Investing in Bonds Part I
Many investors easily make the transition from mutual funds to common stocks. That's a great start, because finding high quality bonds requires the same rigorous process as stocks.
In this article, we're starting a multipart series aimed at helping investors remove any anxiety they might have about investing in bonds. This first installment is going to discuss the reasons companies issue bonds, as well as the typical issuers of these securities. Later on in this series we'll discuss bond terms, how to calculate bond yields, redemption features, and credit quality also known as bond ratings.
Companies Issuing Bonds
Money is the fuel used to grow companies, and most large corporations have several options to choose from. When a company issues stock, they are agreeing to share in the profitability of the company with their stockholders. Purchasing stock is taking partial ownership in that company. If an investor could afford to purchase all the company's outstanding shares, they would own the company.
Issuing bonds is a second source of external funding for a company. When a company raises funds through the issuing of bonds, it is asking investors to lend them money. In exchange for lending the issuer (or debtor) money, the investor (or lender) receives 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. The total amount of money a company raises through the issuing of stocks versus bonds is a very important measure. When more funding is obtained through bonds relative to stocks, the company is said to be highly leveraged. The topic of leverage will be discussed, along with bond ratings, later in this series. It's also discussed in our article: Understanding Financial Ratios.
At a predetermined frequency, companies issuing bonds make interest payments to lenders. From the investor's standpoint, a bond is a fixed income security since they can count on the company paying the same amount of money at a given frequency. 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 four basic types of bonds from which the average investor can choose.
U.S. government securities that are issued by the federal government, specifically the Treasury Department, are known as federal bonds. These bonds are issued by the government when it needs to borrow money, which happens when budgets are not in balance. The term, or maturity, for 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. As an added benefit, the interest payments on federal bonds are normally tax-free.
State and Local Bonds
This next type of bond is offered to the public with the hope of securing funding at the state and local level. The chance of default on these bonds is greater than the federal government's issues. State and local governments can increase taxes, but they can't print more money like the federal government. In some ways, these local governments compete with large corporations for the bond investor's money.
To help make these bonds more attractive, the federal government has allowed them to issue securities that are free from federal income tax. They also have the option of making these bonds free from any state or local income tax. Bonds issued under these conditions are called tax-free municipal bonds, or simply "munis."
Ginnie Mae, Fannie Mae, Sallie Mae and Freddie Mac are all companies that started out as government agencies, and then 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 involves student loans. For the others in this group, the focus is on creating and maintaining a robust mortgage market.
Bonds issued by these pseudo government agencies are backed by the U.S. federal government, which means the risk of default, or credit risk, is very low.
Large corporations can raise funds, or capital, by issuing bonds. The interest rate on corporate bonds is directly related to the perceived, or real, risk associated with the interest payments due to lenders. If a company is performing poorly, 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 paid in order to entice the public to invest in the bond. Securities that are deemed by credit rating agencies to be below investment quality are termed "junk bonds."
In the next article in this series, we're going to explain the most common bond terminology an investor will encounter, as well as the process for calculating bond yields.
About the Author - Investing in Bonds Part I