The loaning of money is a vital part of our economic system. Every day, people take out loans to purchase new cars and homes or pay their college tuition. Just as we sometimes need to borrow money from banks, companies and governments often rely on loans to fund and grow their operations. Just like us, they borrow from banks. However, since banks have a limit on the amount they can lend, companies and governments often need to borrow from the public at large, and they do so by issuing bonds.
Put simply, a bond is just a loan. When you buy a bond, you are doing nothing more than loaning money to the entity issuing the bond. Just as you pay interest on a loan taken out from the bank, the organization issuing the bond promises to pay you interest for the life of the loan. The length of the loan and the amount of interest paid depend upon the terms of the bonds purchased.
Maturity & interest rate
The two main features that define a bond are the maturity date, which indicates when the loaned money (or bond principal) is to be returned, and the coupon – a word used to refer to the interest rate of a bond.
Typically, bonds of a longer duration have a larger coupon (meaning that they pay a higher interest rate) than short-term bonds, since the lender has to wait longer to have their money repaid and thereby assumes more risk. Interest is paid on an annual basis to the bondholder until maturity. Because the interest payment is a set amount per year, bonds are also referred to as fixed-income-securities.
Different types of bonds
Some of the most common bonds are those issued by the U.S. Treasury. These have historically been considered to be among the safest of debt investments, due to the fact that the U.S. government has never defaulted on its debt.
U.S. Treasury bonds with a maturity of ninety days or less are referred to as Treasury Bills (or T-Bills), those with a maturity of between two and ten years are called Treasury Notes, and those with a maturity of greater than ten years are called Treasury Bonds. These can be collectively referred to as Treasury Bonds or just Treasuries. U.S. Treasuries are issued in face values of $1,000, and the interest on Treasury Notes and Bonds is paid out twice annually.
Bonds issued by companies are called Corporate Bonds while those issued by cities, counties and states are called Municipal Bonds or, informally, “Munis.” These kinds of bonds have durations of between three and thirty years.
More on bonds
Another aspect that can affect the interest rate of a bond is the credit-worthiness of the issuing entity. There are several well-known and qualified credit rating agencies that closely analyze and issue credit ratings on the companies, and even governments, that issue bonds. Some of the most respected rating agencies are names you have likely heard before, such as Moody’s, Standard & Poor’s and Fitch Ratings.
When a company has a low credit rating, they must entice potential bond buyers by offering a large coupon or interest rate. Such bonds are called high-yield or junk bonds. Investing in junk bonds is highly speculative.
Some individuals simply hold bonds in order to collect the interest payments. However, much like stocks, bonds can be traded among other investors in the secondary market, before they reach maturity. The trading aspect of bonds can get somewhat complex. Your financial advisor may be able to help you better understand this subject.
Bonds are an important part of a well-diversified portfolio and should be factored into any retirement plan. However, it is crucial that one understand all aspects of bond investing before entering the bond market.
Our top investment advisors can assist you in selecting high quality secure bonds that are right for your portfolio.