Not All Bonds are Created Equal

Not All Bonds are Created Equal

     As markets become volatile, many investors turn to bonds as an alternative to stocks.

Bonds are often deemed a “safe” investment. However, investors need to be aware that bonds, like all investments, do carry some risk, and those risks need to be considered carefully.

     If you are considering purchasing, or have already purchased, bonds for your portfolio, you should understand that not all bonds are created equal. While they are all considered debt instruments, bonds are created by different entities for very different purposes and carry varying risks and tax-related liabilities. Simply put, bonds are issued by companies and government bodies to fund their day-to-day operations or to finance specific projects. When an investor buys a bond, he or she is, in fact, loaning money for a certain period of time to the issuer of the bond.

In return for loaning funds, investors receive the principal amount back, with interest, at the time the bond comes due or “matures.” It is important to keep in mind that the price of bonds moved in the opposite direction of interest rates. When interest rates rise, prices of outstanding bonds fall.

     A bond’s face value, or the price at issue, is known as its “par value,” and the interest payment is known as its “coupon.” The price of bonds will fluctuate, similar to stocks, throughout the trading day. However, with most bonds, the coupon payment will stay the same (some floating-rate securities do exist). If an investor purchases a bond in the secondary market at the face value, the bond is considered to be sold at “par.” If a bond’s price is above its face value, it is sold at a premium. If a bond’s price is below face value, it is sold at a discount.

     In general, there are three main categories that bonds will fall under: Government, Municipal, and Corporate.

     For bond investors looking for low risk investment, the U.S. Treasuries are typically the best bet, as they are backed by the full faith and credit of the U.S. Government. The U.S. Treasury regularly offers three types of securities: Treasury bills, notes, and bonds.

   In addition to U.S. Treasuries, certain federal government agencies or government-sponsored enterprises (GSEs) have been authorized by Congress to issue debt secu­rities to certain groups of borrowers, such as homeowners, farmers, and students. In general, debt securities issued by GSEs are considered to have high credit quality. However, it is important to recognize that issuers in the U.S. Agency market are corpo­rations and that their bonds are not explic­itly guaranteed by the U.S. Government.

   Just as the federal government needs funds to operate, local governments and public entities, such as school districts, often issue municipal bonds to meet their financial needs. Municipal bonds can be issued by states, cities, towns, or public commission to provide money for schools, hospitals, and other public works. These securities provide income that is free of federal and, in some cases, state and local taxes. (Although income generated by most municipal bonds is exempt from taxes, any capital gains earned from the sale of bonds are subject to all federal and most state tax laws, and certain bonds may be subject to the alternative minimum tax.)

     Corporate bonds, unlike U.S. Treasuries and municipal bonds, are fully taxable and may carry greater risk. At the same time, they may offer higher returns than tax-advantaged bonds. Corporate bonds are issued by corporations in the need of capital and are typically issued in denominations of $1,000 with terms of 1 to 30 years. Unlike stocks, bonds do not give the holder ownership interest in the corporation, as they are simply a tool used to lend the corporation funds they need to meet their goals.

     Bonds can be an important part of an asset allocation mix and can be useful in diversifying your portfolio. However, diversification does not ensure a profit or protect against loss in declining markets. To learn whether investing in bonds is right for you, keep in perspective your long-term financial goals and objectives, your tolerance for risk, and investment time horizon. 

Article provided by Bryan Ruder, a Financial Advisor with Stifel, Nicolaus & Company, Incorporated, Member SIPC and New York Stock Exchange. He can be reached by calling the Evansville office at (812) 475-9353 or (855) 62-RUDER.