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Understanding Bond Types

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Agency Bonds

Agency bonds refer to a group of bonds issued by organizations related to the U.S. government. These agencies typically do not have the explicit backing of the U.S. government behind their bonds, although some do.

Most fall into a category of collateral-backed mortgages or loans, meaning there is some asset, usually real estate tied to the loan. These bonds pay higher rates than strict U.S. Treasury issues for the somewhat, although not much, higher risk. These bonds are typically sold in large denominations to institutional investors. Here are some of the better-known agency bonds:

  • Government National Mortgage Association or Ginnie Mae – is owned by the U.S. government. It buys mortgages from lenders and pools them into securities. Its bonds are backed by the full faith and credit of the U.S. Government. For more information, visit the Ginnie Mae Website.
  • Federal National Mortgage Association or Fannie Mae buys mortgages on the secondary market and resells them to investors some of the mortgages may be insured by the Federal Housing Authority (FHA). For more information visit their Website.
  • Federal Home Mortgage Corporation or Freddie Mac is similar to Freddie Mae, but they don’t contain any mortgages guaranteed by FHA. For more information on Freddie Mac visit their Website.
  • Student Loan Marketing Association or Sallie Mae pools student loans instead of mortgages. These are more risky than mortgaged back bonds. For more information visit the Sallie Mae Website.

Municipal Bonds

Local governmental entities like states, counties, townships, cities, utility districts and so on also issue bonds to finance their work.

These municipal bonds, often called munis, fund new roads, schools, sewers and other projects. In some cases, fees collected from the project go to retire the bonds, in other cases tax money is used or a combination of both.

Although not as safe as the U.S. Treasury issues, munis have a good record of security. One of the key features of these bonds is that the income is free from federal income tax.

This tax-free feature, combined with the relative security makes municipal bonds attractive to conservative investors. As an add bonus, in some circumstances, the bonds may be free of state and local tax also.

You buy munis from a broker either at new issue or existing bonds.

Corporate Bonds

Corporations issue bonds to finance large projects that can be paid off over time. Rather than issue new stock or use short-term credit, companies use longer-term bonds to finance new facilities, acquisitions and other needs.

Corporations, even the most credit worthy, do not carry the same degree of safety as governmental issuers; therefore, their bonds pay higher interest rates.

Corporate bonds may offer two features not common in other bonds:

  • Convertible Bonds – This feature allows the bond to be converted into common stock under certain conditions. Those conditions are spelled out when the bond is issued.
  • Callable Bonds – These bonds may be called or redeemed by the company before maturity. A company would call or redeem the bond if interest rates have fallen significantly since they issued the bond. By calling the high interest bond, the company can refinance the debt at a lower interest rate.

Zero Coupon Bond

Another type of bond is the zero coupon bond. The other bond types above differed by issuer. This bond type is issued by many entities, but because it is so different from traditional bonds, I have set it apart.

Zero coupon bond, as the name suggests, pay no regular interest. Instead, you buy the bond at a deep discount and redeem it at full face value.

For example, you might buy a $1,000 par value zero with 10 years to maturity for $700. In ten years, you would redeem the bond for $1,000.

Conclusion

This broad overview of the different types of bonds was meant to give you just that – an overview. Bonds are important to every portfolio. Understanding what they are and how they work is the first step to letting them work for you.

Back to Bond Information Center

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