Differences Between Different Types of Bonds

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Within the Bond Market, there are a number of ways for investors to invest their money.

The term, “fixed income” applies to a person’s income that does not vary with each period.

What is Fixed Income?

If an investor lends money to a borrower, the borrower pays interest once a month and provides the investor with a fixed income in the form of a security. This is referred to as a bond or as a corporate debt when a company does this.

In contrast with return securities such as stocks, fixed income securities such as bonds are issued by corporations as a means of raising money in order to buy new equipment, or to pay for product development. Investors only consider giving money to a company if they believe that they will be given something in return, such as a pledge of part ownership in the company, company stock or the payment of regular interest based on the size of the initial investment, which is essentially the same as offering a bond.

Fixed Income Terminology

Bonds basically promise to pay interest on borrowed money. There are also a number of technical terms frequently used by bond traders and investors.

  • The Issuer is the entity, usually a company or a government that borrows money and pays interest to the investor.
  • The Principal is the amount of money that the issuer borrows.
  • The Coupon of a bond specifies how much interest the issuer must pay.
  • The Maturity is the bond’s end date, at which point the issuer must return the investor’s principal.
  • The Issue is the bond itself.
  • Indenture is the contract that states the bond’s terms.

People who invest in fixed income securities, such as a retired person, may want to receive a regular, dependable payment to live on, but at the same time, not consume principle. An investor can do this with a bond and use the coupon payments as regular income. When the bond reaches maturity, the investor’s money is returned.

In contrast, corporate bonds are issued by a corporation with the intent of raising money to finance the business.

The term “corporate bond,” is sometimes used to refer to all bonds that are not issued by governments.

What is a Corporate Bond?

Corporate bonds listed on major bond exchanges are also called listed bonds. However, the majority of bond trading that occurs in developed markets takes place in decentralized, over the counter, dealer based markets,

Some corporate bonds also include an embedded call option, allowing the issuer to redeem the bond before it reaches its maturity date.

Corporate debt falls into several broad categories.

  • Secured debt vs unsecured debt
  • Senior debt vs subordinated debt

As a general rule, more senior investors in a company’s capital structure have a stronger claim to the company’s assets in the event of a default.

Compared to government bonds, corporate bonds have a higher risk of default. The risk depends on the stability of the corporation issuing the bonds, as well as market conditions and government regulations. Corporate bond holders are compensated for this increased risk with higher yields than government bonds.

What is a Government Bond?

In comparison to a corporate bond, government bonds are issued by a national government in order to denominate its currency. Bonds issued in a foreign currency are called sovereign bonds.

Nations with high or unpredictable inflation sometimes find it economically unviable to issue bonds in their own currency. As a result, they may issue bonds in a more stable foreign currency.

The first government bond ever issued was issued by England in 1695 to pay for a war with France.

Government bonds are sometimes seen as more desirable by investors because they are considered to be risk free. If the government finds it self unable to repay the principal, it can simply raise taxes in order to redeem the bond when it reaches maturity. There are instances, such as the Russian Ruble Crisis in 1998, where a government has defaulted on its domestic currency debt, but such incidents are rare.

In the United States, Treasury Bonds are denominated in US Dollars. In this case the term “risk free” means that US Treasury Bonds are free from credit risk, however there are still other forms of risk, such as currency risk for foreign investors, as well as sudden changes to the inflation rate. Inflation risk means that the principal has less purchasing power when it is repaid. As a result, most government bonds are indexed in order to provide investors with protection from inflation risk.

Sources

Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall.

Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, New York, Harper Collins, 1995. 

Within the Bond Market, there are a number of ways for investors to invest their money.

The term, “fixed income” applies to a person’s income that does not vary with each period.

What is Fixed Income?

If an investor lends money to a borrower, the borrower pays interest once a month and provides the investor with a fixed income in the form of a security. This is referred to as a bond or as a corporate debt when a company does this.

In contrast with return securities such as stocks, fixed income securities such as bonds are issued by corporations as a means of raising money in order to buy new equipment, or to pay for product development. Investors only consider giving money to a company if they believe that they will be given something in return, such as a pledge of part ownership in the company, company stock or the payment of regular interest based on the size of the initial investment, which is essentially the same as offering a bond.

Fixed Income Terminology

Bonds basically promise to pay interest on borrowed money. There are also a number of technical terms frequently used by bond traders and investors.

  • The Issuer is the entity, usually a company or a government that borrows money and pays interest to the investor.
  • The Principal is the amount of money that the issuer borrows.
  • The Coupon of a bond specifies how much interest the issuer must pay.
  • The Maturity is the bond’s end date, at which point the issuer must return the investor’s principal.
  • The Issue is the bond itself.
  • Indenture is the contract that states the bond’s terms.

People who invest in fixed income securities, such as a retired person, may want to receive a regular, dependable payment to live on, but at the same time, not consume principle. An investor can do this with a bond and use the coupon payments as regular income. When the bond reaches maturity, the investor’s money is returned.

In contrast, corporate bonds are issued by a corporation with the intent of raising money to finance the business.

The term “corporate bond,” is sometimes used to refer to all bonds that are not issued by governments.

What is a Corporate Bond?

Corporate bonds listed on major bond exchanges are also called listed bonds. However, the majority of bond trading that occurs in developed markets takes place in decentralized, over the counter, dealer based markets,

Some corporate bonds also include an embedded call option, allowing the issuer to redeem the bond before it reaches its maturity date.

Corporate debt falls into several broad categories.

  • Secured debt vs unsecured debt
  • Senior debt vs subordinated debt

As a general rule, more senior investors in a company’s capital structure have a stronger claim to the company’s assets in the event of a default.

Compared to government bonds, corporate bonds have a higher risk of default. The risk depends on the stability of the corporation issuing the bonds, as well as market conditions and government regulations. Corporate bond holders are compensated for this increased risk with higher yields than government bonds.

What is a Government Bond?

In comparison to a corporate bond, government bonds are issued by a national government in order to denominate its currency. Bonds issued in a foreign currency are called sovereign bonds.

Nations with high or unpredictable inflation sometimes find it economically unviable to issue bonds in their own currency. As a result, they may issue bonds in a more stable foreign currency.

The first government bond ever issued was issued by England in 1695 to pay for a war with France.

Government bonds are sometimes seen as more desirable by investors because they are considered to be risk free. If the government finds it self unable to repay the principal, it can simply raise taxes in order to redeem the bond when it reaches maturity. There are instances, such as the Russian Ruble Crisis in 1998, where a government has defaulted on its domestic currency debt, but such incidents are rare.

In the United States, Treasury Bonds are denominated in US Dollars. In this case the term “risk free” means that US Treasury Bonds are free from credit risk, however there are still other forms of risk, such as currency risk for foreign investors, as well as sudden changes to the inflation rate. Inflation risk means that the principal has less purchasing power when it is repaid. As a result, most government bonds are indexed in order to provide investors with protection from inflation risk.

Sources

Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall.

Mishkin, Frederic S., The Economics of Money, Banking, and Financial Markets, New York, Harper Collins, 1995.

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