Investment Basics - Bonds (2024)

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.

1. 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:

• U.S. Treasury bills mature between 90 days and one year;
• U.S. Treasury notes mature between two and 10 years; and
• 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.

2. Municipal Bonds

Municipal bonds are issued by state and local governments. These bonds are exempt from federal taxes. Also, some states will exempt their 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.

3. 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:

• Short-term corporate bonds: one to five years;
• Intermediate-term corporate bonds: five to 15 years; and
• Long-term corporate bonds: longer than 15 years.

Bond Risks

Bonds are often viewed 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 investment risks. Some considerations when deciding whether to purchase bonds are provided below.

1. 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.

2. 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.

3. Liquidity Risk

Liquidity risk is associated with the ability to convert an investment into cash. Bonds generally have higher liquidity risk because they are not traded on exchanges 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.

4. 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 a buyer to purchase 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.

5. 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 below are based on their credit risk. The lower the bond rating, the higher the credit risk and a greater chance that the bond issuer will be unable to make the bond payments.

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.

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.) A relief association has authority to invest directly, or indirectly, up to five percent of its portfolio in below-investment-grade bonds. The five-percent portfolio limit on below-investment-grade bonds includes direct investment in these types of bonds as well as investments through mutual funds or exchange-traded funds. Many relief associations invest in mutual funds that have a small allocation in these types of bonds. The portion of these mutual funds that include below-investment-grade bonds are counted toward the five-percent portfolio limit.

Additional Resources

More information can be found in our Pension Investment Basic Series found in the Investment Basics Topic.

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.

Last Updated May 2024