Bonds are essentially loans made by investors to borrowers, which can be companies or governments. Governments are major issuers of bonds, and because they have the power to tax and are generally very stable, government bonds are often seen as high-quality investments. While most government bonds carry a lower risk, it’s important to remember that exceptions can occur. Let’s delve into some common types of bonds to understand how they work.
U.S. Treasuries: Considered the Safest Bonds
U.S. Treasury bonds are issued by the U.S. federal government and are widely regarded as the safest type of bond investment available. This is because they are backed by the full faith and credit of the United States government, meaning the government promises to repay the debt.
Interest earned from Treasury bonds is subject to federal income tax, but it is typically exempt from state and local taxes, which can be an advantage for investors. Because of their perceived safety, Treasury bonds generally offer lower yields compared to other types of bonds, and their returns may not always outpace inflation. However, they are highly liquid, meaning they can be easily bought and sold in the market.
There are several types of Treasury securities, each with different maturity dates and features:
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Treasury Bills (T-Bills): These are short-term securities with maturities of one year or less. Unlike most bonds, T-bills are sold at a discount to their face value. Investors don’t receive periodic interest payments; instead, they profit from the difference between the purchase price and the face value they receive at maturity.
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Treasury Notes (T-Notes): Treasury notes have intermediate-term maturities, ranging from two to ten years, offering a slightly longer investment horizon.
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Treasury Bonds (T-Bonds): For investors seeking longer-term investments, Treasury bonds have maturities exceeding ten years, often reaching up to 30 years.
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Treasury Inflation-Protected Securities (TIPS): TIPS are designed to protect investors from inflation. The principal of TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. This means the return on TIPS keeps pace with inflation, preserving your purchasing power.
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Separate Trading of Registered Interest and Principal of Securities (STRIPS): STRIPS are created from existing Treasury notes and bonds. Essentially, the coupon payments and the principal payment are separated (stripped) and traded individually as zero-coupon securities. This allows investors to purchase either the interest payments or the principal repayment separately, catering to specific investment needs.
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Floating Rate Notes (FRNs): Unlike fixed-rate bonds, Floating Rate Notes have a coupon rate that adjusts based on a benchmark interest rate, typically linked to recently auctioned Treasury bills. This feature makes FRNs less sensitive to interest rate changes, as their coupon rate will fluctuate with market rates.
Read more about Treasury securities
Government Agency Bonds: Bonds Backed by U.S. Agencies
Besides Treasuries, various agencies of the U.S. government also issue bonds. These include agencies focused on housing, such as the Government National Mortgage Association (GNMA), often called Ginnie Mae. Interest from most agency bonds is taxable at both the federal and state levels.
Government agency bonds are generally considered high-quality and very liquid, although their yields might not always keep up with inflation. Some agency bonds are backed by the full faith and credit of the U.S. government, making them nearly as safe as Treasury bonds.
However, bonds issued by agencies like GNMA, which are backed by mortgages, are particularly sensitive to interest rate fluctuations. This is because homeowners have the option to refinance their mortgages when interest rates change.
When interest rates rise, refinancing activity tends to slow down. For bondholders, this means less money is coming in to reinvest at the new, higher rates. Conversely, if interest rates fall, refinancing accelerates, and bondholders may find themselves reinvesting principal at lower interest rates, which can impact returns. This is known as prepayment risk.
