A bond is a debt security that an issuer (usually a corporation, government or municipality) issues. When you purchase a bond you lend money to that issuer, in return, the issuer provides you a bond, with a promise to pay a specified rate of interest during the specified time period of the bond, and also to repay the principal at maturity or when the bond becomes due.

 

Types of Bonds:

 

• Corporate bonds: these are bonds issued by private and public corporations. Bonds issued by companies can either be investment grade or High yield

• Investment grade bonds: are bonds that are issued by corporations with high credit rating, the high credit rating usually implies that the companies have low risk of defaulting on payments of interest on the bonds they issue

 

• High yield bonds: these are bonds issued by companies that have low credit rating. The low credit rating implies that these companies have a higher risk of defaulting on their payments or obligations. Because these bonds have low credit rating due to risk they tend to offer high interest rates to compensate for their high risk.

 

• Municipal Bonds: are bonds issued by states, cities, counties and other government entities. There are three types of municipal bonds

         

1. General obligation bonds: these bonds are not secured by any assets but rather the full faith and credit of the issuer. The issuer usually has the power to tax residents to make bond payments.

2. Revenue bonds: these bonds are usually backed by revenues from a specific project or source such as highway tolls or specific government projects. 

3. Conduit bonds: These are municipal bonds issued by the government on behalf of private entities such as hospitals and non-profit universities.

 

U.S Treasuries: these are bonds issued by the U.S treasury on behalf of the federal government. These bonds carry the full faith and credit of the U.S government which makes them almost risk free. They are considered risk free because of the U.S government’s vast resources it has in raising money to pay bondholders. These bonds are usually considered safe.

 

Types of U.S Treasuries

 

• Treasury Bills: short term securities that mature in a few days to 52 weeks.

• Notes: Securities maturing in ten years

• Bonds: Long term securities that mature in 30 years, they pay interest semi-annually

• Treasury Inflation-Protected Securities (TIPs): these are notes and bonds whose principal is adjusted based on changes in the consumer price Index which measures inflation. These securities pay interest every six months and are issued with maturities of five, ten and thirty years.

 

Benefits and Risks of owning bonds

 

Bonds provide a means of preserving capital and also earning a predictable income through steady stream of interest coupon payments before maturity. These interest payments are usually every six months.

Interest from municipal bonds is generally exempt from federal, state and sometimes local taxes.

 

Interest rate risk: this is the risk that interest rate changes can pose to a bonds value. Usually when interest rates rise newly issued bonds become more appealing to investors because the newer bonds have higher interest rates than old ones. Some investors will want to sell their old bonds with lower interest rate in order to buy the new issued bonds with higher interest rates. In order to sell the old bond in order to buy the new high interest rate bond might sometimes have to sell the bonds at a discount.

 

Inflation Risk: this is the risk that a bond investor faces due to the fixed rate of interest on a bond. This is because when prices rise due to inflation a bonds coupon payments stay the same due to their fixed nature.

 

Call Risk: this is the risk that a bond issuer might call (retire) a bond before its maturity as interest rates decline to take advantage of low interest rates. Much like a homeowner will take advantage of low interest rates to refinance a mortgage in order to save money on interest payments.

 

How to buy and sell bonds:

 

Unlike stocks bonds are not traded on an exchange, they are typically bought and sold through intermediaries called dealers in the over the counter (OTC) market. The dealers purchase the bonds from issuers and sell them to investors.  Bonds are sold in the OTC market in $5000 denominations, but prices are quoted in $100 increments. Bonds can be sold at a premium or discount and as a result might not always have their prices sold in $100’s. A bond selling at a premium might be quoted above a $100 due to the premium on the price. A bond selling at a discount might be quoted at a price below a $100 to reflect the discount in price.

A popular way that the average investor can purchase bonds is through a bond fund. Bond funds are mutual funds that invest primarily in bonds.