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David L. Ward Different types of Bonds, and some general guidelines for investments FIN 4310-88; SECURITY ANALYSIS & PORTFOLIO THEORY (Independent Study) Dr. Don Y. Nyonna

Different types of Bonds, and some general guidelines for investments

The Bond market is one of the best ways for individuals and companies to invest. The return within in bonds is measurable and tractable, while normally making a profit. As every kind of institution needs to borrowed money, whether if someone is asking a parent for a few dollars as we did when we were children, to a family needing a bank mortgage, money is a necessity for everyday life. Just as individuals, need money, so do companies, and governments around the world. To expand into new markets may be one reason a company needs, while governments need money for everything from infrastructure to social programs. Nevertheless, there is a problem, large organizations typically need far more money than the average bank can provide, and the solution to the problem is to raise money by issuing bonds (or other debt instruments) to a public market. This allows for thousands of investors to lend a portion of the capital needed by the large organizations. Therefore, to state in as general terms as possible, a bond is nothing more than a loan for which the holder is the lender. The organization that sells a bond is known as the issuer, and it can be thought of that a bond is an IOU, given by a borrower (the issuer) to a lender (the investor). The catch of the IOU, is an organization will not loan hard-earned money for nothing. The issuer of a bond must pay the investor something extra for the privilege of using the money. This "extra" that is needed comes in the form of interest payments, which are made at a predetermined rate and schedule. This interest payment or rate is often referred to as the

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coupon. The face value is the amount borrowed, and the date on which the issuer has to repay the amount is called the maturity date. Bonds are known as fixed-income securities because it is a known fact of the exact amount of cash to be received if the security is hold until maturity. As any good investor trying to make a return on the investment, whether it be for themselves or for a big company it is the knowledge of all the different types of bonds available and how to invest in each of the bond that will make a profit or suffer a loss. Is it the government bonds, Treasury bonds, Treasury notes, Municipal bonds "munis", corporate bonds, zero-coupon bonds, or revenue bonds. There is fixed-income securities, tax-exempt bonds, convertible bonds, and other areas associated with bonds. Now, how would an investor make the right decision on exactly which bond, fixed or not, tax-exempt or not, how long to hold it until the maturity date, as well as, many other questions needed for the best answer. It is certain that the investor ask questions, and tries to come up with some solutions on that is the right bond for the right particular investor at the right time. Marketable securities from the U.S. Government are known collectively as Treasuries, and must follow some guidelines of issuer; as Treasury bonds, Treasury notes, and Treasury bills. Treasury bills technically speaking are not bonds because of the short maturity time associated with them. All debt issued by the Government is regarded as extremely safe, and this holds true with the debt of any stable country. However, with the debt of many developing countries the risk can be substantial higher. It is unfortunate, but like companies, countries can default on payments too. In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories for Government bonds: Bills - debt securities maturing in less than one year.

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Notes - debt securities maturing in one to 10 years. Bonds - debt securities maturing in more than 10 years. Municipal bonds, known as "munis, are one of the best for the investor. The major

advantage to munis is that the returns are free from federal tax are the next progression in terms of risk. They are debt obligations issued by state, city and local governments, generally to raise capital for their daily operations or to fund specific projects. That makes them so attractive is the fact that they are exempt from federal tax, and when purchased by a resident of the state issuing the bond, interest may be exempt from state tax as well. Local taxes, if any, also may be exempted, making them the best return on any investment. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending on your personal situation, a muni can be a great investment on an after-tax basis. What kind of risk is associated with muni are within the ream that Cities do not go bankrupt that often, but it can happen, and when it does it can be devastating for the investor. Furthermore, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely tax free. Municipal bonds can be an attractive investment choice, particularly for individuals worried about the hefty bite taxes can take from their investments. Municipal bonds offer a steady stream of income that is exempt from federal, and sometimes state, income tax. Within the Municipal bond, family is a common type of bond known as the general obligation (GO) bonds. General obligation bonds are unsecured bonds backed by the full faith and credit of the issuing government. Normally issued to finance non-revenue producing public works projects like scools and roads, but are generally paid off with funds from taxes or fees. General obligation bonds are considered the safest of municipal issues, and for that reason, they tend to offer lower yields. Also within the Municipal bond, family is the Revenue bonds. The

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Revenue bond are issued to fund projects that will eventually generate revenue like a toll road. That revenue is used to pay off the bonds, not the taxpayers. However, because they are considered somewhat riskier than GO bonds, revenue bonds typically offer higher yields for the investor. Corporate bonds are known in the business world as when a company issues bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue, and the limit of the debt that makes the largest factor of whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years. Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives. Some other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity. The zero-coupon bond is a type of bond that makes no coupon payments but instead are issued at a considerable discount to par value. To illustrate this, an investor has a zero-coupon bond with a $1,200 par value, with 10 years to maturity; it is trading at $600 so the investor would be paying $600 today for a bond that will be worth $1,200 in 10 years. Municipal bonds can be an attractive investment choice, particularly for individuals worried about the hefty bite taxes can take from their investments. Municipal bonds offer a steady stream of income that is exempt from federal, and sometimes state, income tax. Many investors appreciate not only the tax benefits associated with municipal bonds, but also the fact that, by

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investing in them, they are helping to support projects and pursuits that can benefit their local communities. How to Invest Reliable Income, as well as relative safety are what bonds give to the investor. They pay interest to holders on a regular basis, often semiannually, and are guaranteed this income if they are held to maturity. It is simple; when the bond matures, the principal is returned to the investor. Municipal bonds are considered safer than corporate bonds, for the simple fact that governments are less likely than companies to fail and default on their obligations to repay. See Table 1, the 20-year Municipal bonds history:
TABLE 1

Municipal Bonds Historically Have Low Default Rates 20-Year Annualized Returns by Asset Class (19922011) Municipal Bonds Corporate Bonds 0.10% 1.20% Five-year cumulative default rate 0.00% 0.65% Default rate for A-rated bonds 3.11% Default rate for BBB-rated bonds 0.66% A+ BBB Average rating assigned by Fitch Source: The Fitch Ratings, area to select statistics for Fitch-rated investment-grade of bonds, and historical data.

Given their inherent tax advantage, municipal bonds almost always come with lower yields than taxable bonds, such as Treasury bonds and corporate bonds. Historically, munis trade at 85% to 90% of their Treasury counterparts, levels that factor in the impact of taxes. Investors are wise to determine the taxable equivalent yield on a tax-exempt bond to determine whether it represents a good value relative to a taxable investment, and is within the investors expectations. The investors in high tax brackets seem to benefit over investors that are not. The wise investor

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makes the best determining fact in regards to the taxable equivalent yield on a tax-exempt bond. They must look to see whether it represents a good value relative to a taxable investment. In table two (2), is shown way to calculate the TEY of a bond:
TABLE 2

Calculating a Bonds Taxable Equivalent Yield (TEY) = 35% Investors tax bracket = 5% Tax-exempt bond yield TEY = 5 (the tax-exempt yield being offered) 0.65 (1 minus the investors tax bracket of 0.35) = 7.69% TEY This hypothetical investor would need to find a taxable investment paying more than 7.69% to outpace the return on the 5% tax-exempt bond (on an after-tax basis). For investors subject to state tax as well, the benefits of tax-exempt investing would be even more dramatic. Bond Insurance is what some municipal bonds are underwritten by. This is a third-party bond insurer in order to enhance their credit ratings. The insurers guarantee payment of principal and interests in case the bond issuers were to default. However, as indicated earlier, natural uninsured municipal bonds are generally of high quality in and of themselves. The default rate on municipal bonds as a class is less than one-half of 1%, and no natural AAArated muni has ever defaulted. Individual Bonds Investors may opt to purchase municipal bonds directly from the issuer. Municipal bonds are bought and sold in the over-the-counter market. This is done in this form rather than on an organized exchange. The Municipal Securities Rulemaking Board establishes the guidelines for the municipal market and is subject to the oversight of the Securities and Exchange Commission. Municipal bonds are typically issued in par values of $5,000. Most investors hold municipal bonds to maturity, when their original investment is returned to them, and collect the regular income they generate in the interim. If an investor opts to sell a municipal

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bond prior to maturity, he or she receives the current market price for the bond, which may be more or less than the purchase price. Lastly, a little word about risk in the bond market. As with other fixed income investments, the risks associated with municipal bonds are interest rate risk and credit risk. Bond prices move in the opposite direction of interest rates. When rates rise, bond prices fall, and vice versa. Bonds with shorter maturities react less to interest rate movements than do longer-dated issues. Credit risk refers to the possibility that the issuer of a bond might default on its obligations. Although the likelihood of municipal defaults is lower than in the corporate space, there have been instances (such as Orange County, California, in 1994) where municipalities have filed for bankruptcy, so concisely, risk is always a factor.