A bond is essentially a loan an investor makes to the bonds’ issuer. The investor generally receives regular interest payments on the loan until the bond matures or is called, at which point the issuer repays you the principal. Certain bonds have special provisions. Bond funds pool money from many investors to buy individual bonds that meet the fund’s investment objective.
Most bonds: pay regular interest until the bond matures.
Callable bonds allow the issuer to repay the bond before maturity.
Zero-coupon bonds offer a deep discount and pay accumulated interest at maturity.
See below for more information on callable bonds.
Who Issues Bonds?
Government entities and corporations issue bonds to raise money for their endeavors.
There are five major types of bonds in the U.S. market, representing the five major issuers:
| Bond Type | Description |
|---|---|
| Government (Treasury) |
The U.S. Treasury issues bonds to pay for government activities and pay off the national debt. Yield is lowest among bonds, but considered low in risk if held until maturity. Bonds are exempt from state and local taxes. |
| Agency(GSE) |
U.S. Government agencies (also called Government Sponsored Enterprises) issue bonds to support their mandates, typically to ensure that various constituencies, like farmers, students, and homeowners, have access to sufficient credit at affordable rates. Examples include Fannie Mae, Freddie Mac, and TVA. The yield is slightly higher than government bonds and still very low risk. Some agency bonds like Fannie Mae and Freddie Mac are taxable. Others are exempt from state and local taxes. |
| Municipal (“munis”) |
States, cities, counties, and towns issue bonds to pay for public projects (roads, etc.) and finance other activities. The majority of munis are exempt from federal, state, and local taxes. This can raise the effective yield of munis above other types of bonds, depending on your tax bracket.* |
| Corporate |
Corporations issue bonds to expand, modernize, cover expenses, and finance other activities The yield and risk are generally higher than government and municipals. Rating agencies help you assess the credit risk. Corporate bonds are fully taxable. Rating agencies help investors assess the credit risk. |
| Mortgage-backed |
Banks and other lending institutions pool mortgages and offer them as a security to investors. This raises money so the institutions can offer more mortgages. Examples include Ginnie Mae, Fannie Mae, and Freddie Mac. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds with comparable maturity, and have a low credit risk. The major risk of these bonds is if lenders repay their mortgages early (for example, if interest rates drop), which can result in lower interest payments to the investor. Mortgage-backed bonds are fully taxable. |
How a Typical Bond Works
Bonds have three major components
The first is the face value (also called par value). This is the value of the bond as given on the certificate or instrument. This is the value the bond holder will receive at maturity unless the issuer defaults. If bonds are retired before maturity, bond holders may receive a slight premium over face value. Investors pay par when they buy the bond at its original face value. The price investors pay may be more or less than the face value. See Prices, Rates, and Yields.
Bonds also have a coupon rate. This is the annual rate of interest payable on the bond. For the owner of a bond, the higher the coupon rate, the higher the interest payments the owner receives. The rate is set at the time the bond is issued and generally does not change. Most bonds make interest payments semiannually, although some bonds are offered with monthly and quarterly payments.
Did you know?
Until 1983, all bond owners received an actual paper bond certificate.
This inspired bond terminology. The loan amount appeared prominently on the face of the bond. Bonds included coupons that the owner detached, one for each periodic interest payment, and deposited in the bank.
Example: A typical bond
You buy three bonds with different maturity dates: two years, four years, and six years. As each bond matures, you have the option of buying another bond to keep the ladder going. In this example, you buy 10-year bonds. Longer-term bonds typically offer higher interest rates.
Callable Bonds
Callable bonds are bonds that the issuer can repay early, sometimes after a period of several years, at a predetermined price. The attraction of callable bonds is that they typically offer higher coupon rates than non-callable bonds.
However, you should understand the call risk. If interest rates drop low enough, the bond's issuer can save money by repaying its callable bonds and issuing new bonds at lower coupon rates. If this happens, the bond holder's interest payments cease and they receive their principal early. If the bond holder then reinvests the principal in bonds, he or she will likely have to accept a lower coupon rate, one that is more consistent with prevailing interest rates. This will lower monthly interest payments.
Example: A callable bond
An investor purchases a $30,000 10-year callable bond paying 6.5% interest, which is a higher interest rate than similar non-callable bonds. The bond is callable after five years at a price of 103 (that is, 103% of the face value, or $30,900). If interest rates drop enough, the investor may wind up with their principal returned and be faced with less attractive bond offerings
Zero-Coupon Bonds
Zero-coupon bonds, also known as “Strips”, are bonds that do not make periodic interest payments. You buy the bond at a steeply discounted price and receive one payment at maturity. The payment is equal to the principal you invested plus the accumulated interest earned (compounded annually to maturity)
Zero-coupon bonds are attractive when you want to save for a defined objective and date, such as when a child starts college or you enter retirement. You receive your principal and interest in one lump sum, right when you need the money.
The drawback of most zero-coupon bonds is that you must pay taxes annually on the interest, even though you do not actually receive the interest until maturity. This can be offset if you buy the bonds in a tax-deferred retirement account, or in a custodial account for a child in situations where the child pays little or no tax.
Another drawback is that zero-coupon bonds can be particularly volatile in the open market. This doesn't matter if you keep the bond to maturity. But if you need to sell it early, you may incur a substantial loss.
Example: A zero-coupon bond
You are saving for your child’s college education, which she will start in 10 years. You buy a 10-year zero-coupon bond. It costs you $12,000. In 10 years, you are paid the $12,000 plus the accumulated interest
Test Yourself
- You purchase a $20,000, 5-year bond with a coupon rate of 5%. How many interest payments will you receive and how large will each payment be?
See the answer - You want to invest in a bond for your retirement account, and you won’t need the interest payments until you begin retirement. What type of bond could be useful?
See the answer
Want to Learn More?
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*Any fixed income security sold prior to maturity may be subject to substantial gain or loss. Income from municipal bonds is free from Federal, and in many cases, state and local taxes but may be subject to the Federal Alternative Minimum Tax.
