What Is a Bond?

A bond is a debt instrument--basically an IOU--where an investor is loaning money to the US government, a state, a municipality, or a corporation for a defined time period at a fixed rate of interest.

Why Own Bonds?

Bonds play an important role in asset allocation by diversifying risk, generating income, and preserving capital through varying economic and financial market conditions.

Determining a bonds interest rate

A bond’s interest rate is determined by two features: the bond’s duration and the issuer’s credit quality. Bonds typically pay interest semi-annually; at maturity the issuer repays the borrowed funds (called principal). Bonds with longer durations have higher yields because you’re being paid for keeping your money tied up for a longer period of time. Credit quality determines the likelihood of an issuer repaying its debt.

Bonds are rated by independent rating bureaus, such as Moody’s and Standard & Poor’s, and less credit-worthy issuers have to pay more interest. Standard & Poor’s assigns a letter grade to bonds, with AAA indicating the highest credit quality and D indicating the lowest.

The difference between interest rate and yield

A bond’s interest rate and its yield are not always the same. A bond’s yield is the amount of return it earns over time.

There is an opposite relationship between a bond's yield and its price. When interest rates rise in the marketplace, bond prices fall and their yields rise to be consistent with current rates. The reverse is also true; when interest rates fall, bond prices rise and their yields fall to be consistent with current rates. Under both scenarios, the interest rate of the bond never changes; what changes is your yield based on the price paid for the bond:

• If a bond is purchased at a premium (more than par or $1,000), the yield is less than the coupon.
• If bond is purchased at a discount to par the yield is higher than the coupon.
  

Types of bonds

The main types of bonds are Treasuries (bonds, notes, and bills), municipal bonds, and corporate bonds.

• Treasuries are issued by the U.S. government and are the safest type of bond. Because of their high quality, interest rates are low but default risk is nonexistent. Treasuries are initially sold directly by the government via auction in $1,000 increments but can also be bought from your broker. Treasury bills (T-bills) are a short-term investment with maturities ranging from a few days to 26 weeks. They’re sold at a discount to their face value ($1,000); the full face value is received when T-bills mature and the interest earned is the difference between the amount paid and the face value. Treasury notes have maturities of two, five, and 10 years; Treasury bonds mature in 30 years.
• Municipal bonds are issued by states, cities, and municipalities to help fund various projects. “Munis” are appealing to investors because the interest income is, with few exceptions, exempt from federal income tax, and in many cases, state and local taxes as well.
• Corporate bonds are issued by companies to raise money for different purposes, such as building a new factory or purchasing equipment. They offer higher yields than Treasury bonds of similar maturities and are appropriate for investors who are willing to trade safety for higher returns.

You can buy muni or corporate bonds when they are originally issued or in the secondary market from a broker that owns them.

Why use the services of a financial consultant to buy bonds?

A financial consultant can create a bond portfolio that matches your investment needs. By looking at the amount of risk you’re willing to take, your time horizon, and your tax status, a financial professional can find the best bonds to meet your objectives.