Investors often forget the wide range of possibilities that bond markets offer. However, investors must know the difference when it comes to success in the bond market. Your goals, strategies and risk management determine the kind of bonds which must be in the portfolio.
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US treasury department issues treasury bonds, bills, notes and fixed income debt securities. These are tradable. These are one of the safest investment options as they are secured by the US government. A major benefit of investing in US treasury bills is that investors are exempt from state income tax on interest.
One disadvantage of investing in US treasury bills is that they are one of the weakest performers in terms of making profits. Knowing that, most investors still have them in their portfolio, as they are very safe and predictable.
A major difference in the three types of bonds is their maturity. Treasury bills are issued with a maturity period of less than a year. Treasury notes have maturity periods of 2,3,5 and 10 years. Treasury bonds mature over a term of 30 years.
It is a misconception that all US government bonds are issued by the US treasury department. Some bonds are issued by government agencies like the Federal National Mortgage Association, Fannie Mae and the Government National Mortgage Association, Ginnie Mae. These bonds have higher yields when compared to the US treasury bonds and carry relatively lower risk. But, the catch is, investing in these bonds attracts no state and federal tax benefits.
Municipal Bonds, also referred to as munis, are securities issued by US Municipalities or local governments to fund expenditure like construction of highways, bridges and so on. The biggest advantage for a munis investor is that the interest generated is tax exempt at a federal level in the USA.
Adding to that, if the investor resides in the state that issued the bonds, then he/she is exempt from paying state taxes on the interest earned. Hence, these bonds offer lower yields and returns when compared to taxable bonds.
Few examples of municipal bonds are revenue bonds, general obligation bonds, anticipation notes and insured municipal bonds.
Municipal bonds are also issued in India. In 1997, Bangalore Municipal Corporation issued the first municipal bonds in India. As of now, retail investors are not allowed to invest in municipal bonds. However, retail investors can invest in these bonds once they hit the secondary market.
Indore, the cleanest Indian city, the commercial hub of Central India and the business hub of the state of Madhya Pradesh, led five local bodies that would collect up to Rs 1,200 Crores through the sale of municipal bonds. Indore Municipal Corporation, rated AA (SO), or two levels lower than the top grade, was successful in raising about Rs 140 Crores by selling municipal bonds, which offered 9.25% and has maturity period of 10 years.
High profits come with high risks. These bonds are comparatively riskier than the bonds described above. When we talk about companies and organizations, we generally think of stocks. However, even corporate companies can issue fixed income securities called corporate bonds.
Companies and organizations must be extra careful with the debt they are issuing as it can damage both short term and long term profits. Corporate bonds are issued on the following maturities:
Company Bonds are more volatile and riskier than government bonds. The main advantage of investing in corporate bonds is they offer a much higher return vis-a-vis government bonds.
There are a wide range of corporate bonds, they are as mentioned below:
i) Split coupon bonds
ii) Straight cash bonds
iii) Pay in kind bonds (PIK)
iv) Floating rate and increasing rate notes
v) Deferred interest bonds
vi) Convertible bonds
vii) Multi tranche bonds
SEE ALSO: Corporate Bonds
A foreign bond is a bond issued in the domestic market by a foreign entity, in the local currency of the market. The two main features are that the bond is traded in a foreign market in a foreign currency. The main purpose of investing in foreign bonds is to diversify the portfolio and gain the benefits of investing in different currencies. However, there is a high currency risk depending on rate of exchange. Exchange rates are highly volatile and unstable.
For example, an investor has invested in Japanese bonds called with a 5-year maturity at an exchange rate of 1 Japanese yen for 0.009 US dollar, meaning the person has paid 0.009 USD per bond. At maturity, the exchange rate is 1 Japanese Yen to 0.007 US dollar, which means that the investor receives 0.007 USD per bond.
As mentioned earlier, convertible bonds are a type of corporate bond, which the holder can convert at any given point in time to shares (stocks) of the company. The number of shares is pre-determined at the time of issuing the bond.
This type of security is quite attractive for investors as they yield higher returns than government bonds. The main advantage of investing in convertible bonds is that you can convert to company shares. This is an added advantage if the company is performing well. But the catch is that these bonds offer lower interest rate than other corporate bonds.
A company generally issues convertible bonds to avoid negative market interpretations and reactions which may damage their share price. For example, a company ABC decides to issue shares. The market may view this as a sign of overvalued share price. Hence, the company issues convertible bonds to avoid this and investors can convert them into stocks.
Conventional bonds are the ones whose value, interest pay out frequency, interest rate and maturity date are fixed and specified. Non conventional bonds are those whose interest rates and maturities vary with time.
Zero-coupon bonds or just ‘zeroes’, are the bonds that do not pay coupons or interest. Zeroes are the most common type of non conventional bonds. Common issuers of zeroes are governments and corporations. Zeros are usually sold at a discounted price, but as its name says, do not pay any coupon. Instead investors can redeem at par.
A major drawback of non conventional bonds is the fact that you have to pay taxes on returns, even though you don’t receive them annually. Adding to that, non conventional bonds are more volatile and riskier than the conventional ones.
Although governments and companies issue non conventional bonds, you still must buy “strips” from an authorized broker or a financial institution.
Don’t go by the name, these are stocks that share a few common things with bonds. For example, like regular stocks, preferred stocks too offer dividends. But, like bonds, preferred stocks dividend pay outs are fixed and pre-determined.
The disadvantage of preferred stocks is that stockholders have no ownership in the company and are not empowered to vote for the board of directors. If the company goes bankrupt, then the preferred stockholders receive their money first.
Adjustment bonds are securities issued by a company to raise funds for recapitalization and restructuring. The outstanding debt of the company is shifted to the adjustment bonds and is handed over to bondholders. This is necessary as the company requires changing the terms of its obligations to escape default. Adjustment bonds pay out interest only if the company generates enough revenue.
Junk bonds, also referred to as high-yield bonds and speculative bonds, are corporate bonds with the lowest possible ratings. As the names suggests, they are high-risk and high-return assets, offering a much higher interest rate than government bond.
Even though they seem to be a great investment option, you must approach them with caution. In fact, they offer higher returns than most other bonds and are less volatile than stocks.
According to credit rating agencies like Moody’s and Standard and Poor’s, junk bonds are highly speculative. This, on the other hand, must be considered a serious warning. It means that the issuer is very unstable and financially not strong. It is advisable to be extra careful with investing in junk bonds.
SEE ALSO: Types of Bonds
There are various types of bonds available in the market. On the whole, bonds offer diversification in the portfolio along with tax benefits. You can invest in those bonds that are suitable in aiding to achieve your financial goals and requirements.
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