The Various Categories of Bonds
Investors who are new to bonds tend to be familiar with the term 'Treasury bonds' as these bonds are widely covered by the financial press. These are actually numerous different categories of bonds and most of these are not normally mentioned by the financial press.
U.S. Treasury Bonds
Bonds issued by the U.S. Treasury are the safest and the most popular of all the various types of bonds available. While treasury bonds are not guaranteed as such, they come with the full backing of the U.S. Treasury with assurance that their obligation to bondholders will be met. Basically congress has the power to increase taxes etc to meet their obligations and this effectively makes treasury bonds as good as guaranteed.
Treasury bonds come with a variety of maturities ranging from four weeks up to 30 years and they can be sold prior to maturity. An investor can buy newly issued bonds directly form the U.S. Treasury or they can buy used bonds from a bond dealer.
Bonds issued by corporations are riskier than treasury bonds and pay a higher interest rate. Corporate bonds are extremely popular, but unlike treasury bonds there is a risk of default. The risk with corporate bonds is based on the issuing company's financial position, since the company must have sufficient cash flow to make its interest payments. Fortunately for inventors, there are credit agencies which evaluate the credit risk and assign the company with a credit rating.
Corporate bonds which have a low credit rating are referred to as either Junk bonds or High-yield bonds. These bonds pay a higher interest rate but also more likely to default.
Newly issued corporate bonds can be bought though a bond broker. Also corporate bonds can be sold and used corporate bonds can be bought.
Municipal bonds are issued by a state or local government and these bonds are extremely popular with individual investors due to their tax advantages. Municipal bonds are generally exempt from federal taxes which no doubly contribute to their popularity. They do however pay a lower interest rate than treasury bonds and as such investors need to determine whether the tax advantage will provide a higher net return.
Municipal bonds issued by municipalities are considered safe investments. But there are also municipal bonds issued by non-municipalities such as universities, airports and hospitals which are reliant on revenue to meet their bond obligations and this increases the risk of default.
U.S. Savings Bonds
Savings bonds are issued by the U.S. Treasury and are an alternative to a Certificate of Deposit. Savings bonds are essentially the same as treasury bonds with a few exceptions.
Unlike treasury bonds which can be sold, savings bonds cannot be transferred. This is because with savings bonds the investor's name and social security number are included with the bond and they are the only person entitled to the interest and principle upon maturity. Thus savings bonds have no resale value and the returns are purely the interest they earn.
Investing in savings bonds is very simple which makes them attractive to beginner investors. Savings bonds are bought direct from the U.S. Treasury, but unlike bonds they do not make any coupon payments and as such do not provide an income source. Instead, the interest earned is accrued which means it is added to the face value of the savings bond.
Any time after one year the savings bonds can be redeemed and the investor receives their original investment plus the accumulated interest earned. An early redemption penalty applies if a savings bond is redeemed within five years of issue (the investor forfeits the last three months of interest). Savings bonds cannot de redeemed before the minimum term, which is currently one year. The maximum term for which interest is accrued is 30 years.
Currently there two types of savings bonds - I Savings Bonds and EE Savings Bonds. They are basically the same with some minor differences.
- I Savings bonds can be in either paper form or electronic. The interest rate contains a fixed rate portion and a variable rate portion which is based on the consumer price index (CPI).
- EE savings bonds are electronic only and have a fixed interest rate.
These are bonds issued by federal agencies with the most common agencies issuing bonds being:
- Federal Home Loan Mortgage Corporation (FHLMC) also referred to as Freddie Mac.
- Federal National Mortgage Association (FNMA) also referred to as Fannie Mae.
- Small Business Administration (SBA)
Strictly speaking, only the SBA is a federal agency. The other two are actually government sponsored organizations created by congress and are listed companies.
Agency bonds are considered safe investments as they are backed by the federal government. This implies that should these organizations get in financial difficulties then the federal government will step in to fulfill the issuers' obligations.
Agency bonds can be more complex than treasury bonds are they are mostly purchased by institutions. Retail investors tend not to buy agency bonds directly but tend to prefer using a fund.
Bonds issued buy the governments and corporations of developed foreign countries can help diversify a bond portfolio. The interest rates for bonds are largely determined by the countries inflationary environment. Essentially the higher the inflation rate then the higher the bonds interest rate.
The inflation rate across countries varies considerably as each country deals with its own economic conditions. While the U.S. economy might currently be in a low inflationary environment does not mean that the rest of the world is in a similar position. There are always countries which are currently experiencing low inflation and countries which are battling high inflation.
By including bonds from high interest paying countries, the bond investor can boost their returns and at the same time increase their diversification.
Investing in international bonds involves the currency exchange risk and buying bonds in a foreign currency complicates the investing process. For many bond investors, using a fund simplifies the process as the investor can simply buy fund shares in their home currency.
Emerging Market Bonds
Emerging markets are countries that are not considered to be developed industrialized nations. These economies typically issue bonds in U.S. dollars which is convenient for investors living in the U.S. but inconvenient for investors not living in the U.S.
Bonds issued by emerging markets are frequently government bonds and their interest rates can be high, but they are also come with a much higher risk of default which means investors not receiving their coupon payments and also not receiving their principle at maturity. In addition, emerging market bonds are extremely volatile which can see their value rise and fall dramatically.
Investing in emerging markets is tricky and most bond investors tend to prefer using a fund rather than investing directly.
Safety with Treasuries - as good as guaranteed
The U.S. Federal Treasury issues bonds with various maturities ranging from four weeks up to 30 years. Treasury bonds come with the full faith and credit of the U.S. government which effectively makes them a guaranteed investment.
Note that this does not mean they are actually guaranteed, but that the U.S. government will endeavor to meet its obligations even if it has to increase taxes, print more money etc. Basically they are as good as guaranteed and are the safest bonds compared to municipal bonds and especially corporate bonds.
In addition to their safety, treasury bonds are not callable, thus a Treasury bond holder will continue to receive their coupon payments until maturity with no risk of early recall. Also treasury bonds are extremely liquid which gives them tight spreads compared to other bond types which is a bonus should the investor decide to buy and sell treasury bonds.
The difference between Bills, Notes and Bonds
The difference between treasury bonds, notes and bills is mostly the term till maturity. All maturities have a minimum face value of $100 and can be bought in increments of $100. They are all issued in electronic form and each bond is registered with a serial number.
- Treasury Bills are issued with maturities of 4, 13, 26 and 52 weeks and are bought at a discount to the face value (the interest is the difference between the amount paid and the face value).
- Treasury Notes are issued with maturities 2, 3, 5, 7 and 10 years and pays interest every 6 months.
- Treasury Bonds are issued with a maturity of 30 years and pays interest every 6 months.
The actual price paid for newly issued treasury bills, notes and bonds is determined by an auction process. This means that the price paid is not necessarily the face value. Each investor has a choice of whether to accept the market rate or whether to set a limit on how much to pay. This is analogous to placing a market order to buy stocks or placing a limit order. A market order will ensure the purchase whereas a limit order may not be filled.
Newly issued treasury bills, notes and bonds can be purchased directly from the U.S. Treasury through their website treasurydirect.gov. Unfortunately only market orders are accepted when buying through their website. In order to place a limit bid, investors must use a bank, broker or dealer as only they can place competitive bids. This is similar to buying stocks where a broker is required to place a limit buy order.
Treasury Inflation-Protected Securities (TIPS)
One of the disadvantages with bonds, especially long-term bonds is that inflation can become higher than the bond yield. To offset the effect of inflation, the U.S. Treasury also issues a bond which is adjusted for inflation and they are referred to as Treasury Inflation-Protected Securities (TIPS).
Investors can purchase inflation protected bonds
but the yields are generally lower
The advantage with TIPS is that the principle returned at maturity is increased based on the Consumer Price Index (CPI). If inflation happened to be negative, then the investor simple receives the face value. Thus the principle is only adjusted upwards and not downwards. The disadvantage with TIPS is that the coupon rate is relatively low, thus investors seeking income will receive a lower coupon payment with TIPS.
While TIPS at first sound like a good idea, the U.S. Treasury takes into account the likely future inflation rates and factors this into the TIPS yield. Sometimes the investor will receive a better return with TIPS held to maturity and at other times the return from TIPS will be less than if bonds were held till maturity.
TIPS are bought in exactly the same manner as with treasury bonds and are issued with maturities of 5, 10 and 30 years and sold in increments of $100 with a minimum purchase of $100.
Some professional bond investors suggest that retail investors incorporate a mix of bonds and TIPS which helps smooth out the returns as inflation has a tendency to cycle through periods of high inflation and periods of low inflation.
There may be tax advantages with the coupon payments
An alternative to treasury bonds are municipal bonds which are issued not only by municipalities, but can also be issued by universities, airports and hospitals.
The coupon payments from municipal bonds are generally exempt from federal taxes and these bonds are popular amongst bond investors who benefit from the tax exemption. However municipal bonds may still subject to local state tax, especially if the municipal bonds are purchased by investors living outside the state of issue. Also capital gains tax still applies if a municipal bond is sold for a capital gain.
Municipal bonds generally pay a lower interest rate than treasury bonds of the same maturity and they are not backed by the federal government.
The associated risk with municipal bonds depends on the issuer. Municipal bonds issued by municipalities are the safest bonds as they have the power to increase local taxes in order to meet their bond obligations. The municipal bonds issued by universities, airports and hospitals are the higher risk bonds as these issuers rely on revenue generated to meet their bond obligations.
Thus municipal bonds do carry some risk of default (especially the non-municipality issued bonds) and there is a chance that bondholders may not receive their interest payments and may lose their principle.
In a low interest environment municipal bonds pay around one percentage point less than treasury bonds, but there is no federal tax. Whether this lower interest rate which is tax free translates into a higher or lower net return depends on the individual investor's personal tax circumstances. Bond investors generally hold municipal bonds in taxable accounts and tend to avoid placing municipal bonds into tax-deferred accounts such as an individual retirement account (IRA or Roth IRA).
Due to the federal tax exemption, municipal bonds are the only bond type which is more popular with individual investors than they are with the institutions (such as banks, insurance companies and mutual funds).
Municipal bonds are popular with retail investors,
thanks to the federal tax exemption
Similar to corporate bonds, municipal bonds are often callable, which means that the bond may be recalled before maturity and the principle repaid. The specifications for the bond contract states whether the bond is callable.
The main reason callable municipal bonds are recalled is when interest rates drop and the bond issuer can simply recall their old bonds and issue new bonds at a lower interest rate. Thus the bondholder only ever gets recalled when it's the most inconvenient to them. The bondholder loses their high interest paying bonds and they can now only invest in the lower interest paying bonds. Callable municipal bonds typically pay a slightly higher interest than non-callable bonds in order to attract investors.
Similar to corporate bonds, municipal bonds are also accessed for their credit risk based on the financial strength of the issuer and they are assigned a credit rating. However not all municipal bonds are rated.
As a general rule, the lower credit rating municipal bonds provide a slightly higher interest rate, but the risk of default also increases.
Municipal bonds are dominated by the retail public and are significantly more volatile than treasury bonds. While this makes no difference to investors holding their bonds until maturity, the volatility is an issue for investors selling their bonds before maturity as retail investors typically sell when market conditions are worst. The volatility is due to the relatively low liquidity of municipal bonds and an investor may not even be able to sell their bond. Again this is not a problem if the investor holds their municipal bond until maturity.
Bonds issued by the corporations
Corporate bonds generally pay the highest interest rates and are usually available in $1,000 or $5,000 denominations with maturities ranging from under one year up to 30 years. They are the riskiest type of bonds, both in terms of the investor not receiving their coupon payment and in not receiving their principle at maturity.
Corporate bonds are accessed for credit risk based on the financial strength of the issuing company and the company is assigned a credit rating. These credit ratings are used to broadly classify corporate bonds into two distinct groups - investment grade bonds and speculative grade bonds.
The investment grade bonds are usually just referred to as corporate bonds and the speculative bonds are commonly referred to as junk bonds or high-yield bonds.
The interest rate from corporate bonds tends to be around one-percent higher than that for treasury bonds with a similar maturity in a low inflationary environment. The gap can be higher during periods of high inflation. Junk bonds tend to average a few more percentage points but the risk of default becomes much more significant.
With the interest rate gap being quite small between the ultra-safe treasury bonds and the riskier corporate bonds, many new investors to bonds may well wonder whether it's worth the risk with corporate bonds. After all, if an investor is going to take on risk then why not just invest in stocks and receive around twice the long-term returns available from corporate bonds for the same risk of bankruptcy.
The short answer is that it all depends on the risk appetite and the investing strategy of the investor.
Investor Risk Appetite:
- For the more conservative and risk adverse investor, treasury bonds are more suitable even though they might hold a small portion of corporate bonds.
- For the aggressive or the active investor who is constantly monitoring the financial health of the bond issuing company, then they are likely to sell any corporate bonds deemed too risky. The value of corporate bonds tend to be much more volatile than treasury bonds and active investors make use of this volatility to achieve realized capital gains in the same way as active stock investors achieve realized capital gains.
The Bid-Ask spread tends to be higher with corporate bonds compared to treasury bonds and spread of corporate bonds can range from under 1% to well over 5%. The spread is largely due to the lower liquidity of corporate bonds with the higher spread bonds being more difficult to buy and sell at a fair value.
Corporate bonds tend to perform better than treasury bonds most of the time, especially while the economy is in an expansion phase. However during periods of economic recession, treasury bonds typically outperform corporate bonds.
Junk bonds are also referred to as high-yield bonds and produce higher long-term returns compared to corporate bonds, however the total long-term returns are still several percentage points less than the long-term return from stocks excluding dividends. The same question as with corporate bonds presents itself - why invest in junk bonds? The answer is basically the same as with corporate bonds - conservative investors avoid them outright and active speculative investors seek short-term and medium-term realized capital gains.
Corporate bonds are often callable, which means that the company may cancel the bond contract by recalling the bond before maturity and repaying the bond holder their principle. The specifications for the bond contract states whether the bond is callable.
Investors should be aware that corporate bonds
may be recalled when interest rates drop
The main reason companies recall callable bonds is when interest rates drop and they can simply recall the old bonds and issue new bonds at a lower interest rate. Thus the bondholder only ever gets recalled when it's the most inconvenient to them. The bondholder loses their high interest paying bonds and they can now only invest in the lower interest paying bonds.
Callable bonds do however tend to have a slightly higher interest rate to entice investors to buy these bonds. Granted, if the investor is not intending on holding a callable until maturity then the early recall is not really an issue and the investor receives a higher interest rate in the meantime.
Another option some corporate bonds have is convertibility which means the bonds can be converted or exchanged for the company's shares (usually the common stock). This is a feature that some active investors and especially speculative investors make good use off. Convertible bonds were used extensively by Benjamin Graham who was a famous investor renowned for his hedge fund tactics.
The only real downside with convertible bonds is that the interest rates tend to be less than non-callable bonds of similar maturity and credit rating. So the benefit to the investor is largely dependant on whether they have any intentions of converting their bond to common stock (the conversion is usually done when stock prices are favorable).
Corporate Credit Ratings
Rating corporations for their ability to fulfill their bond obligations
Credit rating agencies rate most of the larger companies and municipalities for their credit worthiness. The rating is based on the companies or municipalities financial strength - this is their ability to pay creditors such as bondholders any coupon payments due and the return of the bonds principle.
The credit rating is for the company's ability to pay its creditors rather than its ability to grow its earnings. Thus a company may have a high credit rating but that does not mean it is a high growth stock. Also the credit ratings are not buy and sell recommendations for a stock or even a bond.
These credit ratings are intended to help bond investors in making an investment decision regarding a particular bond. The higher the credit rating, then the higher the probability that the bondholder will receive all of their coupon payments along with the return of their principle at maturity.
The credit rating is a measure of the risk of default with the bond issuer in not meeting their obligations. As a general rule, the lower the credit rating then the higher the coupon payment. Thus as the risk of default increases, the bond's yield increases.
There are two major credit rating agencies which combined have around 80% of the credit rating business. They are Moody's and Standard & Poor's. These two basically use the same credit rating system and only differ slightly in the rating convention used.
The rating scale used by both Moody's and Standard & Poor's is shown below in Table 1.
Table 1. Corporate credit ratings
From Table 1. above both Moody's and Standard & Poor's broadly split the Bond grade into investment grade and speculative grade.
- Moody's classifies bonds as investment grade if they are rated Aaa down to Baa3.
- Moody's classifies bonds as speculative grade if they are rated Ba1 down to C.
Standard & Poor's
- Standard & Poor's classifies bonds as investment grade if they are rated AAA down to BBB-.
- Standard & Poor's classifies bonds as speculative grade if they are rated BB+ down to D.
Note that the Bond grade in default means that the company or municipality has stopped making coupon payments - not that they are in bankruptcy, even though they might be.
Treasury bonds not rated by the ratings agencies since treasury bonds are backed by U.S. treasury and as such are essentially guaranteed - so there is virtually no risk of default.
The highest ratings given to bonds by the rating agencies are Moody's Aaa and Standard & Poor's AAA - these are the safest bonds with only a slight chance of default (generally well under 1%) and due to their high degree of safety generally only pay a small premium over treasury bonds.
The further down the ratings scale then the higher the interest rates tend to be for the same maturity. Thus the low investment quality bonds pay higher interest rates than prime investment quality bonds for a similar maturity, but the risk of default increases to around 10%.
The speculative grade bonds are usually called Junk bonds or High-yield bonds. The highest grade of junk bonds are still speculative and the lower grade junk bonds are those with a high risk of default (which can be around 20%).
Investors love high-yield bonds, but be aware
that these are junk bonds with a high default risk
The rock bottom quality junk bonds are those that are currently defaulting on their obligations. This does not necessarily mean they cannot regain their ability to meet their obligations but the probability is of this occurring is low. Bonds with this rating will rarely see the full face value returned.
Speculating with these junk bonds is speculative trading that hedge funds are active with and for the most part are not suited for investing purposes.
Even if an investor buys investment grade bonds, there is always the risk that the credit rating can change in the future.
In the future a company or a municipality can be downgraded or even upgraded. If it's downgraded then the bond value will drop and if it's upgraded then bond value will increase - this is due to perceived risks in receiving the coupon payments and the return of principle.
Also diversification becomes increasingly important as the ratings decline - even for investment grade bonds. Generally it is not a good idea to only buy bonds issued by the one company. It's best to diversify by buying bonds from different companies in different industries. If the investor has insufficient capital then it is generally better if a bond fund is used.