Bond Tutorial

What are Bonds?

Bonds are debt obligations issued by governments, municipalities and corporations. As a bondholder, you are lending money to the issuer and in return you are paid interest on the loan (known as the "coupon"). You will receive the face value (known as the "principal amount") on a specified date in the future (known as the "maturity date"). Bonds are a type of fixed income security and are also referred to as debt securities.

Why invest in bonds?

The primary benefit of investing in bonds is that they provide the ability to preserve capital along with a relatively predictable stream of income over a predetermined period of time. Bonds can be used to reduce your overall portfolio risk through diversification. An investment in bonds, like any other investment, should be tailored to your investment objectives and tolerance for risk.

How are bonds bought and sold?

A bid is the price a prospective buyer is willing to pay for a specific bond at a particular time. An offer is the price for which a prospective seller is willing to sell a specific bond at a particular time. A trade occurs when a buyer and seller agree to a specific price. A seller may also sell bonds by requesting bids through a process known as bid wanted.

What are Municipal Bonds?

Municipal bonds, also known as "munis", are debt obligations of a state or local government entity. They are typically used for general governmental purposes and to fund public projects such as roads, hospitals, utilities, or industrial projects. The interest they pay is free from federal taxation and if you buy a bond from your home state, the interest may also be exempt from state income tax. Most municipal bonds pay interest semiannually and return the bond buyer's principal when they mature. The length of a bond may be up to 30 years and may have provisions that allow the municipality to pay back its obligation in advance (known as "call provisions"). Munis typically trade in $5,000 increments.

What are the benefits of Municipal Bonds?

The primary benefit of municipal bonds is that they provide the ability to preserve capital along with a relatively predictable stream of income over a predetermined period of time. Bonds may be used to reduce your overall portfolio risk through diversification.

Other benefits to owning Municipal Bonds include:

Tax-free income

Particularly for investors in higher tax brackets, the tax-free nature of munis makes them an attractive investment vehicle. Interest income from municipal bonds is exempt from federal income tax (in most cases). Those that are not tax-free are specifically designated as such, and the yield on the bond will reflect this. If you buy a bond from your home state, the interest may also be exempt from state income tax. Exceptions to this rule exist including the possibility that income may be subject to Alternative Minimum Tax (AMT). You should always consult your tax advisor if you are unsure of the treatment in your state.

Dependable income

Munis with coupons generally pay interest twice a year, so investors know how much interest to expect and when they will receive payments. Zero coupon bonds pay a known amount upon maturity.

Preservation of capital

Issuers repay the full face value upon maturity of the bond. If a bond is sold prior to the maturity date, the value of the bond may vary, and investors may receive more or less than their original investment.

Investors should consult with a financial and/or tax advisor to determine which bonds meet their investment objectives.

What are Corporate Bonds?

Corporate bonds are debt securities issued by a private corporation to finance expansion or other activities. They typically have three distinguishing features:

The interest received is taxable;

They have a par value of $1000;

They have a term maturity, which means they come due all at once.

Corporate bonds are usually considered either "secured bonds" or "unsecured bonds." Secured bonds are backed by a specific pledged asset and include mortgage bonds, equipment trust certificates and collateral trust bonds. Unsecured bonds are not backed by a specific pledged asset and include debentures and convertible debentures.

What are the benefits of Corporate Bonds?

The primary benefit of corporate bonds is that they provide the ability to preserve capital along with a relatively predictable stream of income over a predetermined period of time. Bonds may be used to reduce your overall portfolio risk through diversification. Other benefits to owning corporate bonds include:

Dependable Income

Corporate Bonds with coupons generally pay interest twice a year, so investors know how much interest to expect and when they will receive payments. Zero coupon bonds pay a known amount upon maturity.

Preservation of Capital

Issuers repay the full face value upon maturity of the bond. If a bond is sold prior to the maturity date, the value of the bond will vary, and the investor may receive more or less than the original investment.

Investors should consult with a financial and/or tax advisor to determine which bonds meet their investment objectives.

What are Treasuries?

Treasuries are debt obligations of the U.S. Treasury and are backed by the full faith and credit of the U.S. Government. They are issued to finance various activities of the U.S. Government. There are several major categories of Treasury securities:

Treasury bills - have 3 month, 6 month, and 1 year maturities. They are issued at a discount, with no periodic interest payments. Instead, the interest consists of the difference between the purchase price and the face value paid at maturity. T-Bills, for short, trade with a minimum of $1,000 and in increments of $1,000 thereafter.

Treasury notes - T-notes, for short, have 2 to 10 year maturities.

Treasury bonds - T-bonds, for short, have over a 10 year maturity and are therefore considered long-term debt instruments.

Treasury notes and bonds trade in denominations of $1,000 and pay interest semiannually.

What are the benefits of Treasury Bonds?

The primary benefit of Treasuries is that they provide the ability to preserve capital with very little to no credit risk along with a relatively predictable stream of income over a predetermined period of time. Bonds may be used to reduce your overall portfolio risk through diversification. Other benefits to owning Treasuries include:

Dependable Income

Treasuries with coupons generally pay interest twice a year, so investors know how much interest to expect and when they will receive payments. Zero coupon bonds pay a known amount upon maturity.

Preservation of Capital

Issuers repay the full face value upon maturity of the bond. If a bond is sold prior to the maturity date, the value of the bond will vary, and the investor may receive more or less than the original investment.

Investors should consult with a financial and/or tax advisor to determine which type of bonds meet their investment objectives.

What are Agency Bonds?

Government Agency securities, commonly called Agencies or government-sponsored entities (GSEs), are private corporations that were chartered by an act of Congress. Most agencies have a credit line with the U.S. Treasury but are NOT backed by the full faith and credit of the U.S Government. Some examples of Agencies are the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC).

What are the benefits of Agency Bonds?

The primary benefit of agency bonds is that they provide the ability to preserve capital along with a relatively predictable stream of income over a predetermined period of time. Bonds may be used to reduce your overall portfolio risk through diversification. Other benefits to owning Agency bonds include:

Dependable Income

Agencies with coupons generally pay interest twice a year, so investors know how much interest to expect and when they will receive payments. Zero coupon bonds pay a known amount upon maturity.

Preservation of Capital

Issuers repay the full face value upon maturity of the bond. If a bond is sold prior to the maturity date, the value of the bond may vary, and the investor may receive more or less than the original investment.

Investors should consult with a financial and/or tax advisor to determine which type of bonds meet their investment objectives.

Key bond components defined

When investing in bonds, there are several components that affect the value of the bond. These components include the issuer, coupon rate, price, yield, maturity, redemption features, credit quality and tax status. Together, these factors determine the value of a bond. This list includes only the most common bond terms; for a list of additional terms, please visit our Glossary of Terms .

Issuer

The issuer is a legal entity (municipality, corporation or government) that has the power to issue a security: e.g. the municipality that is issuing the bond.

Coupon Rate

The majority of bonds have an interest rate that is expressed as a percentage of the principal and is fixed for the life of the bond (for example, a 10 year bond with a 7% coupon would indicate that a bond pays an interest rate of 7% per year for 10 years, or $70 per $1,000 bond per year). However, bonds may have interest that is paid entirely upon maturity (known as zero coupons, or "zeros"), or may have a floating rate, which is adjusted as market interest rates change. Most interest payments are paid semiannually (every six months). That is, the bond above paying a 7% coupon will pay $35 every 6 months for an annual total of $70. If the bond is held to maturity, the investor will also get the face value of the bond, $1,000, on the maturity date 10 years hence.

Zero coupon bonds, as mentioned above, do not pay interest until maturity. Instead, the interest accrues and is paid when the bond matures. The bonds are sold at a discount to the face value, and the difference between the purchase price and the face value represent the interest earned. If the bond we discussed above was a zero coupon bond, it would sell upon issue for $502.57, and at the end of 10 years, the investor would receive $1,000 ($502.57 plus 7%/year).

Price

The price you pay for a bond is determined by a number of factors, including the issuer, coupon, maturity, rating, prevailing interest rates, etc. New bond offerings, called new issues, typically sell at face value. After issuance, bonds are traded in the secondary market. The price that you receive when you sell a bond may be more or less than your purchase price. For example, if you owned a 7% coupon bond, and interest rates dropped, your bond should become more valuable. It would more than likely sell for a premium, or a price greater than the face value. See the Relationship between the Price and Yield.

Yield

Yield is the annual return on an investment expressed as a percentage. Bonds are most commonly evaluated using "yield to call" and "yield to maturity". Yield to call is calculated taking into account the coupon, the time to call date, and the call price. It is based on the assumption that all interest received over the life of the issue is reinvested at the yield. Yield to maturity is calculated taking into account the coupon, the time to maturity, the redemption price and the purchase price. It is based on the assumption that all interest received over the life of the issue is reinvested at the yield.

Lowest Yield

Also known as yield-to-worst. The lowest yield should always be calculated when considering the purchase of a callable security. Investors may not be able to reinvest their money to obtain the same yield if the security is called prior to the maturity date. The lowest yield takes into account the prepayment risk of callable securities and gives investors the lowest yield that they would receive if the security is called at the lowest call price. The lowest yield is determined after calculating the yield-to-maturity and the yield-to-call on the first call date and on all subsequent call dates up to maturity. The lowest yield will be equal to the yield-to-maturity for non-callable securities.

Maturity

A bond's maturity date is a predetermined future date when the principal will be paid by the issuer. Redemption Features While the maturity date is a good indicator as to how long a bond will be outstanding, certain bonds have features that can substantially change the expected life of the investment. These include calls, sinking funds, and other pre-payment provisions.

Call Provisions

A call provision allows the issuer to repay the investor earlier than the maturity date, at a predetermined price on a specific date. A call provision in a bond may affect the value of a bond. This option to repay will usually be exercised by the issuer when interest rates drop and the issuer wants to take advantage of the lower cost of capital. For example, if interest rates drop from 7% to 5%, the issuer can call bonds and reissue new bonds paying out only 5%, or $50/year (as opposed to 7%, or $70/year for the original bond). If a bond has a call provision, you should understand the "yield to call" might be lower than the "yield to maturity." To compensate the investor for the risk that a bond might get called, which benefits the issuer, a bond with a call provision usually pays a higher interest rate than a bond without a call provision.

Sinking Fund

A sinking fund is money accumulated on a regular basis in a separate custodial account that is used to redeem debt securities. The term is also used to refer to the mandatory redemption of term or bullet (non-callable) maturities prior to maturity, the schedule of which is stated at the initial offering.

Credit Quality

Although the default rate on investment grade bonds is low, it is still important to consider credit quality when you are buying a bond. Credit quality can range from the most secure, U.S. Treasuries (often considered risk free) to more speculative (or junk) bonds. Higher quality bonds, (investment grade) bonds pay lower coupon rates, while speculative bonds pay higher coupon rates to compensate the investors for the risk that the bond may default before maturity.

There are several ratings agencies in the U.S. that evaluate financial information and rate bonds on a scale of very safe to speculative. For more detailed information on ratings, please refer to the Glossary under Ratings, and see the details on Moody's, Standard & Poor's and Fitch's ratings.

Bond purchases should reflect your financial goals and risk profile, and should be discussed with your financial advisor if you have questions about which bonds are right for you.

Tax Status

Some bonds offer special tax advantages. There are no state or local income taxes on the interest from U.S. Treasury bonds. There is no federal income tax on the interest from most municipal bonds, and in many cases no state or local income tax. Do you want income that is taxable or income that is tax-exempt? The answer depends on your income tax bracket and the difference between what can be earned from taxable versus tax-exempt securities. The decision to invest in a taxable bond or a tax-exempt bond may also depend on whether you will be purchasing the securities in an account that is tax-deferred, such as a pension account, 40l(k) or IRA.

The Relationship Between Price and Yield

From the time a bond is originally issued until the day it matures, its price in the marketplace will fluctuate according to changes in market conditions or credit quality. The constant fluctuation in price is true of individual bonds and true of the entire bond market, with every change in interest rates typically having an immediate and predictable effect on the prices of bonds.

When prevailing interest rates rise, prices of outstanding bonds fall to bring the yield of existing bonds into line with higher-interest new issues.

When prevailing interest rates fall, prices of outstanding bonds rise to bring the yield of existing bonds into line with lower-interest new issues. Because of these fluctuations, you should be aware that the value of a bond may be higher or lower than its original purchase price if you sell before its maturity.

The Relationship Between Interest Rates and Maturity

There is a direct relationship between interest rates (i.e. yield) and maturity. Plotting the yields of bonds of the same quality with maturities ranging from the shortest to the longest available can show this relationship. The resulting curve is called the yield curve. The most common relationship is that of a rising or positive yield curve. This curve occurs when the yields on shorter-term securities are lower than yields on longer-term securities. The positive yield curve is most common, since an investor who ties up his money for a longer time is taking more risk and is usually compensated by a higher yield.


If short-term rates are higher than long-term rates, then the curve is called a negative or inverted yield curve. An inverted yield curve occurs when a surge in demand by borrowers for short-term credit drives up rates on short-term debt and/or demand for longer maturities increases. If there is little difference between short-term and long-term rates, it is called a flat yield curve.

Assessing Risk

Virtually all investments have some degree of risk. When investing in bonds, it is important to remember that an investment's return is linked to its risk. Generally speaking, the higher the risk, the higher the return. Conversely, relatively safe investments typically offer lower returns. Investors should consult with a financial and/or tax advisor to determine which bonds meet their investment objectives.