Wednesday, July 1, 2009

What are the Different Types of Bonds?

Various entities issue bonds to borrow money. Of course, corporations issue bonds to increase their cash flow. If a corporation goes bankrupt, it may not be able to repay its outstanding loans.

The largest sector of the bond market is U.S. Treasury obligations (treasure bills, notes, and bonds). These securities are backed by the full faith of the U.S. Government, and are thus free from default risk. However, because the risk of these securities is reduced, returns are often diminished. Treasury bills (short-term securities) are zero-coupon bonds, meaning they do not produce semi-annual coupon payments. Zero-coupon bonds are usually purchased at a discount (for example, $950) and the purchaser receives the face value ($1,000) on the maturity date. Treasury bonds and notes (intermediate to long term) are similar to other bonds in that they pay a semi-annual interest payment. Although interest rates offered on treasury securities are usually lower than other bond options, interest earned on these investments are exempt from state and local income taxes.

Treasury inflation-protection securities (TIPS) are bonds that provide investors with a rate of return that is adjusted for inflation. If an investor expects significant inflation or wants to insure that the purchasing power of a portfolio will not be reduced by inflation, TIPS would be an appropriate investment.

Municipal bonds are issued by state and local governments. There are two types of munis. General obligation bonds are backed by the taxing power of the government entity. Revenue bonds are serviced by specified revenue-producing projects such as a toll road. If the project fails to produce revenue, the municipality doesn’t have to repay the loan. Consequently, revenue bonds are more risky than general obligation bonds. Both types of municipal bonds are generally exempt from federal income tax and local tax if the investor lives in the state that issued the bond. Thus, these investments are frequently attractive to individuals in high tax brackets.

Like stocks, bonds can be purchased individually or through a bond mutual fund. A bond fund simply invests in a portfolio of individual bonds. The bond fund manager collects the coupon payments from the individual bonds and reinvests the money into other bonds. When a bond matures, the face value of the maturing bond is most often simply reinvested into a new bond. Bond funds do not have a stated maturity date or coupon, and bond fund investors do not receive a repayment of principle until the fund is sold.


Anonymous said...

How do you know which bond to buy? Which one is best for you?

Lon Jefferies, Fee-Only Financial Planner and Fiduciary said...

If you are not a professional investor, I suggest you invest in a bond fund. A couple of reasons why:

1. Diversification: A bond fund will invest in anywhere from 20 to 1,000 bonds in many different industries, with various levels of risk. If you own only one bond, and the issuing company goes bankrupt, you lose 100 percent of your investment. If you own 100 bonds and one firm goes bankrupt, the blow is dramatically reduced.

2. Diversifying your bond portfolio without using a bond fund would take a significant amount of resources. Remember, a bond's price is usually around $1,000. Thus, in order to purchase a diversified portfolio of 100 bonds, an investor would need approximately $100,000. Meanwhile, you could invest in 100 different bonds within a bond fund for as little as $1,000.

3. Bond fund managers are experts in their field. Do you have time to research the tens of thousands of bond issues out there? Why not capitalize on the knowledge of professionals so you can focus on what you do best?