What are bonds?
Bonds are issued by governments and private organizations and are debts issued by the organization. When you buy a bond, the bond issuer is borrowing money from you with a promise to pay it back on a certain date, and to pay you interest in the meantime.
People commonly think of bonds issued by the federal government (Treasury bonds), local governments (municipal bonds), and corporations such as utility companies (corporate bonds). Bonds can also be issued by other entities such as churches and charities to finance their operations or special projects.
How do bonds work?
Bonds are sold at face value, typically $1,000. When you buy a bond, you are lending the issuer that amount of money, called the “principal”, for a period of time specified in the bond. The bond note specifies the term of the loan. When the term expires, the bond is said to have “matured” and the issuer must repay the principal.
During the term of the loan, the issuer pays a specified interest rate a.k.a. “coupon rate”. The bond note specifies the coupon rate and how often interest payments are made, which is typically every six months.
In the past, bonds were issued in paper form and bondholders would mail in coupons twice a year to receive interest payments. Today, bonds are issued electronically and interest payments are automatically issued by check or direct bank deposit.
Although the face value of a bond does not change after it’s issued, the market value can fluctuate with prevailing interest rates. When interest rates rise, the value of existing bonds decreases because new bonds would come with higher interest rates. When interest rates decrease, the bond’s market value increases.
As a bondholder, you can sell the bond before it matures, but the value may be higher or lower than the face value depending on interest rates at the time. If you hold a bond to maturity, you will receive the specified interest payments and your original loan, as long as the issuer is able to meet its financial obligations.
When the market value of a bond has gone down, you can buy it for lower than its face value (“buying at a discount”), and hold the bond to maturity to receive the full face value, plus any interest payments in the meantime.
A key consideration when purchasing a bond is the risk of default, or inability of the issuer to make required interest payments or return the principal upon maturity. Credit agencies assess bonds’ level of risk based on the issuers’ financial condition. The major credit agencies are Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s. Note that state and local governments also receive ratings based on their creditworthiness and financial status.
Generally, the lower the bond rating the higher the risk, but also the higher the interest rate promised. Issuers with low ratings must promise exceptionally high interest rates in order to attract bondholders.
What are some major types of bonds?
The most popular bonds are issued by the U.S. government, state and local governments, and corporations. U.S. government bonds can be issued by the U.S. Department of the Treasury or by individual government agencies.
Bonds from the U.S. Treasury come in three types. Treasury bills have terms shorter than a year and are sold at a discount to face value. They do not pay interest. Treasury notes have terms of one to 10 years and pay interest every six months. Treasury bonds have terms from 10 to 30 years and also pay interest every six months.
Besides Treasuries, individual government agencies can also issue bonds. These include National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corp. (Freddie Mac).
Treasuries and bonds issued by federal government agencies are backed by the full faith and credit of the U.S. government, and are considered very low-risk. However the interest rate tends to be the lowest among available bond classes.
Municipal bonds are issued by state and local governments to raise money for infrastructure construction such as roads and bridges and for funding new projects like a subway system. Interest on municipal bonds is typically exempt from federal and state income taxes, though bondholders in other states may have to pay income tax in their home states. Municipal bonds have higher interest rates than Treasuries. They also have higher risk, since local governments can go bankrupt.
Corporate bonds are issued by private companies to fund operations or a business purchase. Corporate bonds have the highest interest rates, and also come with the highest level of risk since companies go out of business regularly. Bonds issued by companies with particularly low credit ratings are called “junk bonds” or “high-yield bonds”.
For additional information
For more information about bonds and bond investing, see The Bond Market Association website.
Also see our page about zero-coupon bonds.