Bond Investing Guide 4: Types of Bonds
October 29, 2009
You’re almost ready to make your first investment in bonds. In Part 1 of this series, you learned what bonds are; in Part 2, you learned how you can make money with bonds; and in Part 3, you understood the risks associated with bond investing.
In Part 4 of this series on How to Invest in Bonds, you will learn the different debt instruments you can invest your money in.
First, we’re going to expand our discussion to include not just bonds, but fixed-income instruments in general.
Technically, bonds refer to debt instruments with maturities of 1o years or more. Most people, however, use the term “bonds” loosely to refer to almost any debt instrument regardless of maturity.
By Maturity Period
A fixed income instrument that matures in 1 year or less is called a bill. A popular example is the short-term debt obligation of governments, usually called Treasury Bills or T-Bills.
A debt obligation that matures between 2 and 10 years is called a note. An example is the government’s Treasury Note or T-note.
As explained earlier, a fixed income instrument that matures in 10 years or more is called a bond.
By the Issuer
A fixed-income instrument issued by the national government through its Treasury Department is called Treasury Securities. Depending on the maturity period, these may be Treasury Bills (T-bills), Treasury Notes (T-notes, or Treasury Bonds (T-bonds).
Government agencies can also issue bonds to raise funds. Examples of these agencies in the US include the Government National Mortgage Association (GNMA) or Ginnie Mae and government-sponsored enterprises Federal National Mortgage Association (Fannie Mae), Federal Home Loan Bank Corporation (Freddie Mac), and Student Loan Marketing Association (Sallie Mae). In the Philippines, PAG-IBIG or the Home Development Mutual Fund also issues bonds to raise needed capital.
Local government units sometimes also use debt instruments to acquire funds. Municipal bonds backed by the full taxing power of the municipality is called a General Obligation Bond. Bonds issued by the municipality to finance a government project whose interest and principal payments are dependent on the income of that project are called Revenue Bonds. In the Philippines, examples of municipal bonds are the Puerto Princesa Green Bonds, Boracay-Aklan Provincial Bonds, and Tagaytay City Tourism Bonds.
Lastly, a bond issued by a business entity is called a Corporate Bond. As explained in the first article of this series, corporations use bonds as an alternative to stocks in raising capital. Examples of companies in the Philippines regularly issuing corporate bonds include Ayala Corporation, Globe Telecom, JG Summit Corporation, Filinvest Land, and many more.
By the Interest Coupon Structure
In Part of this series, you learned how a bond investor earns from the regular coupon interest payment. Not all bonds pay regular interest though.
A bond that does not pay any interest rate is called a Zero-Coupon Bond. Since investors don’t receive interest payments, the only way for them to earn is to buy these bonds at huge discounts so they can profit afterwards when the bonds are redeemed at their par value.
Bonds with a stated interest rate but are not paid until maturity are called Accrual Bonds. Investors don’t receive interest prior to maturity but they accrue and compound and are paid during the maturity period.
A bond that pays an initial interest rate for the first period then a higher rate after that period is called a Step-Up Bond. For example, a 10-year maturity bond may offer 5% fixed interest for the first 4 years then starting on the 5th year, the interest rate is 7%.
Floating-Rate Bonds are bonds whose coupon rate is linked to a benchmark rate. This benchmark rate may be the country’s inflation rate, the London Interbank Offered Rate (LIBOR) or other rates. A floating-rate bond, for example, that pays a coupon rate equal to 2% plus the inflation rate will pay 5% if the inflation rate is 3%. If the interest rate is 5%, the bond will pay 7%.
More details of each instrument discussed above will be explained in a later article.
Up Next: How to Invest in Bonds in the Philippines
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