Types of bonds

In general, fixed income securities are classified according to the length of time before maturity.

Here are the 3 main categories:

• Treasury bills: debt securities maturing in less than 1 year.
• notes: debt securities maturing in 1 to 10 years.
• bonds: debt securities maturing in more than 10 years.

Treasury bills (T-bills)

Technically speaking, T-bills aren't bonds because of their short maturity. Governments also issue Treasury notes and Treasury bonds.

All debt issued by the federal government is regarded as extremely safe, as is the debt of any stable country. The debt of many developing countries, however, does carry substantial risk. Just like companies, countries can default on payments. For example, in August 2011, Greek government bonds were considered high risk because of the country's economic issues. At the same period, Canadian government bonds were considered very safe.

Municipal bonds

Municipal bonds are the next progression in terms of risk. Cities rarely go bankrupt, but it can happen.

Municipal bonds have a slightly higher yield than government bonds.

Corporate bonds

Large corporations have a lot of flexibility as to how many bonds they can issue: the limit is whatever the market will bear.

Corporate bonds generally fall into 3 categories:

• short-term: less than 5 years
• intermediate: 5 to 12 years
• long-term: over 12 years

Corporate bonds are characterized by higher yields because there's a higher risk of a company defaulting than a government. The upside is they can also be the most rewarding fixed-income investments because of the risk the investor must take on. After all, companies go bankrupt more frequently than a province of city. A company's credit quality is very important: The higher the quality, the lower the interest rate the investor receives. It's the balance between yield and risk.

Companies can also issue convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.

Zero coupon bonds

This type of bond makes no coupon payments but instead is issued at a considerable discount to par value. For example, a zero coupon bond with a $1,000 par value and 10 years to maturity might be trading at $600. So today you pay $600 for a bond that will be worth $1,000 in 10 years.

"Strip bonds" and "strip coupons" are essentially zero coupon bonds. Their name is derived from the fact that the bonds, originally interest bearing, were "stripped" of their interest payments.

Bond derivatives

Bonds can also be offered as components of a financial derivative. One such product that has gained popularity in the past few years is the principal protected note (PPN).

PPNs typically allow investors to participate in market gains while also acting like a bond by guaranteeing the amount invested.

You can also indirectly invest in bonds through mutual funds or exchange-traded funds (ETFs) that specialize in bonds.

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