Bonds come in many different varieties, and here we will cover just the most common types.
Government bonds can be issued by national governments as well as lower levels of government. At the national or federal level, these government bonds are known as “sovereign” debt, and are backed by the ability of a nation to tax its citizens and to print currency. In the U.S. federal debt is classified according to its maturity. “Bills” are bonds maturing in less than one year, “Notes” between one and ten years, and “Bonds” maturing in more than ten years. Marketable securities from the U.S. government - known collectively as “Treasuries” - follow this guideline and are issued as Treasury bonds, Treasury notes and Treasury bills (T-bills). All debt issued by the U.S. government is regarded as extremely safe, often referred to as “risk-free” securities, as is the debt of many stable countries. The debt of developing countries, on the other hand, does usually carry substantial risk. Like companies, countries can therefore default on payments. Credit ratings agencies also rate a country’s risk to repay debt in a similar way that they issue ratings on corporate bond issuers. Countries with greater default risk must issue bonds at higher interest rates – which essentially increases their cost of borrowing. Governments also issue bonds that are linked to inflation, known in the U.S. as Treasury Inflation Protected Securities, or TIPS.
The government also issues what are known as zero-coupon or z-bonds, which pay no coupon, but instead are offered at a discount at sale. For example, let's say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth $1,000 in 10 years. These bonds are known as Treasury STRIPS in the U.S. Government savings bonds are also zero-coupon bonds that gain value as they mature.
Municipal bonds, also known as "munis" are bonds issued by state or local governments or by government agencies. These bonds are typically riskier than national government bonds; cities don't go bankrupt that often, but it can happen (for example in Detroit and and Stockton, CA). The major advantage to munis for investors is that the returns are free from federal tax, and furthermore, state and local governments will often consider their debt non-taxable for residents, thus making some municipal bonds completely tax free, sometimes called triple-tax free. Because of these tax savings, the yield on a muni is usually lower than that of an equivalent taxable bond. Depending on your personal situation, a muni can be a great investment on an after-tax basis.
The other major issuer of bonds are corporations, and corporate bonds make up a large portion of the overall bond market. Large corporations have a great deal of flexibility as to how much debt they can issue: the limit is generally whatever the market will bear. A corporate bond is considered short-term corporate when the maturity is less than five years; intermediate is five to 12 years, and long-term is over 12 years. Corporate bonds are characterized by higher yields than government securities because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on, where higher credit companies that are more likely to pay back their obligations will carry a relatively lower interest rate than riskier borrowers. Companies can issue bonds with fixed or variable interest rates and of varying maturity. Bonds issued by highly rated companies are referred to as investment grade while those below investment grade are junk or high-yield.
Convertible bonds are debt issued by corporations that give the bondholder the option to convert the bonds into shares of common stock at a later date. The rate at which investors can convert bonds into stocks, that is, the number of shares an investor gets for each bond, is determined by a metric called the conversion rate. The conversion rate may be fixed or change over time depending on the terms of the offering. A conversion rate of 30 means that for every $1,000 of par value the convertible bondholder converts, she receives 30 shares of stock. It is not always profitable to convert bonds into equity. Investors can determine the breakeven price by dividing the selling price of the bond by the conversation rate. Typically, investors will exercise this option if the share price of the company exceeds the breakeven price. Convertible bonds typically carry lower yields due to this right given to investors.
Callable bonds are bonds that can be redeemed by the issuer at some point prior to its maturity. If interest rates have declined since the company first issued the bond, the company is likely to want to refinance this debt at a lower rate of interest. In this case, the company calls its current bonds and reissues them at a lower rate of interest. Callable bonds typically have a higher interest rate to account for this added risk to investors. When homeowners refinance a mortgage, they are calling in their older debt for a new loan at better rates. Putable bonds allow the bondholder to force the issuer to repurchase the security at specified dates before maturity. The repurchase price is set at the time of issue, and is usually par value, and generally works to the favor of investors. Therefore, yields on these bonds tend to be lower.
A third category of bonds is issued by banks or other financial sector participants and are referred to as asset-backed securities or ABS. These bonds are created by packaging up the cash flows generated by a number of similar assets and offering them to investors. If such a bond is backed by a number of mortgages, they are known as mortgage-backed securities or MBS. These bonds are typically reserved for sophisticated or institutional investors and not individuals.
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