Learn about the different types of bonds and how they work…
Originally posted by Thomas (TJ) Underwood on August 30, 2014
It is important that you are aware of how bonds work and you are keenly aware of the different types of bonds available. In this discussion we will discuss the different types of bonds and the advantages and disadvantages of each.
Be sure to apply what you are learning to your individual situation as what may be appropriate for one person may not be appropriate for you.
A bond is an investment instrument (fixed income) that you can utilize to provide income (yield) and possibly profit if the principal amount you paid for the bond goes up. Bond prices are dependent upon interest rate movement.
If you purchase a bond for $10,000 and at 3% yield you will receive coupon payments twice a year for $300. If the bond price rises based on the market (the market interest rate drops) your yield will go down, however your bond will be worth more than you initially paid.
Likewise, if you purchase a bond for $10,000 and at 3% yield you will receive coupon payments twice a year for $300. If the bond price falls based on the market (the market interest rate rises) your yield will go up, however your bond will be worth less than you initially paid.
Some bond funds pay monthly and many bond funds have low expenses.
You must always realize that Bond prices have an inverse relationship—meaning that if the interest rates go up the bond price (amount that you purchased the bond for) will fall. If interest rates go down, the bond price will rise.
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OK, now that we are all on the same page—let’s look at the various types of bonds and see if you could benefit from any at this time!
- 1) Corporate
- 2) GNMA
- 3) Junk or High Yield
- 4) Municipals
- 5) Treasuries
- 6) International Bond Funds
- 7) Series EE and Series I Bonds
Corporate bonds are often used by investors in their portfolio to help reduce the risk of returns from other investments. Many investors use a laddered approach (purchase bonds or bond funds of varying maturities to reduce risk) and many laddered corporate bonds pay 5% or better if properly structured.
GNMA or Government National Mortgage Association Bonds
GNMA (often called Ginnie Mae Bonds) are bonds that offer the full fledge and backing of the U.S. government, however they differ from Treasury Bonds.
GNMA are pools of home mortgages that are backed by the government (they differ from Freddie Mac and Fannie Mae mortgage pools that was involved in the sub-prime debacle in the late 2000’s) and as of Spring 2014 they are yielding 2.25% to 2.5%.
In the same manner that you pay taxes annually on your savings or CD’s—you would also pay on GNMA’s if they were outside of your retirement account. If GNMA’s were inside of your IRA or other retirement account you would have less risk of losing value if interest rates rise, you would have tax-free earnings and you would have the backing of the full faith and credit of the U.S. government.
Junk or High Yield Bonds
Investors usually select Junk or High Yield Corporate bonds so that they can obtain a higher rate of return and possibly an increase in the bond price down the road.
The segment that is considered high-yield would be rated B to BB+ by S & P or B to Ba1 by Moody’s. They can be a good choice during economic expansion and quite risky during an economic decline.
High-yield bonds are also less sensitive to interest rate movement than the other categories mentioned in this discussion. You can buy junk-bonds through a broker or invest through a fund.
Municipal bonds are often considered dangerous due to the horror stories that have circulated in the media lately. However looked at objectively they have a relatively low default rate. You now have the opportunity to choose from a large number of high-quality tax free bonds backed by general tax revenues or user fees and get a higher yield than Treasury bonds of a similar maturity.
Price fluctuations with Municipal bonds are usually more stable than other bonds because the trading is not as frequent with Municipal bonds. Real concern that many local government, school districts and hospitals had over the past few years have been addressed effectively and the risk of not meeting their obligations have been reduced.
However, it is your responsibility to do your due diligence when purchasing bonds or investing in any manner!
The yields on MUNIS as they are often called has been almost 2 to 1 over the past few years as compared to Treasury bonds and it looks as if that trend will continue. You can invest in MUNIS through low-cost mutual funds or you can avoid the fees by purchasing individual municipal bonds through an online brokerage.
The key advantage of Municipals are that it offers you tax free gains whether held retirement inside or outside of your retirement accounts—but are generally more suited for outside of your account due to not being taxable at the Federal and in many cases local or state level.
Treasury bonds are bonds that are backed by the full faith and credit of the U.S. government. When you buy newly issued Treasuries you are in essence lending money to the U. S. Government.
As of Spring 2014 the rate that you would get would be 2.7% for 10 year Treasuries and 3.7% for 30 year Treasuries—which barely covers taxes and inflation whether held inside or outside of your retirement account.
You also have the risk of losing a portion of your principal if interest rates were to rise at any time—prior to maturity.
International Bonds & Bond Funds
Although many domestic bond funds invest a small percentage in markets overseas you may be able to diversify your fixed income investments and receive a more attractive yield (bond yields and inflation on international bonds tend to have a low correlation to the US Bond Market). Be sure you are properly positioned to invest as there will be more risk. In addition to interest rate risk which is always a constant when investing in bonds—you will also have currency risk. Depending on your “life stage” you could use international bonds to increase your nest egg–or utilize them during retirement if you are properly positioned to do so.
To help reduce currency risk some International Bond Funds enter into “currency forward contracts” that lock in an exchange rate to buy or sell a currency on a future date and locks in the foreign currency fluctuations versus the United States Dollar. In addition, other methods are used to reduce currency risk depending on the company that you choose. As with any fund it is important that you are aware of the expense ratio—and particularly with International Bond Funds as there are usually other fees added that you won’t see on the expense ratio but will be charged to your account nevertheless.
Even though you can get hefty returns during good times, market risk can be substantial when bond funds in international markets plummet during volatile times, therefore it can never be stressed enough that you must be in the “right financial position” and at the “right stage in your life” to utilize International Bonds & Bond Funds in your portfolio for maximum results.
Series EE and Series I Bonds
These are also government issued bonds that are sold at a discount of face value and mature over 20 to 30 years. Series I bonds are also adjusted for inflation twice a year.
CD’s & Money Market Accounts
Although they are not in the bond family CD’s and money market accounts are worth mentioning due to the large number of consumers who possess these accounts.
With interest rates so low now Certificates of Deposits and Money Market Accounts are paying paltry returns and that is expected for a while as the FED policy of keeping short term rates close to zero continues!
Final Thoughts on Bonds and Bond Funds
Bonds and Bond Funds can be an effective income and investment tool for investors who have properly positioned themselves for investment success.
That means they have done their homework and are aware of all the risks that are present—and they have properly positioned themselves in a manner that serves their and their family’s best long-term interest.
Be sure to visit our Investments & Personal Finance Page and our Investment Basics Page in particular prior to putting your investment plan in place or at this time if you already have your investment plan in place.
By doing so you can avoid common mistakes that consumers make—without even realizing that they are making mistakes! By doing so you can improve your rate of return and position yourself and your family to live out your future in a more prosperous manner!
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About This Article:
The above article was written by Thomas (TJ) Underwood on October 5, 2014. Thomas (TJ) Underwood is a licensed real estate broker in the state of Georgia and is the writer behind The Wealth Increaser, Home Buyer 411, Home Seller 411, The 3 Step Structured Approach to Managing Your Finances, Managing & Improving Your Credit & Finances for this MILLENNIUM and CREDIT & FINANCE IMPROVEMENT MADE EASY—FREE GUIDE.
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