|
 Investing in bonds is something that you may not be quite as comfortable with as you are with investing in stocks. In fact, many investors can easily make the transition from a mutual fund to individual stock picks much faster than from mutual funds to bond holdings.
If that last statement holds true for you - we've got some good news. We've put together this multipart series can help you get over any anxiety you might have about investing in bonds. In this first installment, we're going to discuss some of the reasons companies issue bonds and the typical issuers of bonds.
Later on in this series we'll discuss bond terms, how to calculate bond yields, redemption features and credit quality / bond ratings.
Companies Issuing Bonds
Money is the fuel used to grow companies and most large corporations have several sources of funding from which to choose. When a company issues stock, then they are agreeing to share the profitability of the company with those investors holding stock in a company. So holding stock in a company is like taking ownership in part of the company. At the extreme, if you could afford to purchase all the shares of outstanding stock in a company, then you would own the company.
A second source of external funding that a company has available to them is bonds. When a company raises funds through the issuing of bonds, it is asking someone to lend them money. In exchange for lending the bond issuer or debtor money, the investor or lender gets a piece of paper that details the interest rate to be paid, frequency of payment and the length or term of the agreement.
Bonds are usually issued in $1,000 increments or notes. They show up on a company's balance sheet as liabilities. How much money a company raises via the issuing of stocks versus bonds is a very important measure. The more funding that is obtained through bonds relative to stocks, the more leveraged a company is said to be. We'll talk about this a little more when we discuss bond ratings later on as well as in our article on understanding financial ratios.
Types of Bonds Issued
Companies issuing bonds pay interest to those holding the bond at a predetermined frequency. From the investor's standpoint, a bond is a fixed income security because they can count on the company paying the same amount of money on the bond each time. For example, an investor holding 100 bonds with a face value of $1,000 that have a stated interest rate of 10% would be entitled to payments of 100 x $1,000 x 10% or $10,000 annually.
There are basically four types of bonds that the average investor can choose from and each of these types of bonds is pretty much defined by the entity that is issuing the security:
Federal Bonds
These are U.S. government securities that are issued by the federal government or more specifically the Treasury Department. Federal bonds are issued by the government when it needs to borrow money when faced with budgets that are not in balanced. The term or maturity of U.S. Treasury bonds range from 3 months to as long as 30 years. Since the U.S. government guarantees payment of interest on these bonds, the risk of default is very low. The federal government can always secure more funding through additional taxes or even the printing of money. In addition, the interest payments are normally tax free.
State and Local Bonds
Much like the federal government, these bonds are offered to the public in the hopes of securing funding at a variety of levels including state and local governments. The chance of default on this type of bond is much greater than the federal government. They can try to increase taxes and are normally successful, but certainly they cannot print more money like the federal government. So in some ways, these local governments compete with large corporations for the bond investor's attention or money.
To help make these bonds more attractive, the federal government has allowed them to issue bonds that are free from federal income tax. They also have the option of making them free from any state or local income tax. Bonds issued under these conditions are called tax-free municipal bonds or simply "munis."
Bonds Issued by Government Agencies
Ginnie Mae, Fannie Mae, Sallie Mae and Freddie Mac are all companies that started out as government agencies and transitioned to the private sector. Each of these agencies has been asked by the federal government to provide for a robust lending market. In the case of Sallie Mae, this involved student loans. For the others in this group, the focus was on creating and maintaining a robust mortgage market.
All of these bonds are backed by the U.S. federal government which means the risk of default, or credit risk, is very low.
Bonds Issued by Corporations
As previously mentioned, large corporations can raise more funds or capital by issuing bonds. The interest rate on corporate bonds is directly related to the perceived or real risk associated with interest payments. If a company is performing poorly, then there is a greater chance they will not be able to pay the interest due on the bonds they've issued.
The higher the perceived risk associated with a particular company, the higher the interest rate will have to be on the bonds in order to entice the public into investing in the bond. Bonds that are deemed by bond rating agencies to be below investment quality are termed "junk bonds."
In our next article in this series on investing in bonds, we are going to describe some bond terminology, and the process for calculating bond yields.
About the Author - Investing in Bonds Part I
Copyright © 2005 - 2007 Money-Zine.com
Investing Resources on the Web |
Home 
