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BOND BASICS
Bonds are an essential element to a diversified asset allocated portfolio, especially for the investor relying on income producing investments.
Government Bonds
Bills - debt securities maturing in less than one yearNotes - debt securities maturing in one to ten yearsBonds - debt securities maturing in more than ten years
Municipal Bonds
Municipal bonds are the next progression in terms of risk. Cities don't often go bankrupt. The major advantage to "munis" is that the returns are free from federal tax. Local governments sometimes make their debt non-taxable for residents, making some municipal bonds completely tax-free. Residents in certain states that do not have a state income tax have the luxury of buying bonds outside of their state of residence. Because of the tax savings, the yield is usually lower than that of a taxable bond. Depending on your personal situation, munis can be a great investment on an after-tax basis.
Corporate Bonds
A company can issue bonds just like it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue. The limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years, an intermediate corporate bond is five to twelve years, and a long term is over twelve years.
Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting. They can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important. The higher the quality, the lower the interest rate the investor receives.
Zero Coupon Bonds
This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, a zero coupon bond with a $1000 par value and ten years to mature might be trading at $600. Meaning, today you would pay $600 for a bond that will be worth $1000 in ten years.
Agency Bonds and Mortgage-Backed Securities Agency Bonds are issued by the Federal Government and various government-sponsored organizations to raise money to help certain areas of the economy. Together, these securities are called agency bonds. These groups sell their own securities as one way to raise money. The U.S. Treasury does not issue any agency bonds.
Agency securities are considered very safe from default. Should they ever default, the government would probably use its credit to guarantee investors’ payments of interest and principal. This is generous protection, since the U.S. Government does not fully guarantee most agency securities.
Most agency bonds are in the form of mortgage-backed securities. These represent investments in a pool of mortgages.
Agency bonds provide yields that are higher than those of Treasury securities. This is because they lack explicit guarantees of safety. Their maturities range from one year to fifty years. Denominations vary from $1,000 to $50,000.
Some well-known agencies that issue securities are:
The U.S. Postal Service - raises funds to help its mail-delivery operations
The Federal Land Banks - raises funds for agricultural projects
The Government National Mortgage Association (Ginnie Mae) - finances housing projects
The Federal National Mortgage Association (Fannie Mae) - finances mortgages for the Federal Housing Administration and the Veterans Administration
The Federal Home Loan Mortgage Corporation (Freddie Mac) - finances federally chartered thrift institutions.
Ginnie Mae, Fannie Mae, and Freddie Mac issue the vast majority of mortgage-backed securities.
Series EE and Series HH bonds
Two types of non-marketable bonds are known as Series EE and series HH bonds. Series EE bonds are the savings bonds that have been popular for decades. They do not distribute interest periodically as many other bonds do. They are purchased at a discount from the face value (par). The discount is calculated using the bond's interest rate and years to maturity. Investors purchase them for less than their face value and let them build up to full face value at maturity.
The minimum face value of a Series EE bond is $50. The maximum face value possible is $30,000. One can purchase Series EE bonds at banks or through payroll deduction plans. The investor can allow the accrued interest to be taxed each year, or they can defer it until the bond is redeemed. The tax may be deferred beyond this date if the investor exchanges his or her bond for a Series HH bond.
Series HH bonds are savings bonds that do pay interest and are sold at their face values. Interest is paid twice per year. The denominations range from $500 to $10,000. Series HH bonds may be redeemed after six months. They normally mature in ten years but can be extended to twenty. Series HH bonds have fixed rates of interest and can only be obtained as exchanges of Series E or Series EE bonds.
Shawn Tierney
Financialjoe
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