What is a bond?

Most people are more familiar with bonds than they think. Have you ever received a savings bond as a gift? Let's say the face value is $100. Whoever bought the bond did not pay $100 for it; they probably paid $50. This savings bond will accrue interest over a period of years until it reaches its face value of $100. At this point, the bond has "matured."But what was going on there? Why did the savings bond gain interest? Essentially, when someone pays his or her $50, the federal government is borrowing that money at an agreed-upon interest rate. This is the way all bonds work. Someone borrows money and agrees to an interest rate, and the lender gets a piece of paper stating this agreement. Bonds are securities that generate a fixed income each year. For this reason, they are known as "fixed-income" securities. A bond can be sold to another person, and the amount of money generated will remain the same.

Types of Bonds:

Bonds can be sold by institutions other than the federal government. Each type of bond is categorized by who is selling the debt, not who buys it. The following are examples of types of bonds.

Bonds issued by the US Federal Government

Because they are sold by the Treasury Department, these bonds are often referred to as "Treasuries." There are many types of Treasuries, with different "maturities" (the amount of time before Treasury reaches maturity), including Treasury bills (a.k.a. "T-bills," which have a maturity of less than 1 year and are issued at discount, meaning there is no fixed interest payment), Treasury notes (with a maturity of between 1 and 10 years), and Treasury bonds (with a maturity of over 10 years).

The government also sells inflation-indexed notes, which guarantee a return higher than the rate of inflation if they are held to maturity. The Treasury Department also sells debt through the Bureau of the Public Debt - including the aforementioned savings bonds. All Treasuries are guaranteed by the federal government, and all interest paid by such securities is exempt from state and local taxes.

Bonds issued by other government agencies

Other government agencies (and agencies like Fannie Mae) issue bonds that are still backed by the US government. These bonds are generally issued for specific purposes such as purchasing a home.

Bonds issued by state and local governments

Tax-free municipal bonds, or "munis," are issued by state and local governments. Just like corporations, state and local governments can go bankrupt (because unlike the US Government, they don't print their own money). And just like corporations, state and local governments must offer competitive interest rates. Unlike corporations, state and local governments can only raise money by raising taxes. To avoid the discontent usually caused by tax hikes, the US Government allows state and local governments to sell bonds which are free from federal income tax on their interest, and the debtors themselves may waive their own taxes. For this reason, creditors in high tax brackets will often find that these bonds will have the highest after-tax yield of any other form of fixed-income investment.

Bonds issued by corporations

Corporate bonds are sold by corporations in much the same way stock is sold. Corporations are very flexible when it comes to how much debt they can issue, but they must offer higher interest rates than the government. This is because there is always a chance that a company can go bankrupt and default on its bonds, so it must make its bonds attractive to investors.

"Convertible bonds" are corporate bonds which may be converted to stock if certain stipulations are met.

One type of corporate bond is the infamous "junk bond." Despite the unattractive name, many people find junk bonds good investments because they are extremely high yield. These are issued by companies with lackluster credit (credit below "investment grade"), so they must offer high interest rates to attract investors.

Bond Vocabulary:

call

"Calling" a bond refers to giving lenders their money back before the maturity date. Not all bonds can be called; a bond will specify whether or not it can be called and how soon it can be called (corporate bonds and state and local government bonds can be called, but federal government bonds are never called).

coupon rate

A bond's coupon rate is the interest rate that the investor will receive. If a $1000 bond's coupon rate is 7.5%, the bond's seller will pay the investor $75/year in interest. When interest is paid varies from bond to bond and will be specified on each bond (monthly, quarterly, etc.).

maturity date

A bond's maturity date is the date when a bond's issuer must pay the principle back to the bondholder. At this point, the bond's issuer is at no further obligation to pay interest to the investor.

par value

Par value is the amount paid to the investor upon maturity of the bond. Basically, the par value of a bond is the principal - the amount originally loaned to the seller of the bond.

yield to maturity

This phrase refers to the fact that the yield on a bond will not always necessarily match the coupon rate. In other words, since the price of a bond will fluctuate (according to interest rates, etc.), the interest paid on such a bond will not necessarily reflect how much money is made. "Yield to maturity" takes into account whether the bond was purchased above or below par value, the assumption that the interest paid will be reinvested, and all the interest paid.

zero-coupon bond

With this type of bond, no interest payments are made. Instead, the investor receives the principle plus all interest owed at the maturity date. The coupon rate is "zero" because the payments are not made on a regular basis; for this reason, these bonds are sold at a fraction of the par value.