I recently came across an article I wrote some time ago about the basic structure of bills, notes and bonds and how they play into the long and short term investment strategies for traders and investors. So far, the feedback regarding some of the earlier articles has been positive so I'm re-posting this for the Advanced GET Community. Enjoy.
~Duane Gott
This week, we are going to delve into Bonds, Notes and Bills (if you haven’t yet guessed) and take a look at the differences between them and how they are used by independent traders and financial institutions alike.
Before we get started, there are a few key terms that we need to understand before we get to the actual definition of these types of investments and how they are traditionally used. The first of these terms is what is called a Debt Security. A debt security is a security that represents a loan from an investor to an issuer (we’ll cover these two in a moment). This means that the investor agrees to loan the issuer of the security an agreed amount of money for a predetermined amount of time at a fixed interest rate.
Ok…who’s who? The investor is exactly that; an investor / trader / speculator; basically you and I are investors. The Issuer is the entity that is borrowing money from you and me. Issuers are typically corporations, governments, or governmental agencies. We (the investors) are loaning corporations or other entities a sum of money with the agreement that the money will be paid back after a certain amount of time and at a predetermined interest rate. Now that we have an understanding of how debt securities work, let’s take a look at the different types of debt securities. The first one we’ll examine is the Bond.
A bond is a type of debt security that is issued for the purpose of raising money by borrowing from investors. Notes and Bill are particular types of bonds. The primary difference between a note and bill is the amount of time (maturity) in which the money will be paid back to the investor. Not only will the money invested be paid back, but also any interest that was earned during the life of the bond. There are several types of bonds. Bonds can be secured or unsecured, and can be qualified by issuer type and credit quality. U.S. Bonds are typically regarded as the safest of all Bond types because the money is backed by the U.S. government. Bonds issued by the government or other governmental agencies are usually tax exempt; both from state and local levels.
One type of bond is what is called a Note. A note is a type of bond that has a maturity rate of five years or less.
The final debt security that we’ll discuss is the Bill. Bills are issued exclusively by the US Government. This type of security often goes by the name Treasury Bill or T-Bill. Treasury Bills are typically set with varying rates of maturity; therefore, there are 30 Year T-Bills, 10 Year T Bills and so forth. For T-Bills with longer maturities, there is usually a high interest rate paid for these instruments.
Let’s take a look at a real world example….
If a 90-day T-Bill is priced at $9800, then you pay that amount and, in 90 days, you will receive $10,000.
While we have spent our time looking at government issued bonds, let’s take a look at non-government issued bonds. Before we go too far, we need to understand what happens when an Issuer is unable to repay the funds it has borrowed from the Investor. Bonds are typically given a rating on how safe they are. The rating basically defines how risky a particular bond may be. The ratings start at AAA (the highest investment quality) and goes down to D (for default). Any bond that receives a rating less than BB, is considered a junk bond. Junk bonds are riskier investments, but can usually yield 3-4% more than a government issued bond.
This synopsis only scratches the surface of the Bond Market. There are literally hundreds of types of bonds that can be helpful in protecting investor capital during bear markets or when the stock market does not provide substantial upside returns.