Breaking Down Different Types of Bonds by Issuer
The most important consideration in choosing a bond is the issuer, since you are counting on this entity to return your investment capital to you. The seven issuer categories include:
· Treasury Bonds – Backed by the government, you help finance the federal budget deficits. Thanks to Uncle Sam’s taxing authority, they’re almost risk-free. The yields are among the lowest, but they have historically continued to perform in the positives, even during economic downturns. The interest is exempt from state income tax.
· Other US Government Bonds – Sometimes called “agency” bonds, these bonds are issued by federal entities like Fannie Mae, Ginnie Mae, and Freddie Mac. These bonds are not fully guaranteed by the US Treasury. Interest on these bonds is taxable at state and federal levels, however.
· High-Quality Investment-Grade Corporate Bonds – Companies with strong balance sheets offer the highest quality corporate bonds. They carry ratings of AAA, AA, A, or BBB by Standard & Poor’s, Moody’s, or both. During downturns, they underperform treasury and agency bonds and they are fully taxable, but generally the yields are still higher than government-backed bonds.
· Low-Quality High-Yield Corporate Bonds (Junk Bonds) – Companies with weak balance sheets and ratings below BBB with substantial risk of defaulting offer high-yield corporate bonds. Companies use your money to expand operations or pay off debts. Those who are in a poor position will offer a higher rate of return to compensate for the elevated investment risk. Yields are generally consistent. However, the company may file for bankruptcy. In the event the company files for bankruptcy, bond holders are paid before stock holders, and there may not be enough assets to return bond holders’ capital investment.
· Emerging Market / Foreign Bonds – The average foreign bond has a third of its assets tied in foreign-currency-denominated debt. The issuer promises to make fixed interest payments and return the principal in another currency. The size of the payment depends upon the exchange rates and the strength of the US dollar. In general, long-term foreign bonds have relatively high-yield.
· Mortgage-Backed Bonds – These loans help build commercial real estate like office complexes, hotels, malls, apartment buildings, and factories. The face value of a mortgage-backed bond represents high risk — $25,000, as opposed to $1,000 or $5,000 for other types of bonds. As with corporate bonds, there is a risk of default.
· Municipal Bonds – Munis are issued by state and local governments in high-yield or investment-grade categories. Entities use your investment on projects like building bridges, highways, hospitals, public housing, roads, schools, and utilities. Their interest is tax-free, but yields vary. They are generally considered one of the most stable investment vehicles, next to treasury bonds and savings accounts. Since they are traded on a secondary market, the they are liquid investments under normal market conditions.
To Choose Among Different Types of Bonds
Choosing among these different types of bonds depends upon your tax bracket. If your tax bill is high, you might consider diversifying your stock portfolio with low-yield municipal bonds that are exempt from federal income tax. Risk tolerance will dictate which bond you select. If you want to play it conservatively and hold onto your fixed-income, stick with treasury, government, or corporate investment-grade bonds. The other types of bonds are prone to stock declines to varying degrees.
Issuer is just one bond characteristic for consideration. Other characteristics include:
· Face/Par Value – The face value of a bond represents how much you’ll receive at maturity. Corporate bonds generally carry a face value around $1,000. Government bonds are often sold with much higher face values – as high as $100,000 or even $1 million. Most bonds are issued slightly below par to trade on the secondary market above or below par, depending on interest rates, credit, and other factors. When bond prices are lower than the stated value, they trade “at a discount.” When bond prices are higher than the stated value, they trade “at a premium,” which means you will receive less at maturity than what you paid for the bond.
· Coupon/Yield – A bond’s coupon or yield is the interest rate the issuer agrees to pay you. It is based on the interest rate environment, inflation expectations, and the likelihood of repayment. (Companies offering high risk of repayment at maturity offer lower coupon payments, whereas less predictable investments offer more interest up front. Some people buy bonds at a premium in exchange for the higher short-term interest payments.) Interest payments can be paid quarterly, semi-annually, or annually. Some bonds sold at an initial discount with full face value repayment do not pay out coupons. For most bonds, though, the annual yield is paid at a percentage of face value – for instance, $100 for a 10% yield on a $1,000 bond. Interest rates can be fixed, adjustable, or variable.
· Maturity – The maturity is the date you’ll be repaid for your investment by the issuer, depending on the issuer’s preference. Government bonds can repay in as little as a couple months to up to 30 years. Corporate bonds typically repay in one to five years, with some bonds maturing in 10, 30, or up to 100 years (for “century bonds.”) The longer you hold a bond, the more chances you have of losing your investment, but you will be offered a higher yield for your increased risk.
You may have landed on this page wondering, “What are the different kinds of bonds?” But we hope by now you realize the choice boils down to your risk tolerance, your portfolio’s gaps, your current needs, your tax profile, and your future financial goals. The 6th Avenue Team at Ingalls & Snyder, LLC helps investors of all levels find the best matches here in our New York City office. For more than 90 years, investors have trusted our Manhattan investment firm to optimize the upsides and minimize the downsides of their portfolios, using core and tactical strategies. Contact us to learn more about bond ETFs and other investment strategies that may be appropriate for your circumstances.
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