In the world of investing, there are many different types of products and vehicles available. One of those products is a bond.
Bonds have their own set of advantages and disadvantages, however.
In this article, we’ll explore what a bond is, the different types, and their characteristics.
What is a bond?
A bond is a type of security. More specifically, a bond is debt. The bond issuer (the company) sells the bond to a bondholder (investor).
The bondholder gives the issuer money and in return, receives a set amount of interest on that bond until it matures, at which point, they’ll receive the principal (the amount they paid for the bond, in a sense) back.
Types of bonds
There are several types of bonds.
- Corporate bonds - Issued by companies and corporations.
- Municipal bonds - Issued by state and local governments. Municipalities issue bonds to raise money for government projects. Also, they are tax-free on the federal level, and there are two types.
- Revenue bonds - Bonds that are paid back through revenue from the project it was issued for. Toll-roads and concessions from a sporting event are two examples.
- General obligation bonds - These bonds are paid back through taxes. Generally speaking, this type of municipal bond is less risky than the revenue bond because the municipality can always raise taxes to pay back their debt.
- Government bonds - Issued by the Federal Government. These bonds are backed by the full faith and credit of the United States Government, so they are sometimes classified as “risk-free” because the government can raise taxes and print money to make good on their debt.
- Government agency bonds - Issued by agencies of the Federal Government (Freddie Mac, Fannie Mae). Also, backed by the full faith and credit of the United States Government.
- Investment grade bonds - Bonds/companies with a credit rating of BBB or higher. Investment grade bonds are more likely to be issued by companies and municipalities with strong financial footing, as they have a greater chance of paying back their debt. Due to the reduced amount of risk associated with this investment, the interest rate is usually lower.
- High-yield (junk) bonds - Bonds/companies with a credit rating below BBB. Companies and municipalities with a below investment grade rating are ones that are seen as riskier. New companies or ones with high levels of debt usually fall in this category. Chicago is an example of a municipality with a low credit rating (B). That said, because there is increased risk with the entity’s ability to pay back the debt, you’re “rewarded” with a higher interest rate.
- Callable bonds - Bonds that have the ability to be called back by the issuer. Often, the issuer will call a bond back because interest rates dropped. For example, if they issue a 6% bond, and one year later, rates drop and they can issue that same bond for 4%, they’ll call the 6% bond and re-issue a 4% to save themselves money. The interest rate is generally higher on this type of bond because there is risk associated with it getting called back.
- Convertible bonds - Bonds that can be converted into stock at some point in the future. The choice to convert or not is up to the investor, however. Because they have this option, they receive a lower interest rate from the issuer.
Characteristics and risks.
Each type of bond has shared risks and characteristics.
- Interest rate risk - If interest rates rise, the price of the bond will go down. Also, being unable to make interest payments to the bondholder. Additionally, bonds come with varying maturity lengths, ranging less than 1 year to 30 years. The longer-term bonds are more sensitive to shifts in interest rates.
- Principal risk - The issuing entity won’t be able to return the principal to you. Usually in the event of a liquidation of the company.
- Call risk - The chance that your callable bond is called back by the issuer.
- Investing characteristics - Historically, bonds have offered a lower return than stocks, though, they generally perform better during bear markets.
- Credit Ratings - The credit rating hierarchy (from Standard and Poor’s, and Fitch) is as follows:
Bonds can be a very useful tool in your investment plan, but it’s incredibly important to know how they work and what the inherent risks are.
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