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Chapter 16 — TYPES OF BONDS
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TYPES OF BONDS

TYPES OF BONDS

FEDERAL GOVERNMENT AGENCY BONDS

types of bonds

Federal Government Agency Bonds, or agency bonds, are some types of bonds issued by government entities but are not secured the same way treasury security is secured. An example of an agency bond might be a bond issued by Sallie Mae. Government agencies can issue bonds to raise funds just like any other institution. Many agency bonds are not actually issued by government agencies but by government “sponsored” agencies. These can include private companies that are doing something that is considered important by the federal government, such as public works programs. These types of bonds are issued by the agency but backed by the federal government. Therefore, these types of bonds are secured by the US government but are still not as risk-free as Treasury securities.

There can be tax benefits that should be kept in mind when investing in these types of bonds. Some are taxable only on the federal level while others might be taxed by both the state and the federal government. The advantage of these types of bonds over treasury securities is that they usually offer a higher return while still maintaining very low risk. Treasury securities are not an investment that many individuals are likely to make. However, agency bonds can be appealing because they allow a risk-averse investor an opportunity to have low risk, potentially save tax expense, and earn a small return.

TAX-FREE MUNICIPAL BONDS

State and local government entities also issue bonds which are called municipal bonds. These types of bonds are usually exempt from taxes on the federal level. State governments might issue bonds to build roads, enhance education, or fund other government operations at the state or local level. Investors might favor these types of bonds because they can help fund their local projects as well as avoid paying taxes on their returns.

Municipal bonds, as one of the types of bonds, carry risk, but for this particular type, risk is slightly more than for other types of government-issued bonds, but investors in these types of bonds are counting on the tax savings and the return when determining overall value. Since there are tax savings, these types of bonds often appear to have lower returns, but can still have a higher value overall. However, not all municipal bonds are tax exempt. Depending on the individual bond, the holder may still have to pay state taxes, federal taxes, or both on their returns. Strategies for managing bond investments can be quite sophisticated. If tax-free income is a concern, then it is best to consult a tax specialist before investing.

CORPORATE BONDS

Corporate bonds are the most common type of bond for individual investors. These types of bonds are issued by corporations and come in a wide variety of maturity dates and yield percentages. Corporations typically issue bonds to fund an expansion. Corporate bonds may include provisions such as calling (buying the bond back before maturity) or converting (exchanging shares of stock for the bond). It is important to understand the details of these types of bonds before investing. It is possible to use bond ratings to assess the quality of bond investment, but there is no guarantee.

Bond ratings and the secondary bond market are important concepts for bond investors. The bond rating is issued by private agencies like Standard and Poor’s or Moody’s. The S&P bond rating system goes from AAA down to C and is fairly easy to understand (AAA is the best rating possible). A “D” rating means the bond is in default. Bonds are only considered “investor” grade if they are above BB rating.

Bonds are sold in the secondary bond market to investors and can be bought and sold at any time before the bond matures, so the price can vary over the life of the bond. It is also important to keep in mind that inflation and the time sensitive value of the investment is also relevant when computing the actual value of the bond.

Quiz

Who might invest in agency bonds?

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  • 1
    A tax conscious investor.
  • 2
    An investor who prefers modest gains to risk taking.
  • 3
    A socially conscious investor who wants to put money into government works.
  • 4
    All of the above.
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