A bond is a form of debt investment through which investors lend money to a corporation or governmental body. It may be thought of as a loan or IOU for a set period of time at a fixed interest rate. Bondholders are considered creditors. Often described as fixed-income securities, bonds are used by government entities and corporations to fund infrastructure projects and expansions. Some similar types of debt instruments, such as short-term commercial paper and certificates of deposit (CDs), have shorter terms and are classified as money-market instruments instead of bonds. Depending upon a bond's terms, the issuer pays interest (the coupon) to bondholders and is also obligated to repay the principal at a specified future maturity date. Interest payments are typically paid annually, semi-annually, or sometimes monthly. Most types of bonds, whether corporate- or government-issued, trade in an active secondary market. As with other types of investments, bonds are rated by various rating services such as Moody's, Fitch, and Standard & Poor's. Ratings are based on the issuer's stability and financial condition, and an assessment of the issuer's ability to repay their debts. Ratings range from “AAA” as the highest quality grade down to “C” (junk bonds) as the lowest grade.

Coupons and discounts

Although many bonds pay interest regularly (coupon), some bonds pay none (zero-coupon), or are sold at a discount, meaning the purchase price is below the bond's par value at maturity. For a variety of reasons, many bonds may trade on the secondary market at a discount under their par values. Fixed-coupon bonds trade with discounts during periods of rising interest rates in the market; although an investor is still paid the same coupon, the bond's sale price is discounted to meet the current market yields. Likewise, bonds are also sold at a discount during periods when the supply is greater than the demand, or when the credit rating of a bond is downgraded, or at times when the issuing entity is thought to be at risk of default. Also, discount notes with a maturity of up to one year are typically issued by government home-loan institutions and by large corporations.

Callable bonds

Some corporate issues contain call provisions that allow the company to repay bondholders early if the marketplace's interest rates change after the bonds are issued. A callable bond, also described as a redeemable bond, has call provisions that allow its issuer to redeem (call) it before the maturity date. Companies may issue callable bonds when marketplace interest rates are expected to drop during the life of the bond. After redeeming these bonds early, often including a premium, the issuer replaces them with new bonds issued at lower interest rates.

What's the difference between stocks and bonds?

When distinguishing between stocks and bonds as different types of investments in corporate assets, a defining difference is that a company's stockholders have an ownership stake (equity) in the company, while the bondholders are creditors (lenders) but not owners. Also, stocks are usually issued and outstanding permanently, yet bonds typically have a specified term ending on a set maturity date for redemption.

Domestic or foreign?

Foreign bonds are debt securities issued in the domestic market by foreign companies and entities. They are generally issued by foreign companies seeking to raise capital in the local marketplace, especially where they have substantial sales. In the U.S. market, foreign bonds may be attractive to investors because they are regulated by our own financial authorities, and also because these dollar-denominated securities can help reduce or avoid risks from currency exchange.

Types of Bonds

Corporate Bonds

Corporate bonds are issued based on a company's anticipated future revenues, and also secured by collateral from company assets. They are used to raise money for expansions and capital improvements. The interest payment (coupon) is usually subject to taxes. The majority of these bonds with terms greater than a year are considered taxable. Short-term corporate debt, maturing in under one year, is called commercial paper. Corporate bonds are issued as blocks with a par value of $1000, and most have a standardized scenario for coupon payments. Corporate debt may be categorized as either unsecured debt or secured debt, depending upon the collateral provided by the issuer. In case of default, the seniority of rights is also important: Bonds may be issued as senior debt or subordinated debt, depending upon the priority of the holder's claim against corporate assets. And, some fast-growing companies issue convertible bonds, which let investors convert their debt security into equity (stock). Investors consider corporate bonds to be riskier than government-issued bonds, and therefore demand higher interest rates, even when the company is perceived as a strong candidate for credit. The better the business, the more debt it may issue, and the lower the interest rate it may obtain. For best success in offering bonds, corporations are expected to be credit-worthy and have a track record of consistent earnings, or a credible story to tell. Most well-rated company bonds are listed on ECNs and exchanges, and the largest volume of trading is completed through dealer-based networks. Companies are considered at higher risk of default than government entities, so corporate bondholders receive higher yields than government holders. These higher yields reflect both the greater chance of default and the possibility of greater losses, and may also include an extra premium for the reduced liquidity of corporate issues. In addition, company bonds face other risks based on fluctuating interest rates or inflation.

Municipal Bonds

Municipal bonds are debt securities issued by agencies of local governments and regional agencies. Issuers of “munis” include cities, counties, state agencies, redevelopment districts, school districts, utilities, maritime ports and airports. Municipal bonds may be issued as general obligations of the government or agency, or they may be secured by dedicated revenues earmarked for repayment. Bond sales are often dedicated to pay for capital expenditures for public works such as roads, schools and other infrastructure. Municipal bonds are attractive to some investors because the interest income which they provide is nearly always exempt from federal tax, and usually from local and state taxes. Munis are priced without delays or restrictions, and they can be traded freely by investors. Bonds offer many good opportunities for investors who take time to do the appropriate research. If you'd like to learn more, contact HedgeZ today.

Government Securities

Treasury securities are U.S. government-issued debt instruments generally with long maturities. They bear fixed interest rates and generally pay interest semi-annually. Income from Treasury securities is usually subject to federal taxation only. The four categories of marketable Treasury securities are: Treasury bonds, Treasury notes, Treasury bills, and Treasury Inflation Protection Securities (TIPS). These bonds are issued in minimum $1000 denominations, and they are auctioned to dealers using both competitive and non-competitive bidding processes. All marketable Treasuries are fully liquid and trade in secondary markets. In contrast, the non-marketable Treasury securities include Savings Bonds for individual savers; these bonds bear various maturity periods, and their face values range from $50 to $10,000 each.

Treasury Bills, Notes and Bonds

Treasury bills have a maturity of one-year or less, while Treasury notes have maturities between two to ten years. The Treasury bond is a fixed-interest-rate debt security which has a maturity term of at least ten years, and typically thirty years. These bonds pay interest semi-annually, and holders' income is subject only to federal taxation. T-bonds may be auctioned in lots of $5 million in non-competitive bidding, which guarantees that a bidder will receive the bond, yet must also accept the fixed rate. On the other hand, the bonds may also be auctioned competitively for thirty-five percent of the offering, with acceptance of the bid depending on the fixed rate of the bond. T-Bills, T-Notes, and T-Bonds play many important roles in the U.S. economy, including providing safe short-term investments for individuals and institutions alike, and providing legally-required collateral for Federal Reserve Banks.