The Retirement Corporation of America

Surveying The Bond Universe

FOR ALL THE complexities of the bond market, all bonds tend to fall into just four categories: Treasuries and other federal-government agency securities, corporates, tax-exempt municipals and mortgage-backed securities.

Now let's take a closer look at each of these categories. This should give you a good idea of the pros and cons of investing in different kinds of bonds and help you start narrowing down which type you think you might want to own.

The World of Treasury Securities

Other kinds of bonds nearly always pay higher interest rates. But only Treasuries are backed by the credit of the U.S. government, the strongest government in the world. When investors anywhere around the globe get nervous about the safety of their money, they flock to Treasuries.

The rates on Treasury bills and on longer-term Treasury bonds and notes are bellwether rates that sets the level of rates on all other bonds. That's because they best reflect the true cost of risk-free capital.

The government sells Treasury securities—bills, notes and bonds—to finance our national debt. Even with the debt under control these days, and actually shrinking, it still amounts to $6 trillion—meaning there are a lot of Treasury securities out in the bonds.

Treasury bills come in maturities of three months, six months or one year. Medium-term Treasury notes mature between two and 10 years and long-term Treasury bonds have maturities of up to 30 years.

Treasury securities of all kinds are extremely liquid. You can buy or sell them any time. As noted earlier, they also can't be called away from you before they mature. So, buying a Treasury guarantees you the rate it's paying for the life of the bond.

Treasuries also offer some tax advantages. The interest on these securities is free from state and local taxes. But you still have to pay federal taxes on that income.

Treasury Bills. Nearly half the debt sold to finance the operations of the federal government is sold in the form of these short-term Treasuries.

The government regularly sells new Treasury bills in auctions. Three-month and six-month bills are auctioned every week (usually on Mondays). One-year bills are auctioned once a month (usually on Thursdays).

Treasury bills are sold in denominations of $1,000 each. You can buy them from almost any bank or brokerage house, or you can buy them directly from the Federal Reserve.

You don't really earn a rate of interest on a Treasury bill. They are sold at a discount and paid off at maturity at face value. To explain that, let's say you have $10,000 to invest in one-year Treasury bills, and you have chosen to buy directly from the nearest branch of the Federal Reserve. (How the process works will be explained later in this lesson. You can reach the nearest branch of the Fed by looking up Federal Reserve in the government pages of your phone book.)

In this case, when you buy those Treasury bills, you send the Federal Reserve Bank a check. Immediately after an auction, you get a "discount" payment back, which is the difference between the bill's face value and its lower auction price.

For example, suppose you sent the Fed a check for $10,000 for a one-year bill that ends up being auctioned for $9,000. The Treasury would send you back $1,000, which is called the "discount rate." And when your Treasury bill matures, you would get back your $10,000—giving you a profit of $1,000. In this case, you would earn 10% on your investment.

But your yield is actually higher because you bought your bill at a discount. In this case, you only paid $9,000 and got back $10,000. A $1,000 return on your $9,000 investment is 9%. This is called the bill's coupon-equivalent yield. It's the measure you should use when you're deciding on whether to put some money in T-bills or invest it elsewhere.

•  When to buy Treasury bills: They're the safest short-term parking place for cash.

Treasury Notes. They mature in two, three, four, five, seven or 10 years. The minimum investment for Treasury notes of all maturities is $1,000.

You can buy from a bank or brokerage house—or, again, from the Federal Reserve. The Fed auctions off notes, selling different maturities at different times throughout the year. Call your nearest Federal Reserve branch for a schedule.

To buy notes, you send the Fed a check for the face amount of notes you want. Right after the auction you will get a small check back, because notes are only sold at a small discount to their face value.

The best advice is not to buy Treasury bills and notes from a bank or a brokerage firm, where you'll pay a sales charge. Instead, buy them commission-free from the nearest Federal Reserve Bank or branch.

•  When to buy Treasury notes. Very short-term notes, those that mature in just two or three years, are a good place to hold money you want to keep on hand for emergencies. They pay higher rates than money market funds while exposing you to very little extra risk. Buy inflation-indexed notes. As noted earlier, they pay a fixed yield plus the current rate of inflation. Short-term bills and intermediate notes are also a good place to put money you think you'll need in five years or less for other things—college tuition, retirement or a special vacation. They ensure that you won't have to sell them at a loss to finance these kinds of major expenses.

Treasury Bonds. They have maturities of as long as 30 years. You buy them for $1,000 each and they are auctioned periodically like Treasury notes and bills. They also sell at a discount to their face value and your yield is determined the same way. You get interest payments from a Treasury bond twice a year.

A word of warning is necessary about Treasury bonds: they are fast becoming an endangered species. With the government running budget surpluses, and actually paying down the national debt, bit by bit, it no longer makes sense to keep paying the higher interest rates it must pay to sell what amounts to a 30-year IOU. So, Uncle Sam has stopped selling 30-year bonds and is actually buying them back from investors.

How long the surpluses will last, and whether 30-year bonds vanish from this earth, cannot be said at this point. As long as they do exist, and as long as the supply is dwindling, 30-year bonds figure to sell at premium prices, simply for their scarcity value. You could do worse than stick some long-term investment capital into 30-year Treasury bonds—earning a nice rate of interest while the bonds are outstanding and probably collecting a premium price over other bonds if you decide to sell.

•  When to buy Treasury bonds: For safety and simplicity, you can't beat Treasuries. You know the bond will never be downgraded or in default. But only buy long-term Treasuries if you plan to hold them to maturity. Even though the market for all kinds of Treasury securities is very liquid, the prices of older bonds fluctuates as they trade in the secondary market. The prices of long-term Treasuries are more volatile than the prices of shorter-term T-notes and T-bills.

U.S. Treasury/Government Funds

Instead of buying individual Treasury bills, notes or bonds, you can take the path of least resistance and invest in a government bond mutual fund. Such funds may buy only Treasury issues, or they may purchase a combination of both Treasuries and federal government agency securities. You can purchase shares in funds that are short-, medium- and long-term. All the rules you learned about investing in mutual funds apply to investing in government bond mutual funds.

Federal Agency Securities

They are bonds issued by almost two dozen different government-sponsored organizations for a variety of purposes.

The chief advantage of buying these bonds compared with Treasury securities is that they typically offer higher rates. You can often get rates on these bonds that are anywhere from one-quarter of a percentage point to a full percentage point higher than the rates on Treasuries with the same maturities. Like most other kinds of bonds, they pay interest twice a year.

You'll find the prices of the most actively traded agency securities listed in the financial pages. They are offered by:

•  The Federal National Mortgage Association (FNMA, which is nicknamed "Fannie Mae").

•  The Government National Mortgage Association (GNMA, which is nicknamed "Ginnie Mae").

•  The Student Loan Marketing Association (SLMA, which is nicknamed "Sallie Mae").

•  Federal Home Loan Banks.

•  The World Bank.

•  The Inter-American Development Bank.

The market for these securities is much smaller than the market for Treasuries. So, agency securities are less liquid. There are some other key differences between Treasuries and government agency securities:

1. Agency securities don't always have the explicit backing of the U.S. government. After all, they aren't issued by the U.S. government, but by an agency of the U.S. government. But they are considered as safe as Treasuries because the federal government has never allowed any of its agencies to default on its bonds.
2. You have to buy agency securities through a broker. You can't buy them directly from the agencies that issue them. Most of these bonds are sold in denominations of $1,000. But some of these bonds are only sold in very large face amounts--as high as $25,000--which puts them out of the reach of many individual investors.
3. These securities are less actively traded than Treasuries. So, the difference, or spread, between their bid and asked prices is typically wider than it is for comparable Treasuries. Because the market is smaller, the prices of these securities also tend to be more volatile, especially when an agency has troubled borrowers. For example, the yields on many bonds issued by the Federal Home Loan Banks fell in the 1980s, when they were dealing with a large number of failing savings and loan associations.

Unlike Treasury securities, government agency bonds are underwritten by brokerage firms. Those firms, in turn, sell them to investors. Brokerage firms that helped underwrite a particular bond offering continue to make a secondary market in those bonds.

Some agency securities have maturities of as long as 30 years. The most common maturity is 15 years, but these agencies also issue short-term notes that mature in five years or less.

Agency issues do share one feature in common with Treasuries: Their interest is exempt from state and local taxes, but not from federal income taxes.

As you've learned, many U.S. Treasury/Government funds buy these securities. Income from these funds is taxed the same way.

Ginnie Maes, Fannie Maes, Freddie Macs. These federal agencies create pools of their mortgages and then sell participations in them to investors.

Ginnie Maes are the highest-yielding government-backed security you can buy. They often boast current yields that are 0.5% to a full percentage point higher than Treasuries with the same maturities. Their big drawback is that the minimum to invest is usually $25,000--a bit stiff for many investors. So, if Ginnie Maes intrigue you, buy them through a mutual fund. There are scores of Ginnie Mae funds—one from virtually every major mutual fund family.

Ginnie Maes are the only mortgage securities that have the federal government's explicit backing. That makes them a bit different from similar securities sold by Fannie Mae and Freddie Mac (the Federal Home Loan Mortgage Corporation). Because they do carry that higher interest rate and because they do have the backing of the U.S. government, Ginnie Mae funds are widely purchased to be held in retirement savings accounts.

When it comes to Fannie Maes and Freddie Macs, the federal government only guarantees they will pay investors their interest and principal on time. As a practical matter, that's a distinction without much of a difference.

But Fannie Maes and Freddie Macs do pay slightly higher yields than Ginnie Maes—typically it amounts to about .25%. All of these securities are virtually as safe as Treasuries.

•  Buy Fannie Maes or Freddie Macs to get that extra .25% yield.

•  Buy Ginnie Maes for total safety.

Of all the kinds of mortgage-backed securities, Ginnie Maes are by far the best known to most individual investors.

If owning a Ginnie Mae fund appeals to you, here's more detail on how they work. Ginnie Maes are a pool of individual mortgages insured by the Federal Housing Administration or guaranteed by the Department of Veterans Affairs. You may even have a mortgage that is guaranteed by one of these agencies. Millions of homeowners like you do. When you buy a Ginnie Mae certificate, you get a share of every homeowner's payment on mortgages in that pool.

When a homeowner pays off one of these mortgages early, you also get a share of that prepaid principal. Ginnie Mae securities are called "pass-throughs" because the money paid in by the homeowner is passed through to you, as current part owner of that mortgage.

That makes Ginnie Maes different from bonds. When you buy a bond, the income check you get every six months is 100% interest. When the bond reaches maturity, you get your principal back.

However, when you own a Ginnie Mae, you get income every month. And, your checks are a combination of two things:

1. Interest you've earned on your investment.
2. A repayment of part of the principal you originally invested.

The size of your check varies each month, depending on how fast mortgages in the particular Ginnie Mae pool you've invested in are prepaid. That means Ginnie Maes aren't for you if you need a predictable amount of fixed income to live on.

There are more drawbacks to owning Ginnie Maes:

•  The yield you may be promised when you buy a Ginnie Mae is only an estimate. How much you make on your investment depends entirely on how fast the mortgages in the pool you have an interest in are prepaid.

•  Prices of Ginnie Maes fluctuate, as do prices of all bonds. You're likely to lose money if you have to sell a Ginnie Mae before it matures.

Ginnie Maes and other mortgage-backed securities often have stated maturities of 20 or 30 years. But they are typically priced and traded on the basis of their "average life," which is usually much shorter. When mortgage rates fall, homeowners often prepay their mortgages. Other homeowners refinance and pay off their old loans. As a result, Ginnie Maes have an average life of about 12 years. Since your principal is being paid back to you a little bit every month over the life of a Ginnie Mae, you don't get anything when a Ginnie Mae matures. All of your principal has already been returned to you.

Ginnie Mae funds work just like any other mutual fund. One of the biggest advantages of owning a fund over an individual Ginnie Mae is that the fund manager is constantly reinvesting all the principal that's coming back as the mortgages in the pool are repaid. When you own an individual Ginnie Mae, you may get this principal back in small amounts that are much harder to reinvest at a decent rate.

Just like any other mutual fund, the price of a Ginnie Mae fund rises and falls, however. If you buy a Ginnie Mae fund, read the prospectus carefully to see exactly what kind of mortgages it buys. Some funds that call themselves Ginnie Mae funds also buy interests in other types of mortgages.

•  When to buy Ginnie Maes. They can be attractive fixed-income investments for their high yields. But buy them for your IRA or other tax-advantaged account. The income from a Ginnie Mae is taxed at the federal, state and local levels.

Corporate Bonds

They are riskier than government securities—anywhere from somewhat riskier to a whole lot riskier, depending on the creditworthiness of the issuer. When you buy a corporate bond, you run the risk that it may fall on hard times, causing its credit rating to go down. If that happens, the price of your bond will also go down. Corporate bonds also sometimes default.

So, they pay higher rates than any kind of Treasury or government-agency security. Most corporate bonds pay fixed rates of interest semiannually. They are usually sold at or about their face value in registered name. Their maturities may be anywhere from about five years to 30 years.

The yield on a new bond is fixed by its coupon rate. But as you've learned, you have to calculate a bond's yield to maturity to compare one corporate bond with another one.

There are two kinds of corporate bonds: secured and unsecured.

1. Secured. Many companies can't borrow simply on their good names. That's why a great number of corporate bonds are secured bonds. These bonds are typically backed by collateral such as real estate or equipment. If the company goes bankrupt, holders of debentures (which are bonds backed only by the good name of the issuing company) get paid ahead of stockholders just like other bond investors.
2. Unsecured. The strongest companies in the country—AT&T, General Motors, Microsoft and the like—can borrow simply on the strength of their good names. Investors don't demand security or collateral because they have no doubts about getting their money back. So big, financially sound companies like these are able to issue unsecured debt.

A company may also issue subordinated debentures. If the company goes belly-up, the holders of subordinated debentures have to get in line for their money behind people who own debentures, but they still get paid ahead of stockholders. Because they have a weaker claim on corporate assets, subordinated debentures usually pay higher rates than debentures.

The minimum investment for bonds listed on one of the major stock exchanges is usually $1,000. For bonds sold in the over-the-counter market, the minimum is typically $5,000. That buys you five bonds, each with a face amount of $1,000.

There are two good reasons to buy newly issued corporate bonds vs. older bonds trading in the secondary market:

1. Newly issued bonds don't have sales charges. When you buy outstanding bonds, you often wind up having to pay hidden mark-ups.
2. It's simpler to buy new bonds. The prospectus for a new issue will tell you the bond's coupon rate, its yield to maturity, credit rating and which brokerage firms have underwritten the issue. If you buy a bond in the secondary market, you have to calculate its yield to maturity yourself (depending on whether you buy it at a premium or a discount to par, or its face value) and research the rating and the terms of the issue.

If you have a broker, he or she should be able to tell you about new financings that have been scheduled. Ask your broker for a prospectus.

The Wall Street Journal, Investor's Business Daily and many other newspapers regularly publish calendars of upcoming new bond offerings.

As a rule, the most actively traded corporate bonds have the smallest spreads between the bid and the asked prices. The biggest spreads are on the most thinly traded bonds.

Corporate bond interest is taxed at the federal, state and local levels. So, you should also keep them in a tax-deferred retirement plan like your IRA or Keogh.

Avoid buying corporate bonds that have special drawbacks, like onerous call provisions. That means the bond can be "called" in for repayment before the maturity date. Let's say that interest rates were high, but now have fallen. You bought the bond because it pays a nice, rich rate of interest. The company calls the bond because it now can sell new bonds at a lower interest rate. You do get back all the money you loaned to the company when you bought the bond. But you now reinvest the money at the current lower rates of interest.

•  When to buy corporate bonds. You may want higher rates than Treasuries offer. Depending on your federal tax bracket, you might net more after taxes with corporates than by buying tax-exempt municipals.

Corporate Bond Funds. As a rule, they stick to high-quality bonds of well-known companies considered the best credit risks. Your biggest concern if you buy one of these funds, then, should be the portfolio's average maturity. Read the fund's prospectus to find out what it is.

Convertible Bonds. Other bonds simply pay a rate of interest during the life of the bond, and pay back the principal when the bond matures. That's it. You have no chance to become an owner of the company, as you would have by buying the company stock. Convertible bonds split the different. They pay interest like any other bond. But, they also are exchangeable for a specified number of shares of a company's stock at a certain price. That price is always below the current market price.

That combination of bonds and stocks can be a very good thing. If bond prices are falling while stock prices are staying up, the convertible feature will keep the convertible from falling as far in price as other bonds. If both stock and bond prices are rising, the price of the convertible will rise faster than that of other bonds, because it can be converted into common stock.

It's not all milk and honey, though. You also have to make sacrifices to buy a convertible. If you like the company, you're usually better off simply buying its stock, or investing in its regular bonds, which pay higher rates.

•  When to buy convertible bonds. They're attractive when the stock market's direction is uncertain. If stock prices rise, the price of the convertible will tend to rise as well. If stock prices fall, you still earn a nice rate of interest on the bond.

Municipal Bonds

They are issued by states, counties, townships and local governments and come in two basic types: general obligation bonds and revenue bonds.

Municipalities sell general obligation bonds to finance their operations and back them with their taxing authority. The city of Chicago would sell general obligation bonds to fund the city's budget and back them up with its authority to collect the taxes that will pay off the bonds. The city of Chicago might also sell revenue bonds to build a new sports arena. They would be paid off by revenue the arena generated. Municipals (munis) typically pay fixed rates of interest for 30 years.

The two important things to remember about municipals:

1.  They pay lower rates than corporate bonds because they offer tax advantages. The interest on munis is exempt from federal income tax.
2. If you live in the state where the bond was issued, the interest is usually also exempt from state and city taxes.

So, depending on your tax bracket, you can earn more from a municipal than you can from a fully taxable corporate bond.

How do you decide whether to buy taxable or tax-exempt bonds? You look at the yield on a muni bond. Then you see how much you would have to earn on a similar corporate bond to net the same amount after taxes. This is the muni's "taxable equivalent yield".

For example, suppose you're in the 27% tax bracket and can buy a tax-exempt municipal with a current yield of 5%. To earn the same amount after taxes, you would have to buy a corporate bond with a current yield of 6.85%.

Don't worry about having to figure tax-equivalent yields. Brokers, banks and mutual fund companies that offer both taxable and tax-exempt funds will do it for you. All you have to tell them is your taxable income and they will compare yields for you and tell you whether you'd be better off in taxables or tax-exempts.

That doesn't mean investing in municipals is entirely tax-free, however. If you sell a municipal bond before it matures, you will owe taxes on any capital gain you make on the sale. All things being equal, you do owe state and local taxes on the income earned from municipal bonds. But, buying a bond from your home state usually makes the income free from local taxes as well. That can be an important consideration if you live in a high tax state.

Low inflation and a healthy economy often make municipals attractive. Here are Three Smart Tips for Buying Tax-Exempt Bonds:

1. Buy newly issued municipal bonds. They offer all the same advantages as buying new corporate bonds vs. older bonds in the secondary market.
2. Don't compromise on credit quality. Stick with municipal bonds rated A or higher. The spreads between the bid and asked prices of municipals are typically very narrow. So, it doesn't make sense to buy low-quality issues. The rates on munis with BAA ratings often have coupon rates that are only about one-third of a percentage point higher than those with AAA ratings.
3. Compare prices. Benchmark yields for newly issued municipal bonds are available in some newspapers and on the Bond Market Association's website,

Municipal Bond Funds. There are national tax-exempt bond funds (exempt from federal, but not state or local taxes) and single-state tax-exempt bond funds (exempt from federal and local taxes if you're a resident of that state). Municipal bonds are issued for varying maturities: short-term, intermediate-term and long-term. You'll find short-term, intermediate-term and long-term tax-exempt bond funds as well.

Since the cost of a single municipal bond is usually $5,000, there is a real incentive to invest in a tax-exempt bond fund. In fact, some experts recommend buying shares in a fund if you have less than $50,000 to invest in individual tax-exempts.

Buy funds with an average maturity of about 10 years—intermediate-term funds. That's what investment professionals consider to be the "sweet spot" on the maturity scale—the maturity that offers the highest yield with the least volatility.

High-Yield (Junk) Bonds.
They are bonds that are considered "speculative," which means they are rated BB by Standard & Poor's (or Ba by Moody's) or lower (see chart on page 25). Most junk bonds are corporates, but some are municipals.

These bonds offer high yields compared with higher-quality issues because they have to in order to attract investors. Companies that issue them have poor credit ratings, or non-existent credit. They may be companies that were once well-respected, but have since fallen on hard times. They may be companies already burdened with a ton of debt. The worst ones are barely surviving on life support.

Municipal bonds often get junk ratings because it's doubtful whether the project they're being sold to finance, from a new sports stadium to another toll road, will generate enough revenue to cover the interest payments as promised. Municipalities that run big budget deficits can also be forced into having to pay high yields on their debt to attract investors.

If you buy an individual junk bond, you have to cross your fingers and hope the bond doesn't default and you lose your interest income from it. If a company files a Chapter 11 bankruptcy in an attempt to reorganize and get back on its feet, you may still get much less than your principal back. You could also be forced to exchange your bond for convertible preferred stock. Unless the company's fortunes improve, you might only see the price of that stock go into a freefall.

The call risk of these bonds is also often significant. If the fortunes of a company or a project a municipality is financing improve, the issuer is likely to call its high-yield bonds and reissue new ones at lower rates.

Liquidity can also be a problem. If you want to sell a junk bond before it matures, you could have real trouble finding any takers.

Because investors like the high yield of junk bonds, there are plenty of junk bond funds to choose from. Virtually every fund family offers at least one—usually designated as a high yield bond fund. Buying shares in one of these funds is the safest way to invest in these securities. They minimize the risk of a default by investing in 100 or more different issues.

•  When to Buy Junk Bonds: The only reason to invest in junk bonds is for their high yields.