A bond is similar to a certificate of deposit (CD). With a
five-year CD, for example, a bank agrees to pay you a set interest rate, say, 6
percent. If all goes according to plan, at the end of five years of earning the
6 percent annual interest, you get back the principal that you originally
invested.
A bond is a debt security, similar to an I.O.U. When you
purchase a bond, you are lending money to a government, municipality,
corporation, federal agency, or other entity known as the issuer.
In return for the loan, the issuer promises to pay you a
specified rate of interest during the life of the bond and to repay the face
value of the bond (the principal) when it matures, or comes due.
Among the
types of bonds you can choose from are U.S.
government securities, municipal bonds, corporate bonds, mortgage and
asset-backed securities, federal agency securities and foreign government
bonds.
There are a number of key variables to look at when investing
in bonds:
- Interest
rate
- The
bond's maturity
- Redemption
features
- Credit
quality
- Price
- Yield
and tax status
Together, these factors help determine the value of your
bond investment and the degree to which it matches your financial objectives.
Interest Rate
Interest Rate Bonds pay interest that can be fixed, floating,
or payable at maturity. Most debt securities carry an interest rate that stays
fixed until maturity and is a percentage of the face (principal) amount.
Typically, investors receive interest payments semiannually.
Some
sellers and buyers of debt securities prefer having an interest rate that is
adjustable, and more closely tracks prevailing market rates. The interest rate
on a floating-rate bond is reset periodically in line with changes in a base
interest-rate index, such as the rate on Treasury bills.
Some bonds have no
periodic interest payments. Instead, the investor receives one payment - at
maturity - that is equal to the purchase price (principal) plus the total
interest earned, compounded semiannually at the (original) interest rate. Known
as zero-coupon bonds, they are sold at a substantial discount from their face
amount.
For example, a bond with a face amount of $20,000 maturing in 20 years
might be purchased for about $5,050. At the end of the 20 years, the investor
will receive $20,000.
Bond's Maturity
A bond's maturity refers to the specific future date on
which the investor's principal will be repaid. Bond maturities generally range
from one day up to 30 years.
In some cases, bonds have been issued for terms of
up to 100 years. Maturity ranges are often categorized as follows:
- Short-term
notes: maturities of up to five years
- Intermediate notes/bonds: maturities of
five to 12 years
- Long-term bonds: maturities of 12 or more years
Redemption Features
While the maturity period is a good guide as to how long the
bond will be outstanding, certain bonds have structures that can substantially change
the expected life of the investment.
Call Provisions For example, some bonds
have redemption, or call provisions that allow or require the issuer to repay
the investors' principal at a specified date before maturity.
Credit Quality
Bond choices range from the highest credit quality U.S.
Treasury securities, which are backed by the full faith and credit of the U.S.
government, to bonds that are below investment-grade and considered
speculative.
Since a bond may not be redeemed, or reach maturity, for
years - even decades - credit quality is another important consideration when
you're evaluating a fixed-income investment.
When a bond is issued, the issuer
is responsible for providing details as to its financial soundness and
creditworthiness.
This information is contained in a document known as an
offering document, prospectus, or official statement, which will be provided to
you by your investment advisor.
Credit Ratings
In the United States,
major rating agencies include Moody's Investors Service, Standard & Poor's Corporation,
and Fitch Ratings.
Each of the agencies assigns its ratings based on in-depth
analysis of the issuer's financial condition and management, economic and debt
characteristics, and the specific revenue sources securing the bond.
The
highest ratings are AAA (S&P and Fitch Ratings) and Aaa (Moody's). Bonds
rated in the BBB category or higher are considered investment grade; securities
with ratings in the BB category and below are considered high yield, or below investment
grade.
There are four types of bonds namely:
- Municipal
Bonds
- Corporate
Bonds
- Mortgage
Bonds
- Convertible
Bonds
Municipal Bonds
Municipal bonds are state and local government bonds that
pay interest that's federally tax free and state tax-free to residents in the
state of issue.
For example, if you live in New York
and buy a bond issued by a New York
government agency, you don't owe New York
state or federal income tax on the interest.
The government organizations that issue municipal bonds know
that the investors who buy municipals don't have to pay most or any of the
income tax that normally would be required on other bonds - which means that
the issuing governments can get away with paying a lower rate of interest.
Corporate bonds
Corporate bonds are issued by companies such as McDonald's,
Macy's, and IBM. Corporate bonds pay interest that's fully taxable.
Thus, they
are appropriate for investing inside retirement accounts. Only lower tax
bracket investors should consider buying such bonds outside a tax-sheltered
retirement account.
Mortgage bonds
You remember that mortgage you took out when you purchased a
home? Well, you can actually invest in that mortgage through purchasing a bond!
Many banks actually sell their mortgages as bonds in the financial markets
allowing other investors to invest in them.
The repayment of principal on such
bonds is usually guaranteed at the bond's maturity by a government agency, such
as the Government National Mortgage Association or the Federal National
Mortgage Association.
Convertible bonds
Convertible bonds are hybrid securities - they're bonds that
you can convert into a preset number of shares of stock in the company that
issued the bond.
Although these bonds do pay interest, their yield is lower
than nonconvertible bonds because convertibles offer you the upside potential
of being able to make more money if the underlying stock rises.
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