Bonds are debt instruments issued by the U.S. government, state and local governments, corporations, and foreign entities.
The issuer borrows money and promises to pay back the debt plus interest twice a year. If the issuer goes bankrupt, bond holders will be paid before stock holders.
Here are some key elements of bonds:
- Principal or face value: amount of the investment.
- Coupon rate: annual income stated as a percentage of the face value.
- Maturity date: the future date the issuer repays the loan.
- Price: current market value of the bond.
- Yield: a fluctuating percentage that is calculated by dividing coupon rate by current price.
- Yield to maturity: your total return if you hold the bond to maturity.
When you invest in bonds, inflation is a major risk. Rising inflation means rising interest rates that drive down bond prices.
Assume an older bond has a 5% coupon and a newer bond has a 7% coupon, and interest rates are now at 7%. To sell the older low-interest bond, you’d have to accept less than face value. As interest rates rise, bond prices fall. But if the current interest rates are 5%, the 7% bond will fetch a premium price. As interest rates fall, bond prices rise.
The credit-worthiness of the issuer is also a major concern.
There are several rating services for bonds. Standard & Poors give bonds letter-ratings, with AAA the highest and CCC the lowest. Bonds with lower ratings pay higher coupon rates, balancing the higher risk with more reward.
There are many different types of bonds.
U.S. Government treasury bonds are the safest, backed by full faith and credit of the US government. Bills mature 60 days to one year, notes mature between 1 and 10 years, and bonds mature 10 to 30 years.
Bonds issued by agencies of the U.S. government consist of pools of residential mortgages loans that pay interest and principal monthly. Zero coupon government bonds are issued at a discount, pay no interest and are worth face value at maturity.
Corporate bonds issued by corporations may have callable dates, allowing the issuer to redeem the bonds before maturity. Check the ratings and note if the debt is unsecured, or secured by the assets of the company.
High-yield bonds are riskier corporate bonds that have low bond ratings but higher coupon, often called junk bonds.
Municipal bonds are issued by state and local governments. Coupon payments are free from federal tax, so they have lower coupon rates. Before you buy, check callable dates and ratings.
Bonds are attractive investments to people within five years of retirement, who wish to preserve their capital, and who need income.
The age of an investor, time horizon, and risk tolerance determines if bonds or stocks, or a mixture of both, is the best route to financial freedom.