A bond is basically a loan from you, the bondholder, to the issuer of the bonds. You receive money from this bond in one of two ways:
- Interest – The bond issuer pays interest (known as the coupon) at regular periods over the term of the bond, and the principal value is returned as the bond expires.
- Discount – Zero-coupon bonds make no interest payments, but are sold at a discount to their face value. You collect your interest at the end of the term based on the difference between face value and the discount.
Bonds are a relatively low risk investment if purchased from creditworthy issuers, and generally provide lower returns than stocks. They may be either secured against collateral, or unsecured with no backing assets.
The typical reasons to invest in bonds are to diversify a portfolio, to lessen risk, to hedge against inflation, or to receive regular fixed income through a coupon rate. Zero-coupon bonds are typically for longer term, tax-sheltered accounts.
Bonds are issued by:
- The United States Treasury – Despite concerns over possible federal government shutdowns and defaults caused by bickering in Washington, Federal Treasury bonds and bills are still considered the safest investments in the world. This is because they are backed by the full faith and credit of the world’s richest and most powerful government. As risk is very low, so are yields relative to bonds issued by corporations and other governments.
- Municipal Governmental Entities – Municipal bonds (“Muni’s”) are issued by states, counties, cities and other governmental entities to build infrastructure or fund operations. When there are revenues derived from infrastructure built with bond proceeds – such as tolls from a bridge or highway – the bonds are backed in part by these revenues. Consequently, they are called Revenue Bonds. If there are no revenues backing the bond issue, they are called General Obligation (GO) bonds.
Muni bonds are normally exempt from federal and state taxes and are riskier than Treasury bonds because municipal bond issuers cannot print money, as can the federal government, to repay bondholders. As the recent bankruptcy of Detroit illustrates, some municipal entities pose greater credit risk than others. Consequently, the interest rates paid by their bonds – and their value to investors at any point in time – are impacted by the issuer‘s credit rating. Because muni bonds are typically tax-free, they pay a lower pre-tax interest rate than corporate bonds of the same credit quality. When investing in munis, therefore, investors must consider their after-tax yield.
- Corporations – Corporate bond issued by highly rated, established companies are typically safe and stable investments, and correspondingly pay lower yields than bonds issued by less creditworthy companies. If a company’s credit is rated BB or lower by Standard & Poor’s (or Ba by Moody’s), it is considered a “junk” bond, and its bonds must pay a substantially higher interest rate to investors. Junk bond investors typically mitigate this credit risk by investing in bonds from multiple issuers.
- Overseas Entities – These are still government or corporate issued bonds, but may be classified separately because the risk assessment may be different – especially for countries that may be considered emerging or politically unstable markets.
Credit quality of bond issuers is assessed and published by the three main rating agencies: Standard & Poor's, Moody’s and Fitch. S&P and Fitch use a ratings system that ranges from AAA at best to D for a defaulting entity. Moody’s ratings are similar. As mentioned above, bonds from corporate and municipal entities in poor financial health are considered high-yield (or junk) bonds – offering a higher than normal return but with correspondingly higher risk.
Rising interest rates make your bonds less valuable, since investors can buy new bond issues that give a better return. Conversely, lower interest rates make your current bonds more attractive than the current rate.
Bond funds offer a professionally managed alternative to direct investment in bonds. These funds are collections of bonds at various stages of maturity and risk levels. Bond fund managers frequently sell bonds before maturity to optimize portfolio duration and value. For this reason, because issuers can default, and because interest rates can rise, it is possible to lose money in a bond fund. Regardless of your bond choices, it is best to diversify your portfolio by issuer and to "ladder" your bonds, staggering their maturity dates so you always have a predictable money stream.
Investing in bonds is similar to investing in other financial vehicles – you are analyzing risk versus return, and higher risk correlates to higher potential return. Understand your reasons for investing in bonds, and pick the route that best fits your strategy.