Before you invest in bonds, you should know what all is available to choose from for your investment portfolio. The best decisions are made when you start with the big picture. So here are the five most important types of bonds that you should consider and where they come from:
1. Treasury bonds
These are bonds that are issued by the United States government and are deemed to be the safest investment in the world. They are often simply referred to as Treasuries.
When you hear politicians complaining about the federal deficit and our $17 trillion national debt, and having to “borrow money from China”, what they mean is that more Treasury bonds will have to be issued to raise money. We have to do this because the amount we owe on our bills exceed the total being collected in taxes.
Of course, a lot of what they say about China is overblown. Fact is, as of 2013, about 65% of all outstanding Treasuries were owned by U.S. government agencies, and the American people. China and Japan held around 8% each, with other foreign nations and entities possessing the rest. Learn more here.
In any event, Treasury bonds also include Treasury Notes and Treasury Bills. In effect, they are all bonds that have different names because of their maturity periods. For example, Treasury Bills mature in 1 year or less, Treasury Notes mature between 1 and 10 years, and Treasury Bonds mature in more than 10 years.
Because Treasuries are so safe, they will likely offer the lowest return on investment out of all bond types. On the upside, you won’t have to pay local and state taxes on the interest you earn. But, unfortunately that benefit doesn’t extend to the federal government.
2. Municipal bonds
These are bonds that are issued by state and local governments to raise money for projects they deem important.
One of the great things about these bonds is that you, as a resident of the state who issued the bonds, won’t have to pay any taxes to the state or federal governments. It’s for this reason that these types of bonds are a favorite among wealthy people.
Just keep in mind that, because of the favorable tax treatment, the interest rates on municipal bonds (or muni’s as they are sometimes called) will be lower than rates on other types of bonds.
So if your income doesn’t put you in the highest income tax bracket, then higher payout corporate bonds may be a better alternative.
3. Corporate bonds
Just like governments, corporations also have projects and initiatives that they want to raise money to finance. It could be used for such things as research and development, new equipment, or even to buy back shares of their own stock.
Most of the big companies that you know about have probably issued bonds at one time or another, or have some in the marketplace right now — Apple, AT&T, Wal-Mart, IBM, Microsoft, General Motors, etc.
Because of their higher interest (pay out) rates, these types of bonds tend to attract average investors.
But of course there are a couple of potential downsides. If a company goes belly-up, that could result in you losing your entire investment. In addition, you’ll have to pay federal and state taxes, where applicable.
4. Mortgage bonds
Have you ever heard the term “mortgage backed securities”? Well, you may not realize it but the bank that owns your mortgage will lump your’s and a bunch of others into a nice package and sell them in the marketplace as bonds.
Now, this is all above board and backed by the federal government. In fact, the vast majority of these bonds are very safe.
But if you’re shaking in your boots a little bit, it’s probably because you’re familiar with the mortgage backed securities that were part of the economic meltdown in 2007. The difference is that those mortgage bonds were comprised largely of high risk subprime (or junk) mortgages that didn’t have government backing.
However, as long as you swim in safe waters, your investment will be fine. But you will have to pay taxes.
5. International bonds
Many other countries outside of the United States offer the same types of bonds that I covered above. You are free to buy them. However, they come with a set of issues that you’ll have to dig deeper into to determine if they are worth your time.
For example, your interest payments will be made in a foreign currency, so when they are translated into U.S. dollars that may or may not work to your benefit. Plus, the bonds will be linked to different economies with their own set of rules.
It is these types of issues that make investing in international bonds a bit riskier. Also, it’s not important for average investors to have foreign bonds in their portfolio to create greater diversification. So I won’t delve into them any further here.
Variations On Bond Types
As might expect, investment bankers are a creative bunch. So over the years, they have come up with several twists and spins on the above bond types. Here are a few popular variations:
These are actually corporate bonds that have a dual purpose. When you buy one of these bonds, the terms of the agreement will allow you to convert it into a specific number of company stock shares if certain conditions are met. But in the meantime it will pay out interest according to an established rate.
So these types of bonds provide an opportunity for you to make even more money through the stock feature. But the downside is that the interest (pay out) rates on these bonds will be lower than those attached to non-convertible bonds.
If you possess one of these corporate bonds, it means that the company can ask for it’s bond back before the maturity date is reached. This could happen if market interest rates in the economy begin to fall.
When these rates fall, the bonds will become more valuable. So the company may conclude that it’s to their advantage to get the bonds back and perhaps issue another pile later on at a lower interest rate.
Zero Coupon Bonds
For most bonds, you’ll be paid interest on a periodic time schedule such as semi-annually, or annually. But there are some government and corporate bond where the face value might say $1000, but you’ll only fork over $900 upfront for it. Then, when the bond matures in a year or two or whenever, you’ll receive a check for the full face value. So, in essence, the interest rate is imputed or built-in.
Now you know the major types of bonds and their variations. The big five include Treasuries, munis, corporate, mortgage, and international bonds. The ones that you select for your portfolio will hinge on your tax bracket, risk tolerance, and overall investment goals. But if you stick with quality, your risk of loss will be extremely low.
|Page 1||Page 2||Page 3||Page 4||Page 5||Page 6|