Different Types of Bonds Explained: Government Bonds
Editor’s note: This is part 1 of a series on different types of bonds. Here is part 2 of this series on corporate and municipal bonds.
Bonds are a core staple of many financial strategies today. They are among the different types of fixed-interest instruments that can be used for generating retirement income, balancing out risks held by other assets, and smoothing out volatility in general.
With a bond, someone has a guarantee that they will be paid interest during its term. Once the bond matures, the principal is paid back to the bondholder. The ability to meet these obligations is backed by the financial strength of the issuer of the bond.
For this reason, government bonds are generally considered to be a type of bond with lower risk than others. After all, the government has the authority to raise taxes and print money to meet its obligations.
There are different types of bonds, and they vary in a number of ways: length of term, interest rates, and the type of issuer, to name a few. It’s helpful to know at a high level about these different bond types and how they might play out.
Here is a breakdown of the different types of bonds and what they involve. In this article, we will go over various types of government bonds available.
Basic Characteristics of Bonds
Before going any further, it’s good to cover the basics of bonds. Governments, municipalities, and corporations issue bonds in order to raise money.
All bonds are issued with what is called a coupon rate, which is the rate of interest that they pay. A bond with a 5% coupon rate will pay interest equal to 5% of the principal each year.
Most bonds are issued at what is called par value. Generally, the par value for a bond is $1,000, as that is the denomination at which it’s often issued.
Some bonds are issued with a par value of less than this amount, and then mature at par value. The difference between bond’s sales price and its price at maturity represents the interest earnings on the bond.
If you buy a bond directly from the issuer at the time of issue and hold it to maturity, you will receive the exact coupon rate of interest paid by the bond.
Bond Values and Interest Rates
But what if you buy a bond in the secondary market? A secondary market is simply a place where investors can buy and sell bonds.
In that case, you may pay more or less than the par value of the bond. The price you pay will depend primarily on interest rates, the credit status of the bond, and other factors.
It’s important to understand the relationship between bond prices in the secondary market and interest rates. This is where interest rate risk can arise.
When interest rates rise, the value of bonds in the secondary market will decline. Why? Bonds with a coupon rate that is lower than what new bonds are paying are worth less than the new bonds.
Investors will therefore only buy the older bonds at a reduced price in order to make up for the lower rate they will receive.
If interest rates decline, then older bonds with higher coupon rates will become more valuable. Investors who buy them are willing to pay a higher price than par value to get them with their higher rates of interest.
Bonds and Credit Ratings
The bonds of today usually have a safety rating assigned to them. These ratings are given by various credit rating agencies. The agencies that rate bonds include Fitch’s, Moody’s, A.M. Best, and Standard & Poor’s.
The higher the rating, the safer the bond is for the investor. For this reason, government bonds typically receive the highest ratings. Municipal bonds tend to have higher ratings after that, and then corporate bonds.
Bonds with lower ratings usually pay higher rates of interest.
The bonds with a credit rating of BBB or B++ or higher are known as investment grade bonds. On the other hand, bonds with ratings below this level are considered to be “junk” bonds. Junk bonds pay the highest rates of interest.
You may have heard of Treasury securities before. These bonds are backed by the full faith and credit of the U.S. government.
They are universally considered to be among the investments with the lowest risk. The interest that they pay is universally exempt from state and local income taxes.
There are three types of Treasury securities:
- T-notes, and
These bonds have maturity periods ranging from 4 weeks to 8 weeks, 13 weeks, 26 weeks, and 52 weeks.
T-bills are sold at a discount and mature at par value. They are sold in denominations of $100.
They are also the only type of government bond with a certain twist. They can be found in both the capital markets (the market for bonds with maturities greater than 270 days) and the money market (the market for bonds and other short-term debt obligations with maturities of 270 days or less).
These bonds have 2-, 3-, 5-, 7- and 10-year maturity periods.
Bonds with the two-year to seven-year maturities are auctioned once a month. The bonds with 10-year maturity periods are auctioned on a quarterly basis.
T-notes are issued with a par value of $100 (instead of the more frequent $1,000). They mature at that same price and pay a stated coupon rate of interest. Interest earnings are paid semi-annually.
These bonds have maturities of 30 years. They are commonly referred to as the “long bond.”
T-bonds are issued with par and maturity values of $100. They are also issued at auction on a quarterly basis, and they pay interest earnings on a semi-annual basis.
These bonds are sold at a discount to their par value and then redeemed for their full face value at maturity. STRIPS stands for “separate trading of interest and principal securities.”
They don’t have an interest rate. Therefore, investors don’t receive interest on a regular basis. Each interest payment is instead registered as a separate security that is also sold at a discount and redeemed at par value.
Any bond sold by the Treasury with a maturity of 10 years or longer is eligible to be sold as a STRIP. They have a range of maturity periods. There are generally federal income taxes involved with this type of bond.
There are two types of savings bonds issued by the U.S. government. EE bonds have a maturity of 20 years. They are issued at half of par value and investors receive the full par value at maturity.
Their growth functions as the interest paid by the bond. Savings bonds don’t trade in a secondary market like Treasury securities. They can only be redeemed directly through the Treasury.
They typically pay very low rates of interest because of their high degree of safety. The interest that is earned from savings bonds is generally exempt from state and local taxes.
Treasury Inflation Protected Securities
These bonds are also known as TIPS. They are linked to an inflationary gauge or index such as the consumer price index (CPI).
When inflation rises, the principal amount of these bonds will increase. However, the amount of interest that they earn will vary according to the value of that principal.
Assuming the bond is held to maturity, the principal is guaranteed. Interest earnings can vary.
The actual interest rate is set at issue. However, the dollar amount that is paid will depend upon the current value of the principal, which may be more than what it was at issuance.
TIPS have maturity periods of 5, 10, and 30 years. They pay interest earnings semi-annually.
Investors will receive the greater of either the original face amount of the bond or the inflation-adjusted amount of principal.
Inflation-Linked Savings Bonds
This type of bond is known for short as an “I-bond.” These bonds resemble traditional U.S. savings bonds in many respects.
They are considered to have lower risk than TIPS. However, they pay a rate of interest that is adjusted for inflation. Like TIPS, I-bond interest rates are tied to the consumer price index (CPI). However, the principal in these bonds remains constant.
I-Bonds typically have maturities of 30 years. Their interest earnings are generally tax-free at the local, state, and federal levels.
Although the interest rates that they pay might be low, they are generally higher than those of traditional savings bonds over long periods of time.
Government Agency Securities
An agency bond is a security issued by a government-sponsored enterprise or by a federal government department other than the U.S. Treasury. Some aren’t fully guaranteed in the same way that U.S. Treasury and municipal bonds are.
These bonds often pay a slightly higher rate of interest than Treasury securities do. Most agency bonds pay interest semi-annually. The interest is often exempt from state and local taxes. However, that isn’t always the case.
Some agency bonds have fixed coupon rates while others have floating rates. The interest rates on floating rate agency bonds are periodically adjusted according to the movement of a benchmark rate.
Federal government agency bonds are issued by the Federal Housing Administration (FHA), Small Business Administration (SBA), and the Government National Mortgage Association (GNMA).
Like Treasury securities, federal government agency bonds are backed by the full faith and credit of the U.S. government. An investor receives regular interest payments while holding this agency bond.
At maturity, the full face value of the agency bond is returned to the bondholder. Federal agency bonds offer a slightly higher interest rate than Treasury bonds because they are less liquid.
A GSE agency bond has unique issuers. They are issued by entities as the Federal National Mortgage Association (Fannie Mae), Federal Home Loan Mortgage (Freddie Mac), Federal Farm Credit Banks Funding Corporation, and the Federal Home Loan Bank.
These aren’t government agencies. They are private companies that serve a public purpose. Thus, they may be supported by the government and subject to government oversight.
GSE agency bonds don’t have the same degree of backing by the U.S. government as Treasury bonds and government agency bonds.
Need Alternative Options to Bonds?
Government bonds can provide safety of principal, guaranteed interest earnings, and peace of mind. However, they aren’t the only type of asset that can do this.
Fixed and fixed indexed annuities also offer a guarantee of principal that is backed by a life insurance company.
Their payouts tend to be higher for guaranteed income than what bond strategies might be able to offer. At times, fixed annuities and fixed index annuities can more offer more growth potential with interest earnings than bonds might give, as well.
Exploring Your Options for Your Goals
One big trade-off is you don’t have as much liquidity with an annuity as you would with a bond. Your financial professional can go over the unique features of different types of bonds, annuities, and other fixed-interest assets that can help you with your financial goals.
Consult your financial advisor for more information and see which options might make sense for your situation. What if you are looking for a financial professional to help you?
No sweat, many independent financial professionals are available at SafeMoney.com to assist you. Get started with our “Find a Financial Professional” section to connect with someone directly. You can request an initial appointment to discuss your situation and explore a working relationship. Please feel free to call us at 877.476.9723 for a personal referral.