About Different Types of Bonds
When it comes to investing, most people think first of stocks. However, bonds come in a close second. Bonds are basically loans made by investors instead of by banks. The bond issuer agrees to repay the bonds according to a prescribed set of terms. The bond holder agrees to lend the money to the issuer under those terms by purchasing the bond.
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The Facts
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There are numerous ways to categorize bonds. One way is by issuer. In this manner, there are "Corporate Bonds" (those issued by companies) and "Government Bonds" (those issued by government entities). Government bonds can be further categorized by which level of government issues them. Bonds issued by the federal government are generally referred to as "Treasuries," while those issued by state and local governments are generally referred to as "Municipal Bonds." Treasuries can be broken down by term with "Treasury Bills" having a term of less than one year, "Treasury Notes" having a term of 1 to 10 years, and "Treasury Bonds" having a term of more than 10 years.
It is also possible to categorize bonds by their specific properties. A bond backed by collateral is a "Secured Bond," while a bond that can optionally be converted into stock is a "Convertible Bond." A bond that does not pay interest during the term of the bond but that is redeemed for a higher amount than originally paid is a "Zero Coupon Bond."
Bonds can also be categorized by their rating in which low-rated bonds are "Junk Bonds" or "High-Yield Bonds" and high rated bonds are "Investment Grade Bonds."
Risk Factors
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There are many risk factors to investing in bonds:
Interest rate risk is the risk that changing interest rates will affect the value of bonds.
Re-investment risk is the risk that when the bond is paid off, the principal cannot be reinvested at the same or higher rate.
Credit or repayment risk is the risk that the bond may not be repaid by the issuer.
Inflation risk is the risk that the value of the repayment will decrease in the future relative to the cost of goods and services.
Market risk is the risk that the value of the bond will decrease due to supply and demand. -
Misconceptions
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Bonds are often portrayed as being safe. While bonds can be safer than other investments, bond values can still decline. If a bond holder sells a bond before the maturity date, the value received is determined by the market, and may be lower than the amount paid by the investor. In addition, some bonds are never repaid due to bankruptcy or other events that prevent the bond issuer from repaying the bonds.
Treasury bills are often considered the benchmark for "risk free." Any other bond carries at least some risk. This risk is often quantified by a rating. Lower rated bonds may be substantially riskier than stocks or other investments.
Benefits
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Bonds provide the bond holder with steady income, absent a problem with the issuer. This income is fixed and regular allowing the bond holder to anticipate the amount and timing of the income. Provided the bond holder keeps the bond until its maturity date, the bond cannot lose value unless the issuer defaults on payment. High grade bonds tend to be less volatile than other investments.
Features
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Bonds generally have several common features. Each bond has a term (how long until it will be repaid), an interest rate, and a schedule for payment of interest (usually annually or semi-annually), except in the case of zero coupon bonds.
In addition, bonds can have specific features as well. Some bonds have a call feature in which the bond may be redeemed by the issuer at a certain date at a certain price regardless of market value. Convertible bonds can be exchanged for a fixed amount of company stock at a certain time.
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