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Bonds Guide

Types of bonds   Examine before buying   How to buy bonds   Notes

A bond is a promise to repay a sum of money at a certain interest rate and over a certain period of time.
Why do organizations issue bonds? Let's say a corporation needs to build a new office building or needs to purchase aircraft. Or maybe a city government needs to construct a new school or repair the streets. Whatever the need, a large sum of money will be needed to get the job done.
One way is to arrange for banks or others to lend the money. But a generally less expensive way is to issue (sell) bonds. The organization will agree to pay some interest rate on the bonds and further agree to redeem the bonds (i.e., buy them back) at some time in the future (the redemption date).

Types of Bonds

Bonds are known as "fixed-income" securities because the amount of income the bond will generate each year is "fixed," or set, when the bond is sold. No matter what happens or who holds the bond, it will generate exactly the same amount of money.

There are four basic kinds of bonds, all defined by who is selling the debt. The first are bonds sold by the U.S. Government and government agencies. The second are bonds sold by corporations. The third type of bonds are those sold by state and local governments. The last type of bond investors might encounter are bonds sold by foreign governments, although these can be difficult for the individual investor to buy and sell outside of a mutual fund.

  • The Federal Government. U.S. Government bonds are called Treasuries because they are sold by the Treasury Department. Treasuries come in a variety of different "maturities," or lengths of time until maturity, ranging from 3 months to 30 years. Various types of Treasuries include Treasury notes, Treasury bills, Treasury bonds, and inflation-indexed notes. (For more info, check out this U.S. Treasury Bonds note.) These all vary based on maturity and amount of interest paid. The Treasury Department also sells savings bonds as well as other types of debt through the Bureau of the Public Debt. Treasuries are guaranteed by the U.S. Government and are free of state and local taxes on the interest they pay.
  • Other Government Agencies. Some government agencies and quasi-government agencies like the Federal National Mortgage Association , the Federal Home Loan Mortgage Corp. , and the Government National Mortgage Association sell bonds backed by the full faith and credit of the U.S. for specific purposes, such as funding home ownership.
  • Corporate Bonds. Companies sell debt through the public securities markets just as they sell stock. A company has a lot of flexibility as to how much debt it can issue and what interest rate it will pay, although it must make the bond attractive enough to interest investors or no one will buy them. Corporate bonds normally carry higher interest rates than government bonds because there is a risk that the company could go bankrupt and default on the bond, unlike the government, which can just print more money if it really needs it. High-yield bonds, also known as junk bonds, are corporate bonds issued by companies whose credit quality is below investment grade. Some corporate bonds are called convertible bonds because they can be converted into stock if certain provisions are met.
  • State and Local Governments (Munis). Because state and local governments can go bankrupt, they have to offer competitive interest rates just like corporate bonds. Unlike corporations, though, the only way that a state can get more income is to raise taxes on its citizens, always an unpopular move. As a way around this problem, the federal government permits state and local governments to sell bonds that are free of federal income tax on the interest paid. State and local governments can also waive state and local income taxes on the bonds, so even though they pay lower rates of interest, for borrowers in high tax brackets the bonds can actually have a higher after-tax yield than other forms of fixed-income investments. Thus, tax-free municipal bonds (also known as "munis") were born.

What you should examine before buying a bond

There are three important things to know about any bond before you buy it: the par value, the coupon rate, and the maturity date. Knowing these three items (and a few other odds and ends depending on what kind of bond you are buying) allows you to analyze the bond and compare it to other potential investments.

Par value is the amount of money the investor will receive once the bond matures, meaning that the entity that sold the bond will return to the investor the original amount that it was loaned, called the principal. As mentioned earlier, par value for corporate bonds is normally $1000, although for government bonds it can be much higher.

The coupon rate is the amount of interest that the bondholder will receive expressed as a percentage of the par value. Thus, if a bond has a par value of $1000 and a coupon rate of 10%, the person holding the bond will receive $100 a year. The bond will also specify when the interest is to be paid, whether monthly, quarterly, semiannually, or annually.

The maturity date is the date when the bond issuer has to return the principal to the lender. After the debtor pays back the principal, it is no longer obligated to make interest payments. Sometimes a company will decide to "call" its bond, meaning that it is giving the lenders their money back before the maturity date of the bond. All corporate bonds specify whether they can be called and how soon they can be called. Federal government bonds are never called, although state and local government bonds can be called.

How to Calculate Bond Yields
The key piece of information to know about a bond in order to compare it with other potential investments is the yield. You can calculate the yield on a bond by dividing the amount of interest it will pay over the course of a year by the current price of the bond.
If a bond that cost $1000 pays $65 a year in interest, then its current yield is $65 divided by $1000, or 6.5%.

Why Bond Yields Can Differ From Coupon Rates
Why not just look at the coupon rate to determine the bond's yield? Bond prices fluctuate as interest rates change, so a bond can trade above or below the par value based on what interest rates are. If you hold the bond to maturity, you are guaranteed to get your principal back. However, if you sell the bond before it matures, you will have to sell it at the going rate, which may be above or below par value.

How to buy bonds

Almost all investors who buy bonds buy them because they are generally safe investments. However, except for bonds from the federal government, bonds carry the potential risk of default, no matter how remote that risk might be. Whether it is a high-yield corporate bond or a bond sold by the sovereign state of Virginia, there is always a chance that the entity that borrowed the money will not be able to make the interest payment.

Bond ratings were developed as a way to indicate how financially stable the issuer of the bonds really is. Developed by third parties like Standard and Poor's and Moody's, bond-rating services give bonds letter or mixed letter and number ratings based on the financial soundness of the bond issuer. To complicate things, the rating agencies use entirely different rating systems, making it very important that you check what the ratings mean before you make any assumptions. The higher the rating, the higher the quality of the bond, with Treasury bonds being rated the highest and "junk" bonds being those with the lowest ratings.

Depending on the bond, it can either trade very frequently at a low commission or it may be very difficult to find a buyer or seller and involve large transaction costs. "Liquidity" is the term used to describe how easy it is to sell something. Highly liquid bonds include U.S. Treasuries, which trade billions of dollars worth every day. Illiquid bonds would include the bonds of a company viewed as close to bankruptcy. Because it is no longer a safe investment, only those speculating that there will be a corporate turnaround are willing to buy those bonds, meaning they trade a lot less frequently. Liquidity has a direct effect on the commission you pay to trade a bond, which unlike stocks, rarely trade on a fixed commission schedule.

  • Use a Brokerage. The most common way to buy bonds, much like stocks, is to use a brokerage account. You can either use a full-service (or full-price) broker or a discount broker to execute your trades.
  • Picking a Broker. Bond commissions vary widely from brokerage to brokerage, so it does not hurt to shop around a little before making your decision. Through a brokerage, you can buy anything from a 30-year Treasury to a 3-month junk bond issued by a corporation on the edge of bankruptcy. You can either participate in the direct offering of the bonds or pick them up in the secondary market, depending on your brokerage.
  • TreasuryDirect. In an effort to make it easier for citizens to buy U.S. Government bonds, the Bureau of the Public Debt started the TreasuryDirect program. This program enables individuals to purchase bonds directly from the Treasury, completely avoiding a brokerage. Investors can establish a single TreasuryDirect account that will hold all of their Treasury notes, bills, and bonds. Investors are issued account statements periodically. Interest and the repayment of principal are made electronically via direct deposit to a bank or brokerage designated by the account holder. As long as the investor has enough money, he can buy any type of Treasury security he wants. Additionally, you can transfer bonds to and from your account as you desire. The Bureau also allows you to direct deposit payments, reinvest money after a bond matures, and sell bonds for a flat fee of $34. To learn more, visit TreasuryDirect on the Web.

Notes

S&P's Ratings Services note
Owned by McGraw Hill, Standard and Poor's Ratings Services is only one division of Standard and Poor's, an investment publisher. This unit rates the debt of various bond issuers to communicate to potential buyers how much risk there is of default - or the lender not making the agreed-upon payments.

Standard and Poor's uses a letter system to rate bonds, adding pluses and minuses when appropriate. From highest to lowest, its basic ratings are: AAA, AA, A, BBB, BB, B, CCC, CC. AAA+ would be the highest possible rating and CC- would be the lowest possible rating. For more information on what these ratings mean, check out the definitions at the S&P web site.

Moody's note
Owned by Dun and Bradstreet, Moody's is one of the largest bond-rating agencies in the world. It assesses the health of various companies, agencies, and governments issuing bonds and rates the bonds accordingly. This rating communicates to potential bond buyers how much risk there is of default - or the lender not making the agreed-upon payments.

Moody's uses a mixed-case letter system to rate bonds. From highest to lowest, the ratings go: AAA, AA, A, Baa, Ba, B, Caa, and C. Most serious bond investors will settle for nothing less than an A rating. High-yield "junk" bonds are bonds that are either rated C or that are not rated at all.

U.S. Treasury Bond note
Treasury Bills. Treasury bills, also called "T-bills," are the U.S. Government's short-term bonds. They come in three maturities: 13 weeks, 26 weeks, and 52 weeks. The 13-week and 26-week bills are auctioned on Mondays and the 52-week bills sell every four weeks. The minimum purchase amount for all bills is $1000. Interest is paid at the end of the term for the 13-week and 26-week varieties and semiannually for the 52-week version.

Treasury Notes. Treasury notes are the U.S. Government's intermediate-term bonds. They come in maturities of 2 years, 5 years, and 10 years, and are sold in minimum amounts of $1000. Two-year notes are sold monthly. Five-year and 10-year notes are sold every three months starting in February. Interest is paid semiannually.

Treasury Bonds. Treasury bonds are the U.S. Government's long-term bonds. They come in only one maturity - 30 years. They are sold to individuals in multiples of $1000. The 30-year bonds are sold three times a year, in February, August, and November. Interest is paid semiannually.

Inflation-Indexed Notes.
Started in January 1997, inflation-indexed notes are Treasury notes that pay a fixed yield plus the current rate of inflation. The inflation rate is calculated by taking the non-seasonally-adjusted U.S. city average Consumer Price Index for All Urban Consumers (CPI-U), which is published every month by the Bureau of Labor Statistics. These notes currently carry a maturity of 10 years and are auctioned off once every three months. Interest is paid semiannually.

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