What Are Bonds?

What are bonds? For those who want to save and invest their money, it is important to understand exactly what they are and how they function to get their full benefits.

Basically, bonds are simple IOUs. Companies and governments often need to raise money in various situations. A government many need more money for everything from wars to social programs. Companies need money for expansion and other purposes. In all these cases, they issue bonds to raise cash. In return, they promise to repay those who purchase the bonds the face value of the bonds at maturity plus interest.

Types of bonds: Government

There are two major types of bonds, and these in turn can be divided into smaller categories. The first significant type of bond is government bonds. Some of the major types of government bonds include:

  • US government bonds: The US government issues various types of bonds known collectively as treasuries. Treasury bonds are the best known, mature in 30 years and pay interested every six months. Treasury bills and notes mature much more quickly. Other types include those that are adjusted for inflation (TIPS) and those that pay interest at current market rates (series EE/E savings bonds). Since all of these are backed by the government, they are considered safe by most investors and will offer lower rates than those deemed more risky. For a more complete listing of US government bonds, see government bonds.
  • Municipal bonds: These bonds are issued by state and local governments to finance spending. Although their risk is relatively low, it is still higher than treasuries. However, they have major tax advantages. These are free of federal taxes on the interest paid and are usually free of taxes on the state and local level (always check for exceptions). Because of this, they offer lower rates than other types of bonds with comparable risk levels.

Corporate bonds

What Are Bonds?

Since they are issued by companies, they generally have a higher level of risk. However, this risk varies greatly with the issuer of the bond. It is important to distinguish corporate bonds from the other major type of company securities: stocks. A stock is a part of a company. Therefore, a stockholder is sharing in both the risks and rewards the company may experience. While bondholders have some risk even though they have priority over stockholders in a bankruptcy, they simply hold part of a company’s debt. Consequently, their only return will be the principle with interest. On the other hand, stockholders have an equity share in the company and can see their investment rise or fall greatly depending on the fortunes of the company.

  • Investment (high) grade corporate bonds: Moody’s and other rating agencies give these bonds the highest ratings. Although they are safer than stocks, they are riskier than the relative safety of government bonds and will thus pay higher interest rates.
  • High-yield (junk) bonds: These are the only other major type of corporate bond that most investors will ever concern themselves with. Since these bonds are issued by less established or new companies, the risk of default is much greater. In turn, they will pay higher coupons, or interest rates.

Changes in bond prices

In addition to understanding what bonds are, it is also important to know why they fluctuate in price. While this fluctuation is not a great as with most stocks, it needs to be taken into consideration. Since the bond issuer has promised to pay back the face value of the bond on maturity, it seems odd to some that the prices of the bonds fluctuates in price.

The main reason bond prices will fluctuate is because of changing interest rates. For example, if the coupon (interest rate) on a bond is 10% and interest rates rise, then people will find themselves holding bonds paying less than they could get elsewhere. Since investors holding such bonds can technically make more if they sell those bonds and purchase ones that pay the prevailing higher rates instead, this will put downward pressure on bond prices (more people will want to sell such bonds than buy them). On the other hand, if interest rates fall, more people will want to buy the bond since it has been set at a higher rate and thus put upward pressure on the bond price.

Another factor is creditworthiness of the issuer. If the entity that has issued the bond is in bad financial straits and may not be able to pay, people holding their bonds will take the opportunity to sell them, even if it is for less than their face value. Those buying such bonds are taking the gamble the issuer will not default, and they are buying at a good discount.

With less time for changes in interest rates or other factors to come into play, shorter and medium term bonds will have a lot less volatility in prices than longer term bonds. However, long-term bonds will converge to par (100% of face value) as the bond approaches its maturity date if the issuer is expected to pay.

Some other popular types of bonds

Foreign bonds, issued by both governments and other entities, offer a way for bondholders to diversify. The risk level of foreign bonds will vary greatly. These bonds are not always denominated in the currency of the nation of the issuer. Those buying bonds issued in foreign currencies need to take into account the possibility of currency fluctuations affecting the price.

Zero coupon bonds pay their entire coupon (interest) when they mature, unlike most other bonds that pay semiannually. Because of this, they are sold at a substantial discount. Note that the discount of any bond is the amount it is sold below par (its nominal or face value).

Inflation linked bonds index the principal and interest payments to the rate of inflation. While this is a great hedge against inflation, they will pay lower rates than other bonds, which are not indexed.

Although bonds are safer than stocks and provide a steady income, they are not without risks. There are many ways to purchase bonds to include in mutual funds or exchange traded bond funds.Carefully research the type of bond before purchasing and keep in mind that any bond paying a higher rate likely has more risk than one paying less.

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