Know Who Issues Debt Before Buying Bonds Online
Before you can buy or sell bonds, you must understand the several types of bonds, based on who sold them. Each type of bond has unique traits and can be bought or sold online differently. The following is a quick rundown of the major issuers of bonds:
U.S. government: Debt instruments sold by the U.S. government are popular because they’re backed by the full faith and credit of the United States, which stands behind these loans and promises that they’ll be repaid. That greatly reduces, if not eliminates, the risk that you won’t get paid. These fixed-income securities are often called Treasurys, and they come in three main varieties: Treasury bills mature in one year or less, Treasury notes mature in more than a year and up to 10 years, and Treasury bonds mature in more than 10 years. TreasuryDirect provides in-depth information about Treasurys.
Even if you’re not interested in buying bonds, the yield on Treasurys is a very important figure to keep in mind. Treasury yields tell you how much return you can get for taking little to no risk. If a risk-free Treasury pays 5 percent, you probably wouldn’t be willing to buy a risky stock unless it would return considerably more than 5 percent.
Treasurys are often called risk-free investments, but that’s not really true. Even Treasurys face interest-rate risk. Say you buy a Treasury that pays 3 percent interest. If inflation rises, and interest rates rise to 4 percent as a result, your 3 percent interest rate isn’t looking so hot anymore. If you sell the bond, you’ll get less for it than you paid. And if you hold onto the bond, your 3 percent interest rate is lackluster.
Government agencies and government-sponsored enterprises: Individual government agencies can also borrow money. Debt issued by agencies is still considered safe, while perhaps not as safe as Treasurys. That means agency bonds may pay slightly higher interest rates than Treasurys.
Some examples of agency bonds include those sold by the Government National Mortgage Association, or Ginnie Mae, to provide financing to low- and moderate-income families to buy homes. Ginnie Mae loans are backed by several government agencies. Similarly, you find lenders called government-sponsored enterprises (GSEs) that, although closely tied to the government and often created by Congress, are private companies and are therefore not technically agencies.
The Federal National Mortgage Association, or Fannie Mae, is a GSE that buys and sells mortgage-backed securities that pass interest and principal payments made by homeowners to investors who own the securities.
Agency debt is in flux as the rules were turned upside down after the financial crisis linked with mortgage loans erupted in 2007 and 2008. Agency debt isn’t technically backed by the federal government, so it’s considered to be riskier than Treasurys. Fannie Mae is a company sponsored by the federal government that used to have its stock listed on the New York Stock Exchange. Investors long believed that the government would quickly step in and intervene if there was trouble. These investors were right in 2008.
As the mortgage market was seizing up in 2008, the U.S. government essentially took over Fannie Mae and Freddie Mac by placing them into conservatorship. While the government took action in 2008, it wasn’t obligated to do so. Since then, the company’s stock was booted from the NYSE (although they still trade on the Over-The-Counter Bulletin Board marketplace). Uncertainty about what the government will do in the future makes agency debt a question in some people’s minds.
Companies: Bonds issued by companies, sometimes called corporates, allow them to pay for equipment and services they need in order to expand or grow. Companies pay higher interest rates than the government because there’s a larger chance they will default or hit hard times and have trouble paying back the money they borrowed. Bonds sold by rock-solid companies are called investment grade. Small companies or companies with shaky finances issue what’s called high-yield or junk-bond debt. Investment-grade bonds pay lower interest rates than junk bonds because investors are more certain they’ll get their money back.
Cities and municipalities: Cities may borrow money by selling bonds, called municipal bonds, or just munis. The biggest attraction of munis to investors is the fact that their interest often isn’t taxable by the federal government. And if you buy a muni bond issued by a government in the state or city you live in, the interest might also not be subject to state or city tax. Munis are often called tax-exempt bonds for this reason. You pay a price for this tax benefit, though. Munis often pay lower interest rates than bonds with similar risk. InvestorGuide.com provides more information about munis.
Don’t just look at the seemingly low interest rate offered by a tax-exempt muni bond when deciding whether you want to buy it. The actual interest rate is higher after you factor in the fact that the interest payments often aren’t taxable. For example, if an investor in the 28 percent tax bracket buys a muni bond paying 5 percent interest, that’s equivalent to a 6.94 percent interest rate from a taxable bond. And that’s a good thing. One other thing to remember: Not all muni bonds qualify for the tax breaks, so be sure to check before you buy one.
Want to compare the interest rate on a tax-exempt muni bond with a taxable bond? The Investing in Bonds website provides a table that converts tax-exempt interest rates to taxable rates for different tax brackets at. Vanguard’s taxable-equivalent yield calculator is more customizable, allowing you to enter different yields and tax brackets.