Types of Bonds and Considerations for Bond Investing

Study Notes

Bonds

Bonds are debt securities in which an investor loans money to an entity (often a government or corporation) for a defined period of time at the agreed upon interest rate. They represent IOUs from the issuer to the bondholder, and they can serve as a protective hedge against stock market declines. There are several main types of bonds, each with its own characteristics.

Government Bonds

Government bonds, also known as treasury bills, are issued by sovereign governments to finance their operations and projects. These bonds are generally considered safe investments because they are backed by taxing power of the respective country's government. However, depending on the economic conditions of that nation, their creditworthiness may vary.

Corporate Bonds

Corporate bonds are issued by companies to raise capital for various purposes, such as expanding their business or paying off existing debts. Corporate bonds typically pay higher yields compared to government bonds due to the added risk associated with investing in a private company rather than a government.

Municipal Bonds

Municipal bonds, also called muni bonds or municipal notes, are issued by local governments – like states, counties, cities, towns, school districts, hospitals, and other public entities – to fund various public works and infrastructure projects. Like corporate bonds, these bonds often offer higher yields than government bonds due to the risks involved with investing in local governments.

International Bonds

International bonds are debt instruments issued by non-U.S. borrowers in U.S. markets. They can be denominated in either foreign or domestic currencies, and they come in two forms: global bonds (issued outside the United States) and Eurodollar bonds (issued domestically). These bonds expose investors to currency risks and political instability associated with the issuing countries.

Junk Bonds

Junk bonds, also referred to as high-yield bonds, are issued by companies with lower credit ratings and higher default risks. Despite the increased risk, junk bonds can potentially yield more attractive returns than safer bonds because they offer higher interest rates to compensate investors for assuming this additional risk.

Investing in Bonds

Investors typically buy bonds through brokerages, banks, or other financial institutions. Bonds are bought at face value and held until maturity, when they mature and return the principal amount plus any accrued interest. Bonds can be purchased individually or through mutual funds or exchange-traded funds (ETFs) that contain a mix of different types of bonds.

When investing in bonds, it is essential to consider factors such as:

Interest Rate Risk: This occurs when the interest rate on your investment falls below the prevailing market rate.
Credit Risk: This refers to the possibility that the issuer of a security will default, meaning they fail to meet their obligations to repay borrowed funds.
Callable Bond Risk: If you purchase a bond and interest rates rise significantly, the issuer may choose to repurchase (call) the bonds early, taking advantage of lower interest rates on the market and leaving you without the bond's original maturity period.

Description

Explore the different types of bonds, including government, corporate, municipal, international, and junk bonds. Learn about key considerations when investing in bonds, such as interest rate risk, credit risk, and callable bond risk.