Bonds are an important part of the financial and investment market. Depending on market conditions, bond prices may move up or down. Prices usually differ from the face value of the bond, and they are negatively correlated with yields, which is important for an investor to understand when it comes to buying bonds.
Before buying any types of bonds, an investor should understand what moves bond prices, why they might want to buy or sell bonds, and other aspects of the bond market. The prices of bonds tend to move up or down based on factors like interest rates.
What is a Bond?
First, it’s important to understand what bonds are. They are one of many types of securities. Bonds are a type of fixed income instrument that are essentially a loan made by a company or government to an investor. The company or government will pay interest on the bond, just as they would with any other loan. Bonds can be considered a sort of IOU between the borrower and lender, and they include the terms of the loan, including the interest payments and whether they will be variable or fixed-rate payments and the date when the principal will be repaid.
Companies or governments issue bonds to raise funds for various purposes. Governments issue bonds to pay for roads, schools or other infrastructure, while companies issue bonds to expand through the addition of new products, pay for research and development, support other projects or hire more employees.
Companies and governments issue bonds on the primary market, and they are traded on the secondary market.
7 Bond Types
There are many different types of bonds ranging from municipal bonds to corporate bonds, Treasury bills and several other types. Within each type of bond, there are additional types, like high-yield bonds or investment-grade bonds under corporate bonds. There are also zero-coupon bonds. Here are seven of the most common bond types.
Agency bonds are those issued to raise money by government-sponsored enterprises (GSEs) like the Federal National Mortgage Association (better known as Fannie Mae). Agency bonds are also issued by a federal U.S. government department other than the U.S. Treasury Department, such as the Small Business Administration or the Government National Mortgage Association (Ginnie Mae).
Most agency bonds pay their coupons on a semi-annual schedule in a variety of increments. In most cases, the minimum investment is $10,000, with additional $5,000 increments. However, bonds issued by the Government National Mortgage Association usually come in $25,000 increments.
Unlike Treasury bonds, agency bonds are not issued with the full faith of the U.S. government, which means there is some level of credit risk associated with them. Like all bonds, there is also interest rate risk associated with them. Most agency bonds are tax-free, meaning interest payments on them are exempt from state and local taxes, which means investors do not pay state income taxes on these securities. However, those issued by the Federal National Mortgage Association, or Fannie Mae, the Federal Home Loan Mortgage Corp (Freddie Mac), and the Federal Agricultural Mortgage Corporation (Farmer Mac) are fully taxable bonds.
Municipal bonds are issued by local governments like states, cities, counties, and other government agencies to fund capital projects such as schools, highways, or other infrastructure. They can also be used to support daily operations. In most cases, the interest received for municipal bonds are exempt from federal income tax. In addition to federal income taxes, they may also be exempt from state and local taxes if the investor lives in the state where the bond was issued.
There are two types of government bonds issued by local governments, which are general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith and credit of the issuer rather than any assets, while revenue bonds are backed by revenues from certain sources or projects like highway tolls.
Companies issue corporate bonds. There are many different kinds of corporate bonds, and they all come with different levels of credit risk. High-yield bonds, also referred to as junk bonds, come with the highest level of credit risk because the companies that issue this type of bond may have less of an ability to pay the money back than those that issue investment-grade bonds. However, the greater the risk involved, the higher the interest rate on the bond.
A foreign bond is issued by a foreign entity in the currency of the market in which it was issued. Companies that do a lot of business in another country may issue foreign bonds in that country. There are other risks associated with foreign bonds, like the impact of two different interest rates.
Convertible bonds are a type of corporate bond that can be converted into common stock in the company that issued them.
U.S. Treasury Bonds
US Treasury bonds are issued with the full faith of the U.S. government. Government bonds issued by the Treasury pay a fixed interest rate every six months until maturation. The Treasury rather than other federal agencies issue Treasury bills. They are issued with 20- or 30-year terms, and investors can buy them from TreasuryDirect. Investors can hold them until maturity or sell them before then.
Savings bonds are also issued by the Treasury to support the government’s borrowing and spending. They provide savers a modest but guaranteed return and are issued with a zero coupon at a discount at a fixed interest rate for a specific term. Savers do not pay taxes on savings bonds. Unlike other types, they can’t be transferred easily to others, and they are non-negotiable.
Types of Bond-Based Securities
There are many different types of bond-based securities. For example, a variety of different funds buy various bond types. Bond funds can include mutual funds, exchange-traded funds and other fund types.
Another kind of bond-based security is Treasury Inflation Protected Securities (TIPS), which are also issued by the U.S. government. They provide protection from inflation, as measured by the Consumer Price Index..
Preferred stocks share some similarities with bonds, but they are not actually bonds. They pay dividends instead of interest and represent a share of the company rather than a loan.
How do bonds work?
When companies or government agencies need to raise funds, they issue bonds, which are securities issued with the backing of the issuing entity. They can be bought on the primary bond market directly from the issuer or traded on the secondary market.
The borrower will then pay interest on a regular basis and repay the principal at the end of the term. Bonds can be short-term securities or long-term securities. Interest payments are usually based on a fixed rate, although they can also have a variable rate.
The initial price of a bond is usually par or a face value of $100 or $1,000. The market price after it starts trading depends on a variety of factors, such as the issuer’s credit quality, the amount of time left before it matures, and the coupon rate compared to other interest rates. Since they have an inverse correlation with interest rates, bonds tend to increase in price with lower interest rates and decrease in price with higher interest rates.
There are a few different kinds of risk associated with bonds. They are credit, interest rate, reinvestment, inflation, and default risk. Callable bonds also have call risk, which means companies can call them in before they mature, ending the payments of interest early.
What are the most common types of bonds?
The most common types are Treasury, corporate, high-yield, investment-grade, and high-yield bonds.
How do you buy bonds?
You can buy bonds from an online broker, which connects investors with investors who are trying to sell them. You can also buy an ETF that buys bonds or buy Treasuries directly from the U.S. government.
Are bonds a good investment?
Bonds tend to have a steady cash flow, which can make them a good investment for many investors. However, bonds do better in certain environments than in others, so this is really a relative question with an answer that changes with the market environment.
For example, since interest rates are historically low right now, the value of bonds generally will increase. However, one factor in the value of bonds versus interest rates is when they were issued. Bonds with low interest rates will be less appealing than those with higher rates. Investors might not be interested in bonds when interest rates are low because they can get better returns elsewhere.
On the other hand, the value of the bond may be less important than the regular payments it generates. Income investors, in particular, look for securities that make regular payments. One good thing about bonds is that their returns are consistent, so they offer income that investors can count on. For this reason, investors may be more interested in long-term rather than short-term securities.
What is a coupon rate for bonds?
The coupon rate is the interest rate paid by the bond issuer on the face value. The coupon rate is based on the par value of the bond rather than the issue price or market price. To calculate the coupon rate, you add up the total amount of annual payments made by the bond and then divide it by the par value. For example, let’s say a bond pays $25 every six months to bondholders. Par value for the bond is $1,000, so we divide $50 by $1,000 to reach the coupon rate of 5%.
Companies or state, federal or local governments issue bonds to raise money for a variety of purposes. Each bond is like a small loan made to the company or government agency, and it offers an excellent way for investors to build a portfolio of investments that make regular payments.
Bonds are better investments at some times than at other times, but the consistency of the payments make them an excellent option for income investors no matter what the environment. Together, stocks and bonds make up a standard portfolio for investors.
This article originally appeared at ValueWalk.