Most investors never directly invest in bonds, excluding perhaps government savings bonds. Instead, you will probably invest in bonds indirectly through mutual or exchange traded funds. This is what I normally recommend to most investors.
So why is it useful to learn a bit about individual bond terms and different bond issues?
The global bond market is massive relative to the equity markets.
In 2014, total global financial assets were an estimated USD 294 trillion. Of that, USD 69 trillion related to global stock markets. The other USD 225 trillion was global fixed income. 76% of financial assets are debt.
If you invest, you will undoubtably own bonds, even if they are part of a fund or other collective investment scheme.
Today we shall look at the typical bond issuers.
Government Bonds
Various levels of government may issue debt instruments.
Government bonds are normally not backed by specific assets. Rather, they are only guaranteed by the government that issues them. So they are unsecured bonds or debentures.
Simply because a nation’s government guarantees its debts, does not mean they are completely safe or not at risk of default. You need to assess each country’s credit rating and relevant risk factors before investing your money in government bonds.
Traditionally, US government bonds were considered the safest bond to purchase. And, as you recall, the lower the risk, the lower the return that will be offered.
While US government bonds are still extremely strong, in March of 2010, Berkshire Hathaway issued 2 year notes at a 3.5 basis point yield less than similar US government notes. This means that the investment community considered Berkshire Hathaway, a public company, to be a lower risk than the US government.
An extremely rare occurrence; one that hopefully will not become common for US government debt issues in the future.
In the past, countries have restructured their debt terms or even defaulted on their bonds.
In 2002, Argentina defaulted on USD 1 billion in debt. In 2008, Ecuador. In 2015, Greece. Many examples out there.
Other countries (states, provinces, municipalities, etc.) have seen their credit ratings fall over time. This increases the cost of borrowing for the countries which puts further stress on each country’s cash flow. That can further increase the probability the country ultimately defaults.
Just because a government issues debt, do not assume it is risk-free.
I should also note that the fortunes of countries (states, provinces, etc.) can also recover. For example, Portugal was considered a risky country in 2010. Yet things have improved since then and their credit rating has strengthened to a degree. Some investors play these ups and downs for profit.
Government Agency Bonds
In certain countries, government agencies issue debt to the public. Examples of government agencies include the US Government National Mortgage Association (Ginnie Mae) or Canada’s Export Development Corporation.
While not directly government bonds, these debt issues are fully backed by the underlying government. In essence, government agency bonds will have the same credit worthiness as the government that is guaranteeing the debt.
Because of the government backing, these bonds are often called “indirect government bonds” or “guaranteed bonds”.
Municipal Bonds
Municipal bonds, or “munis”, are government bonds issued by states, counties, cities, or other lower level governments.
You may find “general obligation bonds” or “revenue bonds” in this category.
General obligation bonds are guaranteed by the issuer and supported through its complete power of taxation.
Whereas the interest and principal of revenue bonds are financed by the cash flow generated from the revenues of the specific project funded by the debt issue.
As general obligation bond interest and principal are covered by all tax sources rather than just the project being financed, they are a lower risk investment between the two. As such, all else equal, revenue bonds will offer higher returns than identical general obligation bonds.
Another important feature of a municipal bond is the tax paid by investors on interest receipts. If you live in the US and own a US based municipal bond, any interest receipts are exempt from US federal income tax. Often, these bonds are also exempt from taxes in the locality and state where the bond was issued.
Because many investors need not pay tax on interest receipts, the offered yields on the bonds are less than other non-tax exempt bonds with similar characteristics.
For example, say you reside in Maine and have a 30% marginal tax rate. You have two investment options. One a US government 5 year bond trading at par, with a coupon of 8%. The other, a local municipal 5 year bond also selling at par, with a coupon of 6%.
On the surface, the 8% yield appears better. However, you always need to consider the impact of taxes. It is the net return that is crucial, not the gross return.
In our example, the net return on the US government bond is only 5.6% [8*(1-0.30)]. A lower amount than the tax-free return of 6% with the municipal bond.
Be aware that one’s tax situation is unique to each person. Before investing in munis, or any other tax impacted investments, always determine the affect to you first.
Corporate Bonds
Like governments, corporations can raise capital through the issuance of debt.
As we discussed previously, debt may be secured by the company pledging specific assets against the issue. Or it may be unsecured, where the bonds fall into the general obligations of the company.
Corporate bonds may be issued in the same fashion as most government bonds. That is, a straight debt issue, with semi-annual interest payments over a fixed period of time. At the end of the term, the face value of the bonds is repaid to the debt holders and the issue is cancelled.
Straightforward bond issues such as these are known as plain vanilla bonds. There is no chocolate sauce, strawberries, or sprinkles on these debt instruments. We will look at slightly more exotic variations shortly.
