Types of Bonds
If you are investing in bonds you should be aware that there are several different types of bonds, each with slightly different characteristics. This article will give a description for several of the major types of bonds you will encounter.
In the U.S. government, as well as in various other governments, bonds are classified according to the length of the period before maturity of the bond. The three categories are 'Bills', which mature in less than one year, 'Notes', which mature between one and ten years after the purchase date, and 'Bonds', a somewhat confusing choice for a label classifying all government bonds maturing over ten years after the purchase date.
Investing in government bonds of developed countries such as the U.S. is generally considered relatively safe whereas buying bonds in a developing country carries considerably more risk.
Just as federal governments issue bonds to raise capital, municipal governments do the same. The advantage with municipal bonds is that they are not taxed federally; some municipalities actually issue bonds whose returns are completely tax free. The yield, however, is often correspondingly lower because of the tax break. However, municipal bonds can be an excellent investment if you are heavily taxed on federal bonds.
Corporate bonds are one of the most effective ways for a company to raise cash, and they generally have quite a bit of flexibility in the amount of bonds they can issue. As usual, the amount is typically dictated by market demand. When corporate bonds are classified according time until maturity, a short-term bond lasts less than five years and a long-term bond is over twelve years.
Corporate bonds will yield higher returns than government bonds because of the higher risk associated with lending to a corporation as opposed to lending to a country; in general it is much more likely that a corporation will go bankrupt. The high yield on corporate bonds makes them potentially the most rewarding type of fixed-income investment.
There are a couple of variations of corporate bonds of which you should be aware. 'Convertible' bonds, offered by some corporations, can be converted into stock by the bond holder. 'Callable' bonds offer the company the option of redeeming the bond before the maturity date; note that callable bonds are no longer strictly fixed-income investments.
Zero Coupon Bonds
This is an alternative type of bond that has no coupon (interest rate), but instead is issued at a discount to par value. Zero coupon bonds and regular bonds, since they are both fixed-income, can be easily compared by calculating the returns.
These are the main types of bonds; there is a progression in perceived risk in the order I've presented the different types (with the exception of zero coupon bonds, which are a class of their own). Government bonds are considered the least risky and corporate bonds the most risky; of course, the returns rise correspondingly with risk. In any case, you should now be more well equipped to decide which types of bonds integrate with your investment portfolio.
U.S. Savings Bonds
Savings Bonds provide a way for individual investors to invest as little as $25 per purchase on a systematic schedule. Savings Bonds are available in a version that pays 90% of the average 5-year Treasury yield (Series EE) and a version that is pegged to the rate of inflation (Series I).