Bonds

Bonds, often called interest-bearing bonds or finance bonds, are similar to an IOU: an entity borrows money at a contracted interest rate and for a specified period by issuing a bond. The entity is then obligated to pay the interest to its bond holders and must repay the borrowed amount of the bond at the end of the bond term. A bond can be compared by calculating its yield (see below).

Bonds are known as " fixed-income " securities because the amount of income the bond will generate each year is "fixed," or set, when the bond is sold. No matter what happens or who holds the bond, it will generate exactly the same amount of money stated in its terms and will be redeemed for its face value. Typically, bonds are sold to the public in face value increments of $1,000. However, once bonds are issued to the public, bond prices can rise and fall relative to its face value. The predictability in cash flow of a bond provides more certainty to investors than stock dividends, which are not contracted . Obviously, a fixed-income security like a bond is quite different from an investment in a stock .

Because it is a fixed-income investment, a bond generally has less risk and lower returns than a stock. Bonds are also less risky investments than stocks because this interest-bearing security is "senior" to a company's stock and therefore must legally be paid before funds are made available to stockholders.

Types of Bonds. There are numerous types of bonds. The primary categories are listed below. More detailed information can be found at the links.

• Treasury Securities --Bonds issued by the U.S. government are called Treasury Bonds or Treasuries because they are sold by the Treasury Department. Treasuries are guaranteed by the U.S. government and are free of state and local taxes on the interest they pay. They are the safest bond you can own.

• Municipal Bonds --Municipal bonds or Munis are issued by state and local governments. Munis are also often called tax-free bonds because the federal government does not require investors to pay federal income tax on the interest paid. State and local governments also often waive state and local income taxes on the bonds, so even though they pay lower rates of interest, for borrowers in high tax brackets the bonds can actually have a higher after-tax yield than other forms of fixed-income investments.

• Government Agency Bonds --Some government agencies and quasi-government agencies like the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp . (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae) sell bonds backed by the full faith and credit of the U.S. for specific purposes, such as funding home ownership.

• Corporate Bonds --Corporate bonds are issued by companies to finance their operations and normally carry higher interest rates than Treasury Bonds (issued by the US Government) or Municipal Bonds (issued by states, counties or cities). The higher interest rate is required because there is a higher risk that the company could default (not pay) its bond .

Bonds can be purchased through your brokerage account or you can buy bond mutual funds. Most bonds are rated by the three major rating services: Moody's Investors Service, Standard & Poor's and Fitch Rating . Bond ratings start at AAA (denoting the highest investment quality) and usually end at D (meaning payment is in default).

There are three important things to know about any bond before you invest: the par value, the coupon rate, and the maturity date. Knowing these three items will enable you to analyze most bonds and compare it to other potential investments.

1. Par value is the amount of money the investor will receive once the bond matures. This means that the issuing company will pay to the investor the original amount that it loaned. Par value may also be called the "principal" or "face amount." As mentioned above, par value for corporate bonds is normally $1,000, although for government bonds it can be much higher.
2. The coupon rate is the interest rate that the bondholder will receive expressed as a percentage of the par value. Thus, if a bond has a par value of $1,000 and a coupon rate of 10%, the bondholder will receive $100 a year. The bond will also specify when the interest is to be paid, whether monthly, quarterly, semi-annually, or annually.
3. The maturity date is the date when the bond issuer has to return the principal to the lender. After the bond issuer pays back the principal, it is no longer obligated to make interest payments. Sometimes a company will decide to "call" its bond, meaning that it is giving the lenders their money back before the maturity date of the bond. All corporate bonds specify whether they can be called and how soon they can be called.

Comparing Bonds. To accurately compare bonds, you need to understand its yield. As I mentioned earlier, bond prices can rise and fall from its par value. Bond prices fluctuate from their par value as interest rates fluctuate. If you hold a bond to maturity, you are guaranteed to get your principal back. However, if you sell the bond before it matures, you will likely sell it at a market price, which may be above or below par value.

So, although a bond may be issued with a face value of $1,000, its price may fall below par value and sell at a discount or a bond's price may rise and sell above its par value or at a premium. A simple example will help you understand bond yields.

Assume you bought a $1,000 bond with a coupon rate of 7.5% that matures in 10 years. This bond would pay you $75 per year for a decade, at which time you will be paid back the $1,000 in principal.

However, what if instead of holding it until maturity (ten years) you decide to sell the bond after seven years? At seven years, long-term interest rates are hovering around 5%. Newly issued bonds, paying that interest rate, would only pay $50 a year, not $75. You would actually be able to sell your bond for more than the $1,000 par value because an investor would be willing to pay a premium for a bond that paid 7.5%.

You can calculate the yield on a bond by dividing the amount of interest it will pay over the course of a year by the current price of the bond.

If a bond that cost $1,000 pays $75 a year in interest, then its current yield is $75 divided by $1,000, or 7.5%.

Now consider that you could purchase this same bond at a discount for $937.50. Its yield would be 8.0%.

If you purchased this same bond at a premium for $1,071, its yield would be 7.0%.

If you hold a bond to maturity, your investment will be returned to you as long as the borrower doesn't default or hasn't gone belly-up. You may choose to sell your bonds before they mature or perhaps buy additional bonds of the same or different issue. In this case, you can make or lose money on the bonds themselves completely separate from the interest that they pay. Your return on your investment depends on the maturity date of the bond, where interest rates have moved, and the transaction costs involved.

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