When you buy a bond, you become a lender. The bond issuer is the borrower. The bond issuer might be a company, a city, a state, or a federal government agency. They may borrow for short periods to manage cash flow or cover operating costs, for example. They may also borrow money for longer-term goals, such as to build new facilities or pay for new technologies. Cities or states may need to build bridges or provide other community services. One common way to borrow money is to issue a bond series and sell units of the series to the public.
Why Own Bonds?
Bonds are a good choice if you're looking to earn a steady income with the potential to beat inflation. Bonds are sometimes referred to as "fixed income" securities. They pay you interest based on a fixed rate for a specified period of time, thus earning you "fixed income."
If you are thinking of buying a bond, consider some of the following questions:
- How much will you earn?
- When will you be paid the interest?
- How long is the loan?
- How reliable is the borrower?
- How much do they want to borrow?
How Much Will You Earn?
The amount that you earn will be based on the bond's face value, coupon rate, and yield.
The face value, or par value, of a bond is its value at maturity, or the date when the loan is paid off. A common face value is $1,000 per bond. It's important to keep in mind that the actual market price of a bond may be higher or lower than the bond's face value. A bond's market price can fluctuate over time depending on a variety of factors, including investor demand, interest rate movement, the bond's maturity date, and the creditworthiness of the issuer.
A bond's coupon rate refers to the interest that will be paid based on the face value of the bond. A bond with a face value of $1,000 and a 7 percent coupon will pay $70 a year in interest. Interest may be divided into quarterly, semiannual, or annual payments, depending on the issuer and the individual bond.
If you purchase a bond at face value, your coupon rate and actual earned yield will be the same. However, bonds are often sold at higher or lower prices than their face values. As a result, your actual yield can be different from the bond's coupon rate. Buying a bond at a discount, or less than its face value, results in a higher yield than the stated coupon rate. In contrast, buying a bond at a premium, or more than its face value, results in a lower yield than the stated coupon rate.
How Safe Is Your Bond?
When you buy bonds, you're taking a risk that borrowers with poor credit ratings may not repay their loans on time or even at all. Two major investor services, Moody's and Standard & Poor's, rate the creditworthiness of bonds. Ratings are based primarily on the credit history and current status of the issuer.
The ratings use a letter system. They go by letters, like at school. The ones with only A’s in their rating are of high quality. The ones with a B in the rating are of medium quality (except for Moody's B rating, which is below medium quality). Bonds with a C are either of low quality or extremely low quality.
Bonds are commonly labeled either "investment grade" or "junk" quality (often called "high yield" instead). The less creditworthy the borrower is, the higher your risk is of not being repaid what you lend. For that reason, higher-risk bonds usually provide a higher interest rate.
You can avoid the issue of creditworthiness entirely by investing in bonds issued by federal government agencies. Repayment of these loans is guaranteed by the full faith and credit of the U.S. government.
Taxable or Tax-Free?
Depending on the type of issuer and your state of residence, the interest you receive from a bond investment may be taxable or tax-exempt. Generally speaking, all corporate bonds are taxable. Municipal and state bonds are typically tax-exempt if you live in the same state where the issuer is located. Federal government bonds are not federally taxable but may be taxable at the state and local levels.
Do Interest Rates Affect Prices?
In short, interest rates and bonds work like a seesaw: When rates rise, bond prices tend to fall. And when rates fall, bond prices tend to rise. If the economy's interest rates rise, newly issued bonds will pay higher interest than the bonds you own. Typically, your older bonds will be worth less, and you'd have to sell them at a discount. If, however, the economy's interest rates drop, newly issued bonds will pay lower interest than the bonds you own. Then your older bonds will be typically worth more, and you'd be able to sell them at a higher price. If you hold a bond to maturity, you will not face these price changes.
Interest rates can also influence an issuer's decision to pay off the bonds early. Just as you can pay off a mortgage at any time without a penalty, many bond issuers have the ability to "call" in the bonds early. Typically, if interest rates drop significantly, a "callable" bond will get called. This allows the bond issuer to get rid of this high interest debt and borrow again at a lower interest rate.
How Long Are You Willing to Tie Up Your Money?
Time also plays a big role in how much risk you'll be taking and how much interest will be paid. In general, the longer you're asked to lend your money, the higher the risk is that something might go wrong—and, therefore, the higher the interest rate is that you can expect to earn. There are three main time-based categories:
- Short-term bonds (generally less than two years)
- Intermediate-term bonds (generally two to 10 years)
- Long-term bonds (generally more than 10 years)
How Can You Manage Risk?
To help manage these risks, many financial professionals recommend holding a variety of bonds with different maturity dates. As with stocks or most types of securities, you generally want to avoid holding a large bond position with a single issuer or type of bond. Bond mutual funds can also reduce risk because they invest in a pool of many bonds.
AARP’s Money Matters Tip Sheet on Investing in Bonds has more information and action steps.
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