Seven Different Types of Bonds Explained
A bond is just a financial instrument that says that the bond issuer owes a sum of money to the bond owner. As a result, bonds can come in a wide range of forms with a wide range of terms, meaning that interested individuals need to make sure that they know exactly what kind of bond that they are dealing with. Otherwise, they could go in with bad assumptions, which can prove to be very expensive in the long run. Here are some of the different kinds of bonds that can be found out there:
Treasury bonds are one of the four kinds of debt issued by the U.S. Treasury for the purpose of funding federal government spending. They have maturities that range from a minimum of 10 years to a maximum of 30 years. Moreover, they have fixed interest rates, which produce interest that is paid to the bond owner on a semi-annual basis. Treasury bonds are exceptional in that they are the closest thing to a risk-free investment that can exist in the real world because of the backing of the U.S. federal government, meaning that they are very, very popular in bad economic times. Other national governments have their counterparts to treasury bonds, but they are by no means guaranteed to be as low-risk and thus low-return as treasury bonds.
U.S. Federal Government Bonds
It is important to note that other segments of the U.S. federal government can issue bonds as well. Primarily, this means the Federal National Mortgage Association and the Government National Mortgage Association. These bonds are not as low-risk as their treasury-issued counterparts, but the upside is that they come with a somewhat higher return in exchange. However, the income from these bonds are taxed at both the federal and the state level, whereas their treasury-issued counterparts are taxed at the federal level but not the state level.
Investment-Grade Corporate Bonds
Companies can issue bonds, thus resulting in what are called corporate bonds. However, investment-grade corporate bonds refer to those that have a rating of either BBB or better from either Standard & Poor’s or Moody’s Investors Service, meaning that they are much more reliable than their more poorly-rated counterparts. Generally speaking, investment-grade corporate bonds aren’t at much risk of being defaulted upon, but since companies are seen as being less resilient than the U.S. federal government, they nonetheless offer higher returns in exchange for the higher risks.
Perhaps unsurprisingly, high-yield bonds have high yields because they come with high risks as well. Essentially, they are the bonds issued by either companies or other entities that have less than BBB rating, meaning that they come with a very real risk of default. Often, high-yield bonds follow the performances of the stocks of the companies that issued them, which makes sense because the people who are interested in these bonds need to pay close attention to how the companies are actually doing. Otherwise, it is very easy for them to run head-long into a bad investment choice while pursuing what look like high profits.
Foreign bonds are just bonds in foreign currencies. This means that both their principals and their interest are in those foreign currencies, which can introduce a lot of complications for U.S. investors. After all, foreign exchange rates can change with remarkable speed. As a result, even if the interest paid out by foreign bonds remains the same, their value in U.S. dollars won’t be.
Mortgage-backed bonds are bonds backed up by either a mortgage or an entire collection of mortgages. Some people might view these bonds with distaste because of the role that subprime mortgage-backed securities played in the Great Recession, but that is more a problem with those particular securities rather than the concept as a whole. Regardless, mortgage-backed bonds are interesting in that they don’t benefit from falling interest rates in the same manner as other bonds because they become less valuable when more mortgage prepayments are made.
Municipal bonds are bonds issued by more local-level governments. They can be either investment-grade or high-yield because their issuers can see enormous variation in creditworthiness. As a result, interested individuals need to be make sure that they know exactly what is going on before investing in them, though to be fair, that should always be true when it comes to investments.