Basically, a bond is a loan. When purchasing a bond, you loan a company or government your money. In return, they pay you interest for using your money. They also promise to fully repay the money you loaned. Whether they meet this promise or default on the bond depends on the ability of the bond issuer to pay.
Bonds are issued by companies and federal and state governments. A corporate bond is issued by a company. A municipal bond is issued by a city or state. A government bond is issued by a government such as the United States of America.
Whether the issuing company or government repays the bond or defaults depends on the creditworthiness of the issuer. Creditworthiness means that the issuer can repay its liabilities and loans. Default is when the issuer fails to repay the loan. Bonds are rated by independent rating agencies on their creditworthiness/risk of default. Each ratings agency expresses their ratings slightly differently but all ratings run from AAA, or Aaa, to C. AAA, or Aaa, ratings indicate that an issuer is very sound and unlikely to default. You can feel secure that your money will be returned. With each step down the ratings ladder, a higher chance of default occurs. AAA or Aaa to BBB or Baa rated bonds are considered investment grade while BB or Ba and lower are considered junk bonds.
Bonds pay interest known as their coupon rate. The coupon rate is fixed when the bond is purchased. The maturity date is also set when the bond is issued. Interest is paid to the bondholder yearly, often in semiannual installments. The interest that can be earned varies with the issuer and the issuer's credit rating. AAA rated government bonds pay the lowest amount of interest; it is believed that you are guaranteed to receive your principal back. Corporate bonds pay more than government bonds since a company's risk of default is higher. Shorter maturities pay less than longer maturities. This is because the longer a bond is held the more likely interest rates will rise affecting the value of the bond. If holding the bond, the owner will lose the opportunity to have earned higher returns. If the bond were sold, the owner would have to take less money for the bond to compensate the new owner for its lower interest payment.
Corporate bonds are subject to both federal and state taxes. U.S. Government bonds are free of state income taxes. Municipals are free of federal taxes. Municipal bonds can be free of state taxes. This occurs if the owner lives in the state that issued the bond.
Bonds also trade on a secondary market. Issued bonds are bought and sold on this market. Bonds are priced so they can trade on the secondary market. If sold prior to maturity, a bond may return more or less than the original value. That's because bond prices fluctuate on the secondary market just like stock prices. Also, a bond price changes in relation to interest rates. If interest rates increase, a bond is worth less. If rates decrease, a bond is worth more.
There are two ways to invest in bonds – individual bonds or bond funds. An individual bond will return a set amount of interest each year. With a bond fund you are not getting actual interest. Instead you receive a dividend and your principal fluctuates up and down with the market. However, a bond fund owns hundreds or thousands of bonds. This eliminates the risk of losing your principal to default. The risk of default is of primary consideration with an individual bond. A bond fund allows you to reinvest your dividends thereby growing your portfolio.
So which should you invest in? A bond fund for corporate or municipal bonds is the best choice. It gives diversity and diminishes or negates default risk. The same would apply for international bonds. As for U.S. Government bonds, either an individual bond or a bond fund would do fine. A good technique when purchasing individual bonds is to create a bond ladder. A ladder is easy to form – place an equal portion of the money you have to invest into different maturities. Junk bonds are too volatile and not recommended.
Look for low fees and no sales charges when choosing a bond fund. U.S. Government bonds can be purchased through TreasuryDirect.gov. There is no cost to purchase.
Bonds are an important part of any portfolio. Bonds provide good and reliable income. They also add balance and stability to a portfolio.