By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor
Part 2, Types of Bonds
Talking Shop with David Koch: What is a Bond?
Part 2, Types of Bonds
If you haven’t fallen asleep yet, welcome to part 2. In part 1 we covered bond jargon and used what I call a “plain vanilla bond” to lay a foundation for understanding how a bond works. To recap: That plain vanilla bond paid a fixed interest rate for 10 years, after which the principal was returned. In this post we’ll discuss some other types of bonds and why some investors would choose one over another.
Collectively, U.S. government bonds, corporate bonds, mortgaged-related bonds, and municipal bonds make up about 85% of the U.S. bond market[i] – we’ll cover these four in this post.
In the U.S., about 35% of all bonds are issued by the U.S. government, collectively called Treasuries.[ii] Most government bonds are either bills, notes, or bonds. Bills mature in one year or less and pay no coupon. They are sold at a discount and then pay their full face value when they mature. Notes mature in as little as two years and as long as 10 years. Government bonds have maturities longer than 10 years. Both notes and bonds pay a fixed interest rate semi-annually; the only difference is their maturity length.
Because Treasuries are backed by the U.S. government they are perceived to have no risk of missing a payment. They also have no risk of default (more on this in part 3). That doesn’t mean that there is no risk at all – they can lose money if there is a move in interest rates (more on this in part 4).
Fun fact: The National Debt is simply the amount of Treasuries out there. Nothing more, nothing less. Feisty cocktail topic: If an American owns a Treasury, is it really debt?
Another type of government bond issued by the U.S. is the Treasury Inflation-Protected Security (TIPS). The semi-annual payments on TIPS are tied to inflation; specifically, to the Consumer Price Index (technically CPI-U, “U” for Urban). When inflation rises, the principal value of TIPS rises along with it. When TIPS mature, the owner is paid the inflation-adjusted principal or, if deflation has occurred, the original principal. TIPS are issued in terms of 5, 10, and 30 years.
Corporate bonds make up about 20% of the U.S. bond market[iii]; think AT&T, Microsoft, etc. Since corporations need to have positive earnings to pay both the interest and the principal at maturity, corporate bonds add the risk of default – an element called credit risk. (Investors don’t need to be concerned with credit risk when investing in U.S. government bonds.) Part 3 will cover credit risk; essentially, corporate bonds will nearly always have a higher return to get investors to buy them instead of Treasuries.
Another 20% of the U.S. bond market is in mortgage-related securities.[iv] About 60% of U.S. households have a mortgage[v]; these are often bundled up and packaged in a Mortgage Backed Security (MBS). These sometimes contain thousands of mortgages and come in basically two types: agency and non-agency.
Agency MBSs are created by one of three agencies: Government National Mortgage Association (known as GNMA or Ginnie Mae), Federal National Mortgage (FNMA or Fannie Mae), and Federal Home Loan Mortgage Corp. (Freddie Mac). While GNMA bonds are backed the U.S. government and have no default risk, Fannie Mae and Freddie Mac have a more complicated backstory. They were both chartered by the U.S. government but have since been privatized. Although they are not guaranteed, the risk of default is negligible.
Private entities like banks can also issue MBSs; these are called non-agency or private-label. They are not guaranteed by the U.S. government and so are riskier.
About 10% of the U.S. bond market is in municipal bonds[vi], also known as munis (pronounced myu-knees). Munis are usually issued by a state or local government. Since only the federal government (technically the Federal Reserve) has the ability to create funds to cover the payments, they have a risk of default that Treasuries do not. Munis can be divided into two broad categories: General Obligation bonds (“G-Os”), and Revenue bonds.
Revenue bonds are repaid by the revenue from a specific tax or fee, like a fuel or hotel tax, or from a levy on a water bill. They are often issued to fund a specific project like a water treatment plant or a bridge, and then repaid through the results of that project, like a fee on the water bill, or a toll on that bridge. General Obligation bonds typically fund an agency’s general account and are repaid through non-specific taxes such as a general sales or property tax.
The most interesting aspect of muni bonds is that most of their interest is federally tax free; additionally, the interest earned on a bond in your home state is also likely free from state income taxes. This is a huge benefit to municipalities because they are able to issue bonds at interest rates lower than the rest of the market, thereby decreasing the amount they need to pay to raise funds – which means less taxes/fees/tolls for you.
Next, we’ll cover the two main risks with investing on bonds: In Part 3 we’ll cover credit risk, and in Part 4 we’ll cover interest rate risk, also known as duration risk.
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The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.