When you buy a bond, you are loaning the issuer of the bond money for a certain period of time. In return for the loan, the issuer promises to pay you fixed interest payments on a regular basis, usually semi-annually, and to return the full principal loan amount to you at the end of the time period. So a bond is essentially an “IOU” written by the issuer of the bond to you. Like stocks, bonds may also be purchased on the secondary market.
How are bonds structured?
Bonds, in the most general sense, are issued with three essential components that will define the terms of the bond.
- Maturity — indicates the life of the bond. Most bonds have maturities ranging from three months to 30 years.
- Par value — also called “face value,” this is the amount the bond holder will be repaid when the bond reaches maturity. For example, if you purchase a $1,000 par value bond, you will receive $1,000 at maturity.
- Coupon rate — also called “interest rate,” this is the percentage of par value you will receive as a fixed interest payment annually. For example, if you purchase a $1,000 par value bond with a 10% coupon rate, you will receive $100 in interest each year.
What kinds of bonds are available?
Bonds are issued by a variety of entities to satisfy a variety of capitalization needs.
- United States government
- United States government agencies
- State and municipal governments
- Corporations
How are bonds different than stocks?
When you buy a corporate bond, you become a creditor to the corporation. Which means if the corporation files for bankruptcy protection, you have a senior claim for return of your principal over stockholders in the liquidation of assets. Principal and interest for bonds issued by government entities are backed by their taxing authority. In the case of U.S. government agency bonds, they are guaranteed by the full faith and credit of the U.S. government.
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