The Different Types Of Bonds Explained

Bonds are fixed income instruments that investors can buy from the government (federal, state or local) or for corporations. When an investor purchases a bond, they are making a loan to a branch of government or corporation.

In exchange for the loan, the issuer of the bond promises to repay the face value of the bond at a specified date in the future (maturity date) as well as provide semiannual interest payments to the investor at a specified interest rate (coupon rate).

Before diving into the different types of bonds, it is important to be familiar with the terms that may be used when discussing the various types of bonds.

Issue price: The issue price of a bond is the original price that an investor bought a bond at. There are three scenarios for the issue price of a bond. 1) The bond can be issued "at par" which means the bond is issued at face value (see below).

2) The bond can be sold at a discount which means that the bond is issued at a price lower than the face value of the bond. 3) The bond can be sold at a premium which means that the bond is issued at a price that is higher than the face value of the bond.

Face value: This is the amount of money that the bond will be worth when it matures on the maturity date. Many bonds have a face value of $1,000. The face value of a bond is different from the issue price of a bond. An investor could buy a bond at a discount for $950, or at a premium for $1,050, but will still receive $1,000 when the bond matures - which is the face value of the bond.

Coupon rate: The coupon rate is the interest rate that a bond will pay on the face value of the bond. For example, a bond might have a 5% coupon rate. If the face value of a bond is $1,000, it would pay out $50 in interest payments ($1,000 x 5% coupon rate).

Coupon dates: The coupon dates are the dates that the bond issuer (either the government or corporation) will make interest payments. Bonds will typically pay interest twice per year.

Maturity date: The maturity date is the date on which the bond "matures." This is the date in which the government or corporation that issued the bond repays the face value of the bond back to the investor.

Treasury bonds or securities are issued by the US government. Conservative investors will often buy these types of bonds for their safety as they are backed by the full faith and credit of the US government. In other words, it is highly unlikely that the US government will fail to repay the bonds.

T-Notes, or treasury notes, are an interest bearing security issued by the US government. These securities have maturities that range from 2 to 10 years in length and pay semiannual interest. Income received from T-Notes is taxed at the federal level, but exempt from state and local taxation. T-Notes are issued in minimum denominations of $100.  

T-Bonds, or treasury bonds, are similar to T-Notes in that they are interest bearing securities that pay interest semiannually. T-Bonds differ from T-Notes in regard to their maturity ranges. T-Bonds are issued with maturities of more than 10 years. The interest earned from T-Bonds is also taxed at the federal level but exempt from state and local taxation.

T-Bills, or treasury bills, are also US government securities but have short term maturity dates less than one year. Investors can buy T-Bills with maturity dates of one month, three months, six months, and one year. T-Bills differ from T-Notes and T-Bonds in that T-bills do not pay semiannual interest.

Instead, T-Bills are issued at a discount. When an investor purchases a T-Bill, they buy it at a discount. When the bond matures, the investor receives the bonds face value. The difference between the discount price and the face value is considered to be the investors interest.

Although treasury securities can provide investors with a feeling of security, inflation can also be of concern. TIPS, or treasury inflation protected securities, are a type of interest bearing treasury bond that investors can purchase if inflation is a primary concern.

The coupon rate that TIPS pay does not increase if inflation goes up. Instead, the principal amount of the bond from which the coupon rate pays is increased. For example, say that an investor invested in TIPS that were issued at $1,000 with a 4% coupon rate.

This investor would receive $20 in semiannual interest payments ($1,000 x 4%)/(2). However, if inflation increases, the principal of the bond may be increased to $1,050. The investor would now receive $21 in semiannual interest payments ($1,040 x 4%)/(2).

On the flipside, if a deflationary period occurs, the principal value of the bond will also be reduced. TIPS are typically available in 5, 10, and 30 year terms. The interest received from TIPS is taxed at the federal level, but exempt from state and local taxation.

Mortgage backed bonds are debt securities that are secured by pools of mortgages. These types of bonds are issued by housing agencies including the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Feddie Mac).

The most common type of mortgage backed bonds issued by these government agencies is called a mortgage backed pass through security. These agencies will purchase a pool of mortgages with similar interest rates and maturities.

Interests in the pool of mortgages are then sold to investors as pass-through certificates. When the home owners in the pool make their mortgage payments, the investors who own the pass through certificates get a portion of this cash flow on a monthly basis. Each payment includes a portion of both principal and interest.

A unique risk to mortgage backed bonds that investors face is the risk of prepayment. If the homeowners in the mortgage pool pay off their mortgages early or refinance their property, the cash flow of the mortgage backed bond may be reduced or not available at all. If there is no cash flow, there is nothing that will pay the investors.

Municipal bonds are issued by states, cities, territories and possessions of the United States. Municipal bonds may have a greater default risk as they are not backed by the full faith and credit of the federal government of the United States.

However, investors may be intrigued by municipal bonds as the interest received is typically exempt from federal taxes. Additionally, many states do not tax the interest on municipal bonds that are issued in state borders when bought by state residents. There are two main types of municipal bonds.

General obligation municipal bonds are backed by the full faith, credit, and taxing power of the issuer. Essentially, these types of bonds can only be issued by those that have the ability to levy and collect taxes such as states and cities.

Since the revenue of general obligation municipal bonds is usually generated from taxation, voter approval is required for these types of bonds to be issued. This is logical as investors are being repaid from taxpayer money.

Although tax revenue is the primary source to repay investors, additional non-tax revenue may also be used to pay the debt service. This can include revenues from parking fees, park and recreational expenses, and licensing fees.

Revenue municipal bonds are issued to finance projects that will generate revenue. The revenue generated from these projects is then used to pay the debt service owed to the bond investors. For example, say a city is building a new airport and needs financing. The city may issue revenue municipal bonds and use the revenue generated by the airport to repay investors.

Another source of revenue that can exist to pay the debt service on these types of bonds can be from lease payments. For example, say a state created an authority to issue revenue bonds to build a new school. The local government that uses the school will lease the facility from the authority. These lease payments would then be used to repay investors.

As the name implies, corporate bonds are issued by corporations. Corporations will issue bonds to finance business activities such as building a new manufacturing facility. Corporations can also raise money for these projects by issuing stock, but the advantage to a corporation issuing bonds is that the corporation does not give up ownership in the company as long as the corporation can fulfill the obligation of any bonds issued.

Secured corporate bonds are not only backed by the corporation's full faith and credit, but also by specific corporate assets. Essentially, if the corporation falls into bankruptcy, the trustee will take possession of the assets that secured the bonds, liquidate them and repay the investors who purchased the bonds.

Corporations may use real estate, equipment, and collateral such as stocks or bonds to secure these bonds. Secured corporate bonds can provide investors with a greater sense of security as there is a tangible asset that protects the investor should the corporation go under.

Unlike secured corporate bonds, unsecured bonds are only backed by the full faith and credit of the issuer. If an investor purchases an unsecured bond from a corporation and the corporation goes bankrupt or defaults on the bond, this investor has the same type of claim of the company's assets as any other general creditor.

The primary function of bonds in an investors portfolio is to reduce the overall risk of a portfolio through diversification. Bonds tend to have low correlation to stocks. In other words, when stocks are zigging, bonds are zagging.

This can help investors reduce the overall risk that is present when investing. Every investor wants the maximum return for a given level of risk. This is great when an investor's portfolio is up, but when the market is down, having bonds in a portfolio can limit the overall decline of a portfolio.

Understanding the different types of bonds can further help an investor build a portfolio that is most suitable for them. Keep in mind this is not a perfect philosophy as bonds and stocks have recently tiptoed into positive correlation.

Navigating proper portfolio construction between stocks and bonds can be difficult for investors. Working with financial professionals, such as a financial advisor, can help investors have a better understanding of how bonds should fit into their portfolio as well as the specific types of bonds they should hold.

One of the largest risks for bond investors is the risk that the issuer of the bond will default - meaning that the issuer will not be able to repay the bond to the investor. This is where a bond's credit rating comes into play. A credit rating is essentially a score that indicates how likely it is that the issuer will be able to repay the bond.

Bonds are given a credit rating by a rating agency. The main agencies are Standard and Poor's, Moody's, and Fitch Ratings. Each agency will rate bonds based upon specific criteria. The higher the rating, the safer the bond tends to be and the lower the rating, the higher the risk.

A bond with a rating AAA to BBB rating from Standard and Poor's and Fitch and a bond with a rating of Aaa to Baa3 from Moody's are considered to be investment grade bonds. Bond's below these ratings may fall into the junk bond category.

Bonds with lower ratings tend to offer higher returns in order to entice investors. Bond investors should be aware of the ratings of bonds before purchasing to properly consider the risks and rewards associated during portfolio construction.

Tax planning is an important aspect of a well rounded financial plan and bond investors should be aware of how they will be taxed when investing in the various types of bonds. The interest paid to investors from treasury securities is taxed at the federal level, but exempt at the state and local level.

Interest from mortgage backed bonds and corporate bonds is subject to tax at both the federal and state level. Interest from municipal bonds is not taxed at the federal level and will vary at the state and local level. Working with a financial and/or tax professional can help an investor carefully consider the tax implications of the various types of bonds.

Bond investors should also consider the inherent risk of inflation that comes from investing in bonds. If an investor has allocated too much of their portfolio towards fixed income securities, their return may not be significant enough to outpace inflation during high inflationary periods.