As a bond investor, you have a wider variety of bonds options from which to choose compared to investing in equities. To invest in bonds that meet your financial objectives, develop a clear understanding of your personal tolerance for risk and tax circumstances. Three of the most common bond types include Treasury bonds, municipal bonds and corporate bonds.
The federal government requires money to finance its annual budget and pay interest on debt obligations. The government bond market, which comprises the largest bond market in the world, consists of Treasury bills – less than one-year maturity, Treasury notes – 1 to 10- year maturities, Treasury bonds – 10 years or more maturity dates and Federal agency bonds.
If you want safety, purchase Treasuries because the taxing authority of the federal government guarantees repayment of principal and interest, which greatly reduces the chances of a default. Investors need to possess an awareness of risks inherent in Treasuries, such as inflation, an inverse relationship to interest rates and low yields.
Inflation – Treasuries lose value during inflationary periods. For example, a Treasury bond that pays a coupon of 4 percent and the rate of inflation measures 4.5 percent decreases the value of the bond. An investor who must liquidate the bond immediately suffers a lost because the bond has a “locked-in” interest rate. Investors can choose bonds, which have a higher yield, but must take on more risk. A person who prefers to avoid higher risk fares better investing in Treasuries.
Inverse Relationship – As interest rates increase, Treasuries, which tend to be more responsive to interest rate changes, prices decrease. In contrast, a decrease in interest rates increases the value of Treasuries.
Low Yields – In exchange for the safety inherent in Treasuries, these instruments offer lower coupons to investors.
Generally, municipal bonds (Munis) refer to all tax-exempts bonds—whether issued by a city county, state or other governmental body. These entities use the money to build schools, hospitals, roads, bridges, sports stadiums, water plants, sewer systems and other public projects. Munis offer tax-free interest payments. However, Munis have state and federal tax consequences regarding the purchase, ownership and sale of bonds that investors must consider. Municipal bonds carry a risk of default; therefore, investors should check the bond ratings before purchasing municipal bonds.
Corporate bonds offer the second largest bond market behind Treasuries. Often called “corporates,” private and public entities issue corporate bonds in amounts of $1,000 or $5, 000. Businesses use the money from these loans to construct new facilities, buy machinery or expand business operations. Most corporate bonds pay a higher yield compared to certificates of deposit or similar municipal bonds. However, investors also take on a higher risk of default.
Many investors prefer corporate bonds because the instruments provide consistent cash flow. Investors select corporate bonds based on the company’s creditworthiness and probability of paying back of the principal and coupon. Corporate bonds help investors diversify their portfolios and meet investment goals by investing in a variety of industries and business structures with a range of credit ratings.
Like Treasuries, corporate bond Investors also have a vibrant secondary bond market, which has the size and liquidity investors need to sell bonds before the instruments reach their maturity dates.