A bond is a fixed income type of investment. Essentially you, as an investor, are loaning money to an entity (corporate or government) for a defined period at a variable or fixed interest rate. Many government and corporate bonds are traded on exchanges. Others are traded only over-the-counter (OTC). Money raised from the sale of bonds is used to finance new projects, maintain ongoing operations or refinance debt.
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Terms used in discussing bonds include bond principal which refers to the loaned funds. This is the amount that must be returned by the bond maturity date. The interest rate paid to lenders (investors) is called the coupon rate or payment.
The issue price of a bond is set at par, typically $100 or $1,000 face value per bond (sometimes more). The actual market price depends on several factors including the credit quality of the issuer, length of time until expiration and the coupon rate compared to the general interest rate at the time. Basically, bond prices move inversely with interest rates.
Varieties of Bonds
Zero-coupon bonds do not offer regular interest payments. Instead they are issued at a discount and their market price eventually becomes face value at maturity. Convertible bonds let you convert the bond debt into stock (equity) at some point if the share price rises to an elevated level.
Some corporate bonds are callable, meaning that the issuer can call back the bonds from debtholders if interest rates drop. Other bonds are putable, meaning that you can put the bond back to the issuer if interest rates rise sufficiently. Finally, most corporate bonds are so-called bullet bonds, with no options and a face value that is paid immediately at maturity.
Government Bond Issuers
Of the 7 primary issuers of bonds, two are U.S. government-based. They include U.S. Treasury and other government bonds known as agency bonds. Other bond issuers include investment-grade corporate bonds, high-yield corporate bonds, foreign bonds, mortgage-backed bonds and municipal bonds.
On the government end of the spectrum, Treasury bonds are backed by Uncle Sam, making them virtually risk free and the interest is exempt from state income taxes. Their yields, however, are going to be the lowest next to tax-free munis. Other government bonds, called agency bonds are low risk with a higher yield than Treasurys but the interest is taxable at both the state and federal levels.
Corporate Investment Grade Bonds
Of the two types of corporate bonds, investment grade is the least risky with ratings of at least triple-B from Standard & Poor’s, Moody’s or both. These bonds come from companies with strong balance sheets. The risk of default is considered remote. Their yields are higher than either Treasury or agency bonds and are typically fully taxable. In economic downturns these bonds tend to underperform Treasurys and agencies.
Corporate High-Yield Bonds
These bonds come from companies with weak balance sheets. They carry ratings below triple-B. Default is a possibility. High-yield bond prices are more closely tied to the health of corporate balance sheets. They track stock prices more closely than investment-grade bonds. According to Charles Schwab’s Steve Ward, "High-yield doesn't provide the same asset-allocation benefits you get by mixing high-grade bonds and stocks."
According to Lipper, the average foreign bond fund has about a third of its assets in foreign-currency-denominated debt with the rest dollar-denominated. With these types of bonds, the issuer promises to make interest payments and return the principal in another currency. The size of the payments when converted to dollars depends on the exchange rate at the time. Obviously if the dollar strengthens against the foreign currency the dollar payments will be smaller. If the dollar weakens the opposite will be true.
Mortgage-backed bonds, which have a face value of $25,000 compared to $1,000 or $5,000 for other types of bonds, involve "prepayment risk." Their value drops when the rate of mortgage prepayments rises. As a result, these types of bonds don’t benefit from declining interest rates like most other bonds do.
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Municipal bonds or “munis” are issued by states and local governments or their agencies. They come in both investment-grade and high-yield varieties. The interest is tax-free, but that doesn't mean they are right for you. Taxable bonds have higher yields than munis, so your tax bracket may determine whether tax free munis or taxable bonds are best in your case.