Understanding Types of Bonds

Understanding Types of Bonds

In order to understand bonds, you really need a basic understanding of stocks. Just like stocks, bonds are securities. You can buy bonds as an investment and expect to make a little bit of money. Unlike risky stocks, which may rise or decline in value, bonds can usually only appreciate.

Bonds may not be as exciting as stocks, but if you can't stomach any risk then bonds may be the better investment for you.

Have you ever looked at your mortgage or income tax payment and wondered why you were not allowed to loan your bank or the government money and charge interest? Well, you are. That is what a bond is: a fixed-income security that is founded in debt.

When you buy a bond, you agree to loan a company or government a certain amount of money for a set period of time, at the end of which you will be repaid along with a little bit of interest. Of course, no bank or company will pay you the same amount of interest on your bonds that you need to pay on your mortgage.

Unlike some homeowners, though, most banks, companies and governments are unlikely to default on their debts to you. In fact, your investment may be considered risk-free.

Categories of Bonds

Unlike stocks, which you can buy and sell whenever you like, when you buy bonds you hold them for a certain amount of time before they mature. This means that when you buy a bond, you have to keep the bond for a set period before you can collect your cash back along with the interest.

Of course, you may be able to buy or sell bonds that you own to other people who are interested in purchasing them to hold before they mature. Once they have matured, though, they do not keep increasing in value.

There are three main categories of fixed-income securities that are based upon the length of time it takes for the security to mature. Debt securities that mature in less than a year are called bills. Those that mature in one to ten years are called notes.

Finally, bonds are securities that take more than ten years to mature. The only differences between bills, notes and bonds is the length of time they require.

Government Bonds

You have probably heard that the United States has a great deal of debt right now, called the deficit. This is a problem because America keeps needing to borrow money, in the form of issuing bonds, just to keep running.

You can loan money to the United States government by buying Treasury bills, Treasury notes and Treasury bonds. American bonds are considered an extremely safe investment, but just like people or companies, governments can default on payment.

Municipal Bonds

You can also lend money to cities by buying municipal bonds. Municipal bonds, called munis, are slightly riskier than Treasury bonds. Sometimes, cities go bankrupt. As a benefit, though, munis are exempt from federal taxes.

Some local governments will even make their munis exempt from taxes for local residents. Because you get to skip paying these taxes, though, munis often offer a lower yield than other types of bonds. They may or may not earn you more money in the long run.

Corporate Bonds

Companies can choose to issue stocks or bonds. If the company is big enough, it can issue as many bonds as the market will buy. Corporate bonds are usually called short term, meaning that they mature in less than five years, intermediate if they mature in five to twelve years, or long-term if they require more than twelve years to mature.

Corporate bonds are riskier than government ones because companies are more likely to go bankrupt than government are. Convertible bonds and callable bonds are both types of corporate bonds; they can be converted to stock or redeemed early, respectively.

Zero-Coupon Bonds

A zero-coupon bond does not make any coupon payments but is issued as a deep discount to value. A zero-coupon bond could be issued with $1,000 in value and ten years to maturity, but might be trading at just $500. This means that you could pay $500 for a bond that you cash in for $1,000 in ten years. Usually, these bonds are the riskiest.

You can buy bonds through your stock broker, a bond broker or even directly from the United States government. The United States sells bonds over the internet at the Treasury's website. This way, you do not have to pay any commission fees and you can collect your interest payments electronically.