When you purchase a bond, you are buying a financial instrument in which the issuer of the bond is taking your money with a promise to pay it back with interest. Bonds are sometimes referred to as a debt security, and their terms dictate when and how much the issuer pays you back. Unlike stocks, which have no clear timetable and rate of return, bonds clearly state how much interest the issuer will pay and when. Monthly, semiannual, or annual are the usual timeframes.
There is also a maturity date fixed to the bond. This date is when the issuer will also pay back the original principal paid for the bond. A very simple example is that you purchase a $50,000 bond with a ten-year maturity date with an interest rate of 3% payable annually. Every year you will receive $1500 as an interest payment, and you will get back your $50,000 investment after ten years.
Once you buy a bond, you can transfer it into the secondary market where it is bought and sold, similar to stocks. In other words, a bondholder does not necessarily have to hang on to a bond until its maturity date. He can sell it ahead of time. While bonds are thought of as a stable investment, they can have high volatility based on the how the general interest rate is doing.
Potential investors look at the credit rating of a bond as a leading indicator of the amount of risk involved. The higher the credit rating, the more secure the investment. Credit rating agencies such as Standard & Poor’s and Moody’s use letter designations, which characterizes the soundness of a bond. Moody’s assigns bond ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C. Standard & Poor’s ratings are similar: AAA, AA, A, BBB, BB, B, CCC, CC, C, and D.
Government bonds are issued by a national government. In general, the government promises to pay periodic interest payments on the bond and to repay the face value on the maturity date. Government bonds are usually issued in the country of origin’s currency. United States bonds are in dollars, of course, and backed by the “full faith and credit” of the United States government.
If you are considering investing in United States Treasury securities, you have a choice of three different bond maturities
- You can invest in short-term (known as “bills”) with a maturity of between one and five years. (Financial instruments that mature in less than a year are known as Money Market Instruments.)
- You also have medium term maturity between six and twelve years (known as “notes”).
- Finally, there is long term (bonds) that have maturities greater than twelve years.
Municipal bonds are issued by a local government, territory, or their agencies. Issuers of municipal bonds can be states, counties, cities, school districts, redevelopment agencies, special-purpose districts, publicly owned airports, seaports and utility districts, and any other government entity at or below the state level. Bonds usually finance capital infrastructure projects needed over the long term. The needs vary greatly, and can be for streets and highways, schools, bridges, public housing, hospitals, sewer, power utilities, water systems, and other various public projects.
Corporations issue corporate bonds to raise capital for a variety of reasons. It can be for ongoing operations or to expand the business. The term “bond” usually applies to securities with a maturity of at least one year. Corporate debt instruments with a maturity shorter than a year are known as commercial paper.
The interest earned (coupon value) on corporate bonds is usually taxable income for the investor. It is tax deductible for the corporation paying it. Sometimes the coupon can be zero. When this happens, the zero-coupon bond sells at a discount. For example, a $1000 face value bond sells for $800. The investor pays $800 but collects $1000 at maturity.
Because the volatility of bonds is lower than that of stocks, they are considered a safer investment. Bonds are not subject to the day-to-day unpredictability of stocks. Their interest payments are sometimes higher than the general level of dividend payments in equities. For many investors, the general certainty of a fixed interest payment twice a year and a fixed lump sum at maturity are attractive.
With bonds, as with all investments, you need to have the best information possible when deciding if you want to invest in government, municipal, or corporate bonds – or some combination of all three. The broad view of bonds is that they are a good investment and should be part of your portfolio in some fashion. However, general account based cash value life insurance, also known as whole life insurance, can be an attractive alternative to a mid-term and long-term bond portfolio with added tax and life insurance benefits.