Basically when an institution needs money they offer to borrow your money for a set time and pay you back plus interest.
A bond is a debt security, meaning that an issuer owes a principle and a coupon to the debt holder. Meaning the issuer is a borrower, the coupon is interest and the holder is the lender.
Based on the current interest rate a bonds coupon can be worth more or less. We'll visit this again later.
What to know about bonds
Bonds can be issued from any institute but they have all have common features. There are lots of kinds of bonds but most are relatively low risk and protect you from inflation.
There are three types of maturity dates:
- short term: no less than one year
- medium term: no less than five years
- long term: no less than ten years
Coupon dates are are paid semi-annual or they pay a coupon every six months.Bonds are rated based on the credibility of the issuer. AAA is the best (investment grade) and C or D (not investment grade) are the worst.
As with all types of investment the higher the rating the lower the yield and the lower the rating the higher the yield.
Because the coupon (interest rate) on new bonds change from year to year, the value of bonds already issued change. Lets say you bought a bond last year at $1000 with a 6% coupon, and your friend bought one this year for $1000 with a 8% coupon.
You're getting $60 every year on your bond and your friend is getting $80 a year on his. Your bond is at a discount because its coupon is less than the current rate.
On the other hand if your friend bought a bond at 5% this year and your bond is at 6% it's at a premium because its coupon is greater than the current rate.
Whats that mean? If you buy a discount bond you'll pay less face value because it's not worth as much and a premium bond has a higher face value because its worth more.
Risk and bonds
As we know the riskier the investment the better the return. There are 3 types of risks for a bond.
Credit risk- the credit quality of the business could deteriorate over time
Interest-rate risk- bond rates could rise, causing bonds to devalue
Inflation risk- inflation could rise and decrease the buying power of future principle
Because of these risks the longer the maturity date the higher the coupon.
Types of bonds
There are four major kinds of bonds:
Corporate: these bonds are sold and repaid by private businesses. Bonds are a major source of long term borrowing. In general these bonds bear higher risk because the payback depends on the business continuing to do well.
Government: government bonds are issued by the U.S government. There is no risk because they can always print more money. Because of that, these bonds are low risk and have lower coupons.
Municipal: these bonds are issued by states. Because states cannot print money there is a little more risk than government bonds. These bonds are not taxable by the fed but are subject to state and local taxes.
Agency: agency bonds are created by the federal government and support public policies and programs. These bonds have a high minimum.
There are 3 bond features you should be familiar with.
Callibility - If a bond is callable the issuer can pay you back before the maturity date. That's not good for you. If interest rates decline the company can repay your bonds, which forces you to buy ones at lower interest rates.
Convertibility - This feature allows the bond holder to convert your bonds into common or preferred stock. This is a good way to still participate in company growth. You should see a broker to help you with this one. If the stock price rises the bond yield is less important.
Zero interest - These bonds have no annual fixed interest payment. However they sell at a huge discount to face value, but the price rises toward maturity. Because of current taxation they are best used in retirement and college savings plans.