Governments and businesses frequently borrow money and in the investment world these loans often take the forms of bonds. The creditor lends money to the bond issuer and the issuer repays the debt along with interest. While people generally regard bonds as conservative investment instruments, some bonds expose investors to higher degrees of risk than others. Commonly traded types of bonds include federal bonds, mortgage-backed-securities, municipal bonds, corporate bonds and international bonds.
The United States Department of the Treasury regularly issues bonds that have a duration of between six months and 30 years. The government initially sells most types of bonds at auction but you can also buy existing bonds on the open market from other investors. However, savings bonds are one type of federally issued bond that you cannot trade, as only the original buyer, the buyer's estate or pay-on-death beneficiary can redeem a savings bond. Some bondholders buy federal bonds at face value and receive bi-annual interest payments. Others buy bonds at a discount to the face value, also known as the par value. Interest payments over time cause the bond to reach its face value at maturity. Federal bonds have the full backing of the United States government, so these bonds have lower yields than other kinds of bonds, as bondholders face minimal levels of default risk.
Mortgage Backed Securities
Government sponsored enterprises like Fannie Mae buy mortgages from lenders and package those mortgages into investment pools. Investors can buy bonds known as mortgage-backed-securities that are backed by these bond funds. The bondholders receive regular interest payments, but can lose money if the mortgage holders go into foreclosure. Some firms sell high-yield mortgage bonds that are backed by mortgages issued to people with poor credit. Investors who buy these bonds have to contend with elevated default risks, whereas some low-yield conservative bond funds actually receive backing from the federal government.
County, city and state governments issue bonds to raise money for schools, roads, emergency services and other essential expenses. You do not have to pay state income tax on bonds issued by government entities located within your state. Furthermore, you do not have to pay federal income tax on interest payments from most municipal bonds. Municipal revenue bonds are used to finance projects such as new parking lots, and bondholders receive interest payments derived from the project's revenue. General obligation bonds are debts of the actual government and tax proceeds are used to cover the interest payments.
Corporations issue bonds to raise money to cover short-term operating costs as well as major projects such as the construction of new work sites. If a firm goes bankrupt, bondholders as creditors have a chance to make a claim on the company's liquidated assets before stockholders. Therefore, while both bonds and stocks can lose all value if the issuer fails, bonds expose investors to lower levels of risk than stocks. Generally, bonds issued by start-up firms pay higher yields and expose investors to more risk than bonds issued by established firms.
Governments and corporations from around the world issue bonds on a regular basis. Investors in the United States can often buy these bonds on the secondary investment market, and some people view these bonds as safe haven investments during periods of domestic recession. However, international bonds expose investors to many risks. Fluctuating currency prices can cause international bonds to lose value and political upheaval can result in bond defaults. Logistically, bondholders have a harder time making claims on a failed firm's assets if that firm operated overseas rather than in the United States.
- Jupiterimages/Comstock/Getty Images