When considering a bond you should think of an I.O.U. As a bond holder, you are loaning your money to another entity such as a government, municipality, corporation or other “issuer.” In exchange for your loan, the issuer provides you with a document which states that they promise two primary things; to pay you interest on a periodic basis and to repay your loan upon maturity of the bond.
There are several types of bonds an investor can purchase. Some of the most common and broad categories are:
U.S. Government Bonds also known as Treasury Bills, Treasury Notes, Treasury Bonds and Federal Agency Bonds.
United States Treasury Securities and direct debt obligations of the U.S. Government. Simply put, you or anyone who either purchases or is a holder of “treasuries” is or has lent money to the federal government. These obligations can range in time/maturity from one month to 30 years, and everything in between. Typically the longer period of time you lend money for, the more interest you will be paid. Throughout most of history, these securities have been some of the most safest investments in the world. In exchange for peace of mind, the purchaser will get a lower rate of return as compared to other types of bond investments.
Other types of government securities are those that are issued by what are known as GSEs (Government Sponsored Enterprises). They are usually federally sponsored but privately or publicly owned corporations. The most commonly known GSEs would be entities such as Fannie Mae and Freddie Mac (Federal Home Loan Mortgage Association). These entities ran into extraordinary financial distress during the credit crunch of 2008. As an example, the bonds of these entities were backed and guaranteed by the federal government. (The stock was not)
Other GSEs to note are the Federal Agricultural Mortgage Corporation known as Farmer Mac and the Government National Mortgage Association known as Ginnie Mae. They all are there to provide assistance to American citizens for various purposes. These entities have come under much political scrutiny since our national debt has been on the rise and tax payers are subject to the burden of funding these organizations.
Municipal Bonds commonly known as “munis” are unique because the interest paid by the issuer is typically exempt from federal income tax. (there are exceptions) Certain states do tax the income, and this should be researched before purchasing based on where your legal residency is listed. These bonds can be issued by state and local governments to fund specific projects such as roads, bridges, schools, hospitals, housing, water and sewer systems and many other public projects for the benefit of their residents.
Some basic types of municipal bonds are insured bonds that have historically been safe investments for the “muni” buyer. Although there seems to be a sea change in that the traditional insurers realize that in the event of a large scale financial meltdown where several issuers are not able to repay their debts, the insurance company may not be able to support the guarantee once thought to be iron clad.
Zero Coupon Municipal Bonds pay interest, usually twice per year, but as the name indicates, they don’t pay the interest to the bond holder. The interest payments accumulate within the bond structure and the holder gets back their principal plus all the interest payments at maturity. Therefore, the bonds are typically purchased at a deep discount to the face amount that you would receive at maturity. These bonds have historically been a favorite to parents investing for their children’s college tuition. They would purchase the bonds when their kids were young, and at maturity they would have a much larger portion than was invested.
Build America Bonds (BABs) are relatively new as of 2009. Many of these issues are not federally tax exempt. They are issued as a federal subsidy from the US Treasury to the states and municipalities for capital projects. These bonds are new, complicated and trade in a market with limited liquidity unlike traditional municipal bonds or other government issued bonds.
Corporate Bonds are also debt instruments issued by many different types of companies to fund capital projects, investments and even operating cash flow. Historically, the corporate bond market has always been larger than the municipal and U.S. Treasury securities markets, although that may be changing with the advent of current U.S. debt outstanding.
An investor interested in purchasing corporate bonds must be aware of some of the risks that are more prevalent than that of government securities. (not to say gov’t securities are risk free) When investing in corporate bonds, you will most likely be compensated for taking on more risk than owning government bonds, but understanding those risks first is extremely important. When you purchase the debt of a company, they are agreeing to pay you interest usually semi-annually and return your original investment or principal payment at maturity. If the company’s financial position deteriorates during your holding holding period, you may be subject to loss of principal and interest if they lose the ability to repay their debts. Many investors consider bonds a safe investment, but in the event of imminent default, the market in those bonds may become illiquid and very difficult to sell your bonds at a reasonable price. Many companies are highly rated and should provide safety of your principal, but as an investor, you should do your homework or be able to rely on someone who understands the corporate bond market.
There are three primary organizations who rate bonds. Moody’s Investors Services, Standard and Poor’s, and Fitch Ratings. These entities have come under extreme scrutiny because of inherent conflicts of interest. They are normally paid by the issuer of a bond to rate that bond. Caveat Emptor!
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