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Bond Basics

A bond is a debt security, a loan similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it "matures," or comes due. There are various types of bonds available for purchase including: U.S. government securities, municipal bonds, corporate bonds, mortgage and asset-backed securities, federal agency securities and foreign government bonds.

BOND RATINGS

Many bonds are graded by rating services such as Moody’s and Standard & Poor. These services evaluate the credit quality of both municipal and corporate bonds. Federal Government bonds are considered the safest investment available because they are backed by the full faith and credit of the U.S. Government, and therefore do not require rating.

Bond ratings are divided into two general categories. Bank grade (investment grade) and speculative (non-investment) grade. A rating of BBB (Standard & Poor), Baa (Moody’s) or better is considered investment grade by the Federal Government. If a bond is rated BB (Standard & Poor), Ba (Moody’s) or below, it is considered a high-risk investment that may not make all interest and / or principal payments. These bonds should only be purchased with risk capital.

BOND YIELDS

A bond’s yield is the amount of the interest payments to the holder in relation to the price paid for the bond. A bond’s yield can be looked at in several different ways. The nominal yield or coupon is the bond’s payout interest rate that is printed on the face of the bond and is set when the bond is first issued. The current yield is the bond’s interest payment divided by the price paid for the bond. The yield to maturity calculation is the annualized return of capital on a bond if held to maturity. There is also a yield to call calculation for bonds that have an early call feature. If a bond has a call feature, the yield to call is calculated using the cost of the bond, the call price, and the earliest date the bond can be called by the issuer.

BOND LIQUIDITY

Keep in mind that should you desire to resell a bond, rather than keep it until maturity, the price you receive may vary from what you paid. For example, if you bought a bond for $1,000.00 with a coupon of 5% that matures in ten years, you would receive $50.00 every year as an interest payment on the debt. On the tenth year you would receive $50.00 interest and a return of your initial investment of $1,000.00. Should you need to sell your bond prior to maturity in the open market, if interest rates have gone up since you purchased your bond, you may receive less than the $1,000.00 you paid for the bond. If interest rates have declined since your purchase, and you want to sell, you may receive more than you initially paid. Other things can affect a bond’s resale value, including changes in a company’s credit rating.

TYPES OF BONDS

There are many different types of bond instruments from which to choose. Some available bond types are:

Corporate

Zero-Coupon

U.S. Government

Municipal

and Collateralized Mortgage Obligations.

Choosing to invest your money in a given bond issue should be determined by among other things, your investment objectives, your current and desired portfolio diversification, income level, investment capital, years to retirement, risk tolerance, and desired liquidity.