Financial Planning for Scientists, Part 9: An Introduction to the Bond Market, Part 2 Last month, we talked about a popular investment vehicle: the bond market. We learned about how the bond market works, how to read a bond table, and why you might want to invest in a bond. For the next 3 months, we'll be taking a closer look at the bond. This month, we'll examine the different kinds of bonds that are out there. Next month we'll learn what a bond's rating means, we'll look at some of the tax implications of investing in a bond (vs. a stock), and we'll talk about some of the risks you subject your money to when you invest in a bond. In our fourth and final installment on bonds, we'll be reviewing some other sites on the Internet at which you'll be able to get more information on how to invest in the bond market. This month's focus is on the different types of bonds that are available. By understanding who is issuing the bonds, and why, and some of the different types of bonds, you'll get a better understanding of how to choose the bond you want to invest in.
The Government Bond
The most common type of bond is a government bond. These are issued by governments to raise money (traditionally so that they can build highways, etc.). You know how we're always talking about government debt? Well, this is part of it.
Of course, the first question should be: "Which government?" Federal treasury bonds, U.S. or Canadian savings bonds, and T-bills are issued by the Federal government. Municipal bonds are issued by state, provincial, and local governments. Typically a U.S. treasury bond is one of the safest investments you can make--they're backed by the Federal government of the United States!
As you might imagine, other countries also issue bonds. Sometimes these bonds are issued in U.S. dollars, other times they're issued in the currency of that particular country. If you're buying a French bond (payable in Francs, for example) remember that you're subjecting yourself to both "country risk" (the risk that the country of France decides not to pay off their debts) as well as currency risk (the risk that the Franc loses some value compared to the dollar).
The Corporate Bond
"Commercial paper" is a bond that is issued by a company instead of by a government. The company (like the government) is essentially promising, "Give me your money, I'll pay you back later, and I'll pay you interest in the meantime." As you might expect, this kind of promise from a company has significantly higher risk than this kind of promise from a government--although the degree of risk depends on the company (and the government ...). Because the company has a higher risk of default, they will usually pay a higher yield.
Zero Coupon Bond
The zero coupon bond is a bond that doesn't pay any interest. Sounds absurd? It's not. Instead, the interest is built into the price of the bond when you first buy it. For example, a typical zero coupon bond will pay $100 at the end of its term and will pay 0% interest. As you might expect, if the term is 5 years away, the bond will sell for a whole lot less than $100. "Zero coupon" is just another one of those fancy terms that means something very simple.
Bearer Bonds vs. Registered Bonds
If you start investing in the bond market, you're likely to hear these two terms bandied about. A bearer bond is simply a bond that is payable to whoever the "bearer" is. Quite literally, whoever holds the piece of paper that actually is the bond is assumed to be the owner. Bearer bonds have "coupons" on them (usually one for every year of the bond's life) that you tear off to redeem your interest. A registered bond, on the other hand, has your name printed on it, or has a serial number and your name in a registry as the owner of that bond.
Bond vs. Debenture
Another term you might hear in the bond world (besides "shaken, not stirred") is "debenture." Traditionally, a debenture is a bond that is backed by the general assets of the corporation or government (and their promise to pay), whereas a bond is backed by a specific asset of the company or government. However, these days, the terms are used almost interchangeably. After all, most of the "bonds" we've talked about (such as municipal bonds) are really debentures.
A securitized bond is a bond that is "guaranteed" by a specific asset or income stream, instead of by a company. For example, if your local neighborhood biotech company wanted to raise money using a bond, they could do it in two ways: First, they could just issue a bond based on their company name and its general assets. But because they're a small biotech company, with high risk of default (i.e., a high risk of not paying off their debts), they would have to pay a very high interest rate in order to make the bond attractive enough for investors to purchase it. This, of course, is very expensive for the company. A second way of issuing the bond would be to issue it based on a specific asset of the company. For example, if the company has a really good patent, they could use the patent to guarantee the bond--promising the patent to the bondholders should the company default in its payments. Better yet, the company could promise its bondholders all of the revenue that is going to come into the company because of the patent. Investors could determine what that sum is going to be, over time, and this (relatively) guaranteed income stream could act as a "security" for bondholders, allowing them to buy the bond with lower risk--thus making the bond more attractive, even at a lower rate of interest. Next month we'll continue our chat about bonds. We'll discuss bond ratings, tax savings, and risks to investing in the bond market.