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. The ABS market has grown rapidly of late and now comprises well over $2 trillion in outstanding debt.

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

Investors who purchase auction rate securities (ARS) are typically seeking a cash-like investment that pays a higher yield than money market mutual funds or certificates of deposit. There generally are two types of ARS, bonds with long-term maturities (20 to 30 years) and preferred shares with a cash dividend. Both the interest on the bonds and the dividend on the preferred shares are variable based on rates that are set through auctions for a specified short term usually measured in days—7, 14, 28, or 35. This is unlike a traditional bond that is issued with an interest rate set for the life of the bond or preferred stock that specifies the dividend rate for the life of the shares. Auction rate bonds are issued by municipalities, student-loan authorities, museums and many others. Some auction rate bonds, such as those issued by municipalities, may offer certain tax advantages. Auction rate preferred shares are issued by closed-end funds.

Recent developments in the credit market have led many of the ARS auctions to fail, which may prevent existing investors from selling their ARS holdings. As a result, ARS investors who treated these securities as a ready source of cash have found themselves short on readily available funds. In response, some issuers of ARS have announced redemptions of shares, generally at par value. In some cases, however, the issuer only offers to redeem some but not all of the outstanding shares. This may leave some investors with holdings they are unable to liquidate. 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.