The Bond Market
by
Charles Lamson
According to The Motley Fool, the global bond market has more than tripled in size in the past 15 years and now exceeds $100 trillion. By contrast, S&P Dow Jones Indices put the value of the global stockmarket at around $64 trillion (https://www.fool.com/knowledge-center/5-bond-market-facts-you-need-to-know.aspx). Given such size, it is not surprising that today's bond market offers securities to meet just about any type of investment objective and suit virtually any type of investor, no matter how conservative or aggressive. As a matter of convenience, the bond market is usually divided into four segments, according to type of issuer. Treasury, agency, municipal, and corporate.
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Treasury Bonds
Treasury bonds (sometimes called Treasuries or government) are a dominant force in the bond market, and if not the most popular, certainly are the best known. The U.S, Treasury issues bonds, notes, and other types of debt securities as a means of meeting the ever increasing needs of the federal government. All Treasury obligations are of the highest quality (backed by the full faith and credit of the U.S. government), a feature that, along with their liquidity, makes them extremely popular with individual and international investors, both here and abroad. U.S. Treasury securities are traded in all the major markets of the world, from New York to London to Tokyo. Treasury notes are issued with maturities of 2, 3, 5, and 10 years, whereas Treasury bonds carry 20- and 30-year maturities (Note that while the treasury is authorized to issue these securities, the last time they issued 20-year bonds was in January 1986 and the last 30-year bond was issued in August 2001. Even so, many of these bonds are still outstanding and actively traded in the secondary market.) All treasury notes and bonds are sold in minimum denominations of $1,000, and although interest income is subject to normal federal income tax, it is exempt from state and local taxes. Also, the Treasury today issues only noncallable securities---the last time the U.S, Treasury issued callable debt was in 1984.  In 1997, the Treasury began issuing its newest security, the Treasury inflation-indexed bond---or TIPs as they are also known, which stands for "Treasury Inflation-Protection Securities." Basically, these securities---which are issued as notes with 10-year maturities, and until 2001, as bonds with 30-year maturities---provide investors with the opportunity to stay ahead of inflation by periodically adjusting their returns for any inflation that has occurred. That is, if inflation is running at an annual rate of, say, 3 percent, then at the end of the year the par (or maturity) value of your bond will increase by 3 percent (actually, the adjustments to par value are done every six months). Thus, the $1,000 par value will grow to $1,030 at the end of the first year and if the 3 percent inflation rate continues for the second year, the par value will once again move up, this time from $1,030 to $1,061 (or $1,030 x 1.03). Unfortunately, the coupons on these securities are set very low, as they are meant to provide investors with so-called real (inflation-adjusted) returns. Thus, one of these bonds might carry a coupon of only 3.5 percent (at a time when regular T-bonds are paying, say, 6.5 or 7 percent). But there is an upside even to this: The actual size of the coupon payment will increase over time as the par value on the bond goes up. For investors who are concerned about inflation protection, these securities may be just the ticket. These securities are a lot more complex than your normal Treasury bonds. Agency Bonds Agency Bonds are an important segment of the U.S. bond market. Though issued by political subdivisions of the U.S. government, these securities are not obligations of the U.S. Treasury. An important feature of these securities is that they customarily provide yields comfortably above the market rates for treasuries, and, therefore, offer investors a way to increase returns with little or no real difference in risk. Some of the more actively traded and widely quoted agency issues include those sold by the Federal Farm Credit Bank, the Federal National Mortgage Association (or "Fannie Maes," as they are more commonly known), the Federal Land Bank, the Student Loan Marketing Association, and the Federal Home Loan Bank. Although these issues are not the direct obligation of the U.S. government, a number of them actually do carry government guarantees and thus effectively represent the full faith and credit of the U.S. Treasury. Moreover, some have unusual interest-payment provisions (interest is paid monthly in a few instances and yearly in one case), and, in some cases, the interest is exempt from state and local taxes.
 Municipal Bonds Municipal bonds are often the issues of states, countries, cities, and other political subdivisions, such as school districts and water and sewer districts. They are unlike other bonds in that their interest income is unusually free from federal income tax (which is why these issues are known as tax-free bonds). Note, however, that the same tax-free status does not apply to any capital gains that may be earned on these securities---that is, such gains are subject to the usual federal taxes. A tax-free yield is probably the most important feature of municipal bonds and is certainly a major reason why individuals invest in them. The higher the individual's tax bracket, the more attractive municipal bonds become. As a rule, the yields on municipal bonds are (almost always) lower than the returns available from fully taxable issues. Thus, unless the tax effect is sufficient to raise the yield on a municipal to a yield that equals or exceeds the yields on taxable issues it obviously does not make sense to buy municipal bonds. You can determine the return a fully taxable bond would have to provide in order to match the after-tax return on a lower-yielding tax-free issue by computing what is known as a municipal's fully taxable equivalent yield:   Municipal bonds are generally issued as serial obligations meaning that the issue is broken into a series of smaller bonds, each with its own maturity date and coupon rate. Thus, instead of the bond having just one maturity date 20 years from now, it will have a series of, say, 20 maturity dates over the 20-year time frame. Although it may not seem that municipal issuers would default on either interest or principal payments, it does occur. Investors should be especially cautious when investing in revenue bonds, which are municipal bonds serviced from the income generated from specific income-producing products, such as toll roads. Unlike issuers of so-called general obligation bonds---which are backed by the full faith and credit of the municipality---the issuer of a revenue bond is obligated to pay principal and interest only if a sufficient level of revenue is generated. General obligation municipal bonds, in contrast, are required to be serviced in a prompt and timely fashion regardless of the level of tax income generated by the municipality.
Caution should be used when buying municipal bonds because some of these issues are tax-exempt and others are not. One effect of the far-reaching Tax Reform Act of 1986 was to change the status of municipal bonds used to finance nonessential projects so their interest income is no longer exempt from federal taxes. Such bonds are known as taxable munies, and they offer yields considerably higher than normal tax-exempt securities. Buy one of these issues and you will end up holding a bond whose interest income is fully taxable by the IRS.
Corporate Bonds
The major nongovernmental issuers of bonds are corporations. The market for corporate bonds is customarily subdivided into several segments, which include industrials (the most diverse of the group), public utilities (the dominant groups in terms of volume of new issues), rail and transportation bonds, and financial issues (banks, financial companies, and so forth). The corporate bond market offers the widest range of issue types. There are first mortgage bonds, convertible bonds, debentures, subordinated debentures, and income bonds, to mention just a few. Interest on corporate bonds is paid semiannually, and sinking funds are common. The bonds usually come in $1,000 denominations and are issued on a term basis with a single maturity date. Maturities usually range from 5 to 10 years, to 30 years or more. Many of the issues---particularly the longer-term bonds---carry call provisions that prohibit prepayment of the issue during the first 5 to 10 years. Corporate issues are popular with individuals because of their relatively high yields.
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 526-530*
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