Bonds come in many different varieties, and here we will cover just the most common types.
Government Bonds
Government bonds can be issued by national governments as well as lower levels of government. At the national or federal level, these government bonds are known as “sovereign” debt, and are backed by the ability of a nation to tax its citizens and to print currency. All debt issued by the U.S. government is regarded as extremely safe, often referred to as “risk-free” securities, as is the debt of many stable countries. The debt of developing countries, on the other hand, does usually carry substantial risk. Like companies, countries can therefore default on payments. Credit ratings agencies also rate a country’s risk to repay debt in a similar way that they issue ratings on corporate bond issuers. Countries with greater default risk must issue bonds at higher interest rates – which essentially increases their cost of borrowing.
Corporate Bonds
The other major issuer of bonds are corporations, and corporate bonds make up a large portion of the overall bond market. Large corporations have a great deal of flexibility as to how much debt they can issue: the limit is generally whatever the market will bear. A corporate bond is considered short-term corporate when the maturity is less than five years; intermediate is five to 12 years, and long-term is over 12 years. Corporate bonds are characterized by higher yields than government securities because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on, where higher credit companies that are more likely to pay back their obligations will carry a relatively lower interest rate than riskier borrowers. Companies can issue bonds with fixed or variable interest rates and of varying maturity. Bonds issued by highly rated companies are referred to as investment grade while those below investment grade are junk or high-yield.
Asset-Backed Securities
A third category of bonds is issued by banks or other financial sector participants and are referred to as asset-backed securities or ABS. These bonds are created by packaging up the cash flows generated by a number of similar assets and offering them to investors. If such a bond is backed by a number of mortgages, they are known as mortgage-backed securities or MBS. These bonds are typically reserved for sophisticated or institutional investors and not individuals.
Unit trusts and OEICs are by far the most popular investment funds. With a unit trust, a fund manager buys bonds or shares in companies on the stock market on behalf of the fund.
The fund is split into units, and this is what you’ll buy. The fund manager creates units for new investors and cancels units for those selling out of the fund. The creation of units can be unlimited, hence why the fund is ‘open-ended.’
The price of each unit depends on the net asset value (NAV) of the fund’s underlying investments and is priced once per day. This means that the value of the units you buy directly reflects the underlying value of the investment. OEICs operate in a similar way to unit trusts except that the fund is actually run as a company. It therefore creates and cancels shares rather than units when investors come in and go out of the fund, but they still directly reflect the value of the assets that your fund manager has invested in.
Investment trusts are publicly listed companies that invest in financial assets or the shares of other companies on behalf of their investors. When you invest you are buying shares in an investment trust, the value of which fluctuates based on:
- The underlying value of the assets they own
- The supply and demand for their shares
How does an investment trust work?
When you purchase shares in an investment trust your money is pooled with other investors and used to purchase a diverse range of shares and assets. In simple terms:
- You buy shares in an investment trust
- The money from your shares is put into one big pot, with the money from other shareholders - this is called the fund
- The fund is then used to buy shares and assets by the fund manager
- The value of these shares and assets fluctuate and are bought and sold over time
- You sell your shares for the market price
Investment trusts tend to be more stable than buying shares in a single company because your money is invested across a variety of companies. This does not eliminate the risk to your money but means that the performance of a single share has less impact because there are many others to counteract it.
For more information on other types of investments, please contact us.