Types of Bonds
No two bonds are the same. Bonds differ according to their inherent characteristics, the nature of the issuer, the credit worthiness of the issuer as well as the markets in which they are issued. All these characteristics have to be taken into consideration before a bond investment decision is made by a potential investor.
Types of Bonds Available to Investors
Bonds can be classified according to the issuing agency. Using this model, four main types of bonds exist. They are named according to the issuing body. These are as follows:
1) Federal government bonds
2) State government bonds
3) Corporate bonds
4) Municipal or local government bonds
Federal Government Bonds
These are bonds issued by a federal or national government of a country. The main reason why these bonds are issued is to cover for budgetary deficits. They are usually issued by a country’s treasury department or finance ministry on behalf of the federal government. The bond instruments are known by different names. In some countries, they are known as Treasury Bills while in some others, they are known as Treasury Notes. Federal government bonds theoretically carry the lowest interest rates of all bond types because the risk of default is lowest. However if you are a holder of Spanish or Greek bonds, you may wish to challenge this claim.
State Government Bonds
Many countries operate a three-tier governance structure which puts states above the local authorities but below the federal governments. State governments can issue state bonds. These are not rated as highly or as secure as federal government bonds, because apart from allocations from the federal government, the only other way for states to raise money is by collection of levies and taxes from businesses.
Occasionally, a company or corporation may decide to issue bonds as a way of raising capital for its operations instead of borrowing from financial institutions or issuing shares to the public. Bonds provide a cheaper and more favourable means of borrowing or raising capital. Bank loans are subject to higher interest rates with the attendant risk of fluctuation. Issuing shares in public offers will lead to a dilution of shareholding; a road many company owners would rather not go. So issuing bonds which are payable at a fixed rate over time is a viable way for companies to raise funds. However corporations must be able to strike a balance between paying sufficient to the bond buyers to make the investment attractive to them, and also being able to conserve as much money as they can from the returns that they expect to make from investments or projects carried out with the bond proceeds. Talking about interests payable on corporate bonds, the interest rates payable to investors in corporate bonds are much higher than the federal government or state government bonds because the risk of default by a corporation is higher.
Local governments and municipal administrations can also issue bonds to fund projects or augment revenue they generate or allocations from the centre. Municipal bonds are much less secure than state or federal bonds, because they depend on local level taxes and subventions from states (where they exist) for their funding. This puts the interest rates payable on municipal bonds at the same level as corporate bonds.
Bonds can also be classified according to the nature of the bond. Using this model, we have the following types of bonds.
1) Government bonds: These are the federal, state and municipal bonds discussed earlier in this document.
2) Asset-backed Securities: These are bonds whose values are tied to a private pool of assets that are not readily convertible to cash. Under this category of bonds, a trust that takes ownership of the assets is established and the bond owners are assigned stakes in this trust through which they can monetize any interest payments on the bond. Various types of assets (e.g. mortgages on real estate) can be used to back up the bonds. Some of these are real estate.
3) Convertible bonds: Convertible bonds are debt securities which, as the name of this bond implies, can be exchanged for ownership of stock.
4) Retractable/Extendable Bonds: These are bonds which traditionally pay a lower rate on the bond, but which do not have a fixed maturity. As the name implies, bond holders have the option of extending the maturity of a short term bond (extendable), or reducing the maturity of a long-term bond. This flexible maturity option is what makes this category of bonds attractive to investors.
5) Foreign Currency Bonds: These are usually foreign bonds that are issued in a different currency other than the currency of the bond buyer. These bonds are peculiar in that their valuation is subject to the vagaries of currency exchange rate fluctuations.
6) Junk Bonds: These are high yield bonds issued by entities with a very high risk of default. Under the ratings regime of the credit ratings agencies, these bonds are below investment grade. Presently, the bonds of some European companies located in some of the sovereign debt trouble spots are very close to being rated junk bonds. As a rule, the higher the risk of default, the higher the yield (or interest payable) on that bond.
Before you decide on whether to participate in that bond issue or not, you need to know the issuing entity and also the characteristics of the bond that you want to purchase. DO not just purchase a bond because it sounds glamorous or because everyone is doing the same thing. Bond buying essentially means that you are acquiring the liabilities of the issuing agencies and taking their word for it. Even Federal governments default on bond repayments. Argentina defaulted on bond repayments in 2002, and Greece has been on the edge several times in the last two years. SO always make sure you know the bonds you are buying before you assume the risk.