Different Types of Bonds
Today I’d like to introduce the different types of bonds that are available to investors. Each will have positives and negatives, as as such, will be of value to a particular investor.
This is more of a general category but it is important to understand. Many of the bonds below can be found in zero-coupon form – for example Treasury bills. A zero coupon bond pays no coupon, but trades at a discount to par value.
For example, let’s say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $500; you’d be paying $500 today for a guaranteed $1,000 payment in 10 years. You’d receive no interest payments (coupon payments) in those 10 years.
There are three different types of corporate bonds: secured corporate bonds, unsecured corporate bonds, and debentures. Secured corporate bonds (or asset-backed bonds) are guaranteed by company collateral, such as leases, receivables (e.g., capital equipment), or property liens (mortgage-backed bonds).Unsecured corporate bonds are not backed by collateral. These bonds are more risky; therefore, companies must pay a higher return on these bonds to sell them. Debentures are long-term unsecured bonds that are backed solely by the issuer’s integrity. The list below summarizes characteristics of corporate bonds:
- Issuer: Corporate bonds are issued by corporations.
- Par value: Corporate bonds are issued in amounts of $1,000 and greater.
- Maturity: Corporate bonds can have varying lengths of maturity. Generally, the maturity length on short-term corporate bonds ranges from one to five years; intermediate-term corporate bonds typically range from five to ten years; and long-term corporate bonds typically mature after eleven or more years.
- Taxes: Corporate bonds offer no tax advantages to the holder and are subject to federal, state, and local taxes.
- Risk and return: Corporate bonds are riskier than government bonds, but corporate bonds offer higher returns. Remember, the higher a company’s bond rating, the lower the risk involved in purchasing that company’s bonds, and the lower the return.
- Ratings: Corporate bonds are generally rated by one or both of the major bond-rating companies (Standard & Poor’s and Moody’s).
- Trading: Corporate bonds may be purchased by brokers, over the counter, or in funds.
- Call provision: Corporate bonds are often times callable.
U.S. Government Debt Securities
The U.S. Treasury issues three different types of bonds: Treasury bills, Treasury notes, and Treasury bonds. Treasury bills are short-term debt obligations; these bonds are issued at a discounted price and may be redeemed at par value upon maturity in three, six, or twelve months. Treasury notes are intermediate-term debt obligations that are issued at or near par value; interest is paid semiannually on Treasury notes. Treasury bonds are long-term debt obligations that are issued at or near par value; interest is paid semiannually on Treasury bonds. The list below summarizes characteristics of U.S. Treasury debt securities:
- Issuer: U.S. Treasury debt securities are issued by the U.S. government.
- Par value: Treasury notes are issued in amounts ranging from $1,000 to $5,000, and Treasury bonds are issued in amounts ranging from $10,000 to $1,000,000.
- Maturity: Maturity length for U.S. Treasury debt securities ranges from three months (for Treasury bills) to more than thirty years (for Treasury bonds).
- Taxes: U.S. Treasury debt securities are exempt from state and local taxes, but are taxed at the federal level.
- Risk and return: U.S. Treasury debt securities are government securities, so they are considered default risk-free. However, because the perceived risk on these bonds is lower, the returns are also lower.
- Ratings: U.S. Treasury debt securities are issued by the federal government; therefore, they are not rated.
- Trading: Newly issued bonds are traded at auction at the Federal Reserve. Outstanding bonds are traded by brokers on the secondary market.
- Call provision: U.S. Treasury debt securities are generally not callable.
U.S. Government Savings Securities
U.S. Treasury savings securities come in many forms: the most common types of U.S. Treasury savings securities are EE bonds and I bonds. EE bonds are sold at a discount, and I bonds are sold at face value and interest is paid at maturity. Both securities have variable interest rates. The list below summarizes characteristics of U.S. Treasury savings securities:
- Issuer: U.S. Treasury savings securities are issued by the U.S. government. They are not marketable (i.e., they cannot be resold to others), but they can be redeemed at local banks.
- Par value: U.S. Treasury savings securities are issued in amounts of $25, $50, $100, $1,000, and $10,000. They can be purchased over the internet without transactions costs.
- Maturity: U.S. Treasury savings securities that are redeemed within five years usually charge a three-month interest penalty. Investors can hold U.S. Treasury savings securities for up to thirty years.
- Taxes: U.S. Treasury savings securities are registered as bearer bonds, which are exempt from state and local taxes. Another benefit of this type of security is that the interest is completely tax-free if it is used to pay for qualified educational expenses. Other taxes are deferred until maturity.
- Risk and return: U.S. Treasury savings securities are government securities, so they have minimal risk. The return on EE bonds is variable and changes every six months. The return on I bonds is also variable: this rate of return changes every six months to account for a guaranteed return over inflation for six months, as well as a real-return component. The real-return component is a guaranteed return amount over and above the return on inflation.
- Ratings: U.S. Treasury savings securities are not rated because they are government securities.
- Trading: U.S. Treasury savings securities cannot be traded. They can be purchased over the Internet and redeemed at local banks.
- Call provision: U.S. Treasury savings securities are not callable.
There are two different types of municipal bonds (“munis”): revenue bonds and general obligation bonds. Revenue bonds are backed by the revenues of a specific municipal project. General obligation bonds are backed by the taxing power of the issuer. The list below summarizes characteristics of municipal bonds.
- Issuer: Municipal bonds are issued by state and local governments.
- Par value: Municipal bonds are often issued in amounts of $5,000 and greater.
- Maturity: Municipal bonds can have varying maturity lengths. Generally, short-term municipal bonds mature in one to five years; intermediate-term municipal bonds mature in five to ten years; and long-term municipal bonds mature in eleven or more years.
- Taxes: Municipal bonds are exempt from federal taxes, and may be exempt from state and local taxes. Municipal bonds are often exempt from state and local taxes if the holder lives in the state where the bond was issued.
- Risk and return: Returns on municipal bonds are generally higher than returns on government bonds to compensate for increased risk, as government bonds are considered essentially risk free. However, returns are generally lower for municipal bonds than corporate bonds because municipal bonds are exempt from taxes.
- Ratings: Most municipal bonds are rated by bond-rating companies.
- Trading: Municipal bonds are traded through brokers and over the counter.
- Call provision: Municipal bonds are sometimes callable.
Agency bonds (agencies) are issued by various federal, state, and local agencies that are authorized by Congress to issue bonds. Examples of agencies that are authorized to sell bonds include the Federal National Mortgage Association (FNMA, also called Fannie Mae), the Federal Home Loan Bank (FHLB, or Freddie Mac), and the Government National Mortgage Association (GNMA, or Ginnie Mae). The list below summarizes the characteristics of agency bonds.
- Issuer: Agency bonds are issued by various federal, state, and local agencies; these institutions have all received congressional authorization to sell agency bonds.
- Par value: Agency bonds are generally issued in amounts of $25,000 and greater. Agency bonds usually require a higher minimum investment than the minimum investment required by other types of bonds.
- Maturity: Agency bonds have varying maturity lengths. Generally, short-term agency bonds mature in one to five years, intermediate-term agency bonds mature in five to ten years, and long-term agency bonds mature in eleven or more years.
- Taxes: Agency bonds offered by Ginnie Mae, Fannie Mae, and Freddie Mac are taxable. Agency bonds offered by other federal agencies are exempt from state and local taxes.
- Risk and return: Agency bonds are more risky than Treasury bonds and consequently pay higher returns.
- Ratings: Some agency bonds are rated by bond-rating companies.
- Trading: Agency bonds are traded through brokers and over the counter; they are also traded directly through banks.
- Call provision: Agency bonds are not callable.
There are three different types of international bonds: international bonds, Yankee bonds, and Eurobonds. International bonds are issued by international companies and sold internationally in various countries and currencies. Yankee bonds are issued by international companies and sold in the United States in U.S. dollars. Eurobonds are issued by U.S. companies and sold outside of the United States in U.S. dollars. The list below summarizes characteristics of international bonds:
- Issuer: International bonds are issued by U.S. or international corporations.
- Par value: International bonds are issued in amounts of $1,000 and greater. The par value of international bonds may be in different currencies.
- Maturity: International bonds have varying maturity lengths. Generally, short-term international bonds mature in one to five years, intermediate-term international bonds mature in five to ten years, and long-term international bonds mature eleven or more years.
- Taxes: International bonds may be subject to federal, state, and local taxes. Depending on where the bond is issued, international bonds may also be subject to foreign taxes.
- Risk and return: Risk and return varies depending on the type of international bond. International bonds are more risky than government and corporate bonds, but they typically offer higher returns than those offered by corporate bonds. International bonds may also be risky in terms of exchange rate (currency).
- Ratings: International bonds are rated in the same way as corporate bonds. Bond-rating companies rate both U.S. companies and large international companies.
- Trading: International bonds are either traded by brokers over the counter or in an exchange. These bonds may also be traded in domestic bond markets of foreign countries, as well as in the Euromarkets (markets outside the United States where securities are traded in the U.S. currency).
- Call provision: International bonds are sometimes callable.
A Few Notes
One side note worth mentioning is that bonds are very much like stocks. They should almost always be held in a diversified ETF or index mutual fund. Owning a good bond ETF will result in your owning thousands of different bonds, so the default risk is much lower. In addition, individual bonds usually cost $1000 or more each, but an investor can get into a good ETF or bond fund for very cheap.
In addition, corporate bonds and any others that are not tax advantaged should be held in tax sheltered accounts, like a 401k. This is because interest payments to the investor are always taxed at full income tax rates, not preferential capital gains or dividend rates like those found in stocks.
However, if tax advantaged bonds are held, they should always be in a taxable account. If you were to hold municipal bonds in a 401k, you would negate any advantage they once had. They return lower rates that corporate bonds to begin with, and that is because they produce tax free returns.
Did I sufficiently cover the different types of bonds that are available to investors? Share your thoughts with a comment below.