It is not uncommon to wrongly distinguish between these instruments. While these instruments do not have the same sex appeal as stocks or options, they can provide investors with a safe, secure place to create returns on their money.

We’ll start with Bonds. Bonds are considered to be a security, much like stocks. The major difference is that when you purchase bonds, you are considered a lender to the company (i.e. you have no stake within the company like a shareholder does). Bonds are typically referred to as fixed-income securities; however this can be misleading as returns are not guaranteed. They are most commonly issued by governments, companies, agencies, etc. as we way to raise capital.

There are several major markets where bonds are bought and sold every day. We will briefly touch on each one.

The Municipal Bonds Market includes bonds that are issued by governments, cities, hospitals, etc. These bonds pay for projects that are considered “public good.” Two examples are when a city or state issues bonds to pay for a local infrastructure project or a hospital to pay for expansion of their building. High tax bracket individuals tend to gravitate towards municipal bonds because of the tax benefits offered. A majority of municipal bonds issued are exempt from local, state and federal taxes.

The largest bond market in the world and by far the most liquid is the Treasury Securities Market. These are government bonds issued by the United States Department of Treasury. There is currently over $3 trillion in outstanding treasury debt. These are the lowest yielding among bonds, however they are also considered to be the lowest risk.

The U.S. Treasury issues three different types of securities: treasury bills, which have a maturity date of 364 days or less, treasury notes which have a maturity of anywhere from two to ten years, and treasury bonds, which mature in 10 years or more. Because these securities are backed by the full faith and credit of the United States Government, they are considered to be “risk free.” Also, the interest earned from these securities is exempt from state and local taxes, but not federal.

The Federal Agency Securities Market, which is a bonds market that allows government sponsored Enterprises (GSEs) to issue bonds, was created by congress to create liquidity for home mortgages, student loans, and more. When you hear about companies like Fannie Mae and Freddie Mac, they use the FASM market to fund their daily operations. Most of the interest an investor accrues on these bonds is also exempt from state and local taxes.

When it comes to corporations that need to issue bonds to raise capital, there is the Corporate Bonds Market. This market allows corporations to raise money to fund investment in technology, business expansion and other business-related purposes. There is an estimated $4 trillion outstanding at any time in the corporate bond market. Bond holders have a senior claim to the companies’ underlying assets, which means if a corporation were to go out of business bond holders would receive capital from the liquidation of those assets before the stockholders would.

A lot has been said in the news as of late about the Money Markets. The instruments traded in these markets include Bankers Acceptances, Certificate of Deposits (CDs) and Commercial Paper.

Banker Acceptances are used by financial institutions to finance international business transactions of goods and services and make up a small portion of the market.
Certificate of Deposits are typically issued by small banks and credit unions. These instruments are FDIC insured and typically pay higher interest rates because they require the lender to wait until maturity date to cash them in.

Many large businesses issue commercial paper, which are unsecured, short-term debt instruments. The life of commercial paper is usually less than 270 days. Because there is no collateral to back these loans, only companies with high credit ratings will typically find investors to purchase their commercial paper. Despite the higher risk involved with commercial paper, investors find these instruments tempting because of their short lifespan and higher interest rates paid.

The Asset-Backed Securities Market represents certificates that are large pools of credit card debt, auto loans, etc. Investors receive payments of both interest and principal. Much has been in the news lately about these securities as they have lost substantial value as people default their various loans. Typically, large financial institutions such as Goldman Sachs and Citigroup trade these instruments.

The final market we cover is the Mortgage Securities Market. In this market, investors purchase ownership into mortgage securities, which are pools of multiple home mortgages. As the mortgage payments are made by the homeowners, investors receive interest payments along with principal. The major risk of these securities are that the cash flow is dependent on the the payments of the underlying mortgages. You can see where a problem might arise… (clear throat).