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Bonds

Used with permission from The United States Securities and Exchange Commission. 

Bonds

What are bonds?

A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time.

When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it "matures," or comes due after a set period of time.

Why do people buy bonds?

Investors buy bonds because:

  • They provide a predictable income stream. Typically, bonds pay interest twice a year.
  • If the bonds are held to maturity, bondholders get back the entire principal, so bonds are a way to preserve capital while investing.
  • Bonds can help offset exposure to more volatile stock holdings.

Companies, governments and municipalities issue bonds to get money for various things, which may include:

  • Providing operating cash flow
  • Financing debt
  • Funding capital investments in schools, highways, hospitals, and other projects

What types of bonds are there?

There are three main types of bonds:

  • Corporate bonds are debt securities issued by private and public corporations.
  • Municipal bonds, called “munis,” are debt securities issued by states, cities, counties and other government entities. Types of “munis” include:
  • General obligation bonds. These bonds are not secured by any assets; instead, they are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders.
  • Revenue bonds. Instead of taxes, these bonds are backed by revenues from a specific project or source, such as highway tolls or lease fees.
  • Conduit bonds. Governments sometimes issue municipal bonds on behalf of private entities such as non-profit colleges or hospitals. These “conduit” borrowers typically agree to repay the issuer, who pays the interest and principal on the bonds. If the conduit borrower fails to make a payment, the issuer usually is not required to pay the bondholders.
  • U.S. Treasuries are issued by the U.S. Department of Treasury on behalf of the federal government. They carry the full faith and credit of the U.S. government, making them a safe and popular investment. Types of U.S. Treasury debt include:
  • Treasury Bills. Short-term securities maturing in a few days to 52 weeks
  • Notes. Longer-term securities maturing within ten years
  • Bonds. Long-term securities that typically mature in 30 years and pay interest every six months
  • TIPS. Treasury Inflation-Protected Securities are notes and bonds whose principal is adjusted based on changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities of five, ten, and 30 years.

What are the benefits and risks of bonds?

Bonds can provide a means of preserving capital and earning a predictable return. Bond investments provide steady streams of income from interest payments prior to maturity.

The interest from municipal bonds generally is exempt from federal income tax and also may be exempt from state and local taxes for residents in the states where the bond is issued.

As with any investment, bonds have risks. Bond investors are relying on the issuer’s ability to pay interest and repay principal. If the issuer has financial problems or defaults, the bondholders could wind up with losses.

Other risks include:

Call risk. The possibility that a bond issuer retires a bond before its maturity date, something an issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates.

Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.

Liquidity risk. This refers to the risk that investors won’t find a market for the bond, potentially preventing them from buying or selling when they want.

Interest rate risk. Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.

How to buy and sell bonds

With the exception of U.S. Treasury debt, bonds typically are not bought directly from the issuer but through an intermediary known as the underwriter.

Unlike stocks, bonds are not traded on an exchange; instead the underwriter buys them from the issuer and resells them to investors in the over-the-counter (OTC) market. Each bond is given a CUSIP number, similar to a ticker symbol, which is a uniform method to identify the security.

Usually, bonds are sold in the OTC market in $5,000 denominations. However, the prices are quoted as if the bonds were traded in $100 increments. Since bonds may be sold at a premium or a discount to the par value, that number is not always $100. Thus, a bond quoted at 97 refers to a bond priced at $97 per $100 of the face value of the bond. This bond is selling at a discount.

Another way to purchase bonds is through bond funds. These are a type of mutual fund that invests primarily in bonds. Depending on its investment objective and policies, a bond fund may concentrate its investments in a particular type of bond. Bond funds can be purchased directly through investment companies or through a broker or adviser.

Understanding fees

All investments have fees. Bonds bought by investors normally include a markup, which consists of the broker-dealer’s costs and profit. An additional commission may be added if a broker-dealer has to locate a specific bond rather than selling one from the firm’s inventory. Each firm establishes its own prices, within regulatory guidelines, which will vary depending upon the type of bond, size of the transaction, and service the firm provides.

Avoiding fraud

Corporate bonds are considered a security and as such must be registered with the SEC. The registration of these securities can be verified using the SEC’s EDGAR system. Be wary of any person who attempts to sell non-registered bonds.

Most municipal securities issued after July 3, 1995 are required to file annual financial information, operating data, and notices of certain events with the Municipal Securities Rulemaking Board (MSRB). If the municipal bond is not filed with MSRB, this could be a red flag.