Plain vanilla bonds are also called conventional bonds or plain vanilla corporate bonds, since these are the most common type of corporate bond to be found on the market. Although they may seem basic, there are some important distinctions between other types of corporate bonds that investors should keep in mind when considering this type of bond.
We will go into more detail about the different types of bonds later in this guide, but first let us take a closer look at what makes plain vanilla bonds so special in the first place.
What are plain vanilla bonds?
An investment, plain vanilla bonds are typically issued by the U.S. Treasury Department or a large corporation and pay interest on a regular, predetermined schedule.
They are called plain vanilla because they do not have any of the frills and special features of other types of bonds. They are also called riskless securities because they are backed by the full faith and credit of the issuer.
In addition, plain vanilla bonds are not subject to call, that is they cannot be redeemed by an issuer before their maturity date. This is done so issuers can control their own cash flow and use it as they see fit rather than having a fixed schedule of payments.
For example, in 2013 Microsoft Corporation issued $1 billion worth of 10 year bonds with a 3 percent interest rate. The bonds were sold on January 23, 2013 at a price of 103 and mature on March 15, 2023. At maturity investors receive $1 billion (the par value) plus interest.
There are no tax advantages for investors who hold plain vanilla bonds until they are sold. This is because interest on these securities is taxed when it accrues.
In addition, any increase in value from purchase price up to maturity is considered capital gain and thus subject to taxes as well. However, there are special rules that apply when a security loses value or becomes worthless prior to its maturity date. This may allow investors in some circumstances reduce their taxes owed by claiming capital loss deductions against capital gains or other income sources such as employment wages.
How do plain vanilla bonds work?
Plain vanilla bonds are a type of investment vehicle that typically pays a fixed rate of interest. Plain vanilla bonds work by borrowing money from an investor and repaying them at an agreed upon time with interest.
The loans are paid back when the bond matures, which is the agreed upon time set in the contract. Investors can buy plain vanilla bonds from a company or from other investors through the secondary market, such as NASDAQ or NYSE.
The borrower pays interest (sometimes called coupon) to investors until it is time for the loan to be repaid. Plain vanilla bonds usually have a stated maturity date when they come due and pay off all principal and interest owed on that date.
In some cases, you can buy and sell plain vanilla bonds before they mature. In that case, it’s called trading a bond or buying on margin. You may want to do that if you think interest rates will rise and want to sell your bond at its higher market value. Or, you may sell a bond short – borrowing a bond from another investor and selling it with an agreement to buy it back later – if you think interest rates will fall and are willing to pay interest on a bond until then because of its lower price when that happens.
The benefits of investing in plain vanilla bonds
One of the benefits of investing in plain vanilla bonds is that they typically offer a higher interest rate than other types of securities. This can be beneficial if you need income from your investments, but if you’re investing for the long term, this may not be as important.
In addition, some bonds have special features that can provide additional benefits such as a guaranteed return or protection against inflation.
Another benefit of investing in plain vanilla bonds is that they’re fairly safe. Although interest rates vary from bond to bond, risk typically increases as you move away from plain vanilla bonds. However, some investors find it difficult to judge how different features can affect security and choose simpler investments as a result.
The risks of investing in plain vanilla bonds
There are two main risks that come with investing in plain vanilla bonds, which are interest rate risk and credit risk. Interest rate risk is the risk of losing your investment due to the fact that you invested in a bond that has an interest rate that was too high for the current market. Credit risk is the chance of default by either the company or country whose debt you’re investing in.
When you invest in plain vanilla bonds, there is less risk than when investing in other types of bonds. Still, there are risks involved and it’s important not to only invest what you can afford to lose because this may not be a good idea if something were to happen and your investments were no longer viable.
How to choose the right plain vanilla bond for you
Every investor has different goals and risk tolerance, so there is no one-size-fits-all plain vanilla bond. Still, there are some common considerations to keep in mind when choosing a plain vanilla bond. These include the following:
* Interest rate * Term (length of the bond) * Maturity date (the date on which the principal is repaid to you) * Credit rating of the issuer or guarantor of the security
Although there are some risks associated with plain vanilla bonds, such as default risk (the chance that a bond issuer can’t make interest payments or repay principal), plain vanilla bonds are considered a low-risk investment.
Plain vanilla bonds generally offer high liquidity and usually have little chance of default because they’re backed by government entities, companies with strong financials or supranational groups like the European Union or World Bank.
The bottom line
Plain vanilla bonds (also known as Government Securities) are the most basic of all bond types. They’re backed by the government, which means that you know for a fact that your investment is safe and secure. There’s no risk of defaulting, because if the government defaults on its debt obligations then it will cease to exist!
Although plain vanilla bonds are considered more conservative than other bond types, there is still a chance that you’ll lose money on this type of investment. If interest rates rise significantly higher than what was originally assumed when the bond was issued, then the value of your portfolio will decrease due to decreased demand.