Bonds investing have been one of the long-established foundations of any well-diversified portfolio. You must consider the amount of time you can invest when building your portfolio. This most especially true with bonds since there are numerous types of bonds, bond-based securities, and bond funds.
In this article we will be tackling the various types of bond-based securities.
What are Bond-Based Securities
It’s not entirely necessary for you to buy actual bonds in order to take advantage of the benefits. You also have the option to buy securities that are based on bonds, like bond mutual funds. These bond mutual funds are made up of various types of bonds.
Types of Bond-Based Securities
Asset-backed Commercial Papers
Asset-backed commercial papers or ABCP are shirt-term investment vehicles that normally reach maturity between 90 and 270 days. They are corporate bond packages collateralized through the value of underlying commercial assets. These assets include real estate, corporate fleets, or other types of business properties.
This bond-based security is usually bought by institutional investors in order to diversify their assets and produce short-term gains. They are normally issued by a bank or another financial institution.
Collateralized Debt Obligations
This type of bond-based security is centered on auto loans and credit card debt. It pools together cash flow-generating assets and repackages them into discrete tranches that can then be sold to investors. Collateralized debt obligations or CDOs are also inclusive of corporate bond bundles.
The senior tranches are considered to be safer they are prioritized on payback in the event of a default. a CDO’s senior tranches will mostly have a higher credit rating because of this. Additionally, as compared to the junior tranches, coupon rates will generally be offered at a lower rate.
Side note: Tranches are pieces of debt or securities meant to divide risk or group characteristics. This is done to make them more marketable to various investors.
These are mostly the same as future contracts. Forward contracts, or simply forward, are non-standardized contracts made between two parties meant to be fulfilled at a specific future time at a price agreed upon today. The settlement can on a cash or delivery basis.
Forward contracts can be used for hedging or speculation. The main difference between forward and futures contracts lies in the fact that forward contracts aren’t traded on an exchange. They are instead found and traded over-the-counter (OTC).
OTC trades can be done either directly between the two parties or through a bank. They are customized to meet the particular needs of the two parties involved. Customization covers the type of commodity, amount, and delivery date.
Future contracts have the same function as options but the buyers are obligated to execute the trade. These contracts are traded on an exchange. These contracts are generally made to buy or sell a particular commodity or financial instrument at a predetermined price at a specific time in the future.
Agreements regarding futures contracts are made on the trading floors of a futures exchange. Depending on the asset being traded, the exchange will also detail the quality and quantity of the commodity.
Interest Rate Swaps
These are contracts that give bondholders the ability to swap future interest rate payments. The parties involved are usually the holder of a fixed-interest bond and the one holding a flexible-interest bond. They are not traded on an exchange and instead are traded over-the-counter (OTC).
The trades are mostly done to obtain a considerably lower interest rate as compared to how high it would have been without the swap. Since they trade OTC, the contracts can be easily customized meet either party’s needs.
These securities are based on bundles of home loans. Much like how a bond functions, they offer a rate of return depending on the value of the underlying assets.
Mortgage-backed Securities or MBSs signifies an ownership stake in a bundle of mortgage loans issued or guaranteed by government agencies. Most of the time, loans that are chosen to be pooled together have similar characteristics.
Owning options gives the buyer the right to trade a bond at a predetermined price on an agreed-upon future date. But it does not make the buyer obligated to do so.
Options are considered to be extremely versatile securities. Because of this, traders decide to use options for speculations. It can also be used to reduce the risk of holding an asset. When it comes to speculation, the outlook of option buyers and writers regarding the security’s performance mostly contradicts each other.
The term “call option” is used to refer to the right to buy a bond. Meanwhile, the term “put option” is used to refer to the right to sell the bond. Options are traded on a regulated exchange.
Total Return Swaps
This type of swap is mostly same to that of in the interest rate swaps. Their main difference lies in the fact that payments of total return swaps are expected to come in different forms. Payments can be based on bonds, a bond index, an equity index or a bundle of loans.
Conducting total return swap or TRS contracts will transfer both the credit risk and market risk of an underlying asset. With the contracts, both generated incomes and any gains in capital will also be transferred. The owner of the asset is the party receiving the set rate payment.
What are Bond Mutual Funds
Most investors now know and understand what mutual funds are. The numbers of people who have come to depend on mutual fund investing have increased over time. They mostly use mutual funds as cornerstones for their investment portfolios and individual retirement accounts.
Bond mutual funds are invested in debt instruments that were issued by governments and/or corporations. It’s exactly what its name implies, a mutual fund designed for those who wish to invest in bonds and other debt securities.
Determining the type of debt that the fund invests in will depend on the focus of the bond. Bond funds or debt funds can invest in government, corporate, municipal, and convertible bonds.
Individual bonds differ from bond funds in terms of value. The individual bonds will not lose value as long as the issuer of the bond does not default. Additionally, the bond investor must hold onto the bond until it reaches maturity.
Bond funds on the other hand are capable of gaining or losing value. Loss in value can be attributed to the fact that fund managers often sell the underlying bonds in the fund even before they reach maturity.
Types of Bond Mutual Funds
There are numerous types of bond mutual funds, here are some of them:
- Municipal bond funds are invested in bonds issued by state and local governments. They are mainly issued to pay for local public projects like school, highways, and bridges.
- Corporate bond funds are invested in bonds issued by corporations. They are mainly issued to act as debt for operating expenses as well as other purchases. Unlike those in municipal bond funds, there are no government institutions supporting the corporate bond funds. Their value can be determined by the strength of the company that issued the bond.
- International bond funds are invested in bonds issued by foreign governments and corporations.
- Convertible securities funds are invested in bonds that are capable of being converted into stock.
Pros and Cons of Bond Mutual Funds
Pros of Bond Mutual Funds
- Investors can benefit from the professional money managers that are experts in their respective fields.
- Bond funds usually pay higher interest rates compared to certificates of deposit, money market funds, and bank accounts.
- Investing in bonds funds is much easier compared to directly owning individual bonds. You don’t have to concern yourself with “laddering” your portfolio, the process of managing the maturity date of various bonds. You can also steer clear of having to deal with the situations like a company calling back the bonds, being forced to sell before maturity.
- There are numerous bond funds that distribute interest and gains in a monthly basis rather than semi-annually. This can lessen the stress for income-oriented investors who wish to rope in frequent deposits for daily necessities.
Cons of Bond Mutual Funds
- Risk does not work the same way it does with individual bonds, where it will decrease the closer to maturity. Individual holdings in bond funds are constantly maturing, being bought and sold, etc.
- Bond funds usually have higher expense ratios.
- Aggressive management can result to high leverage. You might get exposed to significant potential losses if you don’t pay close attention. Average investors should generally avoid leverage bond funds if they have any sense of reasonable risk management.
- There is no definite amount for your annual income.
Bonds have been incorporated into the portfolios of numerous investors over time. There are numerous types of bonds that you can choose from including the various types of bond-based securities. If you find yourself not having the time to invest in individual funds, there’s also the option of investing in bond mutual funds.
Just don’t forget to understand everything you can before deciding to invest in anything. Know your reason for buying what you’re about to buy. With that in mind, there’s a huge chance of you making a wise decision.
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