Contrary to belief, a bond is formal evidence of a debt. When you purchase a bond, the issuer promises to pay you a specified amount of interest at specified times and to repay the principle, usually on a fixed date. In terms of your investment objectives, bonds generally offer the greatest safety of principle and certainty of income. The huge bottom-line difference is the pace of bond market innovation throughout the business community is relentlessly pushing forward.
As a creditor, you have top priority to the income of the borrower and his/her assets. However, by purchasing bonds, you limit your capital gain potential, unless you buy the bond at a discount or it carries warrants. Because bonds usually pay a fixed interest, many investors shy away from them in times of actual or predicted inflation, when a bond would limit their income return.
Since there are various issuers of bonds, the safety and income return of the bond will depend on its issuer and the extent to which it is secured. Generally, federal government bonds are the safest, and for that reason they offer the lowest yields. Corporate bonds are a little less safe, and offer a higher yield.
Bonds offered by state or local political bodies are usually safe; however, the bonds of some smaller government units may be a bit risky. Even large urban governments may fall into financial trouble, as the San Joaquin Valley, California crisis recently demonstrated.
Some low-rate, risky corporate bonds, often called “Junk” bonds, grant little security but offer the highest return of all bonds. Often these corporations must pledge that certain assets are tied in. If the corporation defaults, these assets accrue to the bondholders. Some bonds are not secured by specific company assets; these bonds are known as debentures.
Corporate bonds are as safe as the company issuing them. Only if the firm goes bankrupt or otherwise ceases operations can the bondholder not receive the interest and principle due him/her according to the indenture, which is the company’s statement of payment promises. In case of bankruptcy, the bondholders have a claim against the assets of the firm.
Bond prices fluctuate inversely with market interest rates. As interest rates rise, bond prices fall. As interest rates fall, the market value of your bond increases. If interest rates rise and you need to sell bonds you purchased when rates were low, you may lose money.
What Are Bonds And How Do You Use Them?
Generally speaking, bonds are marketable promissory instruments, typically issued by corporations to obtain credit. The principle is to be repaid by the issuer, usually 10 or more years after the loan is made. Interest is paid periodically. Actually, the term “bond” often refers to any fixed-income obligation, including notes, debentures, certificates, and bills.
Investors refer to the class, type, and rating of a bond. Rating refers to the level of investment risk, evaluated by independent agencies. Ratings run from AAA or Aaa (least risky) down to D (very risky). There are three classes of bonds: federal, municipal, and corporate. The U.S. government issues Treasury securities to raise money for the conduct of its business. Local and state governments issue municipal bonds to finance public institutions and services. Private industry issues debt securities to finance corporate activity.
A few of the many types of bonds include:
Bearer Bond: Bond on which the owner’s name is not registered with the issuer; in some ways equal to cash.
Callable Bond: Bond that includes a call provision stating that the issuer may redeem it before its maturity date under specified conditions often to take advantage of loans available at reduced (and better) interest rates.
Convertible Debenture: Bond issued on the general credit of the corporation, which may be converted into common and sometimes preferred stock of the same corporation.
Discount Bond: Bond quoted at a price below its face value.
First Mortgage Bond: Corporate bond secured by a mortgage on all or part of the corporation’s fixed property.
Flower Bond: Nickname for certain Treasury bonds that can be redeemed at face value for payment of federal estate taxes.
Registered Bond: The name of the owner is registered with the issuer (versus a bearer bond). The owner usually receives interest payments by mailed check.
Serial Bond: An issue that is redeemed on an installment basis in sequential, usually annual, order, until the full amount is repaid.
Bonds usually are issued with a face value of $1,000 or more. When interest rates in the marketplace equal the rate offered by the bond (commonly known as the coupon rate), the selling price of the bond will equal the face value. As rates fluctuate, the selling price of the bond will rise or fall to adjust for the difference.
While bonds are safe and easy to market, they offer little opportunity for growth or higher income. As an alternative, you may want to consider convertible debentures. These are bonds that can be exchanged for shares of stock in the company that issues them at a specified price. Convertibles usually offer higher yields than the underlying stock. If the stock price rises, you can convert your bond or sell it for a capital gain.
Municipal bonds pay interest that is exempt from federal taxes under most circumstances. Yields on municipal bonds ordinarily tend to be fairly low. However, a few years ago many cities, school districts, and government entities began paying high rates to attract unsure investors prior to the tax law changes. The upside: Tax-free bonds may offer higher after-tax yields than U.S. Treasury bills, for instance.
The higher your income bracket, the more you benefit from a tax-free bond, thus, the greater their value to you. If you are in a low to average tax bracket, before investing in a municipal or other tax-free bond, you will need to determine whether your total yield would be higher with taxable bonds.
A particular disadvantage of bonds to the small investor is large units in which bonds are traded. Most corporate bonds are issued at $1,000 face value. To achieve commission reductions and to spread out the risk factor among several companies, you may find the investment cost running into five-figures.