Image via WikipediaHow they work
When you buy bonds, you are lending money to a federal or state agency, municipality, or other issuer, such as a corporation. A bond is like an IOU. The issuer promises to pay a stated rate of annual interest, called the coupon rate during the life of the bond and repay the entire face value when the bond comes due or reaches maturity. The interest a bond pays is based primarily on the credit quality of the issuer and current interest rates. When bonds are purchased, they may be held to maturity or traded. In general, bonds are lower risk investments that have lower returns than stocks.
A bond may be sold at face value, which is the amount returned to the investor at maturity, (also called par) or at a premium (higher price) or discount (lower price). For example, when prevailing interest rates are lower than the bond's stated rate, the selling price of the bond rises above its face value and can be sold at a premium. Conversely, when prevailing interest rates are higher than the bond's stated rate, the selling price of the bond is discounted below face value.
Yield-to-maturity is the effective yield of the bond from the current date until the bond reaches maturity and depends on the total interest payments remaining, and the difference between today’s market value (current price) and par value. Yield-to-call is the same calculation based on the total coupon interest payments remaining between now and the first call date (rather than the maturity date) as well as the difference between today’s market value (price) and the call price.
Bonds are fixed income products, meaning that the amount you will receive is set when you buy it. In this way, bonds are low-risk investments. The bond market as a whole has historically been less volatile than the stock market, as well. Corporate bonds are usually riskier than government, Treasury, or municipal bonds because there is the potential for the corporation to go under and not be able to afford to pay its bonds when they reach maturity. All bonds carry some risk, however, including inflation risk and interest rate risk (because bond prices generally decline when interest rates rise and vice versa.) These two types of risk are related in that inflation leads to higher interest rates. Bonds with the lowest coupons are at the highest risk when interest rates rise.
Short-term bonds (those with maturities of three years or less) usually have lower yields than longer-term bonds, especially those with maturities of ten or more years. This is because the longer a bond is held, the more subject the holder is to inflation and interest rate risk.
Inflation-indexed securities like Treasury Inflation Protection Securities (TIPS) are designed to get rid of inflation risk.
Firms like Moodys Investor Service and Standard & Poor's rate bonds. With corporate bonds, the company's bond rating is based on its financial picture. The rating for municipal bonds is based on the creditworthiness of the governmental or other public entity that issues it. Issuers with the greatest likelihood of paying back the money have the highest ratings, and their bonds will pay an investor a lower interest rate. Remember, in general, the lower the risk, the lower the expected return.
Callable vs. Noncallable
The idea here is the same as with callable and non-callable CDs.
Types of Bonds
Government Savings bonds (EE/E or I bonds) are U.S. government-issued and backed. There are different types of government savings bonds, each with slightly different features and advantages. Series I bonds are indexed for inflation, meaning that they protect against the deterioration of your investment from inflation—the earnings rate on this type of bond combines a fixed rate of return with the annualized rate of inflation. Savings bonds can be purchased in denominations ranging from $50 to $10,000, and typically earn higher interest than savings accounts and CDs, but often lower than other types of bonds.
Ginnie MaeTreasury bonds, bills and notes are sold by the U.S. Treasury to pay for an array of government activities and are backed by the federal government (like Ginnie Maes). Treasury bonds are securities with terms of more than 10 years and that pay interest semiannually. Treasury bills are short-term securities with maturities of three months, six months or one year and are sold at a discount from their face value. The difference between the cost and what you receive at their maturity is the interest you earn. Treasury notes are securities with maturities ranging from two to ten years that pay interest every six months. Treasury Inflation Protected Securities (TIPS) are securities that, like Series I government bonds, protect against inflation. With TIPS, interest is paid on the inflation-adjusted principal.
The Government National Mortgage Association (GNMA aka Ginnie Mae) is a government agency that buys mortgages from lenders, pools them together, and sells shares of the pool to investors (or to brokers who then sell them to investors). The pools are called Mortgage Backed Securities (MBS) aka "pass-through" securities because the mortgage payments (from the home-owners who hold the mortgages) pass through banks (which take out a processing fee) to the investors who've bought the MBSs.
What makes Ginnie Mae MBSs unique is that since the GNMA is a government agency, they get special treatment such as low interest rates on any money they borrow from the government and tax-exempt status from (most) states and municipalities, and are therefore often able to offer higher yields than other MBSs. Plus, Ginnie Mae MBSs (unlike Freddie Mac's, Fannie Mae's, and other MBSs) are fully backed by the U.S. government, i.e. your money is as safe as houses (pun intended) no matter what happens with the housing market, various financial agencies, etc. This means that Ginnie Maes are just as safe as Treasuries but often pay higher interest.
Investors receive a monthly payment either of interest and a portion of principal or of interest only. In the latter case, the principal is paid in a lump sum when the mortgage matures. The minimum investment for Ginnie Maes is $25,000, making them out of reach (or just plain undesirable) for most of us, but that's where mutual funds and the secondary market come in. Like other bonds, Ginnie Maes can be sold by their current owners who are willing to unload them at a lower price because, for instance, their interests are low compared to newer issues or they're close to maturity and there isn't much principal left to be paid.
The risks for Ginnie Maes are minimal but existent. A bunch of the mortgage holders in the pool could decide sell their homes, pay their loans off early, or refinance, causing the investors to be paid back early. This isn't so much a risk as it is slightly unfortunate. You don't lose anything; you just don't get paid as much interest as you would if the mortgages were held to maturity.
Treasury securities are sold in increments of $1,000, and along with government savings bonds, can be purchased online directly from the U.S. Treasury. There is no state or local income tax on the interest earned from Treasury and savings bonds
Municipal bonds are issued by a state, state agency or authority, or a county, city, town or village. The money invested in the bonds is used by these entities primarily for public projects such as building or repairing schools, roads, highways, bridges, hospitals, and low income housing. This type of bonds is among the safest of investment types and is special because of its tax-exempt status. This feature makes munis especially attractive to investors in the highest tax brackets.
The interest munis pay is often lower than that of other bonds, but since other bond interest is taxed, you will not actually receive that much. For a more accurate comparison of actual interest you would receive, use the muni's tax equivalent yield (TEY) for your tax bracket. The TEY will be higher than the stated yield; it's basically the pre-tax yield that a taxed bond would have to pay in order to equal that muni's stated yield. Discount muni bonds may be subject to capital gains tax when sold.
Corporate bonds are basically loans an investor makes to a company in exchange for interest. Buying bonds for a single company is much like owning stocks in a single company; if something happens to that corporation, you can lose some, if not all, of your investment. Bond mutual funds are an alternative that spread the risk among multiple companies. While bond funds can lose money as interest rates increase, they tend to offer greater protection from losses than single bonds or stock funds.
Stocks: What To Look For, How to Trade For Long-Term Gains
Funds: Mutual Funds, ETFs, Closed-end Funds, Hedge Funds, Oh My!
Annuities: What Are They? How Do They Work? And How Do I Find the Right One For Me?