There are ways to borrow money aside from asking a bank for a loan. This is where bonds often come into play. Corporations, governments, and other big borrowers often use them to finance current and future projects. Bonds are debt securities that represent a loan between a borrower, the bond issuer, and a lender, an investor.
Bonds fall into categories based on the entity that issues them. There are, for example, corporate, Treasury, agency, municipal, and international bonds. Each type has a funding purpose and a distinct profile of risks, interest rates, times to maturity, and other qualities particular to the issuer.
What is a bond?
All bonds, which also are known as fixed-income securities, share broad characteristics. In general, they act like IOUs. They outline the details of the loan, specifying how and when the borrower will repay the debt. They document the coupon rate, or the regular interest payments a bond investor will receive. And they indicate the time to maturity, the date when the investor will get back the original amount they paid, or the principal.
Individual bonds are pieces of a big loan that’s been broken into smaller chunks and sold to investors, usually in denominations of $1,000. But U.S. savings bonds can be purchased in denominations as small as $25, while other Treasury bonds are available in $100 denominations.
What are the different types of bonds?
Bonds are classified into five main types.
1. Corporate bonds
Bonds are a major source of capital for companies. Corporations use this form of debt financing for ready cash for current operations and to raise funds for expansion and other projects. Financing with debt is typically cheaper than issuing stock and doesn’t require a company to give up equity or an ownership stake.
Companies can offer bonds that give investors the right to claim the issuer’s underlying assets if the company defaults, or does not make a payment on time. Companies can also issue bonds that are not backed by assets, known as unsecured debt. Convertible bonds let investors convert their holdings into stock. Callable bonds can be paid off before the maturity date.
Corporate bonds are often broken into five categories: public utilities, transportation, industrials, financial, and international. They’re generally issued in $1,000 blocks. Investors can buy them through a brokerage, bank, or other seller. Some corporates trade on over-the-counter markets.
2. Treasury bonds
The U.S. Treasury Department issues bonds to finance federal spending or the country’s debt. The term “Treasuries” describes all types of U.S. sovereign debt across all maturities. The government sells Treasuries at auction four times a year. Treasuries can trade in a secondary market and the same security can be bought and resold by different investors many times before it reaches maturity. The U.S. insures all Treasuries, making them virtually risk free.
- T-bills. These short-term securities mature in a few days to 52 weeks.
- T-notes. Medium-term T-notes mature in two to 10 years.
- T-bonds. This long-term debt matures in as long as 30 years.
The Treasury also offers savings bonds to U.S. citizens. Individuals can purchase them from the TreasuryDirect website or an authorized seller. Only the registered holder can receive payment and savings bonds can’t be sold on a secondary market.
Savings bonds come in two varieties:
- EE bonds. These bonds earn a fixed, government-set interest rate for 30 years. However, the Treasury guarantees that an EE bond will be worth twice what the investor paid in 20 years.
- I bonds. These bonds earn both a fixed and variable rate of return. The fixed rate remains the same for the bond’s life; the variable rate changes every six months based on the U.S. inflation rate. I bonds also mature in 30 years.
3. Municipal bonds
Local and state governments, non-profits, and other public entities issue municipal bonds, also known as munis. These bonds fund daily obligations or big projects. The interest they pay often is exempt from federal income tax. Bondholders who are residents of that municipality generally pay no state or local tax on the bonds.
Munis are structured as either general obligation or revenue bonds. Both raise money for income-producing projects such as toll roads or water-treatment systems. Both types are backed by the full faith of the issuer. They differ in how the investor’s interest and principal are funded.
- General obligation bonds. These bonds raise immediate capital without linking the money to a specific project. The issuer can repay the bondholders with any source of funds.
- Revenue bonds. These bonds pay for a specific project. The project produces the revenue that pays investors’ interest and principal.
4. Agency bonds
Federal agencies other than the Treasury, as well as some quasi-governmental institutions, issue these bonds to fund public needs. There are two types of agency bonds.
- Federal government agency bonds. U.S. government agencies including the Federal Housing Administration (FHA), Small Business Administration (SBA), and Government National Mortgage Association (GNMA or Ginnie Mae) are among agency bond issuers. The bonds support home ownership, business opportunities, and other public initiatives.
- Government-sponsored enterprise bonds. Independent organizations overseen by the federal government, such as mortgage guarantor Federal Home Loan Mortgage Corp. (Freddie Mac), issue GSE bonds. They provide capital to the housing, farming, and other sectors. Bonds issued by these organizations do not enjoy the same explicit government backing that Treasuries and agency bonds do. Mortgage-backed securities, or MBS, are bonds secured by a pool of real estate loans. They’re often sold to agencies like Ginnie Mae and Freddie Mac, enabling lenders to get cash to create more mortgage loans.
5. International bonds.
Governments and companies outside the U.S. issue bonds for the same reasons U.S. entities do. The issuing country’s political, cultural, environment, economic situations, among other characteristics, determine the bond’s sovereign risk. Changes in the exchange rate between the U.S. dollar and the bond issuer’s currency introduce risk that can affect an investor’s returns.
How do credit ratings affect bonds?
People who want to invest in bonds can consult research by companies that analyze and rate an issuer’s credit quality.
Ratings companies grade bonds on the issuer’s financial strength and its ability to pay principal and interest on time. Raters consider an issuer’s balance sheet, profit outlook, competition, collateral, and the macroeconomic outlook. The Securities and Exchange Commission recognizes 10 firms as Nationally Recognized Statistical Rating Organizations (NRSROs). Three of these—Standard & Poor’s, Moody’s, and Fitch—dominate the market.
Ratings companies classify bonds into two major risk categories: investment grade and below investment grade, also called high-yield or junk bonds. Investment grade bonds have a low risk of default. Non-investment grade offerings have a higher default risk but deliver higher returns. Many types of investors known as fiduciaries that manage money on behalf of others, such as pension funds, often are not allowed to hold non-investment grade debt.
Ratings companies further rank bonds on a sliding scale. The farther down the scale, the weaker the issuer’s financial strength. The highest rating is Aaa or AAA, depending on the rater’s classification system. The lowest ratings fall to C or D designations. A rating below Baa3 or BBB- is considered non-investment grade or speculative. Bonds in default are rated D by S&P and Fitch and are included in the C category by Moody’s.
What are the potential benefits and risks of bonds?
Bond investors face benefits and risks when selecting to invest in bonds over other securities..
Potential benefits of bonds
- Regular income. Investors lock in a regular income stream and the return of their principal.
- Precedence vs stock. Bondholders take precedence over equity holders in a financial settlement or liquidation if an issuer defaults.
- Diversification. Because bonds are fixed-income investments that provide a known return, they can offset the volatility of stocks in a portfolio.
- Tax advantages. Treasuries are generally exempt from state and local taxes. Municipal bonds are usually not taxed federally and can be free from state and local taxes.
- Clear ratings. Investors can use bond ratings to gauge an issuer’s creditworthiness.
- Higher yields. Corporate bonds generally offer higher interest rates than government bonds or certificates of deposit (CDs) with comparable maturities.
- Low risk. Bonds in general carry lower risks than investing in stocks. Treasuries and savings bonds are virtually risk free.
Risks of bonds
- Low returns. Bonds generally provide a lower return than stocks.
- Interest rate risk. When interest rates rise, a bond’s price falls. This hurts investors if they need to sell.
- Inflation. Inflation hurts an investor relying on a bond’s fixed interest payments because it reduces the purchasing power of those payments.
- Illiquidity. Bonds often are less liquid than stocks and may not be easy to sell at a desired price.
- Call risk. An issuer might retire a bond before its maturity, depriving the investor of the expected returns.
- Default. Companies can default on their bonds if they can’t repay the debt; countries can default on sovereign debt if they’re unable or unwilling to pay.
The bottom line
Investors can choose among five main types of bonds. Each serves a particular funding purpose and has a profile of risks, interest rates, times to maturity, and other characteristics. U.S. government bonds are virtually risk free but pay investors a relatively low interest rate. So-called junk bonds issued by corporations have a higher default risk than investment grade bonds but compensate by paying higher rates. Investors can assess a bond’s risk through ratings from companies that analyze an issuer’s credit quality.