Not All Bonds Are Created Equally Safe Investments
As rates on savings deposits have looked unattractive to many consumers, safety-conscious investors have been looking around for other places to invest their money. Those who don’t feel comfortable with the stock market often turn to bonds.
In today’s marketplace, however, there are dozens of ways to invest in bonds, and some of these bond investments are not as safe as they may seem. Indeed, bond investors who try for high yields may find that the risks equal the risks they’d take in the stock market.
Bonds are essentially I.O.U.s issued by state and federal governments, mortgage agencies, corporations and foreign entities. When you buy a bond, you’re loaning your money to the organization that issued it.
The safety of your investment depends on the credit-worthiness of the borrower. And the return hinges on several other factors, including interest rates, prepayment rates and, sometimes, currency fluctuations.
Those looking for a high degree of safety have basically three options with bonds: Treasury securities, municipal bonds and mortgage-backed securities.
The safest of the three are Treasuries because the U.S. government stands behind them and is able to guarantee their repayment. But Treasuries also are among the lowest-yielding bonds. Short-term Treasury bills now yield about 4% to 4.5% depending on the maturity date, while 30-year Treasury bonds yield just slightly more than 8%.
Although these investments bear virtually no credit risk, investors do face interest rate risk. If interest rates in general go up, those who bought long-term bonds are stuck with a relatively low-yielding investment. If they want to sell before maturity, they could take a loss, since these bonds would sell at a discount from their face value because of the lower-than-market yield.
Municipal bonds, which are issued by states, cities, counties and some government agencies, are also generally considered safe investments, and they often provide better after-tax returns to investors than Treasuries. (Many municipal issues are free from federal and state income tax, while Treasuries are only free from state income taxes.)
However, in recent years, several municipalities have faced budget crises and ended up defaulting on their debts. This spate of defaults called the safety of the municipal bond market into question. But it doesn’t mean that investors should avoid municipal bonds.
They should, however, be cautious about investing their funds with a municipal issuer. Your bond broker should be able to provide you with two bits of pivotal information, starting with the ratings the bonds will receive from such well-known services as Standard & Poor’s, Moody’s Investors Service and Duff & Phelps. The higher the rating, generally, the safer your principal and interest.
Secondly, you should find out whether the bond is backed by private insurance. In 1980, a mere 3% of the municipal bonds issued were backed by private insurance. But last year, about 30% of the municipal bonds issued had private insurance backing, said a spokesman for the Municipal Bond Investors Assurance Corp. in Armonk, N.Y. The benefit to investors is clear. Private insurance puts a second organization between you and a potential default.
Another option is mortgage-backed securities. Mortgage-backed securities give investors a stake in a pool of mortgages. Commonly, these mortgage securities are issued by one of three organizations: the Government National Mortgage Corp., also known as Ginnie Mae; the Federal Home Loan Mortgage Corp., or Freddie Mac, and the Federal National Mortgage Assn., or Fannie Mae.
Mortgage securities issued by these organizations carry marginal credit risk, because Ginnie Mae, Fannie Mae and Freddie Mac guarantee the timely payment of both principal and interest to investors. Ginnie Mae’s guarantees are supported by the full faith and credit of the U.S. government.
The risk? Prepayment. If interest rates decline significantly, homeowners tend to refinance their mortgages. Ginnie, Fannie and Freddie will forward a pro-rata share of the prepaid principal to investors. But investors would lose out on several years of interest payments.
In other words, your yield is not locked in for any set period. And chances are, it’s when safe investment options are the least attractive that you might have to reinvest the money you put in mortgage securities.
It is also important to note that not all mortgage securities are issued by Fannie, Freddie and Ginnie. Some private investment companies issue mortgage securities that are not backed by a large company or government agency. These securities can promise higher yields, but investors bear the full risk of default and prepayment. These risks can be substantial. Only investors who are able to risk some of their investment dollars should consider these unsecured mortgage-backed securities.
