There are many different types of bond investments available to invest in. Today, I will explain what a bond is and the most common types that individual investors may be interested in so you can understand what might be right for you.
Bonds represent loans to borrowers
Bond investments are loans made to borrowers for a certain period of time at a given interest rate also called the coupon rate. Bond issuers are the borrowers and during the life of the loan they make interest payments usually every six months. At the end of the time period of the loan the borrower then pays back the total principal borrowed. Most bonds pay a fixed coupon payment so they are often called fixed income investments.
The bond issuer can be a government or a corporation. Let’s discuss government bonds first.
The Federal Government issues 3 types of bonds categorized by the length of time the loan is outstanding:
- Treasury bills are short term, 1 year or less and are sold at a price below its stated face value. The bond amortizes over its life and at maturity you would receive the higher face value amount. The difference between what you paid and what you receive at maturity is your interest amount.
- Treasury notes range from 1 year to 10 years and can be referred to as intermediate term bonds
- Treasury bonds last longer than 10 years and up to 30 years. Treasury bonds pay the highest interest rate but have greater risks that an investor should consider. For the duration of the loan, the investor will not have access to the money invested or with a longer term, there may be a greater risk that the lender will be unable to repay the investor. Also, if interest rates rise an investor could get locked in to lending at a lower rate. A bond investor can always resell the bond investment but depending on where current interest rates are versus the coupon payment being paid, the bond could sell for more or less than the original purchased value.
State and Local Governments also issue bonds as well and these are called municipal bonds. Municipalities are borrowing money to build parks, bridges, roads or other projects. The interest that investors receive from these bonds is frequently tax free for residents of the issuing government. It can be worth asking a tax professional if that can apply to you.
Corporate Bonds and Bond Ratings
Corporations issue bonds to borrow money for up to 30 years and pay interest every six months. Most bonds are assigned a rating by a rating agency, such as Moody’s or Standard and Poor’s. The ratings assess the financial strength of the borrowing government agency or corporation and are the rating agency’s evaluation of the borrowers’ risk of default. Ratings range from AAA to D, AAA rated bonds offering the least risk to the investor. There are D ratings as well but this is for borrowers already in default and are considered distressed which is its own area of investing. These ratings are similar to an individual’s credit score. Credit ratings impact the amount of interest a company will need to pay to attract investors.
Terms used to describe credit ratings are:
- Investment grade is the term used for bonds with credit ratings of AAA through BBB. These companies are viewed as being very capable of meeting their financial obligations so the interest rate payments will be lower than those in the category of High Yield.
- High Yield is the term used for bonds with credit ratings of BB or lower. They have lower credit ratings so these bonds pay higher coupon payments. Companies issuing high yield bonds may have high amounts of debt already making them at greater risk of bankruptcy during periods of economic stress. This is something to keep in mind when considering the amount of risk, you are willing to take.
Mortgage Pass thru Bonds are real estate loans pooled together that are packaged by three different federal agencies:
- Federal National Mortgage Association (FNMA) commonly referred to as “Fannie Mae”,
- Government National Mortgage Association (GNMA) commonly referred to as “Ginnie Mae”
- · Federal Home Loan Mortgage Corporation (FHLMC) commonly referred to as “Freddie Mac”.
Investors in Mortgage Pass Through bonds have a claim to the underlying pool of mortgages and earn a portion of the interest payments from the pool. Mortgage bonds pay monthly interest since the underlying borrowers are making monthly payments on their loans. This can be a helpful way to generate income on a monthly basis.
How to invest
When investing in bonds it can be helpful to own a diversified portfolio of bonds that may combine all of these types together. By owning a diversified group of bonds your investment returns can be smoother and can be built to pay out a monthly income stream if that is something you need. Both Mutual Funds and ETF’s can help an investor accomplish this. There are Bond index funds that invest in a diversified portfolio. The most common Bond Index is the Barclays US Aggregate bond index comprised of bonds across sectors that have maturity dates in the intermediate range. A term you will often see on a bond Mutual Fund and ETF Factsheet is Yield. The Yield of a Fund is a snapshot of what the income stream that portfolio pays out, divided by the Price. Since the price of the Fund and value of the underlying bonds fluctuate on a daily basis the Yield fluctuates as well. It’s also important to look at the Mutual Fund or ETF factsheet to see what type of bonds they invest in and how much they charge investors for investing in that ETF or Mutual Fund. As I am sure you would expect, the lower the fee or expense ratio the better it is for the investor.