A bond is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. The Federal government, states, cities, corporations, and many other types of institutions sell bonds.
Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). Some bonds do not pay interest, but all bonds require a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities.
Primarily is better for you to familiarize with the types of bonds available and some of the associated vocabulary. In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories:
-Treasury Bills, or T-bills, are a short-term investment sold in terms ranging from a few days to 26 weeks. They’re sold at a discount to their face value ($1,000), but, when T-bills mature, you redeem the full face value. You pocket the difference between the amount you paid and the face value, which is the interest you earned.
-Treasury Notes are issued in terms of two, five and 10 years and in increments of $1,000. Mortgage rates are priced off of the 10-year note.
-Treasury Bonds are issued in terms of 30 years. They pay interest every six months until they mature.
Treasury Bonds is a category that includes:
Savings Bonds: are probably some of the most boring gifts out there, but it can’t hurt to understand how they work. You can redeem your savings bond after a year of holding it, up to 30 years.
They’re currently offered in two flavors, both issued by the U.S. Treasury:
–EE Savings Bonds earn a fixed-rate of interest (currently 3.4%) and can be redeemed after a year (though you lose 3 months interest if you hold them less than five years), but can be held for up to 30 years. When you redeem the bond, you’ll collect the interest accrued plus the amount you paid for the bond. They can be purchased in the form of a paper certificate at a bank for half of their face value (for example, a $100 bond can be purchased for $50) in varying increments from $50 to $10,000. If they’re purchased online, they’re purchased at face value, but can be bought for any amount starting at $25.
–I Savings Bonds are similar to EE Savings, except that they’re indexed for inflation every six months. These are always sold at face value, regardless of whether you buy paper bond certificates or you buy them electronically.
Agency bonds are not quite as safe as Treasurys, but yet it’s often safer than the most pristine corporate bond. They’re issued by government-sponsored enterprises.
Because these companies are chartered and regulated in part by the government, the bonds they issue are perceived to be safer than corporate bonds. They are not, however, backed by the “full faith and credit” of the U.S. government like Treasurys, which would make them virtually risk-free.
Municipal bonds, or Munis, as they’re commonly known, are issued by states, cities and local governments to fund various projects. Municipals aren’t subject to federal taxes, and if you live where the bonds are issued, they may also be exempt from state taxes.
There is a municipal bond that is more credit-worthy than others, though some munis are insured. If the issuer defaults, the insurance company will have to cover the tab.
Corporate bonds are bonds issued by companies. Corporate debt can range from extremely safe to super risky.
Other important terms talking about a bond are:
Coupon is the word for the interest rate paid by a bond. The word coupon is used because there is a kind of bond that really has a paper coupon attached to it, which could be redeemed for the payment.
Par is also known as the face value of a bond, this is the amount a bondholder receives when the bond matures.
Duration is a measure of a bond price’s sensitivity to a change in interest rates, measured in years.