Bonds are among the most popular investments. They give fixed income to investors, but they are not the only ones at that. There are many fixed-income securities available to investors.
Each type differs from the other, but they all have pros and cons. To make a wise investment decision, you may want to compare the fixed-income securities offered by the market. That way, you can select the option that suits you the most.
Let us have a look at each fixed-income security and see how they differ from bonds.
When we talk of fixed-income securities, most people think of bonds. Such is because companies and governments widely use them to raise capital.
Bonds are instruments of debts used by companies and governments to raise capital. The bondholder or investor is paid annual interest at a fixed rate. Bonds have a fixed maturity period. Upon maturity, you are paid the principal amount of the bond.
Depending on the entity issuing them, bonds are classified into:
Treasury Bonds and Municipal Bonds
Treasury bonds are bonds issued by the federal government. They are issued in multiples of $100 with a maturity period of 20 years to 30 years.
Local governments such as the state or county governments issue municipal bonds.
The chances of default in payment of municipal and treasury bonds are minimal. These bonds are considered risk-free. They pay interest at a lower rate than other bonds, but the payment is guaranteed.
On the positive side, interest from municipal bonds is exempted from taxes.
Corporate Bonds and Junk Bonds
Companies issue corporate bonds. They come in different types depending on the creditworthiness of the issuing company. The highest-ranked corporate bonds are rated AAA. This is the highest quality of bonds. (Standard and Poor's rating systems use letters such as AAA, AA, A, BBB, BB, B and so on up to D)
Bonds with a rating of AAA to BBB are called investment-grade corporate bonds. High-rated bonds are expensive to buy, but the interest rate is low. That is why they are also called low-yield bonds.
Junk bonds are bonds issued by companies that have a high risk of default. They are rated as non-investment grade below BBB. Due to the high risk involved, these bonds have lower demand and, as a result, a lower price.
Junk bonds have a higher interest rate to compensate for the high risk. That is why they are also called high-yield bonds.
Fixed Income Securities
These securities give fixed income. We will look at the features of each security, and then compare it with bonds.
Treasury Bills and Treasury Notes
The government issues treasury bills to raise short-term funds. The maturity period of treasury bills is usually less than one year. They do not have any interest rate. Instead, they are issued at a discount and redeemed at face value.
For example, assume a 3 months treasury bill is sold at a discount price of $900, and the face value is $1,000. You will pay $900 now and receive $1,000 after 3 months. The difference in prices is the earnings you will gain.
Treasury notes are the same as treasury bonds except that they have a shorter maturity period of 2 to 10 years. They pay annual interest at a fixed rate. Investors are paid the principal amount upon the maturity of the notes.
Treasury Bills and Notes vs. Treasury Bonds
Treasury bonds pay a higher interest rate than treasury bills and treasury notes. Such is because they have the longest maturity period. The prices of treasury bonds fluctuate more often than the prices of treasury bills and treasury notes.
These three government securities are sold by auction through the treasury's website. The prices and the interest rates are determined at the auction. After buying treasury bonds, investors can trade them in the secondary market after holding them for at least 45 days.
Since the government issues them all, they have no risk of default unless the government collapses.
Certificate of Deposit (CD)
Any bank you come across from your region provides a certificate of deposit facility. This is one of the most familiar ways of saving money. It simply means depositing your money in the bank for 6 months to 5 years without withdrawing it.
Interest may be paid regularly using the simple interest method, or it may be compounded. If compounded, it is paid together with the principal amount when the deposit matures.
Interest in certificates of deposit is much higher than the one offered by regular savings accounts and in money markets.
Some banks pay higher interests than others. You may want to compare the rates offered by different banks before making your choice.
In case of emergency, the bank agrees to pay you the money before maturity. Withdrawing the money before maturity usually attracts a penalty.
Bonds vs. Certificate of Deposit
Any bank or credit union you walk into offers a certificate of deposit facility. Bonds are offered by governments and a few companies, which have met the requirements of the securities commission.
Certificates of deposit are much safer than most corporate bonds. This is because the Federal Deposit Insurance Corporation (FDIC) insures them. If a bank fails to pay the deposit, FDIC will pay investors up to $250,000 per account.
The main risk faced by Certificate of Deposits and bonds is inflation. If there is high inflation, the principal amount reduces its real purchasing power by the time it is received after maturity.
The safety level of bonds depends on their rating. If the bonds are low-rated, the risk level is higher compared to any certificate of deposit.
Bonds are long-term investments compared to certificates of deposit. Bonds with higher risk have a higher interest rate than certificates of deposit. In certificates of deposit, interest can be compounded, making it higher every year.
Bonds can be sold at any time through the bond market. Depending on the current market prices, you stand a chance to gain or lose if you sell the bonds before maturity.
Certificates of deposits can also be withdrawn before maturity in case of necessity. You can never gain on such withdrawal, but you can lose through penalties depending on the terms of the agreement.
Companies use preferred stocks to raise equity capital, but investors are paid dividends at a fixed rate. They share some characteristics of common stocks and bonds.
Investors in preferred stock have no voting rights, but they have a higher claim on the company's assets than common stockholders do.
Bonds vs. Preferred Stock
Preferred stocks do not have a fixed maturity date. The company that issued them can recall them at any time and exchange them for cash. Bonds have a fixed maturity date, and it is difficult for the company that issued them to cancel them before maturity.
Dividend payment for preferred stock can be suspended if the company is experiencing liquidity problems. Interest on bonds has to be paid first before the dividend for preferred stock is paid.
Preferred stocks are classified as equity capital, while bonds are classified as debt capital. In the case of winding up of a company, bondholders would have a higher priority than investors would in preferred stock.
Preferred stocks are more expensive to the company issuing them because they are not given a tax allowance. Bonds are cheaper since they are given a tax allowance. A company that uses more preferred stock can pay more taxes than the one that uses more bonds.
Preferred stocks are quite risky compared to bonds since they are given a lower priority in paying dividends. On the positive side, preferred stocks usually have a higher rate of return.
Participating preferred stocks are given a share of the company's profit if the profit reaches a certain level. In this arrangement, you get both dividend and a bonus from profits. Bonds do not have this kind of provision.
A debenture is a debt instrument used by companies to raise unsecured capital. This means that there are no specific business assets used as security for the debentures in a payment default.
The issuance of debentures is dependent on faith and trust in the company issuing them. The purpose of issuing debentures is usually specified as they are always used to finance a specific activity or project of the company.
Bonds vs. Debentures
Companies, governments, or other agencies issue bonds. Private companies issue debentures.
Bonds have a lower risk since the assets of the issuing company back them up. Debentures are not backed up by any assets. They are issued based on the reputation and creditworthiness of the issuing entity.
Bonds have a lower interest rate because they have less risk. Debentures have a higher interest rate to compensate for the higher risk involved.
Debentures are issued at a fixed or a floating interest rate. The payment of interest depends on the performance of the company.
Debentures have the option to be converted into shares, while most bonds are not convertible.
Bonds have a long tenure compared to debentures.
Debentures are used to finance specific projects of the business. Payment of the debentures principal amount is done using revenue from the project that the debentures were used to finance. The payment may be delayed if revenue from the project has been delayed.
Debenture holders can apply for the winding up of the company to safeguard their interests in the company. If the company goes into liquidation, bondholders have a higher priority of payment than debenture holders do.
Fixed-income Mutual Funds
Mutual funds are investment options that pool money from many investors. The collected money is invested in bonds, stocks, money markets, and other securities.
Fixed-income mutual funds invest in securities that pay fixed interest rates, such as bonds and other debt instruments.
Bonds vs. Fixed-income Mutual Funds
Fixed-income mutual funds comprise many investors who pool their money to invest them in debt instruments. Bonds are an investment by an individual investor.
Mutual funds are involved in the trading of debt instruments. Most individual bondholders keep their bonds until they reach maturity.
Mutual funds charge management fees to the investors. The management oversees the investment plans on behalf of investors. Individual bondholders manage their investment, and they do not incur management fees.
Mutual funds have a lower risk because they hold a well-diversified portfolio. Individual bondholders face a higher risk, especially if they have invested in low-rated bonds.
Mutual funds pay interest monthly, while individual bondholders receive interest bi-annually.
Control and decision-making of mutual funds are based on the fund managers who are investment experts. Individual bondholders have complete control over their investments.
For you to get a fixed regular income, you have many investment options available. Bonds are the most common but not the only ones.
If you prefer low-risk investments, you have the options of treasury bills, notes, and bonds, municipal bills and bonds, high-rated corporate bonds, fixed-income mutual funds, and certificates of deposits.
If you prefer a higher income and you would not mind a higher risk, you have the options of debentures, preferred stocks, and junk bonds.
Investing is something especially bonds and fixed incomed should be carefully thought. However, having gone through all the options, I believe you now have enough information to make a wise decision.