If you buy a bond, you are lending money. You might be making a loan to the federal government, or to the town where you live, or to a multinational corporation.
Bonds pay a set amount of interest at regular intervals and are known as fixed-income investments. Because the income is predictable, they are suitable for people who need income they can count on. Bonds are frequently the only type of investment retirees own, for example. They are also very popular with people who don't like the fluctuations in the stock market.
Short and intermediate-term bonds are good investments for the intermediate term, when you know that you will need the money in three to five years.
Every bond has a maturity date, when the principal is paid back, and an interest or coupon rate. The interest rate is the percentage of par value that is paid out in interest each year. Par value is the amount printed on the front, or face, of the bond and for that reason is also known as face value.
If you buy a bond at the issue date (when it first comes out), and you hold it until maturity, you will earn precisely the interest printed on the bond and get back its par value at the end.
If, however, you buy or sell a bond on the secondary market (after it has been issued), then its value will depend on the prevailing interest rates at that time.
Example: $1,000 par value bond at 4% interest.
Selling Priceof Bond
The reason for the variation in prices is pretty simple when you think about it. If a bond is issued at 4%, and interest rates shoot up to 6%, who's going to pay full price for a 4% bond? Instead, the bond will sell at a discount to compensate for the low interest rate paid, returning the prevailing 6% on money invested. If, on the other hand, the bond is issued at 4% and the interest rates drop down to 2%, a 4% bond looks pretty good. So an investor will pay a premium for it, earning the prevailing 4% on money invested.
So, although the amount of income you get from a bond remains fixed through its life, its value can fluctuate prior to maturity. If you buy a very long-term bond, you may be locked into an interest rate much higher (if you're lucky) or much lower (if you're not) than the prevailing rates. Bonds have risk, too. It is just that it is a different kind of risk.
This principle applies to all the different kind of bonds.
from 1 to 20 years
Generally more risky but higher yields than government bonds
$5,000 & up
from 1 month to 40 years
Generally exempt from federal taxes; may be exempt from state and local, too. Alternative Minimum Tax may apply.
from $1,000 to $10,000
11 to 30 years
Exempt from state and local taxes.
$5000 and up
from 2 to 10 years
Series EE and Series I bonds
from $25 to $10,000
Mature at face value in 20 years and earn interest up to 30 years.
Exempt from state and local taxes. May be redeemed after 12 months. If used for education may be tax-free.*
$1,000 & up
from 30 days to20 years
Mortgage bonds are taxable; others exempt from state and local taxes.
* Contact your tax professional to review your specific situation.
Corporate and municipal bonds are rated by services like Moody's for their safety. If you want to buy individual bonds, you should look them up first, to see their rating. Treasury notes, bills and bonds are backed by the U.S. government. Safety ratings do not guarantee performance.
Agency bonds are issued by federal and state agencies to raise money for their operations. Federal mortgage bonds like Ginnie Mae and Fannie Mae are two of the best known of these. They have higher risks than Treasuries.
Zero Coupon Bonds
We described some 'plain vanilla' bonds above. You can also get a popular variation known as a zero coupon bond.
Zeros get their name because they pay zero interest until they mature. That means you get all your interest in a lump sum when the bond matures at face value. For example, a $1,000 zero coupon treasury yielding 2.144% and maturing in 10 years, costs only $810 today. That means you invest $810 today and in 10 years you'll receive $1,000.
As you can see from the example, zeros sell at a steep discount from face value to compensate for the missing/delayed interest rate payments. You can purchase zeros with differing maturity dates so that you will receive the lump sum amounts in the years when you need it.
Unless you buy tax-free zeros, such as municipals, you have to pay taxes on the accrued income each year. So, even though you aren't being paid interest, you're still being taxed on it.
Another drawback is that zeros are very volatile. The price will swing dramatically with changes in interest rates. If you think you might need to sell the bond before it matures, this may not be a good choice for you.
SUGGESTION: Zero coupon bonds are ideal for funding future needs such as your retirement or your child's college education. While you may not achieve as high a long-term rate of return as is possible when you invest in stock mutual funds, you do know exactly how much you'll be getting when the bond matures. Zero coupon bonds can help you "lock in" future amounts, particularly as the time when you'll need your money gets nearer. Zero coupon bonds can be purchased through an investment representative or bond dealer.
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