Bonds, also known as fixed-income securities, are debt instruments created for the purpose of raising capital. Essentially loan agreements between an issuer and an investor, the terms of a bond obligate the issuer to repay the amount of principal at maturity. Most bonds also require that the issuer pay the investor a specific amount of interest on a semi-annual basis.

Bond rating agencies like Moody's and Standard & Poor's (S&P) provide a service to investors by grading fixed income securities based on current research. The rating system indicates the likelihood that the issuer will default either on interest or capital payments.

• For S&P the ratings vary from AAA (the most secure) to C.
• For Moody's the ratings go from Aaa to D which means the issuer is already in default.

Only bonds with a rating of BBB or better are considered 'investment grade'. BBB bonds are considered to be suitable for investment by institutions. Anything below the triple B rating is considered to be junk, or below investment grade. Bond ratings are periodically revised based on recent data.

Treasury Bonds are not rated because they are backed by the "full faith and credit" of the United States government. They are considered to be the safest of investments due to the fact that the government has the power to levy taxes in order to pay its debts.

Types of Bonds:

Agency Bonds
Agency bonds are issued by U.S. government-sponsored entities and federally related institutions, which then use the proceeds to finance their activities. Agency bonds help to support projects relevant to public policy, such as farming and small business, as well as to offer assistance to students and homebuyers. Unlike Treasuries, these bonds do not carry the "full faith and credit" guarantee of government issued Treasury bonds.

Federal agencies that issue bonds include:
Farm Credit System Financial Assistance Corporation
Federal National Mortgage Association (Fannie Mae)
Federal Home Loan Mortgage Corporation (Freddie Mac)
Small Business Association (SBA)
Student Loan Marketing Association (Sallie Mae)
Government National Mortgage Association (Ginnie Mae)

Corporate Bonds
Corporate bonds are fully taxable debt instruments issued by private corporations rather than government entities. Corporate bonds usually pay a higher rate of interest than government bonds, and are most often issued with a par value of $1,000.

Corporate bonds are traded on the major exchanges.

Municipal Bonds
A municipal bond, or "muni bond," is a debt obligation issued by a state, city or local government to finance governmental needs or special projects.

There are two general categories of municipal bonds:
Revenue Bonds are backed by the revenues generated by a specific project or agency.
General Obligation Bonds are backed by the full faith and credit, or the taxing power, of the issuer.

Municipal bonds can be further divided into two primary groups:
Public Purpose Bonds: Tax-exempt bonds.
Private Purpose Bonds: Taxable unless specifically exempted.

The tax distinction between public and private purpose bonds is based on the extent to which the bonds benefit private parties; if a tax exempt public purpose bond involves more than a 10% benefit to private parties, then it is taxable.

Treasury Bonds
Treasury bonds are debt instruments of the US government issued in minimum denominations of $1000. Considered to be long term investments, Treasury bonds have maturities of 10 years or longer. Treasury bonds carry the lowest degree of risk and are the benchmark against which all other types of bonds are measured. Although their market value fluctuates, they are considered to be the safest of bonds due to the fact that they are secured by the full faith and credit of the U.S. government.

Zero Coupon Bonds
A zero coupon bond is a corporate bond that makes no periodic interest payments, but is sold at a deep discount from face value. The buyer of the bond receives the rate of return by the gradual appreciation of the security, which is redeemed at face value on a specified maturity date.

For tax purposes, the IRS maintains that the holder of a zero coupon bond owes income tax on the interest that has accrued each year, even though the bondholder does not actually receive the cash until maturity. The IRS calls this “imputed interest”. Because of this interpretation, zero coupon bonds are often used in retirement accounts where they remain tax-sheltered.

Bond Terminology:

Asset-Backed, or Secured, Bond
A secured bond, or asset-backed bond, is backed by collateral. The bondholder has the right to take possession of and sell this collateral if the bond issuer fails to make full interest and principal payments when they are due.

Callable Bonds
Bonds issued with call provisions can be redeemed, or called, at the option of the issuer prior to the maturity date. Issuers will often seek to redeem outstanding bonds when interest rates decline so that they can pay off the bonds, and reissue them at a lower interest rate. The call price is usually above par and the earlier the bond is called, the higher the price. Callable bonds often carry a call protection provision which means that there is a period of time during which the bond cannot be redeemed by the issuer. Call dates and redemption prices are disclosed to investors in the offering statement, and when a bond is called, the investor is notified by mail.

Commercial Paper:
Commercial paper generally refers to short-term commercial loan agreements lasting three months or less. The term “paper” refers to the actual piece of paper on which the borrower’s pledge to repay is printed. Most commercial paper is negotiable, which means it can be bought and sold like a commodity. Since it is issued by corporations, commercial paper is considered to be slightly riskier than 13-week Treasury bills and usually carries a slightly higher interest rate.

Convertible Bond
A convertible bond provides the bondholder with the option to exchange the bond for other securities at some future date and under prescribed conditions. In most cases, a bond will be convertible into shares of the underlying company's stock.

Creditor
Unlike stockholders, who have equity or a unit of ownership in a company, bondholders are creditors who simply hold an IOU from the entity.

Debenture
An unsecured bond, or debenture, is backed by the full faith and credit of the issuer, but not by any specific collateral.

Face Value
Bondholders purchase bonds at what is called face value, or par value. Face value is the amount on which interest payments are calculated. For example, a 10% bond with a face value of $1,000 will pay bondholders $100 per year. Corporate bonds are usually issued with a face value of $1,000, and municipal bonds with face values of $5,000. Bonds are redeemed at maturity at face value unless the issuer defaults.

Fixed Income
Bonds are called fixed-income securities because they pay a specified amount of interest on a regular basis.

Interest Rate
The interest rate, or coupon rate, on a bond is the percentage of par, or face value, that the issuer is scheduled to pay to the bondholder on an annual basis.

For example: A $1,000 bond with a 3% coupon will pay the bondholder $30 per year, usually in six-month installments.

Issuers of bonds generally offer to pay investors a rate of interest that is competitive with other bond rates at the time of issuance. Therefore, the rate of interest paid on a new bond is often similar to other rates of interest, such as the prime rate, mortgage rates, personal loan rates, etc. Interest rates also vary based on other factors, the most important being the creditworthiness of the issuer.

Maturity
The date of maturity on a bond indicates the date on which the security contract calls for the borrower, or issuer, to pay back the investor’s initial investment. At the maturity date the bond is retired and the borrower must repay the full amount of the loan.

Par
Par is equal to a bond's face value; the amount to be repaid at maturity. When coupon bonds are issued, they are generally sold at par value.

Term
The life, or term, of a bond is fixed at the time of issuance. It can range from short term (usually a year or less), to intermediate term (usually two to 10 years), to long term (a period of 10 to 30 years or more).

Yield
A bond’s yield usually differs from its coupon interest rate. Yield may be higher or lower than the bond’s stated interest rate (coupon rate). To determine the yield on a bond, simply divide the bond's annual interest payments by its current market price. It's important to understand that a bond's yield varies inversely with its market price. As bond prices fall, yields rise. As bond prices rise, yields fall.

For example: If an investor paid $1,000 for a bond with a 4% coupon, the investor would receive $40 a year in interest and the yield would be 4%.

However, if the bond loses value and is sold for $800, the new buyer would still receive $40 per year, but the yield would increase to 5%.

How Yield Changes:

Yield to Maturity

YTM is a precise calculation used to determine the annual rate of return an investor will receive if a long-term, interest-bearing security is held to the date of maturity. The calculation takes into account the purchase price of the security, the time to maturity, the coupon yield, the redemption value, and the time between interest payments. Due to the complexity of the calculation, YTM is most often determined by using a bond calculator.

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