Introduction
This chapter provides the basics for definitions, types, and characteristics of bonds. Once you have a firm grasp of how bonds work, you can make an informed decision as to how to use them through our Asset Allocation models and your personal investment planning.
What is a bond?
A bond is a debt instrument in which someone or some entity borrows money from another person or entity with the promise to repay the loan on a certain date, and to pay a fixed interest rate, generally every six months, at an agreed upon rate. Investing breaks down to either "own or loan", so you are either owning the company or lending to it. Bonds can be called by a number of different names depending on the nature of the borrower, among them are; CDs, corporates, munis, notes, bills, bonds and TIPS.
Bonds may seem to be simple and straight forward investments, but they are not. They go up and down in value, have various risk ratings, and could be called away from you. And yes, you can lose money on bonds. They are considered safer than common stock because there is a legal obligation to repay the loan after wages and certain other obligations have been settled by the company. Stockholders are repaid after all the company liabilities have been paid, should the company 'go under'.
'Calls' are the borrower's right to pay you the principal back early. This provision is written in the contract and could be exercised by the borrower when, for example, the borrower is paying you 7% and it can now get a new loan for 5%. Generally this is bad for you, the lender, because it will be harder to find another loan as good as that which was called away.
Kinds of bonds
US Government bonds (also called Treasuries) are those issued as a direct liability of the Federal Government. They are considered absolutely safe as an investment because they have "the full faith and credit of the United States of America" to secure them. That says you will receive all of your investment back and receive interest income while you hold the bonds until maturity. If you should decide to sell those bonds prior to the maturity date, you may receive more or less than you paid for them.
Within the US Government bond structure there have been three names given to differentiate the longevity of the bonds. Those would be Bills, Notes, and Bonds, with the difference being in the length of the time from issue until the bond matures. The Treasury Bill (T-bill) has the shortest maturity which is between 91 days and one year. They are sold at a discount (making them a little different from what we said above). This means, as an example, that you pay $980 to buy a 'bill' maturing in six months, and receive a check for $1,000 at maturity.
The Treasury Note fills the loan period from one to ten years. It functions as previously described by paying you interest every six months until maturity when your capital investment is returned.
The Treasury Bond is the ten year or longer bond. The 30 year bond is once again being issued by the Government.
Most bond issuers also issue what is called a 'Zero Coupon bond' which is sometimes called a 'stripped bond'. Here you buy a bond at a discount and at maturity receive a check for the face amount of the bond. For example you buy a $1,000 bond today for $700 and at maturity you receive a check for $1,000. No interest payments will be made to you through the holding period, but it is pay-as-you-go for tax purposes and you will receive a 1099Int each year. The actual return is often slightly higher than a comparable regular bond arrangement and it is good for planning for a known future expense, such as college or retirement.
There are also other types of bonds which are called government backed securities such as 'Agency mortgage backed bonds'. These are considered safe, but they are not quite as safe as Treasuries because the US Government backing is only implied which is not the same as the "full faith and credit" clause.
Treasury Inflation Protection Securities (TIPS) are a class of Government securities that are backed by the full faith and credit of the Government, and are issued with a maturity from 5 to 30 years. TIPS are designed to reflect changes in the rate of inflation by adjusting the principal value of the security based on the change in the consumer price index (CPI). Because the coupons (interest rate payments) of TIPS represent real yields, they are typically lower than those of traditional Treasury bonds.
The par value of a TIPS bond is adjusted to reflect changes in the rate of inflation. For example, if you purchase a new issue for $1,000 and the consumer price index (CPI) increases by 3% in the first year, the bond's par value would increase to $1030. The coupon is also increased based on the new $1,030 par. You are now earning interest on a $1,030 investment.
Be aware of the tax impact. That increase in bond value of $30 in our illustration is taxable that year, even though you never actually receive a payment. This "phantom income" can be troublesome if you are not aware of it. The rules of 'reciprocity' apply, Treasuries are taxed by the Fed, but not by the States. You now have another factor to consider when comparing corporate bonds taxed by everybody and Treasuries taxed only by the Federal.
EE and H Bonds The EE is a direct obligation of the US Government. Do you remember 'War Bonds'? I would take 25 cents a week to school to buy this bond to help in WWII. It was an E bond which you bought for a discount and it grew to face value of $25, $50 or $100, and maybe larger denominations, all on a seven year schedule. It could be cashed in at a bank for its current value as it moved up to face value. The government has now stopped paying interest on these instruments. They have been replaced by the EE which grows on a 10 year maturity. No taxes are due until they are cashed in. We used them for college for the kids. Again, no State taxes and some additional advantages when use for education.
The H Bond is a Government bond that makes an interest payment every six months. You can convert from EE to H by sending the bonds to a Federal Reserve Bank. The reserve will send you back the H bonds. This is a non-taxable transaction. Be aware that the basis you have in the original EE bond is the basis in the H bond so when the H bond is sold, you may be looking at a large taxable ordinary gain. The advantage in the conversion is creating an income stream without having to liquidate a holding.
Certificates of Deposits (CDs) are time-deposit investments issued by banks or savings and loans with a stated maturity date (between three month and six years). CDs typically offer a higher rate of return than most comparable investments but removing your money before maturity will often result in a penalty. For safety, CDs are comparable to Agency bonds because banks and savings and loans are generally backed by Federal Depository Insurance Company (FDIC), making the US Government have an implied guarantee. The secure amount is $100,000 per account, including interest due to you.
Municipal Bonds, also called 'munis', are bonds issued by a state or political subdivisions such as counties, school districts, water districts, and the like. They pay interest which is usually exempt from federal and in some cases, state and local taxes as well. This happens because of what is called reciprocity between states and the federal government. They agreed to not tax each other. Since you and I do not have to pay income tax on their interest payments, they can get by paying us at a lower rate. Is taxable or tax free better for you as an investment? First, you never put munis in an IRA because you would be making tax free income taxable when it comes out of the IRA into your pocket. Next, which one will leave more money in your pocket after taxes, (3% municipal or 5% taxable)? It comes down to your tax rate. The term double tax exempt is sometimes used to describe these instruments. It means that your interest is not taxable on either your federal or state tax returns. At the end of this topic we have included a chart which allows you to compare the return of a tax free bond with a taxable one.
The above discussed bonds are government related in some form. The following bonds relate to independent business. Interest rates are partly a function of demand and there is currently concern over increasing government borrowing in competition with private enterprise. All are competing for the same fixed return investment dollars. “This increased competition for the ‘fixed income’ dollar, tends to result in a higher interest rate being offered to attract that dollar and the cost of business goes up for corporations.”
Corporate bonds are issued by corporations with a stated interest rate and maturity. Part of the complexity of investing in bonds comes from the safety ratings and length of time until the stated maturity. So now we need to explore how ratings are measured and how maturity effect evaluations.
