Understanding Corporate Debt, Municipal Bonds, & Government Securities

Corporate Debt

Corporations issue bonds to assist in financing expansion, equipment, or operating expenses. Corporate bonds are the company's promissory note for the funds you lend by purchasing the bond. When a company's assets are liquidated in the event of bankruptcy, bondholders have priority over stockholders. Suppose a corporation's debt is deemed investment-grade. In that case, it can also issue medium-term notes through shelf registration, which is less expensive and allows for greater flexibility in note issuance. Federal, state, and local governments tax the interest on corporate bonds at rates applicable to ordinary income.

Typically, corporate bonds carry a fixed interest rate, and interest is paid every six months. The market for corporate bonds is large and liquid, with high trading volumes on average. Public utilities, transportation companies, industrial corporations, financial services companies, and conglomerates account for most corporate bonds. Like stocks, bonds can be traded on the over-the-counter (OTC) market and the New York Stock Exchange by brokers and bond dealers (NYSE). Significant corporations' debt issues on the NYSE are quoted and traded daily. Listed bonds are typically sold in $1,000 denominations, while OTC bonds have a $5,000 minimum.

The value of bonds' principal may fluctuate based on market conditions. Prematurely redeemed bonds may be worth more or less than their original value. Investments with a higher yield target also carry a greater degree of risk.

Municipal Bonds

State and local governments frequently borrow funds to supplement tax revenues and finance projects like new highways, buildings, and public works improvements. The project's revenues back revenue bonds, whereas the issuer's taxing authority backs general obligation bonds. Industrial development bonds finance facilities for private businesses that stimulate economic growth in disadvantaged regions. Some states issue what is known as baccalaureate or college-saver bonds: zero-coupon bonds (see below) that are sold at a discount and assist parents in saving for their children's in-state college education.

Municipal bonds, or munis, have historically attracted investors in the highest tax brackets. This is because municipal bonds with favorable tax treatment can offer a higher return than bonds that pay taxable interest. Regulations vary from state to state, but most state and local governments do not tax the interest on municipal bonds issued within their borders. Additionally, municipal bond interest is generally (but not always) exempt from federal taxation. Whether or not it is taxable depends on the purpose for which the municipality or state will use the bond proceeds. For instance, taxable municipal bonds may be used to finance local sports facilities, investor-led housing developments, and specific municipal refinancing strategies that the federal government deems not to provide a substantial public benefit. Private activity bonds (also known as non-essential function bonds or private purpose bonds) are those in which 10 percent or more of the bond's benefit is allocated to private activities, or 5 percent of the proceeds (or $5 million, whichever is less) are used for loans to parties other than government units. Private activity bonds are generally taxable unless their use is expressly exempt from taxation.

(For example, the American Recovery and Reinvestment Act of 2009 explicitly exempts interest on private activity bonds issued in 2009 and 2010 from being included in the alternative minimum tax calculations.) Most private activity bonds are considered tax preference items and included when calculating AMT liability. Bond interest is typically paid every six months, whereas interest on notes is typically paid at maturity.

Note: If you sell a municipal bond at a profit, you could incur capital gains taxes. The principal value of bonds may fluctuate based on market conditions, and pre-maturely redeemed bonds may be worth more or less than their initial cost. The alternative minimum tax may apply to a portion of municipal bond interest.

Government Securities

The federal government borrows funds similarly to corporations. However, Treasury securities and corporate bonds are very different. Sold by the United States. Treasury, they are backed by the full faith and credit of the United States government. Because the government can always raise taxes to pay off its debt, these bonds are regarded as relatively secure. Treasury securities are frequently used as a standard against which other types of investments are measured. At regularly scheduled Treasury auctions, rates are determined. Treasury securities are issued in increments of $100 and may be purchased in $100 increments (though brokers may set higher minimum purchase requirements). These are the essential Treasury securities for investors:

Government Bills (T-Bills)

These are relatively short-term securities with maturities ranging from four to fifty-two weeks. Treasury conducts regular auctions to sell T-bills and determine their current interest rate. Treasury bills are purchased at a discount to face value from the Treasury and redeemed at face value. The difference between the discounted price you pay for a T-bill and its face value is the interest you receive. For instance, if you purchase a $100 T-bill at auction for $97, you will receive $3 in interest when the bill matures, and you are repaid the total $100 face value. In this example, the discount rate is 3 percent. Typically, money market funds invest in Treasury bills.

Government Notes

Periodically, the Treasury holds auctions to sell various maturities ranging from 2 to 10 years. Notes, unlike Treasury bills, accrue interest every six months until maturity. On the secondary market, they are traded by investors who may or may not hold them to maturity.

Government bonds

There are 30-year maturities available. Institutional investors frequently purchase them with long-term financial obligations and require the relative security Treasuries provide.

Inflation-Protected Treasury Securities (Tips)

TIPS have unique inflation-protection characteristics. In 1997, they were introduced to adjust your initial investment (principal) and the interest paid every six months to reflect changes in the Consumer Price Index, a widely used measure of inflation. If the CPI rises, the Treasury will recalculate your principal to account for the increase. The interest rate is fixed, but it will fluctuate with inflation because it is applied to the adjusted principal amount. If the CPI falls, the principal balance will be adjusted accordingly; if deflation occurs, your principal balance could decrease. When the TIPS matures, you will receive either the principal adjusted for inflation or your initial investment, whichever is greater. TIPS are available with maturities of 5, 10, or 30 years; their prices are determined at auction. As with Treasury notes and bonds, the market value of a TIPS depends on interest rates and returns on other investments, and selling it before maturity can result in a loss.

Treasury securities are exempt from state and local taxes, but the interest is taxable as ordinary income on your federal return. Moreover, investors who hold TIPS in a taxable account will be taxed at ordinary income rates on any increases to the principal amount, even if the increases are not paid until the issue matures.

Treasury Variable Rate Notes

In January 2014, the Treasury began issuing floating-rate notes (FRNs). As implied by its name, the interest rate paid by an FRN can fluctuate over time. Interest payments on an FRN will increase as interest rates rise and decrease as interest rates fall; these weekly changes are based on the most recent discount rate for 13-week Treasury bills. However, quarterly interest payments are made.

Note: The interest rate on an FRN is composed of two components. The spread, which represents the highest acceptable discount margin at the auction where the FRN is initially offered, remains constant for the duration of the FRN. The second component, the index rate, is tied to the most recent 13-week Treasury bill with the highest accepted discount rate. The interest rate equals the sum of the spread and the index rate. This interest rate is applied daily to the principal of an FRN, so interest earned on an FRN accumulates daily.

FRNs have a two-year maturity and are only issued electronically. The minimum purchase is $100, and FRNs must be acquired in $100 increments. FRNs are auctioned off every month by the Treasury. FRNs can typically be acquired through TreasuryDirect or a broker, unlike other Treasury securities. However, you must go through a bank or broker if you wish to sell an FRN (if your FRN is held through TreasuryDirect, you must first transfer it to a bank or broker who will handle the transaction). Like other Treasury securities, interest on FRNs is exempt from state and local taxes but subject to federal income tax.

U.S. Savings Bonds

Similar to the above Treasury securities, the United States issues savings bonds. Treasury. However, because they are not publicly traded, they are not viewed in the same light as other Treasury securities. Savings bonds are registered bonds that bear the owner's name and can only be redeemed by the registered owner or beneficiary. As the name suggests, they are most commonly used for savings; if used to finance a college education, all or a portion of the interest may be exempt from federal taxation (this benefit is phased out for individuals with higher incomes). They are also popular as presents. Tax is deferred on savings bonds until maturity.

There are still two fundamental types that can be purchased directly from the Treasury at www.treasurydirect.gov:

The interest rate on Series EE bonds is variable if purchased between May 1997 and April 2005 and fixed if purchased after May 2005. Interest is paid when the bond is redeemed, which can occur anytime after one year. However, if you redeem an EE bond within the first five years, you will forfeit the most recent three months of interest; there is no redemption penalty after five years. Unlike other bonds, EE savings bonds continue to accrue interest until 30 years after the date of issuance. EE bonds are so-called Patriot Bonds issued after December 10, 2001.

The 1998 introduction of Series I bonds provides some protection against inflation. Combining a fixed rate of return set when the bond is issued with a semi-annual inflation rate that changes twice a year and is based on the Consumer Price Index yields the earnings on an I bond (CPI). I-bonds are sold at face value, and the interest is paid upon redemption. Similar to EE bonds, redemption within five years of purchase incurs a penalty. Even after maturity, they will continue to pay interest until 30 years after the date of issuance.
Depending on when they were issued, some Series E and Series HH/H bonds may have matured but continue to make semiannual interest payments. They are no longer available for purchase. Other older savings bonds, including Series A, B, C, D, F, G, J, and K, and so-called Freedom Shares, no longer pay interest and must be redeemed.

Agency And GSE Securities

Government agencies can issue their own bonds. The same is true for organizations known as government-sponsored enterprises (GSEs), which are private agencies chartered by the U.S. government but are not a part of it. Agency or GSE bonds are frequently referred to by their issuers' nicknames, making them easy to identify. Ginnie Maes is the name given to the bonds issued by the Government National Mortgage Association (GNMA). Freddie Mac bonds are issued by the Federal Home Loan Mortgage Corporation (FHLMC), while Fannie Mae bonds are issued by the Federal National Mortgage Association (FNMA). Initially created by the federal government, Fannie Mae and Freddie Mac became publicly traded corporations whose shares were traded on the New York Stock Exchange. Nonetheless, due to the 2008 financial crisis, both were placed under the control of the Federal Housing Finance Agency; their stocks were delisted in 2010 but may still be traded on the over-the-counter market.

All three package mortgages originated by banks, savings and loans, and other financial institutions that lend money to homeowners to create (or in some cases guarantee) securities known as "mortgage-backed passthrough securities" that can be purchased and sold by investors on the open market. Each investor receives a proportional portion of all payments made by homeowners whose mortgages are included in the pool. These can be extremely sensitive to changes in interest rates, as homeowners may refinance or pay off their mortgages early if rates decline.

Fannie Mae and Freddie Mac also issue coupon-bearing debt securities (agency debentures) to fund the acquisition of mortgages underlying an MBS. Any Fannie Mae or Freddie Mac guarantees are typically backed not by the U.S. government but by the creditworthiness and debt-paying ability of the issuer, whose assets may include mortgages and mortgage-backed securities. As part of a conservatorship of the two entities, the U.S. government has agreed to cover losses of up to $650 billion for each agency. However, there is no assurance that this will continue indefinitely.

Unlike Fannie Mae and Freddie Mac, Ginnie Mae is a U.S. government agency: housing and Urban Development Department. The full faith and credit of the United States government support all Ginnie Mae securities. They typically offer a lower yield than Fannies and Freddies due to their greater security. Ginnie Mae does not issue debentures; its mortgage-backed securities consist of FHA- or VA-insured mortgages.

The federal government also established the Student Loan Marketing Association, which publishes Sallie Maes but is now an independent organization. Other GSEs are not publicly traded companies. For instance, the Federal Home Loan Banks and the Federal Farm Credit Banks are regional bank systems, whereas the Tennessee Valley Authority (TVA) is a government-owned corporation. Because these agencies serve a public purpose, the credit markets assume the government would intervene if a GSE defaulted; however, the government does not guarantee repayment, as it does with Treasury securities and Ginnie Maes.

International Obligations

As in the United States, foreign corporations and governments raise capital by issuing bonds that can be sold domestically or abroad. Foreign companies issue Yankee bonds on the U.S. market; because they are denominated in U.S. dollars, they are less susceptible to fluctuations in the value of the home government's currency. Bonds sold in a foreign market other than the issuer's home country are frequently referred to by names that reflect the foreign market. So-called samurai bonds are denominated in yen and sold in Japan by non-Japanese firms; bulldog bonds are denominated in pounds sterling and sold in the United Kingdom by non-British firms. Unless they are denominated in U.S. dollars, international bonds are subject to currency risk, which is the possibility of incurring losses due to fluctuations in the value of the issuer's home currency.

Also, bonds issued by emerging countries may have high yields because the risk of default may be much higher in countries with a higher likelihood of economic or political instability; they may also pose a greater liquidity risk if they are not frequently traded. Eurobonds are medium- or long-term bonds issued by significant borrowers, governments, other public entities, and large multinational corporations. Eurobonds are denominated in a currency other than the issuing country's currency. Eurobonds are simultaneously offered to investors in several countries upon issuance. Eurobonds typically feature a fixed interest rate determined at issuance and paid annually or semiannually. Government bonds issued by member states have been redenominated due to the introduction of the euro and the establishment of a single European financial market.

The Lynch Retirement Investment Group, LLC has prepared some of the following materials. The material is considered reliable, but Raymond James Financial Services, Inc. does not guarantee that the foregoing is accurate or complete. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. This information is not intended as a solicitation or an offer to buy or sell any security or product referred herein. The investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results. Raymond James Financial Services, Inc. does not provide advice on tax, legal, or mortgage issues. These matters should be discussed with the appropriate professional.  Investing involves risk, and you may incur a profit or loss regardless of the strategy selected.

Bond prices and yields are subject to change based on market conditions and availability. If bonds are sold before maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall, and when interest rates fall, bond prices generally rise. Unique risks are associated with investing in bonds, such as interest rate, market risk, call risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences. To learn more about these risks and the suitability of these bonds for you, please get in touch with our office.

Bonds are subject to risk factors, including:

1) Default Risk - the risk that the issuer of the bond might default on its obligation

2) Rating Downgrade - the risk that a rating agency lowers a debt issuer's bond rating

3) Reinvestment Risk - the risk that a bond might mature when interest rates fall, forcing the investor to accept lower rates of interest (this includes the risk of early redemption when a company calls its bonds before maturity)

4) Interest Rate Risk - this is the risk that bond prices tend to fall as interest rates rise.

5) Liquidity Risk - the risk that a creditor may not be able to liquidate the bond before maturity.
Long-term Corporate Bonds are debt obligations of the issuing corporation.

High-yield bonds are not suitable for all investors. The risk of default may increase due to changes in the issuer's credit quality. Price changes may occur due to changes in interest rates and the bond's liquidity. When appropriate, these bonds should only comprise a modest portion of a portfolio.

Investments in municipal securities may not be appropriate for all investors, particularly those who do not stand to benefit from the tax status of the investment. Municipal bond interest is not subject to federal income tax but may be subject to AMT, state, or local taxes.
The U.S. government guarantees U.S. government bonds and Treasury notes and, if held to maturity, offers a fixed rate of return and guaranteed principal value. U.S. government bonds are issued and guaranteed as to the timely payment of principal and interest by the federal government. Treasury notes are certificates reflecting the U.S. government's intermediate-term (2 - 10 years) obligations.

Treasury Bills are certificates reflecting the U.S. government's short-term (under one year) obligations.

Treasury Inflation-Protected Securities (TIPS) protect against inflation by adjusting their principal amount annually based on the Consumer Price Index (CPI) and then paying interest on that new amount.  The principal amount is readjusted yearly based on the prior year's CPI, meaning it can go down and up. When TIPS matures, the investor receives either the current principal value or the original amount invested in the TIPS bond, whichever is higher. TIPS offers the benefit of diversification and a hedge against inflation. The U.S. government guarantees their principal value, and they are highly liquid  - they can be bought or sold before they mature. If sold before maturity, an investor will receive the current market value, which may be more or less than the amount invested. TIPS will lose value in deflationary periods. They should be held only in nontaxable accounts such as an IRA because increases in the principal amount are considered taxable income in the year they occur, even though the principal amount is not returned to the holder until maturity.