Investment Basics - Bonds

Bonds are IOUs that are issued by companies and governments to finance day-to-day operations or to finance certain projects. Investors can buy bonds directly or purchase shares of pools of bonds through mutual funds or exchange traded funds. The original amount invested when a bond is purchased is called the principal. Usually, the principal is returned to the investor when the bond matures. In addition, investors usually receive interest payments at specific times each year until the bond matures. Bond maturity periods vary depending on the particular bond. 

Types of Bonds

Bonds are generally issued by domestic and foreign governments and corporations. Most domestic bonds are issued by one of three groups: the U.S. government; a state or local government; or a corporation.

• U.S. Government Bonds

U.S. government bonds issued by the U.S. Treasury are considered very safe and the income earned is exempt from state and local taxes. U.S. government bonds are issued based on years to maturity as follows:

1. U.S. Treasury bills mature between 90 days and one year;
2. U.S. Treasury notes mature between two and 10 years; and
3. U.S. Treasury bonds mature between 10 and 30 years.

Bonds are also issued by U.S. government agencies and instrumentalities that have different ratings and risks.

• Municipal Bonds

Municipal bonds are issued by state and local governments. These bonds are exempt from federal taxes. Also, some states will exempt their own citizens from paying taxes on their bonds, making certain municipal bonds completely tax-free. Since public pension plans do not pay income tax this tax-free aspect of municipal bonds is of little value to a relief association.

• Corporate Bonds

Generally, corporate bonds carry more risk than U.S. government bonds or municipal bonds. They are usually categorized by years to maturity as follows:

1. Short-term: one to five years;
2. Intermediate-term: five to 15 years; and
3. Long-term: longer than 15 years.

Bond Risks

Many view bonds as an integral part of a well-diversified portfolio. Bonds are generally considered safe and reliable investments and can provide a continual stream of income. As with all investments, bonds do have some risks associated with them. Some considerations when deciding whether to purchase bonds are provided below.

• Inflation Risk

Inflation can erode a fixed-interest rate bond’s value over time. As inflation rises, a bond’s fixed interest rate is diminished, especially for long-term bonds. Some bonds have variable interest rates. 

• Interest Rate Risk

Bond prices are inversely affected by interest rates. When interest rates rise, bond prices go down. During times of inflation interest rates often go up, reducing the value and interest income from bonds. 

• Credit Risk

Credit risk is associated with a bond issuer’s ability to make interest payments on time and repay the principal when the bond matures. The bonds ratings above are based on their credit risk. The lower the bond rating the higher the credit risk of a particular bond. A higher credit risk means there is a greater perceived chance that the bond issuer will be unable to make bond payments.

• Liquidity Risk

Liquidity risk is associated with the ability to convert an investment into cash. Bonds generally have higher liquidity risk because there are not exchanges to trade bonds on, as there are with stocks. Bond ratings and years to maturity are a large factor in the liquidity of a particular bond. Bonds with short maturity dates and with high credit ratings are generally much more liquid than bonds with long maturities and lower credit ratings.

• Market Risk

Market risk relates to supply and demand. When there is a large demand for bonds, market risk is lower because it is easier to find someone to buy your bonds at full value. When demand is lower for bonds and supplies of bonds increase, market risk is at its highest because bonds are more difficult to sell and often sell for less than face value. If you buy a bond and hold it to maturity, then market risk will not be a factor.

Bond Ratings

Bonds are rated according to risk. Bonds are usually rated by agencies such as Moody’s Investors Service or the Standard and Poor’s Corporation. The chart below shows the bond ratings along with the grade and risk of default for each rating.

Bond Rating	Grade	Risk
AAA	Investment Grade	Lowest Risk
AA	Investment Grade	Low Risk
A	Investment Grade	Low Risk
BBB	Investment Grade	Medium Risk
BB/B	Junk	High Risk
CCC/CC/C	Junk	Highest Risk
D	Junk	In Default

 

Investment Authority

Relief associations are authorized to invest up to 100 percent of their portfolio in government and corporate bonds, subject to certain limitations and quality ratings. (See Minn. Stat. § 356A.06, subds. 6 and 7.) Relief associations do not, however, have authority to directly invest in below-investment-grade (junk) bonds or in international bonds. Sometimes mutual funds have small positions in below-investment-grade bonds or international bonds. If so, these securities will be subject to the 20 percent portfolio limitation on “other investments.” 

Additional Resources

Additional information is provided for in a Statement of Position on Relief Association Investment Authority and in another Statement of Position on Relief Association Investment Policies.

Published last in the April 2010 Pension Newsletter