Lesson 2: Bonds

Exploring the Different Types of Bonds
A wide range of bonds exists, each with unique characteristics depending on the issuer. Issuers can offer different features on these bonds, use various underlying assets to generate returns, or change the repayment methods. Bonds can vary greatly, but some features are exclusive to specific types of bonds; for example, municipal bonds are often tax-exempt. However, bonds cannot have more than one issuer or conflicting features, like being both coupon and zero-coupon.

Although this variety is advantageous for both corporations and investors seeking specific bonds for their needs, understanding these options requires more effort than choosing everyday products.

Considering corporate bonds
Corporate bonds are issued by corporations to raise capital through debt. These bonds are particularly significant for corporate finance. While there’s nothing exceptionally unique about them, the performance metrics used to assess the investment risk are critical. Corporate bonds play a vital role for both investors and issuers, making them an important topic in corporate finance.

Gauging government bonds
Governments, like corporations, issue bonds to raise capital. Governments are some of the largest and most popular bond issuers globally. They issue bonds to fund spending when their expenditures exceed revenues. In some cases, bonds are issued to finance specific projects rather than general deficits. For instance, a government might sell bonds to build a power plant, repaying the bonds with the profits generated by the plant.

The following sections briefly cover different types of government bonds.

Treasury bonds
Treasury bonds (T-bonds) are long-term government debt instruments that mature in 1 to 30 years. They carry high interest rate risk but are also highly liquid, making them popular with investors.

In the United States, there are several types of treasury bonds, often referred to as different “series”:

• Standard T-bonds pay coupon interest every six months and are highly tradable.

• Series I bonds are non-traded savings bonds with values ranging from $25 to $5,000, generating returns based on a fixed interest rate and inflation.

• Series EE bonds offer a fixed interest rate return and have values ranging from $25 to $10,000.

Some bonds continue to pay interest after maturity if they are not withdrawn.

Treasury notes
Treasury notes are shorter-term than treasury bonds, lasting from two to ten years, with values ranging from $100 to $5 million, in $100 increments. They have varying interest rates and can be sold at prices other than face value, depending on demand.

Treasury bills
Treasury bills (T-bills) have the shortest maturity among treasury investments, maturing in less than a year. They offer low returns and have a face value starting at $100. Sold at a discount, T-bills reach full face value upon maturity.

T-bills are considered risk-free investments due to their short maturity and the low default risk of the issuing government. They set the benchmark for assessing the risk and return of other investments. Investments with higher risk must offer higher returns than T-bills. This concept is explored further in later chapters.

Treasury TIPS
Treasury Inflation-Protected Securities (TIPS) are a special type of treasury bond that adjusts for inflation. The principal value of TIPS is pegged to the Consumer Price Index (CPI), providing interest payments twice a year while protecting against inflation risk.

Treasury STRIPS
Separate Trading of Registered Interest and Principal Securities (STRIPS) are treasury bonds engineered to separate interest payments from principal repayment. This allows investors to purchase either the interest payments or the principal repayment, effectively creating two distinct investment opportunities.

Municipal bonds
Municipal bonds are issued by smaller government entities, such as states, counties, cities, or municipalities. They come in two types:

• General obligation bonds, similar to T-bonds, raise capital and are repaid through taxation and fees.

• Revenue bonds fund specific projects expected to generate revenue, which is used to repay the bonds.

The key advantage of municipal bonds is their potential tax-exempt status, making them attractive to investors seeking tax-free returns.

Clipping coupon bonds
The term coupon bond originates from the era when bonds were physical paper with attached coupons representing interest payments. Today, coupon bonds still exist, but they no longer require physical coupons. Instead, interest payments are made periodically, similar to the traditional method.

In contrast, zero-coupon bonds do not make periodic interest payments. Instead, they are sold at a deep discount and pay the full face value upon maturity.

Backing up with assets
Asset-backed securities, though not technically bonds, function similarly to municipal revenue bonds. Corporations issue these securities to raise capital, repaying investors with the revenues generated by the underlying assets.

For example, a bank might issue an asset-backed security to raise funds for a business loan, repaying the security with the interest earned from the loan.

Mortgage-backed securities are a specific type of asset-backed security backed by mortgages. These securities gained notoriety during the 2007 financial crisis, as they were used to distribute the risk of subprime mortgages, leading to widespread financial losses when those mortgages defaulted.

Converting bonds
Convertible bonds offer the flexibility of converting the bond into a predetermined number of shares of stock. This allows investors to benefit from rising stock prices while still holding a bond that guarantees returns if the stock underperforms.

For corporations, issuing convertible bonds can raise equity without causing investors to doubt the stock’s value