Bonds 101: Understanding Bond Ratings And Types Of Bonds

We recently kicked off a series of articles to help bridge the gap about bonds. Today, we’re going to cover bond ratings and types of bonds.

The average individual investor has little knowledge of the bond universe. But ignoring such a huge market means you may be leaving income on the table.

Our first article covered some basic bond terminology and discussed the relationship between price and yield. If you missed it, be sure to go back and read it if you want to learn more.

There is much more to say about bonds. But for today, we’ll stick with exploring bond ratings and types of bonds, as well as their benefits and risks. Let’s dive in…

Bond Ratings

Bond rating agencies, such as Moody’s and Standard & Poor’s (S&P), provide a valuable service to investors by grading fixed-income securities based on current research, indicating the likelihood of the issuer defaulting on interest or capital payments.

The S&P bond rating system ranges from AAA (the most secure) to C, while Moody’s ratings go from Aaa to D, meaning the issuer is already in default. Only bonds with a rating of BBB or better are considered “investment grade.” Bonds rated BBB are considered suitable for investment by institutions, while anything below triple B is considered “junk” or below investment grade. The ratings agencies periodically revised bond ratings based on recent data.

bond ratings table

Note: Treasury Bonds do not carry ratings. This is because the the United States backs the debt it issues by the “full faith and credit” of the government. This means the government has the power to levy taxes to pay its debts. For this reason, they are the safest investments.

Types of Bonds

Agency Bonds

Agency bonds are issued by U.S. government-sponsored entities and federally related institutions. The proceeds fund their operations. Examples include Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. These bonds are considered relatively safe investments, as they are backed by the full faith and credit of the U.S. government. However, it’s important to note that this backing only applies to the timely payment of interest and principal and does not guarantee the value of the bond itself.

Investors looking for a steady stream of income may find agency bonds attractive, as they often offer higher yields compared to other fixed-income securities. Additionally, because they are issued by government-sponsored entities, they may also appeal to investors looking for a lower-risk investment option.

Corporate Bonds

Corporate bonds are issued by companies and are used to raise capital for various purposes, such as funding new projects, financing acquisitions, or refinancing existing debt. Unlike agency bonds, corporate bonds are not backed by the U.S. government, which makes them a higher-risk investment option. They are also fully taxable. However, they also offer the potential for higher yields compared to other fixed-income securities.

Corporate bonds are traded on major exchanges and are often issued with a par value of $1,000.

Investors considering investing in corporate bonds should carefully consider the financial strength of the issuing company, as well as the specific terms of the bond. It’s also important to look at the company’s credit rating. It’s also important to consider the type of bond and its maturity date. Some corporate bonds have a fixed interest rate, while others have a floating rate that can change over time. Additionally, some bonds have a shorter maturity date, while others may have a longer term of several decades.

Investors may want to consider a mutual or exchange-traded fund focusing on corporate bonds for broader diversification.

Municipal Bonds

State and local governments issue municipal bonds, also known as “munis.” They fund various public projects, such as building schools, highways, or water treatment plants. Muni bonds offer tax advantages for investors, as the interest earned on these bonds is typically exempt from federal income taxes and, in some cases, state and local taxes.

Investors looking for a lower-risk investment option may find municipal bonds to be an attractive choice. As with agency bonds, municipal bonds are considered relatively safe investments because they are backed by the issuing government. However, it’s important to note that the financial health of the issuing government can impact the safety of the investment.

When investing in municipal bonds, it’s essential to consider the creditworthiness of the issuing government, as well as the specific terms of the bond. It’s also important to look at the issuer’s credit rating, which measures its ability to repay its debts. Governments with higher credit ratings are generally considered safer investments, while those with lower ratings carry a higher risk of default.

There are two general categories of municipal bonds:

Revenue Bonds are backed by the revenues generated by a specific project or agency.
General Obligation Bonds
are backed by the issuer’s full faith and credit or their taxing power.

Municipal bonds are further divided into two primary groups:

Public Purpose Bonds: Tax-exempt bonds.
Private Purpose Bonds: Taxable unless specifically exempted.

For broader diversification, investors may want to consider a mutual or exchange-traded fund focusing on muni bonds.

Treasury Bonds

Treasury bonds are debt instruments of the U.S. government issued in minimum denominations of $1,000. They typically have maturities of 10 years or longer. Treasury bonds carry the lowest degree of risk and serve as the benchmark against which all other bonds are measured. Although their market value fluctuates, they are considered the safest of bonds because they are secured by the full faith and credit of the U.S. government.

For broader diversification, investors may want to consider a mutual or exchange-traded fund focusing on treasury bonds.

Zero-Coupon Bonds

A zero coupon bond is a corporate bond that makes no periodic interest payments. Instead, it is sold at a deep discount from face value. The bond buyer receives the rate of return by the gradual appreciation of the security. This is redeemed at face value on a specified maturity date.

The IRS maintains that the holder of a zero coupon bond owes income tax on the interest accrued each year. The IRS calls this “imputed interest.” Because of this interpretation, zero coupon bonds are often used in retirement accounts where they remain tax-sheltered.

The Bottom Line

Understanding bond ratings and different types of bonds are crucial to making an informed investment decision. Be sure to weigh the benefits and risks of each bond issue before investing.

As we said in the previous article, bonds offer relatively low-risk income and are a worthwhile option for most investors. What we have covered here are bond ratings and various types of bonds. This is by no means meant to be an exhaustive overview of bonds.

Stay tuned for more follow-up coverage.

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