannually for inflation based on changes in the Consumer Price Index-Urban Consumers (CPI-U), which is a tool used to measure inflation. So, this means your interest payments are calculated on the inflated principal.
But how does that help you? Let’s say you bought a 10 year TIPS. If inflation occurs throughout the life of the bond, your interest payments will increase. At maturity, if the adjusted principal is greater than the face or par value, you will receive the greater value.
TIPS are backed by the “full faith and credit” of the U.S. government because they’re U.S. Treasury securities. Therefore, TIPS carry virtually no credit or default risk. So what is the risk and reward? You as the TIPS investor are sheltered from inflation risk. In fact, you benefit during periods of inflation. So what’s the catch? The trade-off is that the base interest rate on TIPS is lower in most cases than that of other Treasuries with similar maturities. In periods of deflation, low inflation or no inflation, a conventional Treasury bond can be the better-performing investment.
But what happens if deflation (a negative inflation rate) occurs – would my TIP investment be worth less than what I paid for it? No, unless you paid more than the face value of the bond or sell it before it matures. Upon maturity, the U.S. Department of the Treasury agrees to pay the initial face value of the bond or the inflation-adjusted face value, whichever is greater.
The Separate Trading of Registered Interest and Principal of Securities, or STRIPS is one of the few unique types of bonds. The program lets investors hold and trade the individual interest and principal components of eligible Treasury notes and bonds as separate securities.
A strip bond has its coupons and principal “stripped off” and sold separately to investors as new securities. An investment bank or dealer will usually buy a debt instrument and “strip” it. Thus, separating the coupons from the principal amount. The coupons and residue create a supply of new strip bonds which are sold separately to investors. A strip bond has no reinvestment risk because there are no payments before maturity.
STRIPS can only be bought and sold through a financial institution or brokerage firm (not through TreasuryDirect), and held in the commercial book-entry system.
I know what your thinking “agency.” This isn’t the CIA borrowing money to build black sites throughout the world. Agency securities or “agencies” is a term used to describe two types of bonds:
- bonds issued or guaranteed by U.S. federal government agencies
- bonds issued by government-sponsored enterprises (GSEs)—corporations created by Congress to foster a public purpose, such as affordable housing
Bonds issued or guaranteed by federal agencies such as the Government National Mortgage Association (Ginnie Mae) are backed by the “full faith and credit of the U.S. government.” This is similar to Treasuries. That means they are committed to paying interest payments, and to return the principal investment in full to you when it reaches maturity.
Bonds issued by GSEs such as The Federal Agricultural Mortgage Corporation (Farmer Mac) — are not backed by the same guarantee as federal government agencies. Bonds issued by GSEs carry credit risk.
It is important to gather information about the enterprise that is issuing the agency bond, particularly if it is issued by a GSE. These are publicly traded companies that register their stock with the SEC and provide disclosures that are publicly available, to include;
- annual reports
- quarterly reports
- current event reports
Why is that important? These documents can give you insight into the economic health of the company, and short- /long-term goals. These company filings are available online on the SEC’s website. It is important to learn about the issuing agency because it will affect the strength of any guarantee provided on the agency bond. Evaluating an agency’s credit rating before you invest should be standard protocol.
Munis pay a specified amount of interest (semiannually in most cases) and return the principal to you on a specific maturity date. Most munis are sold in minimum increments of $5,000 and have maturities that range from short term (2 – 5 years) to very long term (30 years).
When considering an investment in municipal bonds, bear in mind that no two municipal bonds are created equal. Carefully evaluate each investment, being sure to obtain up-to-date information about both the bond and its issuer.
The number of muni bonds available is staggering, and the fierce competition among dealers to gain a piece of the business should give you pause. It goes without saying, but do your due diligence.
The reason most investors buy municipal bonds is because they afford favorable tax treatment on the interest you earn. Interest on the vast majority of municipal bonds is free of federal income tax. Indeed, municipal securities are the ONLY securities for which this is the case.
What if I buy in state or out? If you live in the state or city issuing the bond, you may also be exempt from state or city taxes on your interest income. Bonds issued by Puerto Rico, Guam and other U.S. territories are tax-exempt for residents of all states.
Not all municipal bonds are free from federal tax. Taxable municipal bonds may be issued to finance projects that the federal government won’t subsidize. To compensate investors for the non-tax break, these bonds offer yields higher than tax-exempt municipal bonds.
International and Emerging Markets Bonds
Just like buying bonds from the U.S. government and U.S. companies, you can purchase bonds issued by foreign governments and companies. Since interest rate movements may differ from country to country, international bonds are another way to diversify your portfolio. Since information is often less reliable and more difficult to obtain, you risk making decisions on incomplete or inaccurate information.
Like Treasuries, international and emerging market bonds are structured similarly to U.S. debt, with interest paid semiannually. However, European bonds traditionally pay interest annually. Be warned though, there are increased risks in buying international and emerging market bonds. In addition, the cost associated with buying and selling these bonds is generally higher and requires the help of a broker.
International bonds expose you to a mixture of risks that are different for each country. A country’s unique set of risks is known collectively as sovereign risk. A nation’s political, cultural, environmental and economic characteristics are all facets of sovereign risk. Unlike Treasuries, which carry essentially zero default risk, default risk is real in emerging markets, where the sovereign risk (such as political instability) could result in the country defaulting on its debt. Think Venezuela! Like that bad!
Additionally, investing internationally also exposes you to currency risk, something not considered with U.S bonds. Simply stated, this is the risk that a change in the exchange rate between the currency in which your bond is issued—euros, say—and the U.S. dollar can increase or decrease your investment return. Because an international bond trades and pays interest in the local currency, when you sell your bond or receive interest payments, you will need to convert the cash you receive into U.S. dollars.
When a foreign currency is strong compared to the U.S. dollar, your returns increase because your foreign earnings convert into more U.S. dollars. Conversely, if the foreign currency weakens compared to the U.S. dollar, your earnings are reduced because they translate into fewer dollars. The impact of currency risk can be dramatic. It can turn a gain in local currency into a loss in U.S. dollars, or it can change a loss in local currency into a gain in U.S. dollars.
Some international bonds pay interest and are bought and sold in U.S. dollars. These are called “yankee” bonds and are issued by large international banks. In most cases they receive investment-grade ratings from credit rating services such as Moody’s and Standard & Poor’s. Both of these services evaluate and rate domestic bonds, but also provide Country Credit Risk Ratings that are helpful in determining risk levels associated with international and emerging market government and corporate bonds.
What’s next? The Bond Series: Bonds and Interest Rates