Introduction to Bonds

Bonds Features
Types Of Bonds
Bond Ratings
Bonds Issuing Entities
Trading And Valuing Bonds
Bond Market Index
Investing In Bonds

A bond is basically issued to finance the future. It is a loan that investors give to corporations and governments - Federal, state, or local. The lenders earn interest, and the borrowers get the cash they need.

In finance, a bond is a debt security, similar to an I.O.U., in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity.

A bond is simply a loan in the form of a security with different terminology: The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Bonds enable the issuer to finance long-term investments with external funds. Note that certificates of deposit (CD) or commercial paper are considered to be money market instruments and not bonds.

Bonds and stocks are both securities, but the major difference between the two is that stock-holders are the owners of the company, meaning they have an equity stake, whereas bond-holders are lenders to the issuing company. Another difference is that bonds usually have a defined term, or maturity, after which the bond is redeemed, whereas stocks may be outstanding indefinitely. An exception is a consol bond, which is a perpetuity - bond with no maturity.

Issuing bonds - Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and resell them to investors. Government bonds are typically auctioned.

Why own bonds? - Bonds are a good choice if you are looking to earn a steady income with the potential to beat inflation. Bonds are sometimes referred to as fixed income securities. They pay you interest based on a fixed rate for a specified period of time, thus earning you fixed income.

If you are thinking of buying a bond, consider some of the following questions:

    * How much will you earn?
    * When will you be paid the interest?
    * How long is the loan?
    * How reliable is the borrower?
    * How much do they want to borrow?

How much will you earn? - The amount that you earn will be based on the face value, coupon rate and yield of the bond.

The face value, or par value, of a bond is the value of the bond at maturity, the date when the loan is paid off. A common face value is $1,000 per bond. It's important to keep in mind that the actual market price of a bond may be higher or lower than the bond's face value. A bond's market price can fluctuate over time, depending on a variety of factors including investor demand, interest rate movement, the bond's maturity date and the credit worthiness of the issuer.

The coupon rate of a bond refers to the interest that will be paid based on the face value of the bond. A bond with a face value of $1000 and a 7% coupon will pay $70 a year in interest. Interest may be divided into quarterly, semi-annual or annual payments, depending on the issuer and the individual bond.

If you purchase a bond at face value, your coupon rate and actual earned yield will be the same. However, bonds are often sold at higher or lower prices than their face values. As a result, your actual yield can be different from the coupon rate of the bond. Buying a bond at a discount, or less than its face value, results in a higher yield than the stated coupon rate. In contrast, buying a bond at a premium, or more than its face value, results in a lower yield than the stated coupon rate.

Taxable or tax-free? - Depending on type of issuer and your state of residence, the interest you receive from a bond investment may be taxable or tax exempt. Generally speaking, all corporate bonds are taxable. Municipal and state bonds are typically tax exempt if you live in the same state where the issuer is located. Federal government bonds are not federally taxable but may be taxable at the state and local levels.

Do interest rates affect prices? - When rates rise, bond prices tend to fall, and when rates fall, bond prices tend to rise. If interest rates rise, newly issued bonds will pay higher interest than the bonds you own. Typically, your older bonds will be worth less, and you would have to sell them at a discount. If, however, the interest rates drop, newly issued bonds will pay lower interest than the bonds you own. Then your older bonds will be typically worth more, and you would be able to sell them at a higher price. If you hold a bond to maturity, you will not face these price changes.

Interest rates can also influence decision by the issuer to pay off the bonds early. Just as you can pay off a mortgage at any time without a penalty, many bond issuers have the ability to call in the bonds early. Typically, if interest rates drop significantly, a callable bond will get called. This allows the bond issuer to get rid of this high interest debt and borrow again at a lower interest rate.

Here are three types of risks that can affect the value of bonds you buy:

Interest rate increases. You will not face this risk if you hold bonds until maturity, but if you buy and sell bonds, you will. If you buy a bond and then interest rates rise, your bond loses value. This is because other investors can buy higher-rate bonds, so you would have to sell yours at a lower price to make them attractive. But, if interest rates fall, you can sell your bonds at a higher price.

Credit risk. The borrower may not be able to pay the loan on time, or at all. A bond credit rating gauges credit worthiness of the issuer. Junk bonds are issued by credit-troubled companies, so there is a high risk of default.

Calls. If you buy a callable bond, the lender has a right to call the bond, meaning pay you back before the maturity date. Typically, the lender has a way to get cheaper financing - probably because interest rates have fallen. Before buying a bond, check to see if it is callable.