Smart Bond Investing

Individual Bonds


Money Market Securities and More

A number of other bond categories exist that are primarily traded by professional investors and differ from Treasuries, munis, corporates, agencies and mortgage-backed securities.

Money Market Securities

Money market instruments include bankers' acceptances, certificates of deposit and commercial paper. Bankers' acceptances are typically used to finance international transactions in goods and services, while certificates of deposit (CDs) are large-denomination, negotiable time deposits issued by commercial banks and thrift institutions. Commercial paper takes the form of short-term, unsecured promissory notes issued by both financial and non-financial corporations.

Some combination of these products makes up a money market fund. All money market funds are required to have a dollar-weighted average portfolio maturity that cannot exceed 90 days. While money market securities are highly liquid (you can usually receive your money in a few days, compared to months or years with a CD), the interest you earn on your money tends to be quite low and may not keep pace with inflation.

Asset-Backed Securities

Asset-backed securities (ABSs) are certificates that represent an interest in a pool of assets such as credit card receivables, auto loans and leases, home equity loans, and even the future royalties of a musician (for instance, Bowie bonds). Once you get beyond mortgage-backed securities, which are a type of asset-backed security, investing and trading in the asset-backed market is almost exclusively done by more sophisticated investors. The interest and principal payments on the pool of assets are passed through to investors in the form of short-term bonds that generally carry an investment-grade credit rating, and these bonds are relatively liquid.

Preferred Securities

There are two common types of preferred securities: equity preferred stock and debt preferred stock. Equity preferred stock is much like common stock in that it never matures, and it declares dividends rather than awarding regular interest payments. Debt preferreds, on the other hand, pay interest like traditional bonds, and since they are corporate debt, they stand ahead of equity preferred securities in the payout hierarchy should the company default. However, many preferreds are hybrids—they contain a combination of debt and equity features, and it is not always clear which type of security they are. Unlike traditional bonds, preferreds generally have a par value of $25 instead of the traditional $1,000. They also tend to pay interest quarterly, rather than the traditional semiannual payment associated with most bonds. Most preferreds are listed just like stocks, with the majority trading on the New York Stock Exchange. Like traditional bonds, preferreds tend to have credit ratings, and upgrades and downgrades often play an important role in the price a preferred can command in the secondary market.

Auction Rate Securities

Auction rate securities (ARS) are often debt instruments (corporate or municipal bonds) with long-term maturities, but their interest rates can be regularly reset through Dutch auctions. ARS can also refer to preferred stocks with dividend payments that reset through the same process. The frequent auctions—held every seven, 14, 28 or 35 days—also allow investors who want to liquidate their investments to do so. But when there is no demand for ARS, the auctions fail and investors can’t access their investments. They have to wait until the next successful auction or until the security matures, which may not occur for several years. When an ARS auction fails, current investors will generally receive an interest rate or dividend set above market rates for the next holding period—up to any maximum disclosed in the offering documents.

For many years, investors purchased ARS seeking cash-like investments that paid a higher yield than money market mutual funds or certificates of deposit. Those expectations changed in early 2008 when credit market turbulence led many ARS auctions to fail. Many ARS investors who treated these securities as a ready source of cash before 2008 found themselves short on readily available funds. In response, some issuers of ARS offered to redeem shares at par value. Others have only offered to redeem some but not all of the outstanding shares. For more information, see FINRA’s Investor Alert, Auction Rate Securities: What Happens When Auctions Fail.

Event-Linked Bonds

Event-linked bonds—also called insurance-linked, or “catastrophe” bonds—are financial instruments that allow investors to speculate on a variety of events, including catastrophes such as hurricanes, earthquakes and pandemics. It is one way that insurance and reinsurance companies can transfer the risk of some or all the policies they underwrite for a particular disaster or disasters to investors who are willing to assume the risk. Event-linked securities generally offer higher interest rates than similarly rated corporate bonds. But, if a triggering catastrophic event occurs, holders can lose most or all of their principal and unpaid interest payments.

While individual retail investors generally cannot invest directly in event-linked securities, you can find out whether any of the bond funds you own invest in catastrophe bonds or other similar event-linked instruments. Check your fund’s prospectus and statement of additional information (SAI) to see whether your fund is authorized to invest in event-linked securities and if so, how much. You can typically find this information under the headings “Investment Objectives” or “Investment Policies.” For more information, see FINRA's Investor Alert, Catastrophe Bonds and Other Event-Linked Securities.

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