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An Introduction to Investing in Bonds

Updated on May 24, 2010

An Introduction to Investing in Bonds

Ever needed to borrow money from someone? Of course you have. Whether you needed cab fare or just forgot your lunch money, people borrow money every day. Well, large organizations often need to borrow money, too. But unlike your average person, large entities such as corporations and governments have different needs and it can be difficult to get as much money as they might require. It’s not just a matter of paying back the amount they borrowed; they need to sweeten the deal, offer lenders a reason to loan them money, specifically they pay interest for the privilege of borrowing money. One way to collect a company, or government can get the money they need is to issue bonds.

Bonds are basically a form of debt that is sold to the public in increments, normally $1,000. In return for lending them money, the lender gets a document that specifies how much money was lent out and for how long, what the agreed-upon interest rate is, and how frequently the interest will be paid.

No one knows when the first bonds might have been issued. We do know that New York City issued the first municipal bonds in the United States in 1812, raising money to build a canal. Since then, deficit-laden governments across the world use bonds as a way to finance their operations. For instance, the U.S. Government, as of May 20, 2010, has $8,476,842,609,085 in outstanding public debt, in the form of bonds held by the public. Many companies looking to finance expansion sell debt to get the money they need. Even individuals frequently take out  loans, whether in the form of credit cards, student loans, or mortgages, all of which are essentially private bonds.

Types of bonds

Bonds are referred to as "fixed-income" securities because the amount of income you receive as the bondholder each year is "fixed" when the bond is sold. No matter what happens or who holds the bond, it will generate exactly the same amount of money.

There are four basic kinds of bonds, depending on who is selling the debt. The U.S. government and its agencies offer one form, corporations another, and state and local governments a third. A fourth comes from foreign governments, but these can be challenging for the individual investor to buy and sell, outside the confines of a mutual fund, and have tax implications beyond the scope of this Hub.

Let's take a closer look at the issuers of three of these bonds.

  • The federal government. U.S. government bonds are issued by the Treasury Department and thus are referred to as Treasuries. These bonds come in a variety of different maturities ranging from three months to 30 years, with the interest rate varying depending on the term. Various types include Treasury notes, bills, bonds, as well as inflation-indexed securities. The Treasury Department also offers savings bonds and other types of debt to finance the government. Treasuries are guaranteed by the U.S. government, making them the safest bonds to hold and are free of state and local taxes on the interest they pay. Other government agencies, as well as quasi-government agencies, such as the Federal National Mortgage Association, sell bonds that are fully backed by the credit of the U.S. for specific purposes, such as funding homeownership.
  • State and local governments. With state and local governments there is a danger of bankruptcy, and to help attract investors they have to offer competitive interest rates, just as corporations do. But unlike corporations the only way that a state can raise its income is to raise its taxes, never a popular move. To help get around this dilemma, the federal government allows state and local governments to sell bonds that are free of federal income tax on the interest paid. State and local governments can also choose to waive their own income taxes on the bonds, so that even though their bonds pay less interest, for borrowers in high tax brackets, the bonds can have a higher after-tax yield than other forms of fixed-income investments offer.
  • Corporations. Companies are able to sell their debt through the public markets just as they sell stock. A company has a lot of flexibility on how much debt it can issue and what interest rate it will pay, although it must make the bond attractive enough to interest investors, or else no one will buy them. Corporate bonds generally offer higher interest rates than government bonds do to offset the risk that the company might go bankrupt and default on the bond, unlike the government, which can just print more money if it needs to. High-yield bonds, also known as junk bonds, are corporate bonds issued by companies whose credit quality is below investment grade. Convertible bonds can be exchanged for common stock if certain provisions are met. Corporate bonds are fully taxable by state and federal governments.

Par value, coupon rate, maturity date
There are three things about any bond you need to know before you buy it: the par value, the coupon rate, and the maturity date. Knowing about these three items -- and a few other odds and ends, depending on what kind of bond you're buying -- allows you to analyze the bond and compare it with other potential investments to ensure you're getting the best investment for your money.

  • Par value is the amount of money the investor will receive once the bond matures, meaning that the entity that sold the bond will return to the investor the original amount lent out, called the principal. Par value for corporate bonds is usually $1,000, although for government bonds, it can be much higher.
  • The coupon rate is the amount of interest the bondholder receives, as a percentage of the par value. So, if a bond has a par value of $1,000 and a coupon rate of 10%, the person holding the bond will receive $100 annually. The bond will also specify the how often the interest is to be paid, either monthly, quarterly, semiannually, or annually.
  • The maturity date is the date when the bond issuer has to return the principal to the lender. After the debtor pays back the principal, it is no longer obligated to make interest payments. Sometimes, a company will decide to "call" its bond, meaning that it is giving the lenders their principal back before the maturity date of the bond. All corporate bonds will specify whether they can be called and how soon they can be called. While Treasuries are never called, state and local muni bonds can be.

How to calculate bond yields
Probably the most important piece of information an investor needs in comparing a bond with other investments is the yield. You can calculate the overall yield of a bond by dividing the amount of interest it pays annually by the current price of the bond. If a bond worth $1,000 pays $75 in annual interest, then the current yield is $75 / $1,000, or 7.5%.

Why not just look at the coupon rate to determine the yield? Because the price of the bond fluctuate as interest rates change. So a bond can trade above or below the par value, based on current interest rates. Holding the bond to maturity, you are guaranteed to receive payment of your principal. However, if you sell the bond before it matures, you will have to sell it at the going rate, which may be above or below par value.

For example: Back in 1972, you bought a $1,000 bond with a coupon rate of 10% and a maturity date of Dec. 31, 2009, from a company called Wahoo, Inc. This bond would pay you $100 per year until Dec. 31, 2009, at which time you get back the $1,000 in principal.

Fast forward to 2008, and the interest rates have fallen to 5%. If the bond were issued today, it would pay only $50 a year, not $100. Because of the fall in interest rates, you could sell your Wahoo, Inc. bond for greater than the $1,000 par value. Why? Because an investor in 2008 would be expecting only a 5% yield but the bond pays interest of 10%, twice the current market rate. Investors will pay a premium to be able to take advantage of it.

Yield to maturity
Because you can buy a bond above or below par value, bond investors often use another kind of yield called "yield to maturity." The yield to maturity not only includes the interest payments you will receive all the way to maturity, but it also assumes that you reinvest that interest payment at the same rate as the current yield on the bond, and it takes into account any difference between the current par value of the bond and the trading price of the bond at that time.

If you buy a bond at par value, then the yield to maturity will be very close to the current yield, which is exactly the same as the coupon rate. Yield to maturity is especially important when looking at so called zero-coupon bonds, a type of bond that pays no interest until the maturity date, when you receive all of your principal back plus interest for the entire period the money was borrowed. Because zero-coupon bonds have no current yield, any yield associated with them is always a yield to maturity.

Buying bonds

For most investors, buying bonds are relatively safe investments that can help balance out a portfolio heavy on stocks. However bonds do carry the potential risk of default, no matter how remote that risk might be. Some people have argued that even Treasuries can be at risk of default, as seen by the 2010 financial crisis in Greece. Whether it's a high-yield corporate bond or a one sold by the City of Denver, there's always a chance that the entity that borrowed the money won't be able to make the interest payment.

That's why it is important to check bond ratings. Bond ratings were developed in the 1930's as a way to gauge a bond issuer's financial stability.Third-party credit-rating agencies, such as Standard & Poor's and Moody's, provide ratings involving a mixture of letters and numbers to indicate an issuer's financial soundness. To complicate things even more, each agency uses it's own rating systems, different from the other. So it's important that you check what the ratings mean before you make any assumptions. When you figure that out, you can be assured that the higher the rating, the higher the quality of the bond. Treasury bonds will be rated the highest, junk bonds the lowest.

Some bonds trade frequently for a low commission, while others can involve large transaction costs and don't have an easy time finding a buyer or a seller. The degree of ease with which a bond can change hands is referred to as its liquidity. Highly liquid bonds include U.S. Treasuries; billions of dollars' worth of them trade every day. Illiquid bonds would include those from a company that may be close to bankruptcy. Because such bonds are no longer considered a safe investment, only speculators that think there will be a corporate turnaround are willing to buy them, and as a result, they trade a lot less frequently. Liquidity has a direct effect on the commission you pay to trade a bond, which, unlike a stock, rarely trades on a fixed commission schedule.

The most common way to buy bonds, much like stocks, is to use a brokerage account, whether a full-service broker or a discount broker. Bond commissions vary widely between brokerages, so really do your homework before settling on any one brokerage. The advantage of working with a brokerage, you can buy anything from  30-year Treasuries to a three-month junk bonds. Depending on the brokerage, you can participate in direct offering of the bonds or pick them up in the secondary market. Some brokerages also offer exchange traded funds that package bonds in stock-like packages that can be easily bought and sold.

Treasury Direct
To help make buying U.S. government bonds easier for the general public, the Bureau of the Public Debt started the Treasury Direct program, which lets people purchase bonds online directly from the Treasury department. Investors can establish a Treasury Direct account that will hold all of their Treasury notes, bills, and bonds. Interest and principal payments can be made using direct deposit to a bank or brokerage that the account holder specifies, and the holder receives periodic account statements. The investor can transfer bonds to and from the account, and as long as the investor has enough money, can buy any type of Treasury security. The bureau also lets account holders reinvest money after a bond matures and sell bonds for a flat fee.

Well now, there certainly is a lot of information here. We examined the variety of bonds available, the three things every investor needs to know before buying one -- par value, coupon rate, and maturity date, and we looked at where to start looking to buy your first bonds. You are now able to calculate the bond yield, which will help you compare a bond to other investments. And we looked at how bonds are considered safe investments, even though there are risks, that you can assess by checking out the bond's rating. Hopefully this gives you a good place to start on your investments and I wish you good fortune in your investing endeavors.


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