What Are Bonds and How Do They Work?

Bonds are securities, like stocks. When you buy a bond, you are in effect lending a company or the government, referred to as the bond issuers, some money for a specific period of time, typically anywhere from less than one year to 20 years. The bond issuers promise to pay you back for the full loan amount, also called par value, face value, maturity value or principal, and usually with regular interest payments on the par value. The bondholder receives the par value of the bond when the bond reaches its maturity date, meaning the specified period of time is up. For instance, if a bond has a maturity date of January 1 2020, that means the par value will be paid to the bondholder at that date.

Most bonds have an interest rate, also called the coupon or nominal rate, applied to the par value that the bond issuer will pay to the bondholder on a semiannual basis. The annual amount that the bondholder is paid in interest is called the coupon. If the coupon rate on a $1000 bond is 8%, that means the bondholder will be paid an $80 in interest for that year, or in other words, the coupon is $80. Because of the interest payments, bonds are considered a type of fixed-income security. Bonds can have different types of interest rate structures and some bonds may not pay any interest at all (these are called zero-coupon bonds).

Bonds come with different maturity dates; some may have maturity dates one year away and some may come to term in 15 years. The time to a bond’s maturity date, also called the term to maturity, can be considered short-term, intermediate-term or long-term. Short-term bonds have a maturity date one to five years away, intermediate-term bonds have a maturity date 5 to 12 years away and long-term bonds have a maturity more than 12 years away.

When you buy a bond, you will pay a listed market price for the bond. This price is usually quoted as a percentage of the par value of the bond. For example, a $1000 bond with a 6% coupon rate that is selling for $900 would be said to sell for 90. Bonds that sell for less than their par value are said to be trading at a discount, and bonds that sell for more than their par value are said to be trading at a premium. You will also frequently see a bond’s yield to maturity listed next to its purchase price. The yield to maturity is the average rate of return an investor can expect if she purchases the bond and holds it until maturity.

Bonds are typically considered a less risky investment compared with stocks. Shareholders, as partial owners, can reap high rewards if the company’s value soars, but could also see their stocks become worthless should the company price drop. Bonds are not without risks, however. If your bond issuer goes bankrupt, secured creditors like banks are paid first, followed by unsecured creditors like bondholders. Stockholders have the last claim on assets during liquidation and may not receive anything if creditors' claims are not fully repaid.

The Three Types of Bonds

Bond Type Benefits
Treasury Bonds
Issued by: U.S. Treasury
Considered one the world’s safest investments, hence pays out the lowest yields in the world
Municipal Bonds
Issued by: State or local governments
These securities usually have higher yields than US Treasuries, but are considered less safe. Interest from these bonds may be exempt from federal and sometimes state income taxes
Corporate Bonds
Issued by: Corporations
These securities usually have higher yields than US Treasuries, but are considered less safe than US Treasuries

Treasury Bonds

There are three main types of Treasury bonds; all are fixed-interest debt securities issued by the U.S. government that are guaranteed to be paid out plus interest. 

Treasury Bills (T-bills) are short-term government securities with maturities ranging from a few days to 52 weeks. Bills are typically sold at a discount from the par value. For instance, you might pay $990 for a $1,000 bill. When the bill matures, you would be paid $1,000. The difference between the purchase price and face value is interest. It is possible for a bill auction to result in a price equal to par, which means that the Treasury will issue and redeem the securities at par value. If you pay $1,000 for a $1,000 bill, this means you are getting 0% interest. Minimum purchase is $100, in multiples of $100.

Treasury Notes are government securities that are issued with maturities of 2, 3, 5, 7, and 10 years and pay interest every six months. Minimum purchase is $100, in multiples of $100. Yields for notes are determined at auction.

Treasury Bonds pay interest every six months and mature in 30 years. Minimum purchase is $100, in multiples of $100. Yields for bonds are determined at auction.

Municipal Bonds

When you purchase a municipal bond, you are lending money to a state or local government entity, which in turn promises to pay you a specified amount of interest and return the principal to you on a specific maturity date. Bonds issued by universities can also be categorized as municipal bonds. Income from many - although not all -  U.S. municipal bonds are exempt from both federal and state taxes.

Some bonds, however, are taxable at the federal level but untaxed at the state level. Also called "taxable municipal bonds", these are bonds that are not subsidized by the federal government, since the bonds are to fund activities that are not deemed to provide a significant benefit to the general public. Examples include investor-led housing, local sports facilities, and borrowing to patch up pension plans. Taxable municipal bonds offer yields comparable to those of other taxable sectors, such as corporate bonds. 

Example of a federal income taxable, state income non-taxable muni bond: The town of Hamden, Connecticut, issued a $125 million pension bond to reduce the deficit in its underfunded pension plan in Feb 2015. Example of a fully federal and state income taxable muni bond: Harvard University issued about $400 million in taxable municipal bonds (although state and local governments are traditional issuers of municipal bonds, universities may also offer them through various means.)

Corporate Bonds

Corporate bonds are issued by private companies and corporations. Income from corporate bonds are taxable, and these bonds are typically denominated in amounts of $1,000 or more. Maturity terms are generally from 1 to 20 years but can be extended much further. The value of these bonds will depend on the credit rating, and because of this there are higher risk levels associated with these investments. At the same time, however, this creates the potential for higher yields.

"Junk bonds" is a colloquial term used for bonds issued by companies considered to be new and unproven. These bonds are viewed by the market as riskier than other corporate bonds since there is lot of uncertainty about their future, and these companies will not be able to guarantee repayment of the bond. These bonds offer higher yields but are coupled with a higher risk of default, as signified by these companies’ lower credit ratings.

Comments and Questions