How to Invest: Corporate Bonds vs Treasury Bonds

by Monday, September 29, 2014

How to Invest: Corporate Bonds vs Treasury Bonds


Types of Bonds / who is issuing them?

Agency Bonds (Agencies):
Securities issued by government organizations and government sponsored entities or GSE’s make up a sector of bonds referred to as agencies. These bonds are generally appointed to assist in public aid, including agricultural and housing-related projects. The Government National Mortgage Association (Ginnie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the Student Loan Marketing Association (Sallie Mae) and the Federal National Mortgage Association (Fannie Mae)

Are Bond investments Safer than the Dollar?

 

Treasury Bonds, What you should know before you invest

 

U.S. Government Bonds (Treasuries):
Treasuries are bonds issued and backed by “the full faith and credit of the US Government,” which makes them one of the safest ways to invest. They are not liable to credit risk in part because in order to “redeem the bond at maturity” the government can hike up taxes or print money. Treasuries usually provide lower yields in regard to other bonds and the income that bondholders receive is only taxed at federal, not local or state, level. The Treasury Bill is one way to invest through the federal government, with only 1 year to invest or less – it is considered one of the least risky methods of investment. Treasury Notes mature in 1 – 10 years and accrue a fixed rate of interest every six months up until the point of maturity. Treasury Bonds are US debt that matures in 10 – 30 years. T Bills, T Notes and T Bonds are all issued in face values of $1,000. A definite advantage of these Treasuries is that they are not callable, not to mention, they can be held in your name rather than the name of the brokerage firm.

More on Treasury Bonds

Municipal Bonds (Munis):
Municipal bonds function at the local, state and federal level, to raise funds for a project. When a purchaser invests in a Muni they are loaning the funds from the authority that issued it. In return, that authority pays a coupon rate until the bond matures. This interest rate paid to investors is tax exempt from federal taxes, and much of the time this applies to tax exemptions on the local and state level as well. Once the muni matures, the authority pays the par value. As you would imagine, munis help fund municipal government related ventures, meaning they may benefit you fairly directly if you purchase the bond at your local municipality. Munis can come in handy in the arena of city projects that relate to education, transportation and infrastructure, to name a few. At times, these bonds may be callable, which means the authority that issued the bond may pay off the principal amount before the maturity date, as well as the accrued interest and are eligible to cease paying their coupon payments. This will reduce the overall yield because the investor has less time to earn interest on it. Cities do not bankrupt often, but that might happen. The yield on this bond is basically lower than other taxable bonds.

There are two types of municipal bonds, general obligation bonds, which are not backed by a revenue source but are supported by the full faith and credit of the issuing entity. The issuer’s ability to levy taxes, particularly property taxes, supports the bond’s interest payments and repayment of principal. There may be a special tax considerations free from federal income tax. If you live in the city or county where this bond is issued, it’s possible you will be exempt from state and local taxes. These bonds are usually voted on as they help fund community-related projects. The bond elections are held to allow tax payers to vote on whether or not they wants taxes to increase to provide funding for a particular bond funded project or to reject the issuing of bonds which means there would have to be an alternative to raise the funds for the project. Some citizens may view the bond debt as an inconvenient expense while those of the opposite viewpoint will see it as a community investment. There may be special tax considerations earned on G.O. bonds. For example, the interest earned is often free from federal income tax. If you live in the city or county where this bond is issued, it’s possible you will be exempt from state and local taxes and may pay lower interest rates.

And like any bond, it comes with default risk; some municipal securities are covered by bond insurance, which can guard against risk. Insured bonds are underwritten by a private insurer that guarantees repayment if the issuer defaults. Since G.O. bonds don’t usually trade on an active basis they are very susceptible to the principles of supply and demand which exposes them to market risk when it comes to buying and selling. They are also subjected to interest rate risk, the risk that changing interest rates could affect your bonds value or reinvestment risk where funds are reinvested at lower interest rate levels.

Corporate Bonds (Corporates):
These bonds are available to both large and small companies to gain capital, set new products in motion, subsidize construction and/or cover any extra expenses that may exist. Corporate bonds function like most bonds, as the investor (in this case the company) must pay an amount (face) per bond that is issued. Each bond that is issued goes for $1000 and the investor must pay the bondholders a pre-determined amount of interest on a semi-annual basis. Once the bonds mature, the company (or investor), must pay back the principal amount to the bondholders as long as they haven’t defaulted in payment.

Corporate bonds can exist in the form of secured or unsecured bonds. The secured bonds are safeguarded by a pledged asset value that the issuer can designate as collateral. Because they are a high level of priority, these secured bonds are sometimes referred to as senior secure bonds. They are higher up in the ladder of individuals who get paid back, including subordinated or junior bonds.

Corporate bonds are also categorized according to asset type, including mortgages, financial obligations and machinery equipment among others. Mortgage bonds are secured by a lean on mortgage or property owned by the issuing corporation imparted to bond holders. Mortgage bonds are backed by assets that can’t be liquidated and are also considered high-grade, safe investments. Obviously, this goes to show that you can never tell under all circumstances and any investment can turn out to be risky in the end.

Collateral trust bonds are secured bonds that are backed by the issuer’s investments in other corporations. The issuing corporation may own stocks in other companies and may use them in the loan. Unsecured bonds are characterized as debentures. A debenture is not guarded by any kind of collateral – it is an arrangement made by a business to raise money for their investments.


Zero Coupon Bond:

A bond that does not accrue interest because there is no coupon payment. It is initially sold at a steep coupon price, lower than its face value, and once it matures the investor receives the principal amount. Any zero bonds in your account are taxable and can be viewed as a compounding interest income (yearly interest plus the principal), not a capital gain.

STRIPS are a type of zero coupon bond that stem from interest paying bonds. They stand for “separate trading of registered interest and principal of securities” rooted in Treasury bonds. An investment bank buys the bond but sells the interest payment separately. In this case, the strip bond is sold at a discount price but no longer burdens the investor with an interest payment. These bonds can be reinvested and convert their interest payment into a higher yielding bond but it can be sold on the secondary market before it matures.

Discount bonds:
Discount bonds only include the principal amount at their redemption and are issued below par.

Commercial Paper:
Commercial Paper is a source of operational capital finance unassociated with the bank. It is said to be an unsecured promissory note at a fixed maturity of 1 – 270 days (nine months). They usually don’t have a developed secondary market, but many issuers redeem their commercial paper at maturity.

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