Bonds are debt investments. They represent a loan you make to an institution—a corporation, government, or government agency—in exchange for interest payments during a specific term plus the repayment of your principal when the bond comes due. Because the income you receive from a bond is generally fixed at the time the bond is created, bonds are often considered fixed-income investments.
Bonds are usually described based on these key characteristics:
Par value or face value: the amount you’re lending and expect to be paid back, usually $1,000 per bond, but sometimes in multiples of $1,000
Term: the length of time until the bond matures
Maturity date: the date on which the principal is to paid in full to you
Interest: the percentage of the loan amount the borrower will pay you for the use of your money over the term
You can make money with bonds in two ways:
Interest. The interest payments from the bond normally provide you with a fixed source of income for the bond’s term. In most cases, the rate is fixed at the time the bond is issued.
Capital gains. You might also make a profit by selling a bond before maturity at a higher price than you paid for it.
The interest rate is part of the contractual relationship you have with the borrower. It’s determined by a number of factors, including the bond’s term, current market rates, and the creditworthiness of its issuer, which depends on the risk associated with the likelihood of the issuer’s repaying the bond. In general, longer-term bonds pay higher rates to reward you for committing your money for an extended period, but that’s not always the case. It’s also typical for a low-rated issuer to have to offer higher rates to attract interest in its bonds.
There are several major categories of bonds that are available in the bond marketplace, which you may own either directly or through bond mutual funds or exchange traded funds.
Corporate bonds are issued by companies to raise capital for their business activities. A company may have a host of reasons for choosing to issue bonds rather than sell stock. Some companies are concerned about watering down, or diluting, the value of existing stock by issuing new shares. Others might want to raise money while remaining privately owned. Still others might find it less costly to issue bonds, given prevailing market conditions.
Municipal bonds, also known as munis, are issued by municipalities—local governments at the state, county, or city level—either to supplement tax revenues or to pay for public projects, such as building a new hospital or maintaining roads or bridges. A muni is repaid either from tax revenues or from fees collected by the government that issues the bond. One major appeal of munis is that the interest they pay is usually free of federal income tax, and may also be free of state or local income taxes in the jurisdictions where they are issued. Investors in the highest tax brackets, however, should take into account that interest on some munis may be subject to the alternative minimum tax (AMT). In addition, any capital gains are taxable at all levels of government.
Agency bonds are issued both by government agencies and by government-sponsored enterprises (GSEs), which are entities like the Tennessee Valley Authority, a power utility owned by the federal government, that operate like corporations but have charters from the government to provide some public service. The largest GSEs in the U.S. include the Federal Home Loan Bank (FHLB), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
Treasury securities, also known as Treasuries, are debt offerings from the United States Treasury Department. They’re backed by the full faith and credit of the U.S. government and are considered to have essentially perfect credit. Treasuries come as short-term Treasury bills, mid-term Treasury notes, and long-term Treasury bonds. While you do have to pay federal income tax on the interest from Treasuries, you do not pay state and local taxes on that income.
Asset-backed securities are loans, accounts receivables or other assets that are securitized, or packaged into bond offerings, by investment banks and mortgage corporations. These securities make it possible for you to invest in these debt markets by buying the bonds, while making the money you lend available to borrowers who want to finance their purchases. For instance, mortgage-backed securities, such as those offered by mortgage corporations Fannie Mae and Freddie Mac, make the money collected from selling bonds available to lenders and ultimately to borrowers who want to buy a home. Asset-backed bonds are called pass-through securities because the payments of interest and return of principal that these borrowers make are returned to the bondholders.
Because bonds are loans, investing in bonds involves credit risk—that is to say, the risk that the borrower won’t pay you back as promised. Because of credit risk, whenever you lend money, you need to evaluate whether the borrower has the financial ability to make interest payments and repay your principal according to your agreement. For example, on a personal level, someone with $1 million in his or her bank account is probably a better credit risk than someone with $100 in the bank. The same is true with corporations, and, in a slightly different way, with municipal governments.
Other things to take into account are how much debt the borrower already has, whether the borrower seems financially solid, and how the borrower has paid back debt in the past. The situation is somewhat different with mortgage-backed securities, since in that case the repayment is from thousands of individual borrowers repaying their mortgages rather than a single corporation or government entity.
You would find it difficult to gather sufficient information to gauge a bond issuer’s credit risk on your own. Fortunately, there are several companies, known as Nationally Recognized Statistical Rating Organizations (NRSROs), which do this for you. They are A.M. Best Company, Inc., Dominion Bond Rating Service Ltd. (also known as DBRS Ltd.), Fitch, Inc., Japan Credit Rating Agency, Ltd., Moody’s Investors Service, Rating and Investment Information, Inc., and Standard & Poor’s Ratings Services. Their bond analysts rate bond issuers’ credit on a scale ranging from the highest quality, meaning the lowest credit risk, to the poorest quality, which may mean the company is in default and is no longer able to pay its debt obligations. Corporations and municipal governments that receive the top ratings issue what’s called investment grade debt. Debt of the U.S. government is not rated because it is considered free of default risk.
Bond issuers with high credit ratings can borrow money from investors at lower rates. In contrast, for lower-quality bonds to be attractive to investors, they have to offer higher interest rates. The riskiest bonds offer very high rates of interest but involve a higher chance of default. If the risk pays off, investors could collect more money than they could with safer bonds, but if it doesn’t, they could end up losing principal as well as interest. In this sense, high-risk bonds—also known as junk bonds and sometimes referred to as high-yield bonds—are more speculative, and investors who purchase them tend to trade them like stocks rather than hold on to them for the income.
Bond interest payments are also called the bond’s coupon, since in the past, paper bond certificates came with coupons you cut off, or clipped, and exchanged for interest payments. Today, you no longer need to turn in a coupon to collect your interest payments. They simply arrive on schedule, typically twice a year. The payment and schedule are set in the bond agreement, usually at a fixed rate but sometimes not. For example, a stepped-coupon bond will change interest rates at certain dates—going from 3% to 5%, for example. A floating-rate bond will adjust the interest rate periodically, according to a specific measure of current rates, to keep your coupon payments in line with payments made by new bonds.
Your interest rate is sometimes, but not always, the same as your yield. Yield is a measure of how much an investment is paying per dollar invested, calculated by dividing the annual interest by the price. A bond with a higher yield is more profitable. When you shop for bonds, you’ll find that brokers and online comparison tables will quote yields, and the financial press often discusses yields rather than coupon rates in its bond coverage.
There are several ways to calculate a bond’s yield, so it’s important to know which yield you’re dealing with when you read about bonds or compare them.
The simplest yield calculation—coupon yield—is exactly the same as the bond’s interest rate. You calculate coupon yield by dividing the amount the bond pays you per year by the bond’s par value. For example, if par value were $1,000 and each year you received two coupon payments of $25 each, you would divide $50 (the year’s total) by $1,000 to get a 5% coupon yield.
If you buy the bond at issue for par value and hold it to maturity, coupon yield is what you’ll be concerned about. But if you buy a bond on the secondary market, the price will probably have moved higher or lower than par. In that case, you’ll want to look at a number called current yield, which you calculate by dividing the interest by the actual market price.
Let’s say you were thinking of buying a bond paying 5%, or $50 a year, but that it’s selling at a discount for $925. The bond’s current yield in this case would be 5.4% ($50 divided by $925), which is slightly higher than its coupon yield. Likewise, if the bond were selling at a premium, meaning a price higher than par, its current yield would be slightly lower than its coupon yield.
The yield that brokers and bond tables tend to provide is the bond’s yield-to-maturity (YTM). YTM is a more complicated calculation that’s designed to give you a better idea of the bond’s total earning power over its whole term. It factors in all the remaining coupon payments, but it also includes any profit or loss you’d realize when full par value was repaid, as compared to what you paid to buy the bond. YTM also includes the effect of compounding, by assuming that every coupon payment is reinvested at the same coupon rate as the original bond.
Interest rates change all the time, of course, and when you receive a coupon payment, it’s more likely than not that the rate you’ll get by reinvesting it will differ from the rate of the original bond. Still, YTM is a more comprehensive measure of a bond’s true earnings potential over its entire term, especially if you plan to reinvest your coupon payments rather than use them as income.
Even U.S. Treasury notes and bonds, which are considered to have zero credit risk, are not risk free. Like all bonds, they’re subject to interest rate risk, or the consequences of changes in the rate that borrowers are paying. This risk affects you if you’re reinvesting a maturing bond and the current rates are lower than the rate you were earning. It means your yield will be less.
Interest rate risk also affects you if you want to sell an older bond before it matures. The reason is that bond prices and rates move in opposite directions. When interest rates go up, prices of existing bonds go down because they are paying the older, lower rate and so providing a smaller yield. When rates go down, prices of existing bonds go up because they are paying a higher rate.
For example, if your bond has a coupon yield of 5% but new bonds of the same type offer a coupon yield of 6%, no investor will pay the same price for your bond as for the new one because it would mean less income. They’ll be willing to pay only a lower, or discount, price to bring the yield closer to the yield from the newer bond.
Of course, interest rate changes can also work in your favor. If you own a bond paying 5% interest, but new bonds of the same type are paying only 4%, you can probably sell your on the secondary market for a higher price, or at a premium.
In addition, changes in interest rates mean that there’s an opportunity cost to committing your money to a bond at the current rate. If rates should go up after you buy a bond, your money will be locked in at the old rate. To invest at the new rate, you’d either have to sell your bond at a discount or come up with investment money somewhere else. In addition, interest rate changes affect your actual YTM because you’ll be reinvesting your coupon payments at the going rate, which is different from your original rate.
Longer-term bonds are more susceptible to interest rate risk than shorter-term bonds, since they lock your money in for a longer time and because interest rates can change much more over extended periods. That’s why the debt securities with the lowest risk of all are U.S. Treasury bills because their terms are so short—4, 13, or 26 weeks. With such as short time frame, rates typically change very little before maturity. That’s a primary reason that T-bills are described as cash equivalent investments.
In addition to being vulnerable to interest rate risk, longer-term bonds are also more susceptible to inflation risk, which is the erosion of the buying power of your money due to rising prices over time. Because of all these added risks, longer terms bonds usually must pay higher interest rates to attract investors.
One popular way to manage one aspect of interest rate risk—the risk that your bond will mature when rates are low and you’ll have to buy new bonds paying a lower yield—is to stagger the maturity dates of your bonds, so they don’t all mature at once. Using this technique, known as laddering, you purchase bonds that mature at regular intervals, such as one or two years apart, so that the evenly spaced maturities resemble the rungs of a ladder. If you receive repayments of principal at different times, rather than having all your bonds repaid at once, you may be able to avoid having to reinvest all your money at an unattractive rate and missing out on more attractive rates at other times.
Some bonds, known as put bonds, give you the option to redeem your bond, or exchange it for par value, before the scheduled maturity date. While put bonds leave you less vulnerable to interest rate risk, since you won’t risk having to sell your bond in the secondary market at a discount, they also offer lower coupon rates in exchange for this lower risk.
Bonds usually make coupon payments twice a year, but zero-coupon bonds, also known as zeros, pay interest all at once, at maturity, along with the repayment of principal.
If you’re investing for a future goal when you’ll need a sum of money at a particular time, a zero-coupon bond may be a useful investment. One way zeroes can be handy is that they pay you interest on the interest that you’ve earned but haven’t received, at the YTM rate. This eliminates the possibility that you might have to reinvest your coupon payments at a lower rate than the bond itself is paying. However, the market price of zeros can be extremely volatile in the secondary market, so they may be a good investment choice only if you are fairly certain you will hold them to maturity.
Because zeroes are priced differently from coupon-paying bonds, you need less up front to make a substantial investment. Instead of paying par value, you buy them at a deep discount, or much less than par value, and you’re repaid par value at maturity. The discount represents your total income from the bond.
One catch with zeroes, however, is that you may still owe income taxes on the coupon payments during the term of the loan even though you haven’t received them. For this reason, it may make sense, if you plan on investing in zeroes, to do so through a tax-deferred account or to purchase tax-free municipal zeros issued in the state where you live.
A bond issuer may choose to call a bond—repay the principal to a bond’s investors before its maturity date—if the bond allows it. These callable bonds specify the times at which the issuer may call the bond, either in the form of a call schedule, with specific dates on which the bond may be called, or as a single date, beyond which the bond may be called at any time.
The risk that your bond will be called makes it more vulnerable to reinvestment risk, or the risk that you’ll find yourself forced to reinvest your principal at a lower interest rate than you were receiving on the called bond. That’s especially likely to occur because issuers generally call bonds when interest rates drop. By paying back their high-interest debt and borrowing at lower rates with a new bond issue, issuers can finance their activities more cheaply. However, it leaves you holding cash to reinvest when interest rates are low.
Issuers may sometimes choose to pay back, or redeem, only part of a total bond issue. In that case, investors to be repaid may be chosen by lottery. In addition, some bonds have a series of calls built in, with a feature known as a sinking fund—money that the issuer sets aside specifically to pay back a certain chunk of the total debt in stages.
Because calls can make a bond less attractive to investors, issuers may specify that the bond will be redeemed at higher than par, giving you the chance to realize a profit if your bond is called. If you want to consider how much you’ll make on your investment if the bond is called versus how much you’ll make if it matures on schedule, you can ask your broker for a yield figure known as yield-to-call, or yield-to-first-call. This number tells you what your yield would be if your bond were called at the earliest possible date.
Investing in bonds can require a relatively large outlay of principal. Although par value is usually $1,000, many bonds are not available individually and are sold only in lots of five or more. Agency bonds in particular may have a minimum investment of $10,000.
Because of this high initial investment, it’s more typical for institutions, such as mutual funds and pension funds, to own corporate and agency bonds than it is for individual investors. Some of the same issues exist with municipal bonds, but certain issuers may market to individuals in part to build community support for expensive projects.
Treasury securities, however, are the exception. New issues are sold by the Treasury directly to the public on the TreasuryDirect Web site at www.treasurydirect.gov, and you may buy bills, notes, and bonds individually with a minimum investment of $1,000.
To buy or sell all other bonds, you usually need to work with a broker, who matches you with sellers and buyers through a bond dealer. Sometimes the broker’s own firm has bonds in their own inventory to sell, and these may be priced better than bonds the broker must buy from another firm. Bond prices are not as transparent at stock prices, in part because the commissions you pay when you buy or sell them are not reported separately, as stock commissions are.
While some bonds trade on the major exchanges, the majority of corporate bonds trade over-the-counter and, until recently, it was difficult for individuals to find current prices. Today, extensive real-time trade information and end-of-day index information on corporate bonds is displayed without charge in the Market Data section of FINRA’s Website.