Now that we know what bonds are, let’s dig in a little deeper and identify the main types of bonds we will encounter:
Categories of Bonds
Before diving any deeper into understanding bond funds, we should take a quick look at the main categories of bonds:
These bonds are issued (created and distributed) by a country’s Treasury Department. Governments use them to support their spending on infrastructure, education or their day-to-day operations. The U.S. government bonds are the most popular ones and they offer bonds of different maturities and risk characteristics:
A.k.a. T-Bills. They are bonds issued by the U.S. Treasury that have a maturity of one year or less (short term). They are virtually risk-less and yield very little returns.
These are government bonds with maturities between one and 10 years (short-mid term). They typically offer slightly higher returns than T-Bills and are somewhat riskier.
These are government bonds with maturities longer than 10 years (long term). They tend to yield higher returns at a higher risk, although they’re still considered conservative investments.
They are issued by local government entities like cities, states or municipalities in order to fund local, public projects and operations. They are normally safe, tax-free investments.
These are bonds issued by corporations to fund their expansions, acquisitions, etc. There are many types of bond issues that offer different payment schedules and risk and return prospects. The most common type is the fixed-rate bonds, but there are also zero-coupon bonds, convertible bonds, callable, putable bonds, etc. For now, we will focus on fixed-rate bonds and we’ll discover the rest in future sections.
Companies pay you interest to entice you to buy their bonds (lend them money). The rate of interest (coupon rate, or the amount they will pay you periodically to hold the bond) is determined by the level of trustworthiness of the issuing institution and the maturity of the bond.
Let’s see an example to explain this:
Remember SmartPies Co.? Laura’s pie-making company that was doing amazing. Now, Laura is trying to raise more capital to go into the ice cream industry, and instead of selling more stock (partial ownership) or going to a bank for a loan, she decides to issue bonds.
Laura asked you and your friend, Jim, to lend her $1,000 each. She promised to return the $1,000 you lent her after five years (5-year maturity) and she said she’d return Jim’s $1,000 in 10 years. Also, she promised that she’d pay you both $50 every six months unless you sell the bond before the contract ends (the agreement would transfer to the consequent buyer).
Your friend wasn’t quite happy with the deal Laura proposed because he’d be getting paid the same amount as you but he’d have to hold it for longer, which would reduce his liquidity and increase uncertainty in the company’s financial situation for the length of the contract. This is due to the uncertainty of the future in finance, the further you go into the future, the higher the risks of financial distress. So, he complained to Laura and threatened to take his money elsewhere unless she paid him $90 every six months for 10 years. Laura, who really needed the money, understood that he had a point and countered by offering $80 every six months and the $1,000 at the end of 10 years. Jim accepted and bought one bond of SmartPies, Co.
As a smart investor, you stopped to analyze the deal thoroughly before buying anything. By doing some analysis into SmartPies Co., you realized they weren’t doing as amazing as it seemed, the company was in a lot of debt and you thought there was a chance they wouldn’t make enough money to pay you back; therefore, you talked to Laura and explain that it was not worth it for you to take the risk of lending her money because you may not get it back.
She really needed the money, so she decided to increase the interest payment to $75 every six months (from $50/semester). With this new deal in front of you, you took another minute to crunch the numbers (which we’ll teach you how to do in the future) and decided that this higher reward was worth the risk of possibly not getting all your money back.
This is a very simplified example of what actually goes on in the bond market, there are many forces that move the prices of bonds and test the trustworthiness of companies and institutions. It is crucial that you take the proper steps before investing in any bonds (or any assets, really). In reality, bond markets have thousands of huge investors (mostly institutional) trading an enormous amount of bond deals in bond markets.
Bond Rating & Quality
There are multiple sub-classes of corporate bonds depending on the company’s risk prospect or the quality of the contract. As we’ve seen, the riskier the investment is, the higher the return will have to be to entice investors to buy. Bonds of the lowest quality (a.k.a. riskiest) are called high-yield bonds (or junk bonds), they tend to pay out a lot but chances are you may not get your money back. Better quality bonds offer lower yields but are more secure. Theoretically, the safest corporate bonds are called investment-grade bonds. Also, Government and Municipal bonds also have ratings.
Bond-rating is the way most institutions and investors measure the trustworthiness of a particular bond issue and its issuer. It serves as a way for investors to know what they are buying is sound or not. Ratings are usually assigned by private, independent institutions, like Moody’s Investors Services or Standard & Poor’s. These companies analyze the financial health (or its ability to pay back their lenders) of bond issuers and issues and assign them a grade depending on their findings. Each rating institution has its own grade system but most of them use letters or symbols, or both.
|GRADE||RISK LEVEL||STANDARD & POOR’S||MOODY’S|
|Investment Grade||Lowest Risk||AAA||Aaa|
|Investment Grade||Lower Risk||AA||Aa|
|Investment Grade||Low Risk||A||A|
|Investment Grade||Moderate Risk||BBB||Baa|
|High Yield (Junk)||High Risk||BB, B||Ba, B|
|High Yield (Junk)||Highest Risk||CCC, CC, C||Caa, Ca|
Even though bond ratings are a reliable way to get a feel for a company’s or a bond’s financial health, we recommend that you take your time to thoroughly research and analyze them yourself before investing.
In the next section, we will introduce a very important topic: risk and how it affects the finance world.