When it comes to buying bonds, you should be most concerned with answering, where did the bond come from? You want to assess the credibility of the issuer so you can increase your odds of repayment. This is based on the idea that the funds you use to purchase the bond act like a loan to the bond issuer.
Accordingly, bonds can be split into 7 groups differentiated by the type of issuer. Here they are:
Treasury bonds are issued by the U.S. government. These are exempt from state-level interest rate taxes and are considered to be very safe investments since they’re backed by the federal government.
Other U.S. Government bonds
These types of bonds are issued by government organizations like Freddie Mac, Fannie Mae and Ginnie Mae. These are also considered to be very low-risk but not quite as low risk as treasury bonds. As such, you may find slightly higher returns on these ones.
Investment-grade Corporate bonds
These are issued by companies or organizations that are in good financial standing and have solid balance sheets. All of these bonds have a rating (from Moody’s or Standard and Poor) of at least triple B – BBB. This means that all bonds have a rating of either BBB, A, AA or AAA (being the best). Given the financial standing of these companies, the risk of default is usually very low. Though, it should be noted that these bonds typically underperform treasury bonds when the economy is in a downswing.
High-yield Corporate bonds (i.e. junk bonds)
At the other end of the spectrum, these corporate bonds are seen as having a higher risk. Mainly because they are issued by companies or organizations with weak balance sheets compared to their investment-grade counterparts. It’s said that these are more closely tied to the health of a company’s balance sheet than investment grade bonds.
Foreign bonds pay interest in the form of foreign currency. Of course, these are susceptible to exchange rate fluctuations which can affect your overall interest payment once converted into US dollars. Of course, the stronger the US dollar is, the lower the interest payment. Whereas the weaker the US dollar, the higher the interest payment you receive.
These types of bonds are said to not be affected by falling interest rates the way other types of bonds benefit from this occurrence. The value of these bonds drop when the rate of prepayment increases. This means that more people are paying off their mortgages early, lowering the potential interest fees to be enjoyed. Of course, this lowers the overall value of the bond since there are less profits (i.e. interest revenue) to be enjoyed.
Municipal bonds offer a feature that isn’t offered by most bonds. That is, its interest payments are not taxed at a federal level. This can be very helpful for those bordering the next tax bracket. Keep in mind that this lower risk also comes with a lower return.
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