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There are at least five different types of bonds. They each have different sellers, purposes, buyers and levels of risk vs return .
1. The most important are the U.S. Treasury bills, notes and bonds , issued by the Treasury Department. They are used to set the rates for all other long-term, fixed-rate bonds (more on that in a minute). Treasury sells them at auction to fund the operations of the Federal government.
They are also resold on the secondary market. They are the safest, since they are guaranteed by the world's largest economy. That means they also offer the lowest return. However, they are owned by nearly every institutional investor. corporation and sovereign wealth fund . The Treasury also sells Treasury Inflation Protected Securities (TIPs ) that protects against inflation.
2. Savings bonds are also issued by the Treasury Department. but are meant to be purchased by individual investors . That's why there issued in low enough amounts to make them affordable for individuals.
I Bonds are like Savings Bonds, except they are adjusted for inflation every six months.
3. Quasi-governmental agencies, like Fannie Mae , Freddie Mac or Ginnie Mae, sell bonds that guaranteed by the Federal government.
4. Municipal bonds are issued by various cities. These are tax free, but have slightly lower interest rates than corporate bonds. They are slightly more risky than bonds issued by the Federal government, as cities occasionally do default.
5. Corporate bonds are issued by all different types of companies.
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They are riskier than government-backed bonds, so they offer a higher rate of return. They are sold by the representative bank.
- Junk bonds or high yield bonds, are corporate bonds from companies that have a bigger chance of defaulting. They offer higher interest rates to compensate for the risk.
- Preferred stock is technically a stock, but acts like a bond. It pays you a fixed dividend at regular intervals, much like a bond payment. It's slightly safer than a stock, because the holder gets paid after bondholders, but before common stockholders.
of Deposit is like a bond issued by your bank. You essentially loan the bank your money for a certain period of time, and it guarantees a fixed rate of return.
Types of Bond-based Securities
You don't have to buy an actual bond to take advantage of its benefits. You can also buy securities that are based on bonds. These include:
Bond exchange-traded funds (ETFs) perform like mutual funds, but don't actually own the underlying bonds. Instead, they track the performance of different classes of bonds. They pay out based on that performance.
Bond-based derivatives are complicated investments that get their value from the underlying bonds. These include:
- Options gives a buyer the right, but not the obligation, to trade a bond at a certain price on an agreed-upon future date. The right to buy a bond is called a call option and the right to sell it is the put option. They are traded on a regulated exchange.
- Futures contracts are like options, except they obligate participants to execute the trade. They are traded on an exchange.
- Forward contracts are like futures contracts, except they are not traded on an exchange. Instead they are traded Over the Counter (OTC ), either between the two parties directly or through a bank. They are often very customized to the particular needs of the two parties. For example, Mortgage To-Be-Announced (TBAs) are forward contracts for mortgage-backed securities sold at a future date.
- Mortgage-backed securities are based on bundles of home loans. Like a bond, they offer a rate of return based on the value of the underlying assets.
- Collateralized debt obligations are based on auto loans and credit card debt, but also included bundles of corporate bonds.
- Asset-backed commercial paper are one-year corporate bond packages based on the value of underlying commercial assets, such as real estate, corporate fleets or other business property.
- Interest rate swaps are contracts that allow bond holders to swap their future interest rate payments. These are typically between a holder of a fixed-interest bond and one holding a flexible-interest bond. They are traded over the counter.
- Total return swaps are like interest rate swaps, except the payments are based on bonds, a bond index, an equity index, or a bundle of loans. (Source: Introduction to Fixed Income Derivatives. Enis Knupp and Associates; CBOE, Overview of Derivatives )