Investing in bonds is considered to be generally safe since this type of investment offers a fixed rate of interest. Aside from that, bonds also promise to give back the initial money invested at the maturity date. Although bonds give lower returns than the stock market, the lower amount of return is offset by the lower risk that bonds present. The returns from bonds are also much better as compared to cash investments like certificates of deposit or savings account.
There are many types of bonds available since every bond selling in the public market has some specifications that make it different from other bonds. To make it easier to understand the types of bonds available, it is useful to categorize them according to interest rates given, issuers, and bond composition.
Types of Bonds – Interest Rates
Depending on how the interest rate is calculated, bonds can be differentiated between no-coupon bonds and bonds with interest coupons.
Floater bonds – This type of bond is one that gives a variable interest rate. What makes it variable is that the interest rate is set by the issuer after each interest period. The interest rates are usually derived from certain benchmark rates and there can be upper or lower limits set for the interest rate spread. Because of the varying rates, investors should be careful to look closely at how the interest rates are calculated, so that they will know exactly what to expect when investing in floater bonds.
Zero coupon bonds – No coupon bonds means that investors don’t get fixed interest payments. Instead, the bonds are issued at a price that is well below their usual par value. When the investment matures, profit is taken from the difference between the issued price and the current par value.
Low Yielding Bonds – This bond type has a low coupon and is issued at prices below the nominal value. Investors usually invest in these bonds primarily for tax purposes.
High Yielding Bonds or Junk Bonds – When credit ratings for bonds were made, agencies made a grading system to reflect the credit quality of bond issuers. The bonds with the highest quality were graded “AAA” while riskier bonds were given a “C” or even a “D” for default grading. Bonds that are considered to be investment grade usually have a “BBB” grading or higher. Most investors were restricted in investing in grade bonds, while speculative bonds received a negative connotation. Because only a few people were willing to purchase these high yield bonds, they became known as “junk” bonds.
Bonds can also be categorized by the issuing body. There are two main categories for issuers, the government and private issuers.
US Government Securities – Bonds offered by the government is also known as Treasuries. They are issued as Treasury bonds, Treasury notes, and Treasury bills. Treasuries can come in a variety of “maturity” periods. Some can be as short as three months, while others as long as thirty years. Treasuries are guaranteed by the United States government and are free of local and state taxes on the interest that they pay.
Municipal Bonds – These bonds are issued by cities and they are also called as “munis”. They are riskier than treasury bonds simply because although cities don’t go bankrupt often, it can happen. However, the major advantage to this type of bond is that the returns are free from federal tax. Local government can also make their debt non-taxable for residents, making some municipal bonds completely tax free. Because of the savings that investors can get on tax, some municipal bonds can give lower yield rates than taxable ones.
Corporate Bonds – Companies are well known for issuing stock, but they are also capable of issuing bonds. Corporate bonds are generally characterized by offering higher yields because they also carry a higher risk as compared to treasury or municipal bonds. This is because the risk of companies defaulting and going bankrupt is much higher than that of the government. On the upside, corporate bonds can also be one of the most rewarding fixed-income investments because of the risk investors are taking on. It is very important to check on the company’s credit quality when investing in these types of bonds. The higher the quality, the lower the interest rate, but also the lower the risk. Generally, short term corporate bonds can be less than five years, immediate is five to twelve years, and long term is more than twelve years.
Agency Bonds – Aside from the government and corporations, government and quasi-government agencies may also issue bonds. Some agencies who participate in this are Federal National Mortgage Association or Fannie Mae, and Federal Home Loan Mortgage Corp o Freddie Mac. They sell bonds which are backed by the full faith and credit of the United States for specific purposes like funding home ownership.
Aside from interest and issuer, there are also other criteria that can help differentiate bonds. These are based on specific characteristics.
Convertible Bonds – These bonds can be issued by publicly listed companies. They give fixed-interest securities that give investors the right to exercise an option on shares or trade for shares. With this type of bond, investors may convert the bond into shares of the company upon the bond’s maturity. When the conversion rights are exercised, the bond will then expire. Convertible bonds are a cost effective way for companies to raise money. The issuers can lower market-prevailing interest rates which they must usually pay the investors. In return, the company can make the low interest rates juicy for investors by offering a promise that the investors have the right to buy the company’s shares at a previously set and lowered price.
Structured Bonds – These are also fixed-interest bonds. They function like any normal bond with a fixed interest rate, however, these bonds have conditions attached to them that may affect interest rates.
Investing in bonds is considerably safer than investing in stocks. This is a good option for those who are planning to use their money soon such as those who are nearing retirement age, or those who need to use the cash for their child’s education. Just like stock investing, the higher the risk the investor is willing to take, the higher the returns will be as well. Generally, one of the safest bonds to acquire would be Treasury bonds because it is highly improbable that the United States government will declare bankruptcy. And although corporate bonds may give higher returns, this can also be offset by higher risk.