Bond Basics

What is a bond?

You may think of a bond as a loan you make to an organization such as a corporation or government that agrees to repay the full amount (face value) of the bond by a specified date, known as the maturity date. The maturity date can range from one day to as long as 30 years. Bonds appeal to investors because they offer a predictable stream of interest payments while preserving principal.

What's the difference between bonds and stocks?

As noted above, when you purchase bonds, you are making a loan and therefore you become a creditor to the organization issuing the bond. When you purchase stock, you become a shareholder (or owner) of the corporation issuing the stock. The primary advantage of being a creditor is that you have a higher claim on assets than a stock shareholder. This means that in the event of a bankruptcy, bondholders are paid first. As a shareholder, unlike a bondholder, you have the right to vote at shareholder meetings on issues of corporate policy, the board of directors and other key matters of the corporation's direction.

Generally, bonds are considered less risky than stocks for several reasons. Bonds carry the promise to return the face value of the security to the holder at maturity, whereas stocks do not. Also, during periods of economic stress, bond prices are less vulnerable to wide swings or volatility than are stock market prices.

What different types of bonds are available?

Bonds are issued by government and corporate organizations. The fundamental difference between each of the bonds described below is the organization that issues the bond along with the associated interest yield and risk.

U.S. government bonds are considered the safest because the U.S. government guarantees them, but they generally pay the least amount of interest compared to other kinds of bonds with similar maturity dates. There are three primary types of government bonds commonly known as Treasuries and classified according to the maturity of the bond:

1. Treasury Bills—maturing in less than one year
2. Treasury Notes—maturing in one to ten years.
3. Treasury Bonds—maturing in more than ten years

Generally, the longer the maturity, the higher the interest rate you can expect. In addition, the income you earn is exempt from state and local (but not federal) income taxes.

Municipal bonds—"munis" as they are often referred, are issued by local governments, most often states and local municipalities. They help local or state governments to pay for public projects, such as the construction or improvement of schools, streets, highways, hospitals, bridges, low-income housing, water and sewer systems, ports, airports and other public works. In addition, interest earned is federal income-tax free. In some cases, local governments also waive income tax on interest earned on municipal bonds. Generally, municipal bonds pay less than other kinds of bonds with comparable maturity dates because of the tax advantages they offer and relative safety.

Mortgage-backed securities—when you invest in mortgage-backed bonds, you are generally investing in a portion of a pool of loans, usually first mortgages on residential properties. As the underlying loans are paid off, you receive payments of interest and principal over time. These bonds help make credit available to more people by giving lenders access to large pools of capital, which helps them manage their risk. Many of the bonds are issued by recognizable institutions such as Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). Attractive interest rates, creditworthiness and diversity of available securities have made them increasingly popular among individual investors.

Agency securities—are bonds issued by Government Sponsored Enterprises (GSEs) created by Congress. These bonds help finance projects and activities such as farming, small business, or loans to first-time homebuyers. Agency bonds are not guaranteed by the US. Government, however, credit risk is still considered minimal. Agency bonds offer a higher yield than most Treasuries and are considered very safe. A few of the federal agencies that issue bonds include, Government National Mortgage Association (GNMA), Farmers Housing Administration (FHA), and the Small Business Administration (SBA).

Corporate Bonds— are issued by public and private companies attempting to raise capital in order to finance or expand business, often by building facilities or purchasing equipment. They generally offer higher interest rates than government or agency bonds with similar maturities. The difference in interest rates results from investor perceptions regarding the chance that the borrowing company will be unable to pay interest and return the investment principal when promised. Critical to a corporate bond is its credit rating. The higher the quality, the lower the interest rate an investor receives. Generally a short-term corporate bond is less than five years; intermediate is five to twelve years, and long term is over twelve years.

Foreign government bonds—as the name implies, are bonds issued by the governments of countries outside of the United States. Foreign bonds carry a couple of distinct risks. First there is currency risk, which can result in gains or losses resulting from changes in currency exchange rates. Second, bonds issued outside of the U.S. may have different rules than in the United States in the event of default such as bankruptcy proceedings.

Several important terms you should know about bonds

Interest or Coupon—The coupon represents the amount the bondholder will receive as interest payments. It is called a coupon because many years ago, bonds had an actual coupon attached that could be torn off and redeemed for interest payments. Now, most interest payments occur electronically and are paid every six months.

Yield—Yield refers to the actual investment rate of return an investor receives on a bond. If you buy a bond at face value, your rate of return is the actual interest rate you're receiving for your bond, but if you buy a bond from the bond market after it is issued, you may pay more or less than the bond's face value and your yield will vary accordingly. Here's the math to figure out your yield: simply divide the annual coupon (interest) amount by the face amount of the bond. For example, if you buy a bond at its $1000 face value with a $100 annual coupon amount, the yield is 10% ($100/$1000). It's when you don't purchase the bond at the face amount that calculating yield becomes that much more important. Let's say that the price of a bond goes down to $800 before you purchase it. You will receive the 10 percent coupon that pays $100 annually. Because you are paying less for the bond, your yield will be 12.5% ($100/$800). Now, if the bond price is greater than the face value, your yield is reduced compared to the coupon interest rate. For example, if the bond goes up in price to $1200 before you purchase it, the yield shrinks to 8.33% ($100/$1200). What's important to understand is that what your bond is actually yielding, your rate of return, may be more or less than the coupon interest rate, depending on what you paid for the bond.

Price—As with stocks, bond prices change daily. A bond's price fluctuates throughout its life in response to a number of economic variables. If you sell a bond before it matures, the price you receive may be more or less than what you paid for it and more or less than its face value. However, if you hold it to maturity, you will receive the face value—also known as par value—of the bond.

Quality—When people refer to a bond's quality, they are referring to its credit rating. Many bonds are assigned specific credit ratings by nationally recognized rating agencies, such as Moody's Investors Services, Standard and Poor's Rating Services and Fitch Ratings. These rating agencies assess the organization's financial stability and its ability to pay back its debt. Bond ratings provide a report card of an organization's financial stability and its ability to pay back its debt. Below is a chart illustrating the range of ratings issued by three major rating agencies.

Bond Rating

In general, the safer the investment, the lower your yield will be; the riskier the investment, the higher your yield will be.

What are the primary risks of investing in bonds?

As with all investments, you should consider the risk/return tradeoff when investing in bonds. Though generally considered less risky than stocks, bonds do carry some unique risks.

Interest rate or market risk—rising and falling interest rates affect the price of an individual bond. When interest rates rise, bond prices fall. Because of these market fluctuations, the value of the bond may be higher or lower than the purchase price or original face value if sold before maturity.

Credit risk—if the issuer runs into financial difficulty or declares bankruptcy; it could default on its obligation to pay the bondholders.

Liquidity risk—you may not be able to find a buyer for your bonds in the market place unless you are willing to sell at a discount to the fair market value.

Call risk—if a bond is callable, the issuer can pay off the debt early and the bondholder will be denied the potential for additional income from the interest payments on the bond. An issuer will call a bond much like a homeowner refinances his or her mortgage when interest rates fall.

Inflation risk—inflation causes a dollar in the future to be worth less than a dollar today. An example of this risk can be seen when inflation reduces the purchasing power of a bond investor's future interest payments and principal.

Investing in bonds

An easy way to invest in bonds is through a fund, such as the Domestic Bond Fund offered by the General Board. Funds are professionally managed and are diversified with a number of bonds of different issuers with different maturity dates. Consequently, when interest rates move up and down, the bonds in the fund react differently. Bond funds do not have a specific maturity date since they are actively managed, and bonds are being added and eliminated from the portfolio in response to different market conditions and investor demands. For more information about the General Board's Domestic Bond Fund, visit our Domestic Bond Fund information page.