The two main types of corporate bonds are secured and
unsecured. Secured bonds have specific property such as real estate,
machinery, or equipment, to which, an independent trustee holds the title. If the bond issuer fails to make an interest or
principal payment, the bondholders can lay claim to the property. This adds a measure of security to the
bondholder’s investment, but does not guarantee a capital return. Unsecured bonds have no specific collateral
backing. These bonds are generally defined as
debentures or subordinated debentures.
Debentures are solely backed by the good faith and credit of the
issuing corporation. Subordinated
debentures are also backed by the credit of the issuing company, but due to their
subordinated status these bonds have much lower claim on the company’s assets than do
other types of bondholders in the event of a default.
Because of this higher risk status, subordinated debentures generally
offer a higher interest rate than secured bonds and often have features
built in that will allow them to be converted to common stock.
Zero-Coupon Bonds
Zero-coupon bonds do not make interest payments. Instead the bonds are sold at a discount and
accrete to face value. For example, the buyer
pays $200.00 for the bond today, and when the bond matures in 20 years it will have a
value of $1,000.00. Taxes are due on the
bond’s accreted value every year even though you do not realize any gain until the
maturity date. Because these bonds pay no
interest, their market prices tend to fluctuate more than similar bonds that have a
coupon. There is no “reinvestment
risk” due to the fact that there are no interest payments to reinvest. Zero-coupon bonds are an excellent option for
someone that wants a fixed dollar amount in the future for something such as college. Zero-coupon bonds can also be an effective
instrument for the investor anticipating lower interest rates. When interest rates change, a zero’s price
changes much more as a percentage of its market value than an ordinary bond’s price,
therefore causing their values to rise quickly in times of falling interest rates.
U. S. Government Securities
Treasury Bills, or T-bills are short-term investments. These are issued in denominations of $1,000 to
$1,000,000 and are sold by auction on a weekly basis. The winning bidder pays for the
T-bill at a discount to face value (like a zero coupon bond). Upon maturity the security holder redeems the
T-bill for the value on its face. T-bills
have maturities of 13, 26 or 52 weeks.
Treasury Notes pay interest every six months. They are sold at auction every four weeks in
increments of $1,000 to $1,000,000, and have maturities of 2 to 10 years.
Treasury Bonds are sold at auction twice a year. They are long-term securities (maturities of 10 to
30 years) that pay interest every six months. These
bonds also have face values from $1,000 to $1,000,000.
Treasury Bonds can also have call features that the other government
securities do not have.
Treasury STRIPS (Separate Trading of Registered Interest and
Principal) are investment options that perform like a T-bill or a zero-coupon bond. The advantage of STRIPS is that they are secured
by the U. S. Government. Additionally, they do not have reinvestment risk and they can be
a short or long-term investment, ranging from 6 months up to 30 years.
Municipal Bonds
Municipal bonds are issued by state governments, cities, counties, U.S.
territories, U. S. authorities and other governmental entities, such as school
corporations. They are used to raise money
for projects for the public good. Municipal securities have maturity schedules similar to
other debt instruments. Generally terms of
maturity are one to thirty years. Muni bonds
usually provide Federal tax–free interest income, offer a high degree of safety, and
a reliable source of interest income. These
bonds come in a varied array of choices depending on your investment needs, such as risk,
liquidity, maturity and choice of issuer. Muni
bonds have an active secondary market giving them liquidity if you want to sell prior to
maturity. Zero-coupon bonds are also
available as municipal securities.
Collateralized Mortgage
Obligations
Collateralized mortgage obligations, or CMOs, are debt securities
backed by a pool of mortgages, usually single-family homes.
CMOs are issued by private corporations, as well as government sponsored
corporations such as Federal Home Loan Mortgage Corporation (FHLMC (Freddie Mac)) and
Federal National Mortgage Association (FNMA(Fannie Mae)).
Due to variables such as early loan repayment and changes in interest rates,
a CMO investor can and usually will experience a variable principal repayment and
therefore fluctuating income. Because of the
underlying mortgage properties, CMOs are a relatively safe investment, but unknowns, such
as homeowner refinancing and rising interest rates can effect principal repayment and the
amount of time the investor has to remain in the investment. Government National Mortgage Association bonds,
(GNMA (Ginnie Mae)), are mortgage-backed securities that are similar to other mortgage
bonds. Some of the differences include, GNMAs
are issued in $25,000 minimums and are backed by the full faith and credit of the U.S.
Government.
