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Course 410
Bond Basics, Part 2

Introduction

Portfolio 409 covered key bond terms (such as credit quality and duration), explained the relationship between bond prices and interest rates, and what inflation can do to bonds.

In this course, we’ll discuss different types of bonds. Just as you wouldn't want to have all of your stocks in just one style, you also want to diversify your bond portfolio. A well-rounded bond portfolio could have some exposure to most, if not all, of the following bond types.

Government Bonds

Considered the safest bond type, government bonds are backed by the U.S. Treasury. Interest is taxed at the federal level but not at the state and local level.

There are two main types of government bonds.

Savings Bonds: These bond types defer paying out interest until the bonds are redeemed. A portion ofI-Bonds' interest adjusts along with inflation rates

Treasury Bonds: The maturity of the security determines what type of Treasury you (or your fund) own. A Treasury bill has a maturity of one year or less. A note has a maturity of two to 10 years. A bond has a maturity of more than 10 years.TIPShave a fixed interest rate, but investors' principal adjusts along with inflation rates. Because TIPS investors pay taxes on the interest income as well as on the inflation adjustments to their principal, it's best to hold TIPS in tax-deferred accounts.

Mortgage-Backed Bonds

Mortgage bonds are made up of a pool of home mortgages. The agencies that issue these bonds include GNMA (Government National Mortgage Association--a U.S. government agency), Freddie Mac, and Fannie Mae (Freddie and Fannie are government-sponsored enterprises). Private institutions such as banks also issue mortgage-backed securities.

A big risk with these bonds is that mortgage holders will prepay their mortgages, and the bondholders will not get the interest they thought they would. Because these bonds carry prepayment risk, their interest payments are a little higher.

Municipal Bonds

Municipal bonds, which are issued by state and local municipalities, offer interest payments that are exempt from federal taxes and may also be exempt from state and local income taxes, depending on where you live. These bonds typically offer lower yields than Treasuries because of their tax benefits.

To help decide between a taxable bond fund and a tax-exempt bond fund, take the taxable fund's yield and multiply it by 1 minus your tax rate. This is the fund's tax-adjusted yield. For instance, if you are in the 25% tax bracket and you are comparing a taxable-bond fund paying 4% with a muni fund paying 3.5%, you'd multiply 4% by (1 - 0.25) and compare that with 3.5%. On an aftertax basis, the fund with the 4% yield would yield only 3%. So in this case, the muni fund offers a higher aftertax interest rate.

Other Bond Types

Generally considered the riskiest type of domestic bond, bonds issued by corporations, as opposed to government entities, typically offer the highest interest payments. Those bonds with the lowest credit quality ratings (BB and below) are considered "junk" bonds.

For diversification beyond the U.S. and exposure to foreign currencies, world bond funds have been attracting investor assets recently. Such funds usually invest the lion's share of assets in bonds issued by foreign governments, but they may also hold bonds issued by foreign corporations. Emerging-markets bond funds have historically been considered even riskier, but they have been gaining a lot of attention recently, too, as their yields are often higher than bonds from U.S. issuers.

Quiz 410
There is only one correct answer to each question.

1 What type of bond is considered the “safest”?
a. U.S. government bonds
b. Mortgage-backed bonds
c. Corporate bonds
2 Who issues mortgage-backed bonds?
a. Agencies such as GNMA
b. Private institutions such as banks
c. Both A and B
3 An investor in a high tax bracket might consider which type of bond?
a. U.S. government bonds
b. Mortgage-backed bonds
c. Municipal bonds
4 Which type of domestic bonds tend to offer the highest yields?
a. U.S. government bonds
b. Mortgage-backed bonds
c. Corporate bonds
5 What do world-bond funds offer U.S. investors?
a. Exposure to foreign currencies and diversification
b. Lower yields than most U.S. securities
c. Better quality than U.S. government bonds
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