Definition of Bonds ... and the Nitty-Gritty

We'll start with a simple definition of bonds and talk about why bonds are issued. We'll also look at the important terms involved, the advantages of investing in bonds, and review the main types of bonds.

What are Bonds?

Here's a simple definition of Bonds

If you are buying a bond, you are the lender. Depending on the type of bond you buy, the borrower (also called issuer) could be a big company, the Federal Government, a State, or a Local Municipality.

Why are Bonds Issued?

Companies and governments need money for their day to day operations. Issuing bonds is one way to raise money. But unlike issuing stocks, the borrower has to pay periodic interest to the lender as well as return the amount borrowed at a predetermined point in the future.

Terms Involved

Let's extend our definition of bonds to cover some important terms:

• Face value (par value) - the price you pay when you buy a bond. Quite literally, this is the value printed on the face of the bond -- usually $1,000. The bond issuer promises to return this money to you at a predetermined date in the future.
• Maturity date - this predetermined date in the future is called maturity date.
• Coupon - the periodic interest rate determined at the time of purchase. This interest will be paid regularly till the maturity date.
• Price - Not everyone holds a bond till its maturity date. Bonds can be traded in the open market .... for a price.
• Yield - There are two types of yields when it comes to bonds:

  • Current yield - this is annual payout divided by the price of the bond. {current yield = annual payout/price}. When a bond is purchased at face value, the current yield is simply the coupon.
  • Yield-to-maturity - This is a far more complex formula. Yield-to-maturity considers the price you buy the bond for, the face value, and all subsequent annual payouts re-invested at the same rate as the coupon. It is similar to the internal rate of return on an investment.
    Really interested in the math? Well, you asked for it....
    

    Price = c/(1 + r) + c/(1 + r)² + . . . + c/(1 + r)ⁿ + B(1 + r)^-n
    

    where
    c = annual coupon payout
    r = rate of return
    n = number of years to maturity
    B = face value
    

    
    

Why Invest in Bonds?

Historically, the stock market has a higher return on investment compared to bonds. However, investing in bonds is suitable for certain situations:

• Capital preservation: Bond holders get their original investment back barring a company or local Government going bankrupt. Investors with lower tolerance for the risk that comes with the gyrations of the stock market find this safety in bonds very appealing.
• Income: A bond coupon is constant throughout its life. This fixed rate provides a valuable source of income with very low risk -- a great investment for retirees. Also, bond coupons typically tend to be higher than interest rates offered by most banks on savings accounts.
• Tax advantage: Certain types of bonds (e.g. Municipal Bonds) yield interest that is exempt from Federal Income Taxes and most state and local income taxes. This can be especially useful for individuals looking to minimize their tax liability.

Main Types of Bonds:

The common types of bonds that most U.S. investors buy are:

1. U.S. Government Bonds - These are also called Treasurys or U.S. Savings Bonds. Treasurys are considered the safest bond investments, because they are backed by "the full faith and credit" of the U.S. government. These bonds are grouped into three kinds:

   • U.S. Treasury Bills - 90 days to 1 yr. maturity

   • U.S. Treasury Notes - 1 to 10 yr. maturity

   • U.S. Treasury Bonds - Over 10 yr. maturity.

2. Municipal Bonds - Also known as Munis, these are a slightly riskier compared to Treasurys. But they have great tax advantages. The interest on Munis is free from federal income taxes. And if you happen to be a resident of that local government, you have a good chance of protecting your interest from state and local income taxes. The tax advantage comes with a lower coupon, though, compared to Treasurys.

3. Corporate Bonds - These come with the highest risk because corporations are more likely to go bankrupt than governments. Coupons on Corporate Bonds are higher to compensate for the increased risk. Based on maturity, they can be classified as:

   • Short Term - less than 5 yr. maturity

   • Intermediate - 5 to 12 yr. maturity

   • Long Term - greater than 12 yr. maturity

In summary, we looked at the definition of bonds and discussed why bonds are issued. We also covered the different terms involved in bond investing and the advantages of this investment. We wrapped up by covering the major types of bonds -- primarily U.S. Treasurys/U.S. Savings Bonds. This gives us a fairly good grounding on the topic of Bonds.

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