Bond Basics: Pick Your Type

Bonds can help diversify your investment plan. They tend to be less volatile and less risky than stocks, and when held to maturity, can offer more stable and consistent returns. 

Bonds are IOUs issued by corporations, federal, state and local governments and their agencies. When you buy a bond, you become a creditor of the corporation or government entity; it owes you the amount shown on the face of the bond (par value), plus interest. 

Get to know all the different types and figure out which ones belong in your portfolio. 

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Secured bonds

Secured bonds are backed by specific collateral which reduces the risk for investors. Typically, they are backed by a lien on part of a corporation's facilities, equipment or a defined revenue stream. If the corporation defaults or goes bankrupt, those assets can be sold to pay off the bondholders and are aided by the trustee of the bond to help recover your money. 

Debentures

Debentures are unsecured bonds, backed only by the general ability of the corporation to pay its liabilities. If the company goes broke, debentures won’t be paid off until secured bondholders are paid. It’s important to take notice of the issuing company's financial reputation and how they are rated by credit rating agencies. 

Subordinated debentures

Subordinated debentures, also called junior debt, are another step down the totem pole. You don't get paid until after holders of so-called senior debentures get their money. Because subordinated debts are only repayable after other debts have been repaid, they are more risky than secured or more senior debt.  

Zero-coupon bonds

Zero Coupon bonds may be secured or unsecured. Zero coupon bonds do not pay interest during the life of the bonds. These bonds are attractive because you buy at a deep discount from their face value, which is the amount that you will receive when the bond "matures" or comes due. 

Municipal bonds

Municipal Bonds are issued by state or city governments, or their agencies. The two most common types are general obligation and revenue bonds. The interest paid to holders of both revenue and general obligation municipal bonds is exempt from federal income taxes and, usually, income taxes of the issuing state.

• General obligation bonds are not secured by any assets. They are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders and are a safer investment than revenue bonds.
• Revenue Bonds are not backed by the government's taxing power but by revenue streams from a specific project or source, such as highway tolls. Some revenue bonds are “non-recourse,” meaning that if the revenue stream fails to meet projections, the bondholders do not have a claim on the underlying revenue source.

US Treasury Securities

 U.S. Treasury securities are debt obligations issued by the U.S. Department of the Treasury. Treasury securities are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government. The income from Treasury securities may be exempt from state and local taxes, but not from federal taxes. 

• Treasury bills (T-bills) mature in 1 year or less and do not pay an interest rate, but are sold at a discounted price compared to the face value, or par value. The bond pays the full par value upon maturity
• Treasury notes (T-notes) mature in 2, 3, 5, 7, or 10 years. Coupon payments are made twice a year, either at a fixed or floating rate
• Treasury bonds (T-bonds) mature in 20 or 30 years. These are the longest-term bonds and as such typically offer the highest coupon payments 
• Treasury Inflation-Protected Securities (TIPS) are indexed to the rate of inflation on a daily basis as measured by the Consumer Price Index (CPI). When inflation is high, these bonds are worth more; when there’s deflation, they are worth less. They also offer a coupon
• Series EE savings bonds are a low-risk way to save money. They earn interest regularly for 30 years or until you cash them. As of 2013, EE bonds are issued in electronic form only. You must have a TreasuryDirect account to buy and manage new EE bonds. These bonds have a fixed rate of interest that is set when you buy the bond. The interest is earned monthly and is compounded semiannually
• Series I savings bonds protect you from inflation. The actual rate of interest for an I bond is a combination of a fixed rate and an inflation rate. The combined rate can, and usually does, change every 6 months. The new rates are announced every May 1 and November 1. Rate changes for your bond occur every 6 months from the issue date of your bond

Agency securities

Agency securities are loans to government agencies or federally-backed private corporations. While agencies are government-sponsored enterprises, they are not backed by the full faith and credit of the U.S. government, but there are a few exceptions. 

Agency securities that are issued by the following agencies are backed by the full faith and credit of the US government:  

•  Small Business Administration (SBA) 
•  Federal Housing Administration (FHA) 
•  Government National Mortgage Association (Ginnie Mae) 
•  Tennessee Valley Authority (TVA) 

Callable bonds

Callable bonds are bonds that can be redeemed by the issuer at set points before the listed maturity date. That means the issuer pays you the call price and any accrued interest, and doesn’t make any future interest payments. Callable bonds give issuers—such as corporate and municipal entities—the option to effectively refinance their debt later at a better interest rate, much like you might refinance your mortgage. Unfortunately, that results in you losing interest income at a rate you may not be able to match and having to find another suitable investment for your money. 

Convertible bonds

Convertible bonds are corporate bonds that can be “converted” or swapped for the same company's common stock at a fixed ratio. A  convertible bond’s conversion ratio specifies how many shares of common stock it can be redeemed for. The ratio is specified in its indenture (the legally binding document that outlines the terms and rules of the bond) when it is issued. For example, a 4:1 convertible bond is redeemable for four shares of stock. The higher the ratio, the more shares the bond is worth.

Conversion price is the bond’s par value divided by its conversion ratio. It is also the minimum price the stock of the underlying company must reach in order for the bond to become eligible for conversion into shares.

For example, suppose you buy five convertible bonds issued by AT&T at $1,000 each. The bonds pay 7% and each is convertible into 40 shares of AT&T stock. When you buy the bonds, AT&T is selling at $20 a share. Because the break-even conversion price is $25, you've paid $5 a share for the conversion privilege. If AT&T stock climbs above $25, you can make a profit by converting your bonds to stock. If the price were to go to, say, $30, you could quickly turn your $5,000 bond investment into $6,000 worth of stock.

 Bottom line 

If you are risk-averse—bonds give you security that stocks can’t deliver. And as you edge towards retirement, most people are advised to shift away from stocks and into bonds as a way of reducing exposure to market swings. Bonds are safer than stocks and can provide a predictable income stream. They are a great way to diversify your portfolio and offer a hedge against market volatility.  

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