Buying Individual Bonds
Posted on November 13, 2007 in the Bonds, Investing category
.Bond’s are a valuable but overlooked component of a successful portfolio. Although the stock market attracts more attention from the financial media, for some investors who are a little uncomfortable with the rarefied levels of the stock market, bonds and bond funds can offer piece of mind and the potential for a pretty good rate of return also.
What Is A Bond?
A bond is simply an IOU issued by a corporation or a government entity. When an investor purchases a bond, he or she is lending the issuer a specified amount of money (the principal) for a specified period of time (the term), which may be anywhere from a few months to 100 years. In return, the issuer pays regular income at a rate that is set when the bond is issued (that’s why bonds are sometimes referred to as fixed-income investments). When the term is up and bond matures, the issuer repays the principal to the bondholder.
Why you should consider investing in bonds
There are two main reasons why investors should consider adding bonds to their portfolio:
Stable Income: The interest income earned by bond funds is generally higher and more stable than the interest earned by other investments like money market funds, certificates of deposit, or bank passbook accounts. This is very appealing for many investors, particularly retirees, who need income on a regular basis to live on.
Diversification: Many investors in the stock market also hold bonds to help smooth out the inevitable fluctuations in the value of their overall investment portfolios. Although bonds fluctuate in value just as stocks do, bonds do not always move in the same direction or to the same degree as stocks.
What are the different types of bonds?
The four most common types of bonds that investors can buy are those issued by the federal government and its agencies, state and local governments, and corporations. An Explanation of each is below:
U.S. Treasury:
Securities offered by the U.S. Treasury come in three forms:
- U.S. Treasury bills , which have maturities ranging from 90 days to 1 year.
- U.S. Treasury notes , which have maturities from 1 to 10 years.
- U.S. Treasury bonds , which have maturities from 10 to 30 years.
Bonds issued by the U.S. Treasury constitute the largest sector of the world’s bond market. U.S. Treasury bonds are considered the safest of all investments because they are legally backed by the “full faith and credit” of the U.S. government. This means that the government pledges to use its full taxing and borrowing authority, as well as revenue from non-tax sources, to pay the interest and repay the face amount of the security. Because of this backing, U.S. Treasury securities have very little credit risk and carry the lowest yields. Interest paid on Treasury bonds usually is exempt from state and local income taxes, but is not exempt from federal income taxes.
U.S. Government Agency
U.S. government agency bonds and securities are issued by agencies that are owned, backed, or sponsored by the U.S. government. While the full faith and credit of the government back some of those bonds and securities, others carry less formal guarantees.
The most common agency issued security are mortgage pass-through securities such as those issued by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). Mortgage pass-through securities are backed by home mortgage loans. By purchasing mortgage pass-through securities, investors are making mortgage loans to homeowners through intermediary companies. Homeowners make monthly mortgage payments to mortgage-servicing companies and those payments flow through to investors holding the mortgage pass-through security. Of these agencies, only Ginnie Mae offers securities that are backed by the full faith and credit of the U.S. government. Nonetheless, bond market professionals believe that all of these securities have a very high credit quality, meaning that the issuing agency is very likely to pay the bond’s interest and principal in full and on time. Indeed, these agency securities are regarded as equal or even superior to bonds issued by the most creditworthy corporate borrowers.
Corporate Bonds
Corporations to finance expansion and other activities issue corporate Bonds. They vary in maturity from short-term (between 1 and 5 years) to intermediate-term (between 5 and 10 years) to long-term (more than 10 years).
Most corporate bonds are rated by independent bond-rating agencies such as Moody’s Investors Service, Inc., and Standard & Poor’s Corporation on the potential of the company to both interest on time and the principal back at maturity. These agencies assign companies a letter-coded rating by to indicate their relative credit quality.
The higher-rated corporate bonds are considered investment grade and are usually well regarded companies. To be considered investment-grade, a bond must be rated BBB or better by Standard & Poor’s, or Baa or better by Moody’s. Corporate bonds with a lower rating or no rating are sometimes called high-yield bonds because of the higher interest rates they must pay to attract investors. These lower-rated corporate bonds, or “junk bonds,” are considered speculative because the issuers are believed more likely to default.
Municipal Bonds
State governments and municipalities to support their financial needs or to finance public projects issue Municipal Bonds. Interest paid on municipal bonds are generally free from state and/or federal income taxes which is why they are also known as tax-exempt, or tax-free, bonds. However, capital gains earned on a municipal bond investment, like capital gains on any security, are subject to federal and, possibly, state and local income taxes as well.
Like corporate bonds, municipal bonds come with a variety of ratings to reflect the fact that some state and local governments are financially stronger than others are. Municipal bonds, which have maturities ranging from less, than 1 year to 40 years, are usually most appropriate for investors in higher tax brackets.
Advantages of buying Individual Bonds
An investor can buy individual bonds through a brokerage house (and pay a commission) or you can also buy Treasury securities directly from the Federal Reserve with no commissions or fees (call 1-202-874-4000). The question for most investors is should I buy individual bonds or invest in a bond fund?
There are 3 reasons why investing in individual bonds is a better decision than buying a bond fund:
- Control of capital gains: By owning the bonds themselves, the investor chooses when to buy or sell the bonds and thus has control over the timing of any taxable capital gains or losses. If you own a bond fund, the fund manager controls this.
- No management fees. By holding the actual bond instead of a bond fund, you do not have to pay any professional management or record-keeping fee. Thus you keep all the income produced by the bonds before any applicable taxes.
- Fixed Maturity date: Individual bonds are great if you need a certain amount of money on a certain date. For example, if you know you have to pay a college tuition bill in twelve months if you buy a $1,000 bond that pays 5% interest you will receive $50 in interest and $1,000 in principal in the next year for a total value of $1,050. If you invest in a bond fund, you have no control over what your principal will be.
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Hey…I was enjoying reading this…where is the rest of it??
Sorry about that David. Somehow the bottom part of the post got erased. It is fixed now.