A bond is essentially a loan an investor makes to the bonds' issuer. That issuer can be the federal government (as in the case of Treasury bonds) or a local government (municipal bonds), government-sponsored enterprises (like Fannie Mae), companies (corporate bonds) or even foreign governments or international corporations.
The investor, or bond buyer, generally receives regular interest payments on the loan until the bond matures or is "called," at which point the issuer repays you the principal. Bond funds pool money from many investors to buy individual bonds according to the fund’s investment objective.
Most bonds pay regular interest until the bond matures.
Callable bonds allow the issuer to repay the bond before maturity.
Zero-coupon bonds offer a deep discount and pay all the accumulated interest at maturity.
Who issues bonds?
Governments, government-sponsored enterprises, and corporations issue bonds to raise money for their endeavors. The financial health of the issuer determines how highly (or not) the bonds are rated; higher rated bonds are considered to be safer and therefore pay less interest, whereas lower-rated bonds pay higher interest rates to compensate investors for taking on more perceived risk. An issuer's credit rating can change in either direction over time. In addition to the ratings and interest payments, the institution issuing the bonds can also determine whether or not the income is taxable. A roundup of the types of bonds and information on their issuers follows:
The US Treasury issues bonds to pay for government activities and service the national debt. Treasuries are considered to be extremely low-risk if held to maturity, since they are backed by "the full faith and credit" of the US government. Because of their safety, they tend to offer lower yields than other bonds. Income from Treasury bonds is exempt from state and local taxes.
Government-sponsored enterprises issue bonds to support their mandates, which typically involve ensuring certain segments of the population—like farmers, students, and homeowners—are able to borrow at affordable rates. Examples include Fannie Mae, Freddie Mac, and the Tennessee Valley Authority. Yields are higher than government bonds, representing their higher level of risk, though are still considered to be on the lower end of the risk spectrum. Some agency bonds, like Fannie Mae and Freddie Mac, are taxable. Others are exempt from state and local taxes.
States, cities, counties, and towns issue bonds to pay for public projects (roads, sewers) and finance other activities. The majority of munis are exempt from federal income taxes and, in most cases, also exempt from state and local taxes if the investor is a resident in the state of issuance. As a result, the yields tend to be lower, but still may provide more after-tax income for investors in higher tax brackets.
Corporations issue bonds to expand, modernize, cover expenses, and finance other activities. The yield and risk are generally higher than government and municipal bonds. Rating agencies help you assess the credit risk by rating the bonds according to the issuing company’s perceived creditworthiness. Income from corporate bonds is fully taxable.
Banks and other lending institutions pool mortgages and "securitize" them so investors can buy bonds that are backed by income from people repaying their mortgages. This raises money so the lenders can offer more mortgages. Examples of MBS issuers include Ginnie Mae, Fannie Mae, and Freddie Mac. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds. The major risk of these bonds is if borrowers repay their mortgages in a "refinancing boom," it could have an impact on the investment's average life and potentially its yield. These bonds can also prove risky if many people default on their mortgages. Mortgage-backed bonds are fully taxable.
Some issuers simply aren't as credit-worthy as others. These can include local and foreign governments, but generally high-yield bonds refer to corporate bonds issued by companies that are considered to be at greater risk of not paying interest and/or returning principal at maturity. As a result, the issuer will pay a higher rate to entice investors to take on the added risk. Ratings agencies such as Standard & Poor's, Moody's, and Fitch evaluate the financial health of a bond issuer and assign a rating that indicates their opinion of whether the bond is investment grade or not. Bonds rated below investment grade are considered speculative and higher risk.
How a typical bond works
Bonds have 3 major components:
The first is the face value, also called par value. This is the value the bond holder will receive at maturity unless the issuer defaults. Investors pay par when they buy the bond at its original face value. If bonds are retired by the issuer before maturity, bond holders may receive the par value or a slight premium. The price investors pay when buying on the secondary market (in other words, not directly from the bond’s issuer) may be more or less than the face value. See Bond prices, rates, and yields.
Bonds also have a coupon rate. This is the annual rate of interest payable on the bond. (The term "coupon" hearkens to the time bond certificates were issued on paper and had actual coupons that investors would detach and bring to the bank to collect the interest.) The higher the coupon rate, the higher the interest payments the owner receives. With fixed-rate bonds, the coupon rate is set at the time the bond is issued and does not change. Most bonds make interest payments semiannually, although some bonds offer monthly and quarterly payments.
Third, bonds have a stated maturity date. Generally, this is the date on which the money you've loaned the issuer is repaid to you (assuming the bond doesn't have any call or redemption features).
Callable bonds are bonds that the issuer can repay early, sometimes after a period of several years, at a predetermined price. The attraction of callable bonds is that they typically offer higher rates than non-callable bonds.
However, you should understand the call risk. If interest rates drop low enough, the bond's issuer can save money by repaying its callable bonds and issuing new bonds at lower coupon rates. If this happens, the bond holder's interest payments cease and they receive their principal early. If the bond holder then reinvests the principal in bonds with similar characteristics (such as credit rating), they will likely have to accept a lower coupon rate, one that is more consistent with prevailing interest rates. This will lower monthly interest payments.
Example: A callable bond
An investor purchases a $30,000 10-year callable bond paying 6.5% interest, which is a higher interest rate than similar non-callable bonds. The bond is callable after 5 years at a price of 103—that is, 103% of the face value, or $30,900. If interest rates drop enough, the investor may wind up with their principal returned and, when seeking to reinvest the principal, be looking at yields that have fallen since the time of their original investment.
Zero-coupon bonds, also known as "Strips," are bonds that do not make periodic interest payments (in other words, there's no coupon). Instead, you buy the bond at a discounted price and receive one payment at maturity. The payment is equal to the principal you invested plus the accumulated interest earned (compounded annually to maturity).
Perhaps the best-known example of a zero-coupon bond is a US savings bond, which is a "non-marketable" Treasury security that can be bought directly from the Treasury or most banks. (Fidelity sells other "marketable" zero-coupon Treasury securities that can be bought and sold on the secondary market.) There's a reason these bonds are a favorite gift of many parents and grandparents: Zero-coupon bonds are attractive when you want to save for a defined objective and date, such as when a child starts college. You receive your principal and interest in one lump sum at maturity.
Let's say you’re saving for your child's college education, which will begin in 10 years. You could buy a 10-year zero-coupon bond that costs you $16,000, though its face value is $20,000. In 10 years, at maturity, you receive face value of $20K.
Zero-coupon bonds have a few drawbacks. First, in most cases, you'll have to pay taxes annually on the interest, even though you do not actually receive the interest until maturity. This can be offset if you buy the bonds in a tax-deferred retirement account, or in a custodial account for a child in situations where the child pays little or no tax.
Zero-coupon bonds can also be particularly volatile in the open market, and particularly susceptible to interest rate risk. This doesn't matter if you keep the bond to maturity. But if you need to sell it early, you could incur a substantial loss.