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Bond Basics Part 2: Types of Bonds

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A useful guide to the world of bonds...

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Be sure to read the rest of the Bond Basics series:



Types of Bonds

  • Municipal Bonds: A city or state-issued instrument. Interest on municipal bonds are generally tax exempt. If the bond was issued in the bondholder's state of residence, interest is usually exempt from state tax. Interest is generally paid semi-annually. Municipal bonds are generally favored by high income earners.

  • Government Bonds: Bonds that are issued by the U.S. Treasury. U.S. Treasury bonds are used to finance the federal government debt and are considered to have the bond market's lowest risk because they are guaranteed by the U.S. Governments "full faith and credit" or, in other words, its taxing authority.

  • Corporate Bonds: A debt obligation issued by a corporation, such as IBM. Corporate bonds have ratings from AAA (such as Johnson and Johnson (JNJ)) all the way down to BBB- (Standard and Poor's) or Baa3 (Moody's). Interest is generally paid semi-annually.

  • Federal Agencies: Government agencies and government sponsored enterprises such as Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC) issue debt to support their role in financing mortgages that enable Americans to buy homes (they were chartered in 1938). Only GNMA has the "full faith and credit" backing of the U.S. Treasury. FNMA and FHLMC have "implied backing." These issuers are also know as GSE's or "government-sponsored entities." These securities are deemed to be of very high quality by the investment community and offer excellent liquidity.

  • High-Yield or "Junk Bonds": According to Bloomberg, a junk bond is a "speculative" bond with a rating of BB+ (Standard and Poor's) or Ba1 (Moody's) or lower, but with a higher yield than investment grade bonds. There are two distinct types of junk bonds. First, many junk bonds are issued by young companies or companies with questionable credit and no access to bank credit; they are frequently issued to finance corporate takeovers. The second type of junk bonds are "fallen angels." These bonds are represented by companies that were formerly investment grade, but whose fundaments have deteriorated to no longer warrant an investment grade rating. A high profile fallen angel is General Motors (GM), which has seen its rating fall from AAA to B over the years. Interest payments are usually made semi-annually.

  • Pass Through Mortgage Backed Securities: Perhaps the most confusing of all bond types, also called mortgage pools. Mortgage backed securities are debt instruments with a pool of real estate loans as the underlying collateral. The mortgage payments of the individual real estate assets are used to pay interest and principal on the bonds. Also known as "pass-through securities," because interest and principal is passed-through from the mortgage holder to the servicing agent to the bond holder. The servicing agent earns a fee for performing the service.

  • Collateralized Mortgage Obligations: Otherwise known as CMO's, these are securities in which mortgage pools are combined and separated into short, medium and long term securities (called tranches). Tranches are set up to pay different rates of interest depending upon their intended maturity. In the case of both mortgage pools and CMO's, maturity dates can be a moving target. This is because pre-payment speeds of the underlying mortgages change as interest rates change. Generally, as rates rise, prepayment speeds decrease and maturities "extend." Vice versa, as rates fall and maturities shorten. This market is a mostly institutional market as advanced analytics are necessary to calculate the yields and potential changes in maturities, prices and yield. Individuals need to be careful in this area.

  • Asset Backed Securities: Otherwise known as ABS, these are bonds backed by financial assets. These financial assets typically consist of receivables other than mortgage loans. These include credit card receivables, auto loans, manufactured housing contracts and home-equity loans. These bonds are deemed very safe and favored by institutions. It is one of the fastest growing markets with issuance of just $1.2 billion in 1985. There are now $2.6 trillion of ABS outstanding according to http://www.investinginbonds.com. Many times ABS have the same challenges as mortgage backed securities in terms of varying prepayment speeds, and hence, maturities.

  • Derivatives: According to Bloomberg, a derivative security is a financial instrument whose value is based on, and determined by, another security or benchmark (i.e. stock options, futures, interest rate swaps, floating rate notes, caps/floors). This is a market dominated by institutions due to their complexity and are rarely suitable for individual investors.

  • Adjustable Rate Bonds: Bonds whose coupons change periodically based upon an underlying index, like prime, LIBOR of COFI (11th district cost of fund index). Investors buy and sell these depending on which way they think the underlying index will move.

  • Closed-End Bond Funds: Closed-end bond funds are mutual funds that only offer shares once, usually in an initial public offering. Then they trade as an equity would on an exchange. Closed end funds can be municipal or corporate (investment grade or junk) and are sometimes leveraged to add yield to the portfolio in the form of a "carry trade." Closed-end funds trade at both premiums and discounts to net asset value, usually discounts. Most individuals that buy closed end funds at IPO get burned as they are offered at an automatic premium to NAV because of brokerage and other fees associated with the offering. Most of the time, it pays to wait for them to settle down and wait for them to go trade at a discount - usually 45 to 60 days. The amount of discount or premium generally represents investor's attitudes towards the bond market. The more pessimism, the larger the discount. This is in direct contrast to open-ended funds, where investor sentiment is reflected by issuance of new shares or redemption of outstanding shares.
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