Educate Yourself on the Basics of Investing in Bonds (Treasuries, Municipal and Corporate Bonds
Updated: Apr 2, 2020
Bonds can play an important role in an Investor’s portfolio because they can help to diversify your portfolio, and they are believed to be less risky than owning stocks, because they are generally less volatile than stocks. The bond Issuer (Government entity or Corporation) pays a set interest rate, at predetermined intervals (usually annually or semi-annually), and returns the principal on the maturity date.
A Bond is a fixed income instrument (you will be paid a fixed amount for each year that you hold it), that is really a loan that you/the Investor makes to a Borrower (Federal Government, State and/or Municipal Governments, and Corporations.)
There are 4 Major Bond Types
Treasury Bonds: These are issued by the U.S./Federal Government and they have long maturities – 10 years or longer.
-The rate of return is generally the lowest of the 4 major bonds, but;
- The risk is lowest/most secure because they have the backing of the United States Government.
Agency Bonds: U.S. Government Agencies or Government-sponsored enterprises issue bonds to help pay for public policy projects such as student loans, Farm loans, Small Business Loans etc.
Municipal Bonds: Bonds issued and backed by municipal and state governments, hoping to raise capital for public projects like schools, transportation (roads, bridges etc.), utilities etc. *The major appeal of Municipal Bonds or “Munies”, is that the interest payments are typically exempt from Federal, and some state and local taxes.
Corporate Bonds: Bonds issued by large corporations to help fund expansion into new markets, major building projects/plant expansions etc.
Key Characteristics of bonds that an investor must consider when thinking of investing in bonds include:
· Coupon Rate: This is the yield (interest rate) paid on an annual basis by the Issuer.
· Maturity: The date when the principal, or par value, is paid back to the Investor, which ends the Issuer’s obligation.
· Tax Status: Some government and some municipal bonds are tax exempt, so income and capital gains are not subjected to taxation.
· Callability: The ability of some bonds to be called/bought back, before the pre-set term of the bond.
· Investment Grade/Risk: Credit or default risk is the risk that the Issuer will not be able to make the agreed upon interest and principal payments. *”Safety” is usually defined as the Issuer having sufficient operating income and cash flow to pay off its bond debt as expected.
· Secured/Unsecured: Secured bonds offer some sort of collateral in case of default.
The two most common bond rating agencies are Standard & Poors, and Moody’s and these agencies show ranges of abilities for issuers to repay their debt obligations. Ratings range from very high grade (i.e. AAA) down to Junk Bond status, and likewise an Issuer’s ability to repay its obligations as promised, range from excellent to “default is more likely” – see charts below.
Standard & Poors Ratings Scale for Long-Term Bonds
The following chart provides further detail on what each letter grade means for the issuing entity. *
Moody’s Long-Term Rating Scale
Aaa Obligations rated Aaa are judged to be of the highest quality, subject to the lowest level of credit risk.
Aa Obligations rated Aa are judged to be of high quality and are subject to very low credit risk.
A Obligations rated A are judged to be upper-medium grade and are subject to low credit risk.
Baa Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.
Ba Obligations rated Ba are judged to be speculative and are subject to substantial credit risk.
B Obligations rated B are considered speculative and are subject to high credit risk.
Caa Obligations rated Caa are judged to be speculative of poor standing and are subject to very high credit risk.
Ca Obligations rated Ca are highly speculative and are likely in, or very near, default, with some prospect of recovery of principal and interest.
C Obligations rated C are the lowest rated and are typically in default, with little prospect for recovery of principal or interest.
Just like Corporate Borrowers, states and municipalities are also rated for credit worthiness by independent agencies, and the resultant “coupon rate” is higher with the higher assumed risk by the Borrower.
If you would like to diversify your portfolio, and if you are looking to reduce the level of risk so that you are more comfortable with managing your own investment portfolio, it might make sense to investigate some of the top investment grade Corporate Bonds that are available.
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