If you buy a bond, you are lending money. You might be making a loan to the government, or to the town where you live, or to a multinational corporation.
Bonds pay a set amount of interest at regular intervals and are known as fixed-income investments. Because the income is predictable, they are suitable for people who need income on which they can count. Bonds are frequently the only type of investment retirees own, for example. They are also very popular with people who don’t like the fluctuations in the stock market.
Short- and intermediate-term bonds can be good investments for the intermediate term, when you know that you will be needing the money in 3 to 5 years.
Every bond has a maturity date, when the principal is paid back, and an interest or coupon rate. The interest rate is the percentage of par value that is paid out in interest each year. Par value is the amount printed on the front, or face, of the bond and for that reason is also known as face value.
If you buy a bond at the issue date (when it first comes out), and you hold it until maturity, you will earn precisely the interest printed on the bond and get back its par value at the end.
If, however, you buy or sell a bond on the secondary market (after it’s been issued), then its value will depend on the prevailing interest rates at that time.
Example: $1,000 par value bond at 6% interest.
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Current Interest Rate
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Selling Price of Bond
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4%
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$1,500
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6%
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$1,000
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8%
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$750
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The reason for the change in prices is pretty simple when you think about it. If a bond is issued at 6%, and interest rates shoot up to 8%, who’s going to pay full price for a 6% bond? Instead, the bond will sell at a discount to compensate for the low interest rate paid. If, on the other hand, the bond is issued at 6% and the interest rates drop down to 4%, a 6% bond looks pretty good. So an investor will pay a premium for it.
So, although the amount of income you get from a bond remains fixed through its life, its value can fluctuate prior to maturity. If you buy a very long-term bond, you may be locked into an interest rate much higher (if you’re lucky) or much lower (if you’re not) than the prevailing rates. Bonds have risk, too. It’s just that it’s a different kind of risk.
This principle applies to all the different kind of bonds:
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Bond Type
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Par Value
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Maturity
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Comments
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Corporate bonds
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$1000
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from 1 to 20 years
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Generally more risky but higher yields than government bonds
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Municipal bonds
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$5000 & up
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from 1 month to 40 years
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Exempt from federal taxes; may be exempt from state and local, too.
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Treasury bonds
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from $1000 to $1 million
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10 years & up
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Exempt from state and local taxes.
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Treasury notes
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$5000 & up
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from 2 to 10 years
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Exempt from state and local taxes.
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Treasury bills
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from $10,000 to $1 million
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3 months; 6 months; 1 year
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Exempt from state and local taxes.
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Series EE and Series I bonds
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from $50 to $10,000
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from 6 months to 30 years
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Exempt from state and local taxes. May be redeemed after 6 months. If used for education may be tax-free.*
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Agency bonds
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$1000 & up
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from 30 days to 20 years
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Mortgage bonds are taxable; others exempt from state and local taxes.
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* See the section on taxes later or contact your tax advisor.
Corporate and municipal bonds are rated by services like Moody’s for their safety. If you want to buy individual bonds, you should look them up first, to see their rating. Treasury notes, bills and bonds are backed by the U.S. government.
