The subject of bonds is incredibly complex and important. We plan to continue talking about them. But before we go further, let’s make sure we understand what we are working with.
Knowing what a bond is is a greats start if you are new to the subject, but assuming that you know as much, let’s dive into each type a little deeper than before. This will be valuable to any investor considering bonds, and to anyone who so much reads the newspaper and has a small interest in the economy.
Chances are we have (or our parents or friends have) dealt with bonds in some capacity in our life, perhaps without even fully knowing it. They are a central part of the way that money flows from one party to another and an essential part of the way that money grows in our personal finances and in the economy at large.
So, here are 12 types of bonds that are common in the bond market and a few characteristics that differentiate them from one another.
1) Savings Bonds (EE and I series)
We will start with one of the most common and safe bonds, the EE and I series savings bond. These are considered to be among the safest bonds available because they are backed by the U.S. government.
The interest rate of both bonds changes over the life of the bond. The interest payments are not paid in the form of coupons, but all at once at the maturity date when cashed in.
With an EE bond, the interest rate is reset every 6 months based on long-term Treasury rates but will not change between reset periods.
I-series bonds receive a fixed interest rate that is adjusted semiannually for inflation.
Therefore, in times of high inflation, I-series bonds are likely to be a better investment than EE bonds, but when inflation is low or volatile, the interest rates may point investors toward EE bonds as a more attractive proposition.
Some other details worth noting:
Something that makes all savings bonds unique is that they are not able to be bought or sold in the secondary market; they are unmarketable.
Further, EE-series bonds are guaranteed by the government to double in value within the first term (usually 20 years), but I-series bonds are not.
Also, any interest payments that are paid (coupons) are tax-free income on a local level but not on a federal level.
EE bonds are sold at half of face value and will mature after 20 years. I bonds are sold at face value and will mature after 30 years.
2) U.S. Treasuries
Another relatively safe option in the bond market is the U.S. Treasury bond. In other words, these bonds have very low credit risk.
For this reason, these bonds may well have a lower interest rate as a trade-off.
Treasury Bonds have a fixed interest rate and make payments semi-annually. This interest rate is taxable on a federal, but not local level.
The maturity of a treasury bond ranges from 10 to 30 years and have a minimum denomination of $1000.
Unlike Savings Bonds, there is a vibrant secondary market for Treasury Bonds.
3) Municipal Bonds
Municipal bonds are issued on a local government level such as cities and states, and are therefore free from Federal Taxes. If it is issued by the state in which you are a resident, then they are also free from state taxes.
For this reason, municipal bonds often offer lower pre-tax yields, and are typically more attractive to people in higher tax brackets.
If the gains from avoiding taxes are greater than the losses from a lower interest rate, municipal bonds may make sense as an alternative to Treasury Bonds.
Municipal bonds are similar to Treasury Bonds from an investor standpoint beyond tax-ability. Credit risk is low, and structures are comparable as their market prices fluctuate inversely with interest rates.
4) Corporate Bonds
Occasionally the term “corporate bonds” is used to refer to all bonds that are not sold by the government. More specifically and correctly though the term refers to bonds that are sold by a company in order to raise funds for a number of reasons.
These reasons can include future operations, research & development, and special projects.
They trade in a decentralized market, usually “over-the-counter”, and can be grouped together to form a variety of funds (more on funds in a future article).
Corporate Bonds have a higher interest rate than treasury and municipal bonds, but carry higher risk since repayment is contingent upon future profits of the firm. All businesses have a higher risk of default than the U.S. government.
Typically corporate bonds have standard coupon payments until maturity.
At maturity, the investor can then claim the face value of the bond.
Bond payouts can be tax deductible for corporations, and the income gained from interest is subject to income tax for the investor.
There are more types of bonds than these, and these and others can be modified and combined into a vast array of things, but these 4 types of bonds are the backbone to this very vibrant and intriguing market.
The great thing about bonds is that they are accessible to everyone. Children can invest in some bonds, while other bonds are not understood by even the most seasoned professionals.