Investing Unit 5: Bonds

January 06, 2009 Print Friendly and PDF




Before discussing various types of bonds, some background is in order. Bonds are debts or IOUs of corporations or government entities. Bond issuers promise to pay a specified rate of interest, called a coupon rate, periodically and to repay the face (a.k.a., par) value of the bond (e.g., $1,000) at maturity. Corporate and municipal bonds are typically sold by brokers, who receive a sales commission. Bonds are subject to interest rate risk. If interest rates rise, the value of previously issued bonds will drop as investors demand a price adjustment equivalent to earning the prevailing interest rate. If interest rates drop, a previously issued bond will be worth more than its face value because investors would be willing to pay a premium to obtain a bond paying more than the currently available rate. The value of long-term bonds is affected more than short-term bonds by interest rate fluctuations. Bonds are also subject to call risk. This means that a bond issuer may choose to retire existing bonds, issued when interest rates were high, and reissue them with new debt at a lower interest rate.

The capacity of bond issuers to repay their debt is rated by various commercial firms such as Moody’s and Standard & Poor’s. Bonds rated Baa to Aaa by Moody’s and BBB to AAA by Standard & Poor’s are considered investment grade. Those with lower ratings are termed substandard grade or, in more popular language, "junk bonds." Since it is not good marketing to use the word "junk" to sell something, substandard grade bonds or bond funds can often be recognized by the words "high yield" in their title.

U.S. Treasury Securities

Treasury securities are an obligation of the U.S. government and are considered the safest of all debt instruments because there has never been a default in payment. This concept is sometimes stated with the words "full faith and credit of the U.S. government." Treasury securities are sold at periodic government auctions. They are exempt from state and local income taxes due to the principal of reciprocal immunity. This means that the federal government doesn’t tax state and local debt (e.g., municipal bonds) and state and local governments don’t tax federal debt (e.g., Treasury securities).

There are two types of Treasury securities currently available for purchase: bills and notes. All require a $100 minimum deposit with larger amounts purchased in multiples of $100. Treasury bills have the shortest term of all Treasury securities and come in maturities of up to 52 weeks (1 year). They are bought at a discount with investors paying the face amount up front and receiving back an amount, called "the discount," equal to the interest rate determined by the most recent auction. At maturity, an investor’s original purchase amount (principal) is returned. If interest rates are 4%, for example, an investor with a $1,000 Treasury bill would receive a discount of $40 ($1,000 x 0.04) shortly after purchase and their $1,000 principal back at maturity.

Treasury notes currently come with 2-, 3-, 5-, and 10-year maturities. They pay a fixed rate of interest semi-annually until maturity, when investors get their principal back. For example, a $1,000, 5-year Treasury note with a 5% yield pays $25 every six months ($50 per year). The yield on Treasury notes is generally higher than that of bills to compensate for the risk of investing longer and the greater volatility that accompanies interest-rate changes.

Treasury bonds are issued for a term of 30 years. Like Treasury notes, they pay a fixed rate of interest every six months until maturity. The yield on Treasury bonds is generally higher than that of notes to compensate for the risk of investing longer and the greater volatility that accompanies interest-rate changes.

Treasury securities can be purchased from a bank or brokerage firm for a fee of about $50 or with no fee from the Federal Reserve Bank’s "Treasury Direct" program. An application, called a tender form, is required and can be obtained by calling 202-874-4000 for a list of Federal Reserve Banks or through the Treasury Department Web site https://www.treasurydirect.gov/indiv/indiv.htm. With Treasury Direct, an investor must specify a bank account where their interest payments can be deposited electronically. Treasury securities also can be sold through the Treasury Direct program for a nominal charge.

Municipal Bonds

Municipal bonds are debt instruments of state and local governments or government-related entities (e.g., bridge or highway authorities). General obligation (GO) bonds are backed by the full taxing ability of the issuer and are considered the safest of municipal bonds. A second type of municipal bond, the revenue bond, is backed by some type of revenue-generating source (e.g., fares, tolls, fees) and generally pays a slightly higher rate of return.

Municipal bonds are generally attractive to persons in the 25% marginal tax bracket and higher. Even though municipal bonds pay a lower return than other bonds, investors keep more of what they earn because the interest is generally federally tax-exempt. Interest is also state tax-exempt, if bonds are issued by an investor’s state of residence. An exception is the so-called private purpose municipal bond sold to finance sports stadiums, airports, hospitals, and the like. Municipal bonds are generally sold by brokerage firms in $5,000 increments with less expensive "minibonds" requiring a lower amount (e.g., $500). Interest is paid semi-annually. Investors can also obtain the tax advantages of a municipal bond by purchasing a municipal bond mutual fund, often for an initial investment of $1,000 or less. To determine your marginal tax bracket, refer to Figure 1 in Unit 7, Tax-Deferred Investments.

Corporate Bonds

Corporate bonds are debt instruments issued by for-profit companies to raise capital for expansion and/or ongoing operations. They are generally sold in $1,000 increments and pay taxable interest twice a year. Corporate bonds generally pay higher interest rates than government bonds with comparable credit ratings and maturities. Investing in a corporation is a greater risk than a government entity that has the ability to raise revenue through taxes. Thus, investors must be compensated accordingly. The least risky of all corporate bonds is a mortgage bond because it is backed by a company’s land and buildings. Bonds backed by non-real estate assets (e.g., airplanes, securities) have more risk. The highest risk corporate bond is a debenture, which is a corporate bond backed only by a company’s future earnings and promise to repay. Conservative investors will want to select mortgage bonds issued by investment grade (i.e., highly rated) companies.

Convertible Bonds

As their name suggests, convertible bonds are a type of corporate bond that allows investors to "have their cake and eat it too," almost. They provide the upside potential of stocks (the opportunity to participate in company earnings) with the downside protection of bonds (a fixed return and repayment of principal at maturity). Convertible bonds can be exchanged for a specified number of shares of common stock of the issuing company. As the price of the company stock increases, the convertible bond price also increases because the option to convert becomes more valuable. This relationship is true whether an investor chooses to convert or not. The trade-off is that convertible bonds generally convert to fewer shares of stock than you could buy for the cost of a bond. Almost all convertible bonds are callable. Even though they are a "hybrid" investment, convertibles (like all bonds) are sensitive to interest rate fluctuations. They can be purchased as individual securities in $1,000 increments or through convertible bond mutual funds.

Zero-Coupon Bonds

As their name implies, zero-coupon bonds pay no (zero) annual interest. Instead, they are sold at a deep discount and eventually grow to full face value ($1,000). An investor might pay only $200 or $300, for example, for a bond that matures in 15 or 20 years. Brokers may require a $5,000 purchase, however, or five times the initial cost. For example, an 8% zero-coupon bond with 15 years to maturity would cost $308. To purchase five such bonds ($5,000 face value) would cost $1,540 (5 x $308). So, in this example, if you invest $1,540 now, you know you'll get back $5,000 in 15 years. This return might be suitable for a goal you want to achieve in 15 years (e.g., future education expenses of a young child).

Many investors like zero-coupon bonds for their relatively low upfront cost and predictability. An investor knows exactly how much they’ll have at maturity. Two disadvantages of zero-coupon bonds are their extreme volatility with interest rate changes and the fact that annual increases in value are considered taxable income. Immediate taxation can be avoided, however, by using zero-coupon bonds for tax-deferred retirement plans, such as IRAs, or by buying tax-exempt (e.g., municipal) zero-coupon municipal bonds.

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This work is supported by the USDA National Institute of Food and Agriculture, New Technologies for Ag Extension project.