Although you’re not a lending institution, such as a bank or savings and loan, you may actually be a different type of lender if you invest in bonds. Even the
Bond Issuance Vs. Loans
In the strictest sense, bonds are loans (called debt securities) that investors provide to issuing entities. But this type of loan follows a different structure, for example, than the mortgage loan you have for your house. You'll likely make monthly payments to repay your mortgage loan, but an issuing entity for a bond typically pays the entire loan in full at a certain maturity date.
And not only is a bond structured differently from other types of loans, but the roles of the lenders and borrowers also seem to be reversed. In the mortgage example, it’s typically a “big” institution (bank, savings and loan or mortgage company) who is the lender. But when bonds step into the lending equation, the “big” institution (company, corporation or government) does an about-face and becomes the recipient of the loan, putting you in the position of lender.
Who Issues Bonds?
Companies, corporations and school districts are among the numerous entities that can issue bonds. Since 1812, when the city of
Types of Bonds
The different types of bonds populate a financial spectrum from big business to small municipalities. Government, corporate and asset-backed securities are the primary bond types.
Some cities may enter the investing arena of bond issuance by issuing bonds for other entities, including hospitals and non-profit schools. In these cases, city governments pay the investors and the private entities, which are called “conduit borrowers,” repay the bond-issuing city government. The risk for investors is that they may not be paid if the conduit borrower defaults on making payments to the city, because the city typically is not obligated to pay investors if this happens.
About Government Bonds
“Government” casts a wide net, including the federal government, states, cities, counties and various municipalities. Bonds issued by the federal government are called “sovereign” debt, which is funded by the country’s printing of currency or taxing its citizens.
Government bonds are further broken down into classes, according to when they mature. Government bills mature in less than a year; notes mature between one and 10 years; and bonds mature in more than 10 years. Some bonds have maturity dates that stretch 20-plus years from their purchase date; not surprisingly, these bonds pay investors a higher interest rate for their long-term investment commitment.
Another type of government bond is the municipal bond. Also called “munis,” or "city bonds" if the government entity is a city, these bonds may be issued by government agencies as well as state and local governments. The investing risk is typically higher for munis than federal government bonds; for example, a city can go bankrupt and default on its bond payments.
About Corporate Bonds
Corporations represent a large sector of the bond market. They have a wide range of flexibility in issuing debt securities, typically depending on market pressure. One downside to investing in corporate bonds is a higher risk for investors, compared to government bonds. But a perk for the higher investing risk typically is a higher yield on the investment.
When corporations issue bonds, their length to maturity divides them into three classes: short-term corporate bonds mature in less than five years; intermediate corporate bonds mature in five to 12 years; and long-term corporate bonds mature in more than 12 years.
Corporations may issue convertible bonds, which offer their bondholders the option to convert their bonds at a certain date to shares of common stock. Corporations may also issue callable bonds, which offer their bondholders the option to redeem their bonds before their actual maturity date.
About Asset-Backed Securities
Also known as “ABS,” asset-backed securities represent bonds that are created from the collective cash-flow package of a similar pool of assets. For example, a bond may be composed of a pool of mortgage loans called mortgage-backed securities, also called MBS.
Categories of Bonds
The SEC notes two primary categories of municipal bonds:
- General obligation bonds. These are bond offerings that are not secured by any assets and rely on the “full faith and credit” of their issuers.
- Revenue bonds. These are bond offerings that are backed by the revenues its proposed project is expected to generate (such as a highway toll) instead of by tax proceeds.
Examples of Bonds
Bond offerings include everything from borrowing money to fund a state’s infrastructure needs, such as roads and bridges, or to pay the wages for city employees. Bonds may fund the building of a new airport or the expansion of an existing airport. Other bonds may raise construction funds to build schools, hospitals and libraries. To meet a municipality’s water needs, bonds may be issued to build or repair water/wastewater facilities.
Bond Interest Rates
Just like traditional loans, bonds also pay interest to the lender. A bond interest rate is called a coupon rate, and coupon rates typically are fixed – they do not fluctuate depending on market trends, and they do not adjust at periodic intervals. But the specific coupon rates for different types of bonds can vary widely.
At first glance, a seemingly low interest rate of 2.3 percent may not be attractive to many bond investors. But because bonds also yield tax-free advantages, the combination of the coupon rate plus the tax benefits could make this bond a lucrative investment. For example, depending on your tax bracket as well as other factors, you could potentially net 6.5 percent interest (or more) as a tax-equivalent yield on a municipal bond that has a 2.3 percent coupon rate.
Bond Maturity Dates
A bond’s maturity date is the date by which a bond issuer pays the lender (bond investor) in full for the principal amount the lender invested. Bonds have widely variable maturity dates, some of which may stretch 30 years in the future.
Serial bonds are bound in groups, with different bonds in the group having different maturity dates throughout the series. This series may be spread across a time span as short as one year or as long as 20 years. Term bonds generally have longer maturity dates than serial bonds – from 20 to 30 years – and they may mature on one date or on numerous dates throughout certain intervals.
Although an investor may sell a bond before its maturity date, bonds that are redeemed early will not yield their maximum potential.
Bond Yields and Types
A bond’s yield is the annual return on its investment, factoring in the bond’s purchase price.
- Current yield. Expressed as a percentage, a bond's current yield is what you’ll receive in interest payments, as represented by the ratio of the annual dollar amount of interest the bond pays to its original purchase price.
- Nominal yield. Expressed as a percentage, the nominal yield represents only the periodic percentage of interest the bond pays.
- Yield-to-maturity. Expressed as a dollar amount, a bond's yield-to-maturity is the sum of its principal plus its compounded interest that you’ll make over the life of the bond if you hold your bond to its maturity date.
- Yield-to-call. Some bonds may be “called” by the issuer, which means they are paid in full before their maturity dates. When this happens, the yield-to-call represents the total dollar amount of principal plus compounded interest that you’ll make if your bond issuer repays you before the bond’s maturity date.
- Realized yield. If you decided to sell a bond before its maturity date, its realized yield represents the estimated rate of return you'll receive by selling it early.
Bond Investment Advantages
Although all investments carry a measure of risk, bonds are the choice of many investors for numerous reasons:
- Some types of bonds, for example, municipal bonds, are generally tax-exempt from federal income tax. The IRS allows taxpayers to exclude the interest from bonds from their gross income on federal tax returns. Some states also allow this exclusion, for a double tax benefit, if you invest in bonds that are issued in the state where you live. On the flip side, many corporate bonds are not tax-exempt. Because of the many intricacies to tax-exempt benefits of bonds, the SEC recommends that investors seek advice from a tax professional to make an informed investing decision.
- Generally speaking, bonds are a “safer” investment than stocks because a bond’s day-to-day performance isn’t characterized by the more volatile nature of stocks. (Be watchful, though, for “junk bonds,” which are riskier than other types of bonds.)
- Income from bond investments typically follows an even and predictable path, which offers conservative investors a more secure investment vehicle.
- Bond interest rates are usually higher than savings accounts offer.
Bond Investment Disadvantages
The disadvantages of investing in bonds, just as investing in anything, call for a review of the risks associated with your investment. Some of the specific risks associated with bond investing include:
- Call risk. All bonds are not “callable” – that is, able to be repaid by the borrower before their maturity dates. But for bonds that are callable, your rate of return will likely fall short of what you’d anticipated for your investment.
- Credit risk. Governments as well as corporations that issue bonds have the potential to default on bond payments if they succumb to financial difficulties. Check a potential bond issuer’s credit rating to review its financial health. And although you won’t make your bond investment decision based solely on a company’s credit rating, this is a helpful tool to add to your research toolbox.
- Interest rate risk. Once you’ve purchased a bond, you’re generally locked into its fixed interest rate. But the interest rate risk you take is holding a long-term bond for many years that’s at the mercy of market fluctuations. For example, if market interest rates rise, the value of your bond goes down. And because you’re locked into that fixed interest rate, you cannot sell the bond before its maturity date and move your money into a higher interest-bearing vehicle without also losing more of the bond’s value.
- Broker risk. Before you purchase a bond through a broker or financial adviser, check the broker’s credentials. In fact, the SEC advises potential investors to make sure brokers are properly credentialed with the required licenses and registration before you invest your money. Another heads-up is that the compensation you pay a broker typically is not disclosed on your confirmation statement. The SEC recommends asking your broker to disclose all commission fees and markups that may not be in the “fine print.” Visit the SEC at Investor.gov to vet your broker before moving forward; you can perform an internal search by entering your keywords in the search field, or click on the tab labeled "Research Before You Invest" for more information.
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