Types of Bonds

by Wes Bridel on December 10, 2010

in Stewardship

What types of bonds can you invest in and how are they different?  As we’ve been alluding, there are many types of bonds, including: municipal, US government, foreign government, corporate, mortgage-backed or asset-backed securities, and agency bonds. Preferred Stocks are also very similar to bonds and in fact are much more similar to what we’re describing here than they are to common stocks which you are probably more familiar with.

We won’t spend a lot of time on each type, but will cover a few differences…

Municipal Bonds are popular with higher income savers because they are perceived as being low risk and they often come with tax free dividend payments depending on where you live.  Because of this, they also pay a very low interest rate.  Be careful if investing here because many states and municipalities are going broke fast and this might not be as safe as it seems.  Some municipals bonds are asset backed (for instance by a toll road) and thus have some level of safety built in, while most are backed simply by the taxing power of the entity issuing the bond.

Agency Bonds are quasi-governmental company bonds.  These agencies (such as Fannie Mae (FNMA), Freddie Mac, etc) were at the heart of the 2008 debt bubble explosion and can be extremely risky, or they can be 100% backstopped by the US Government.  Be careful.

Mortgage Backed Bonds are the other type of bond that was at the center of the debt crises.  Wall Street bundled many loans together and got them a AAA rating simply based on the fact that we hadn’t seen a sharp drop in real estate values in many decades.  These ended up being pure junk.

Corporate Bonds are a safer choice in many ways because they are more predictable than government.  You know what the company is trying to do and political motives rarely enter the picture.  The company is trying to profit.  They might be a great credit risk, a horrible one, or somewhere in between, but you can ascertain this by examining their financials.  Of course, a company’s fortunes can change, but this is part of the inherent risk involved in investing.  We’ve already mentioned the fraud of Enron and of course this too can happen.

There are many funds which specialize in corporate bonds and they can have great variety depending upon whether they specialize in a certain duration (maturity), grading (indicating default risk), or sector.

Overall, you can make a pretty educated guess about how able the company will be to pay off your bond as promised by examining its records.  Higher rated bonds will be more likely to pay you as promised and will promise a lower interest rate because of this.  Some corporate bonds are “Callable” which means that if interest rates decline substantially, the company will pay you your principal early to get out of the long term commitment.

If the company is to go through difficult financial times and not be able to pay its bond dividend payments as promised, the stock will approach zero (wiping out the owner’s (stock holders) of the company) and the bond holders will either reorganize the company or sell off its assets to be paid back for the money that was lent to the company.  Because bond holders are first in line in he case of default, bonds are considered much “safer” than stocks.  This is true to the extant that we’ve mentioned, but in some economic environments, could end up being riskier because stocks have the ability to appreciate with severe inflation while most bonds do not.

The more “High Yield” a bond or bond fund is, the higher the expected interest payment will be, but also the more volatile it will be when markets shift.  These type of bonds seem fantastic when the market is calm &/or interest rates are falling, but can drastically fall in value when the market falls.  This often coincides with a stock market crash and so you’ll notice they perform very similary to equities.  Of course, we are speaking here only about a bond fund or a high yield bond that you are trying to sell.  As long as you are holding onto the bond until maturity, the only thing that matters is whether or not the particular company you have lent money to can repay you.  The market value of the security doesn’t affect you in this case (because you’re not trying to sell it).

The opposite can be true too.  Buying a high yield bond or bond fund when everything seems bleakest, but when in fact the economic environment is improving, and lead to huge upswings in value (again, much like the stock market.)

Preferred Stocks are very similar to bonds.  They are promised set dividends and do not typically enjoy the same appreciation expectations of stocks, but do enjoy greater price stability like bonds.  They are behind bond holders in line if a company defaults, and therefore they receive higher dividend payments.

Next, we’ll get into the different types of foreign bonds…

Some other posts on  Bonds we’ve done areWhat is a Bond?, Treasury Inflation Protected Bonds, Shorting Treasury Bonds, & Treasuries Might Be Risky, Are Other Bonds Risky?

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