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Understanding the Different Types of Bonds

Investors who have aversion to the inherent risk involved in investing in securities find a better option in bonds. Bonds offer capital preservation as well as fixed returns at its maturity. That’s why bonds are good investment vehicles in terms of additional income stream or as a means to diversify your investment portfolio.

Different Types of Bonds

BondsThere are different types of bonds and they are categorized based on the entities that issued them. Different bonds have varying levels of risk and reward. Here’s a run through on the most common bonds that you’ll encounter in the market today:

US Government Securities

When you invest in U.S Government-issued bonds, you are basically lending to the US Department of the Treasury. Thus, the government is obliged to pay the principal capital at its maturity date as well as interest at a specified time intervals. You can buy a US government bond directly from the Department of Treasury website or from your brokerage account.

US Government securities are categorized based on its maturity dates and these are as follows:

  • US Treasury bill or T-Bill – a T-Bill’s maturity date ranges from 90 days to a year. Interest of a T-Bill is exempted from local and state income taxes; and it is computed as the difference between the cost to purchase the bill and its value during maturity.
  • US Treasury Note – a U.S treasury note’s maturity ranges from 2-10 years. Interests accrued are usually paid semi-annually; so investors can expect a semi-annual income stream from this government security.
  • US Treasury Bonds – a U.S treasury bond’s maturity ranges from 10-30 years. Interests are paid semi-annually and are exempted from state and local taxes.
  • US Government-Issued Zero-Coupon Bond – these are discount bonds that are redeemed at full face value at its maturity date. A zero-coupon bond’s price can be highly volatile. It’s best to hold these kind of bonds in a tax-deferred account since you will have to pay taxes on the bond’s “phantom interest” based on its current market value even if you don’t receive any interest on the bond until its maturity date.

Municipal Bonds

This type of bonds is issued by the state or local governments. Municipal bonds involve a higher level of risk compared to a U.S Treasury bond. After all, you won’t probably hear of the U.S government defaulting; but there’s a slight default risk with municipal bonds.

When you plan to invest in municipal bonds, there are 2 important things to consider: interest rate and taxes. Typically, “munis” are exempted from state, local or city taxes. However, if you purchased a bond at a heavily discounted price and sell it for profit, you may be taxed on capital gains. That’s why in determining whether a higher-yield taxable bond is a better option you need to weigh your options using after-tax returns as the basis of your decision.

Corporate Bonds

This kind of bonds is a debt instrument issued by private companies as a means to raise capital. Because the bond is backed by the corporation and not the US government, these are riskier instruments compared to the full faith and credit US government-issued bonds. And because you’re expected to take on a riskier investment vehicle, in the same token, there’s a higher-yield potential compared to US treasuries of the same maturity dates.

When you invest in a corporate bond, it’s important to know the credit ratings of the corporation that issued the bonds. Credit ratings are assigned based on the perceived ability of the issuer to pay the specified interest and principal amount at its maturity date. A credit rating of AAA has the lowest level of risk; while a credit rating of D has the highest level of risk.

Bonds are generally safer investment vehicles. However, you still need to define your investment goals and exercise due diligence to determine if it’s the right kind of investment for you.

Guest Post contributed by Patrik Fonce. Patrik is a trader with more than 10 years of experience trading financial markets. He is also a writer and works currently at QuantShare Trading Software.
 
photo credit: Ahmad Nawawi

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