What Are the Different Types of Bonds?
Learn The Different Types Of Bonds
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What Are the Different Types of Bonds?
From an investor’s point of view, understanding what are the different types of bonds on offer today means being able to make a more informed decision about which, if any, to invest in. Bonds of all kinds are financial investment products and they can often outperform traditional investment models. Before we examine the different types of bonds on the market, it will be beneficial to look a little closer at what bonds really are. Surprising though it may seem, some people who invest in corporate bonds or even government bonds do so without having a complete picture of what constitutes a bond investment.
The History Of Investment Bonds
Firstly, it should be mentioned that bonds have been a way of successfully raising finance for thousands of years. Rulers of city states would sometimes offer bonds – which promised a repayment against them in the future – so that they could purchase grain, for example. Indeed, the Mesopotamian city of Ur had an entire market devoted to bonds over 4,000 years ago. As such, no one should be put off investing in a government bond because it is a newfangled investment product – it is, in fact, one of the oldest. Essentially, issuing a bond allows a business or a municipal body to obtain money in the relative short-term.
Why Do Investment Bonds Exist?
Some companies that don’t wish to borrow money from financial institutions or sell equity in their business use them routinely as a means of generating working capital. Without the need to issue shares on a stock market, any organisation can borrow money from individuals and other businesses which are willing to buy bonds. Effectively, the bond is a form of credit that the issuing company or public body promises to repay in full and, most importantly, with interest. Although bond types vary significantly, they all share this feature. High yield bonds may offer greater interest rates and some fixed rate bonds may provide a steadier return, but the primary reason you would take one out is to achieve a return on your initial investment.
The Lengths Of Investment Bonds
Another key point about bonds is that they run over different lengths of time. Some short-term government bonds, for instance, will mature after as little as twelve months. In certain business environments, where longer term investments are needed to achieve a substantial return, corporate bonds might be offered over 5 or 10 year terms. A good example of this would be in the renewable energy sector where companies that issue biofuel and wind plant bonds require a reasonable length of time in order to establish themselves in the energy market.
Term To Maturity
Whichever sector of the economy that a bond is issued in, the length of time that it will take to come to fruition for an investor is referred to as its term to maturity. Anyone considering making an investment in a bond ought to have a good understanding of what sort of investment terms they should be looking at given their personal attitude to risk and wealth management goals. Thankfully, expert help is available to guide you through the entire process of selecting the right sort of bond for you.
Now we have established the key features of both corporate bonds and government bonds, it is time to look a little further into the major differences between various bond types. Read on to discover what are the different types of bonds available to UK investors these days.
What Are the Different Types of Bonds Issued By Governments?
Government bonds are used by national governments to raise funds for infrastructure projects as well as day-to-day expenditure. In the UK, government bonds are sometimes referred to as gilts. A three year gilt is simply a government bond issued by the UK government with a term to maturity of three years. Often issued as fixed rate bonds, these sorts of investment are incredibly stable because – at the most fundamental level – they are secured against the government’s own coffers and the revenue derived from UK taxpayers.
As well as UK investors, government bonds often attract investors from overseas who might want to shift their money into another location, perhaps because of economic uncertainty at home. Buying a UK government bonds means being able to invest in the UK without needing to worry excessively about the vagaries of the international currency markets. Indeed, the same is true of UK investors who are looking to create a portfolio of investments which go beyond British shores. Foreign bonds are also available to UK citizens who wish to invest in them instead of, or as well as, home government bonds. In the US, government bonds are referred to as Treasury bonds because they are issued by the Federal Treasury.
About Treasury Bonds
In fact, in the US, bonds issued by the Treasury are only called bonds if they have ten or more years left to run until they mature. Those which will mature within the next year are known as bills while notes are any bonds which have between one and ten years left to run. Although this terminology can be confusing to UK investors who may be more used to dealing in government gilts, there is little difference between them – they are all government backed bonds of some description.
Why You Might Invest In A Government Bond?
You might consider making an investment in a bond issued by a government for any number of reasons. One of the main ones is that they offer a very stable return and, as such, they often tend to suit the more cautious type of investor. However, it is not only national governments that issue bonds to investors. You could also opt for local authority bonds in UK markets, too. These are issued as a way for local councils to secure financing without the need to go to traditional sources of credit, such as banks.
UK Municipal Bonds
UK municipal bonds are issued to investors so that county councils and unitary authorities have access to lower cost credit which can be spent on local infrastructure and things like housing projects. These sorts of investments are ideal for people who want to see a good return on their investment whilst helping to improve their local community by allowing a council close to them to gain access to credit at reasonable rates.
What Are the Different Types of Bonds Issued By Corporations?
If you are looking at some of the best bonds to invest in, then you should certainly consider the merits of corporate bonds as well as those issued by the government. Investment-grade corporate bonds are often able to offer a higher rate of return than those which you would find in the public sector and it is for this reason alone that many people prefer them. Terms to maturity vary greatly in the corporate bond sector with anything from short-term corporate bonds of a few years right through to long-term bonds that run over a decade being available.
When a highly rated company issues a corporate bond, it is referred to as being of investment grade. However, investment-grade corporate bonds are not the only type available. Those which are issued below a so-called investment grade are known as high-yield bonds. In both cases, bonds issued by corporations are more likely to offer a more attractive rate of return than those issued by governments. A brief comparison of fixed-rate bonds on the private and public sector will bear this out.
High Returns On Corporate Bonds
The principal reason that corporate bonds pay at a higher rate then government ones is that they incur a greater level of risk whether you are looking at investment-grade or high-yield bonds. Essentially, this is because private sector operators are more likely to default on debts than governments. As such, corporate bonds suit investors who have a freer attitude to risk than those who would restrict themselves to more cautious, government-backed investments only.
Advantages Of Corporate Bonds
Of course, a major advantage of corporate bonds is that they offer an opportunity to invest in a manner which really suits your personal attitude toward risk. Taken as a whole – from investment-grade to high yield bonds – every type of investor is catered for with the range of interest rates and terms to maturity on offer. In fact, even those people who want to gain a stake in a company can benefit from the corporate bond market because convertible bonds are also available. This financial product works just like a conventional fixed-rate bond but it allows bondholders to convert their investment into company shares at a future date if wanted.
If a bondholder thinks that the share price of a company they hold a bond in is likely to rise, then a healthy profit can be generated this way. Of course, the reverse is also true if the rate of conversion between the bond and shares in the equity of the business is not so favourable. Nevertheless, many investors like the flexibility that this form of corporate bond affords them.
What Are Asset Backed Securities?
Although they are referred to as asset backed securities by the financial services industry, this form of investment really is a type of bond. Asset backed securities, also known as ABS for short, are bonds which have some collateral behind them. The financial assets that back this type of investment vary according to the issuing organisation. For example, an asset backed security might be issued by a bank which leverages the money it receives from loans that it has issued to its customers as an asset. As well as banks, other types of financial institutions offer the chance to invest in asset backed securities.
Who Else Uses Asset Backed Securities?
Common ones are car financing businesses and credit card companies. In fact, some mortgage lenders also secure funds making use of this type of security and these ones are sometimes referred to as mortgage-backed bonds. The important thing this that in all such cases, it is the future revenue stream that the business has from its own lending that is used as the asset which backs the security.
Why Do Company’s Use Asset Backed Securities
Financial institutions use asset backed securities as a way to attract inward investment. Sometimes, this is used to expand the business into a new commercial territory and sometimes it may be to use as working capital, that is, to provide new loans to customers. Many consumer finance companies use them in order to provide a pooled form of marketable security. The financial industry refers to this practice as securitisation. It is worth noting that asset backed security investments are nowhere near as old as bonds. In fact, the very first ABS to be issued was in the mid-1980s. However, they are a growing part of the bond market and understanding them is crucial if you want to gain a full picture of what are the different types of bonds.
Pools And Tranches
As mentioned, asset backed securities tend to offer investment opportunities over pooled financial assets, typically loans that have been issued. However, these pools are also commonly organised into different groups, known as tranches. The reason that similar asset pools are put into tranches is that they can be organised in a more rational way. For example, some tranches might have a similar interest rate associated with them.
Others might have a similar expected maturation date or contain loans within a pool that have similar rates of delinquency (non or late payments). It is only after a financial institution which offers asset backed securities has organised its tranches that these types of bond are sold to individual investors.
In the main, most of the securities that are marketed will be associated with the most attractive looking tranche. Known as the senior tranche, this type of investment opportunity will be regarded by many as the most stable and have an investment-grade rating that makes it appealing to a wide range of investors. Lower tranches will often contain riskier loans within them, often with credit that has been issued to people or organisations with lower credit ratings. However, higher yields can often be expected of asset backed securities that are derived from secondary tranches. As such, these sorts of security bond are worth looking at by people who want secure investments as well as people who have a less cautious attitude to risk.