Investing in Bonds 101: Background (cont.)
Part 1 or 3, page 2
Federal Bonds
These are issued by the U.S. federal government, more specifically the Treasury Department which controls the nations money. These federal government bonds are issued when our government needs to borrow money to cover over spending, pay its debt, when our national budget is not balanced. A U.S. Treasury bond term, or maturity, range from 3 months to 30 years and are backed by the full faith in our government and its ability to make good on all of its debts. Since the U.S. government guarantees payment of interest on these bonds, the risk of default is low. The federal government can always secure more funding through additional taxes, raising inflation, or even by printing more money to help pay its debts. In addition, the interest payments are often tax free. Many retirees like investing in these as they provide a regular and dependable income with low risk, when compared to stocks or other investments.
State and Local Bonds
Similar to the federal government, bonds are issued by state and local governments which are offered to the public in the hopes of securing funding for a variety of projects. The chance of default on these types of bond is slightly greater than the federal government. State and local governments can try to increase taxes, but unlike the federal government cannot print more money or raise inflation. In some ways, these state and local government issued bonds compete with corporate bonds for an investor's money.
To help make these bonds more attractive, the federal government has allowed them to be issued free from federal income tax. States and local governments also have the option of making them free from state and local income tax as well. These types of bonds are called tax free municipal bonds – your will also hear the them referred to as munis.
Government Agencies Bonds
Ginnie Mae, Fannie Mae, Sallie Mae and Freddie Mac were government created entities, then, during the Reagan years, were privatized and under the Obama administration put them again under government control. Each of these agencies was created by the federal government to provide a robust lending market by buying up loans, funded in part by the sale of bonds and federal tax dollars. In the case of Sallie Mae, it is involved in student loans. For the other agencies in this group, the focus was on creating and maintaining a robust mortgage market.
The bonds these agencies issue are backed by the federal government which means the risk of default, or credit risk, is low, but as we saw, in the Recession of 2007 (while they were privatized in the years before 2008) they may have in part contributed to the increased risks of investors - investor's holding what is called “toxic assets” in ARM mortgages. These mortgages were falsely rated higher than should have been and bundled with loans rated much higher and resold as bonds. It was greed out of control to the point where those selling these investments got rich and investor’s lost out.
Corporate Bonds
As mentioned above, larger companies and corporations can raise money, also referred to as capital, by issuing bonds. The interest rate on corporate bonds is often higher than government issued bonds and are directly related to the associated risk. If a company performs poorly, then there is a greater chance, risk, they will not be able to pay the interest to the bond investors and the chance of default also goes up. But, despite this, many investor’s like these as they have a higher rate of return on investment.
The higher the perceived risk associated with a particular company, the higher the interest rate will be on the bonds they issue to entice the public into buying their bonds. Bonds which have been deemed by ratings agencies to have a lower quality are termed junk bonds.
Next, bond terminology and calculating bond yields.>>>
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