Bonds

What are Bonds!

If you’re not clear if you know what bonds are, whether you’re interested in them or if they can benefit you, you’ve come to the right place. If you’re going to delve into bonds, you first need to understand what a bond is and what it isn’t.

When corporations, federal agencies, municipalities and other entities need capital for expenses, they often offer to the public what is called a bond. It is to the entity’s advantage to issue bonds, instead of borrow money from a bank, because banks apply greater restrictions when lending money.

Whatever entity offers the bonds is called the issuer. Those who purchase the bonds are called the investors.

A bond is basically an IOU you purchase from the issuer for a specific dollar amount. It is termed a fixed-income security, since you receive a fixed amount of income during the lifetime of the bond. It is an investment you make that is paid back to you with a fixed amount of interest. It has specific terms in regards to the duration of the bond and the amount of interest that will be paid throughout the lifetime of the bond.

For example, you purchase a $4,000 bond at 6 percent interest that will mature in 4 years. You will receive $240 ($4,000 x 6 percent) in interest annually every year for the next four years. Most bonds payout interest semi-annually. If your bond does, then you would receive two payments of $120 each year for four years. In addition, when your bond matures, or its term ends, you receive your initial investment back.

What a Bond Isn’t

Bonds are an animal unto themselves. They are unlike stocks in that when you buy bonds, you don’t own a share of the company. You have a guarantee, though, from the company that your investment will be paid back to you. You don’t get that guarantee when investing in stocks.

You don’t own a share of the company when you purchase a bond. Instead, you own some of the issuer’s debt, which means you become a creditor of the issuer. You do, however, own a part of the company when you purchase stock. Investing in bonds is considered less risky than investing in the stock market; although, there are higher risk bonds that are issued.

One advantage of bonds is that if the entity that issued the bond goes bankrupt, bondholders are paid before shareholders.

So, What About Municipal Bonds?

Municipal bonds are bonds issued by municipalities or their agencies. A municipality could be a state, county, city, public school district or other government entity. When you buy a municipal bond, you lend money to a government entity. The government entity promises to repay you not only the initial purchase price of the municipal bond on a specific date, but also a specific amount of interest throughout the duration of the municipal bond.

One of the primary reasons people invest in municipal bonds is that they are often exempt from federal, state and local income taxes. General obligation bonds are issued in order to raise quick capital for expenses. The issuer of these types of bonds is able to pass the expense along in the form of taxes. Revenue bonds are a type of municipal bond that provide for infrastructure projects, such as roads, lighting, sidewalks, schools and others. The issuer of these types of bonds receives income generated by the projects.

Both of these types of bonds are tax-exempt, and attractive as an investment, since it is a low risk that the entities will go bankrupt or not pay their debts.

As with all bonds, municipal bonds pay out a specific interest, typically semi-annually, and mature within a specified timeframe.

Tell Me About Corporate Bonds

Corporate bonds are issued by corporations, ergo, the “corporate” in corporate bonds. They are bonds issued in order for private or public corporations to expand their businesses. Issuance of corporate bonds is typically in increments of $1,000 or $5,000.

In contrast to municipal bonds, the interest you receive from investing in corporate bonds is taxable. Also in contrast, corporate bonds are higher risk investments than municipal bonds. With the higher risk, however, interest earned is typically higher, too.

What Are Treasury Bonds?

Treasury bonds, often called T-Bonds, are issued by the federal government. They are the bonds with the longest maturity, issued in 20-year or 30-year terms. These bonds are taxed at the federal level only.

Unlike other bonds, treasury bonds are auctioned, and can be sold on the secondary market. You can bid on treasury bonds using several different venues – online directly from the government at TreasuryDirect.com or through a dealer, broker or bank.

This type of bond is more complex than the other bonds. Terms like competitive or non-competitive bidding are used when purchasing treasury bonds, along with set rate and stated rate.

If you make a non-competitive bid, then you are guaranteed to receive the amount of bonds you bid on. You will not know, however, what the interest rate will be until after the auction closes.

For competitive bidding, you are not guaranteed to receive the bonds you bid on. You state the interest rate you want to receive. If your stated rate is equal-to or less-than the highest acceptable yield, then you will receive all or part of the bonds you bid on. If not, you won’t.

Although, you can make a non-competitive bid online through Treasury Direct, you cannot make a competitive bid online. Instead, you may do so through a dealer, broker or bank.

The highest acceptable yield is the rate set by the average of all stated rates, or competitive bids. Even if your stated rate is lower than the highest acceptable yield, if your bid is accepted, you will receive the same yield. Everyone whose bids are accepted receives this same yield.

The maximum bidding allowed for non-competitive bidding is $5 million. For competitive bidding is the maximum is 35 percent of the offering.