What are the Different Types of Bonds?

Last week, we did an extensive overview of the different types of money market instruments available to investors. Today, we will analyze the different types of bonds and their characteristics.

Overview

Conservative investors are generally the people who inquire most about the types of bonds. Capital preservation while generating income would be the typical goal behind an investment in a bond. Although bonds do fluctuate in value, they tend to fluctuate less then stocks. There are many types of bonds trading in the bond market. What separates one bond from another may be the issuer, maturity, the interest rate of the bond, or rating among many other things. In this blog, I will attempt to shed some light on some of the types of bonds that you can invest in.

What are Bonds?

Bonds are promissory notes issued by a borrower to a lender in exchange for money. Each bond has a set maturity. Upon maturity, the borrower, or issuer, will repay the loan in full. Bonds also have a predetermined interest rate. This is the amount of annual interest that you can expect to earn on the face value of the bond between the time you purchase your bond and the time it matures.

Bonds fluctuate in value. You can buy a bond at face value, or par. You can pay above or below par. This will affect your yield as the amount of interest a bond pays won’t change. Bonds bought below par will yield higher than the stated interest rate (the bond’s coupon). Bonds bought above par will have a lower yield than the coupon.

Bonds are rated according to the rating agency’s perception of the issuer to make timely payments of interest and principal to the lender. Issuers with higher credit ratings will pay less interest to investors than issuers with lower credit ratings.

When bonds are sold by an issuer to investors those with longer maturities can be expected to pay an interest rate that is higher than those that mature sooner.

Who Issues Bonds?

Bonds are sold by many different types of organizations. They include:

• The U.S. Government
• Foreign Governments
• State and Local Governments
• Government Sponsored Entities
• Corporations

What are the Types of Bonds?

• U.S. Government Treasury Bonds – Treasury Bills, Treasury Notes, Treasury Bonds
• International Bonds – Bond of developed and emerging economies
• Municipal Bonds – issued by state and local governments to finance municipal undertakings
• Investment Grade Corporate Bonds – rated as investment grade by the rating agencies
• High Yield Corporate or Junk Bonds – rated as below investment grade by rating agencies. Higher interest rates paid due to higher risk of default
• Convertible Bonds – Bonds that tend to pay a lower rate of interest but have a feature that allows investors to convert the bond into shares of the issuer on underlying stock hits strike price
• Mortgage Bonds – Pools of mortgages of residential and or commercial properties packaged together as a bond. Some are guaranteed by the U.S. Government. Some are backed by the U.S. Government Sponsored Entities. Others rated by rating agencies as to credit worthiness of mortgage pool.

Risk Factors

Although the various types of bonds are generally considered more conservative than equities they are not without investment risk. Investment risks should be weighed carefully and understood before you invest in bonds. Some of the major risk factors are:

• Interest rate changes will affect the value of a bond
• Changes that weaken the financial strength of the issuer will affect the value of the bond negatively
• Rating agency upgrades and downgrades
• Changes in the business environment that affect the issuer
• Inflation reduces your purchasing power and makes the value of the income stream generated by a bond less valuable

To Learn More About Bonds, Read Our Extensive Overview Here.