A bond is simply a promise to repay money, with interest, on a certain date in the future. While stocks represent ownership shares in a corporation, a bond is an. Thanks to some of my colleagues in the investment world, especially Marilyn. Cohen, official tech consultant on this book, who knows bonds better than. Your friendly guide to trading the bond and bond fund market Bonds and bond funds are among the safest and most reliableinvestments you can make to ensure.
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Bond Investing For Dummies helps you do just that, with clear explanations of everything you need to know to build a diversified bond portfolio that will be there . Examples of fixed income securities include various bond types as well as investments that hold bond collections, such as bond mutual funds and bond ETFs. BOND BASICS. What is a bond? A bond is a type of investment that represents a loan between a borrower and a lender. Think of it as similar to getting a.
The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds.
Most bonds have a term of up to 30 years. Some bonds have been issued with terms of 50 years or more, and historically there have been some issues with no maturity date irredeemable.
In the market for United States Treasury securities, there are three categories of bond maturities: short term bills : maturities between one and five years; medium term notes : maturities between six and twelve years; long term bonds : maturities longer than twelve years.
Coupon[ edit ] The coupon is the interest rate that the issuer pays to the holder. Usually this rate is fixed throughout the life of the bond. The name "coupon" arose because in the past, paper bond certificates were issued which had coupons attached to them, one for each interest payment.
On the due dates the bondholder would hand in the coupon to a bank in exchange for the interest payment. Interest can be paid at different frequencies: generally semi-annual, i. Yield[ edit ] The yield is the rate of return received from investing in the bond. It usually refers either to The current yield , or running yield, which is simply the annual interest payment divided by the current market price of the bond often the clean price.
The yield to maturity , or redemption yield, which is a more useful measure of the return of the bond. This takes into account the current market price, and the amount and timing of all remaining coupon payments and of the repayment due on maturity.
It is equivalent to the internal rate of return of a bond. Credit quality[ edit ] The quality of the issue refers to the probability that the bondholders will receive the amounts promised at the due dates. This will depend on a wide range of factors. High-yield bonds are bonds that are rated below investment grade by the credit rating agencies.
As these bonds are riskier than investment grade bonds, investors expect to earn a higher yield.
These bonds are also called junk bonds. Market price[ edit ] The market price of a tradable bond will be influenced, amongst other factors, by the amounts, currency and timing of the interest payments and capital repayment due, the quality of the bond, and the available redemption yield of other comparable bonds which can be traded in the markets.
The price can be quoted as clean or dirty. The net proceeds that the issuer receives are thus the issue price, less issuance fees. The market price of the bond will vary over its life: it may trade at a premium above par, usually because market interest rates have fallen since issue , or at a discount price below par, if market rates have risen or there is a high probability of default on the bond. Others[ edit ] Indentures and Covenants — An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement.
Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority or super-majority vote of the bondholders.
Optionality: Occasionally a bond may contain an embedded option ; that is, it grants option-like features to the holder or the issuer: Callability — Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option.
These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so-called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
Puttability — Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option. These are referred to as retractable or putable bonds. Call dates and put dates—the dates on which callable and putable bonds can be redeemed early.
There are four main categories: A Bermudan callable has several call dates, usually coinciding with coupon dates.
A European callable has only one call date. This is a special case of a Bermudan callable.
An American callable can be called at any time until the maturity date. A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of a deceased bondholder to put sell the bond back to the issuer at face value in the event of the bondholder's death or legal incapacitation.
This is also known as a "survivor's option". Sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically.
The entire bond issue can be liquidated by the maturity date; if not, the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, download bonds in open market, then return them to trustees. Bonds are often identified by its international securities identification number, or ISIN , which is a 12 digit alphanumeric code that uniquely identifies debt securities.
Bond certificate for the state of South Carolina issued in under the state's Consolidation Act. The following descriptions are not mutually exclusive, and more than one of them may apply to a particular bond: Fixed rate bonds have a coupon that remains constant throughout the life of the bond. A variation are stepped-coupon bonds, whose coupon increases during the life of the bond.
Floating rate notes FRNs, floaters have a variable coupon that is linked to a reference rate of interest, such as Libor or Euribor. The coupon rate is recalculated periodically, typically every one or three months. Zero-coupon bonds zeros pay no regular interest.
They are issued at a substantial discount to par value , so that the interest is effectively rolled up to maturity and usually taxed as such. The bondholder receives the full principal amount on the redemption date. An example of zero coupon bonds is Series E savings bonds issued by the U. Zero-coupon bonds may be created from fixed rate bonds by a financial institution separating "stripping off" the coupons from the principal.
In other words, the separated coupons and the final principal payment of the bond may be traded separately. High-yield bonds junk bonds are bonds that are rated below investment grade by the credit rating agencies. Convertible bonds let a bondholder exchange a bond to a number of shares of the issuer's common stock.
These are known as hybrid securities , because they combine equity and debt features. Exchangeable bonds allows for exchange to shares of a corporation other than the issuer. Inflation-indexed bonds linkers US or Index-linked bond UK , in which the principal amount and the interest payments are indexed to inflation.
The interest rate is normally lower than for fixed rate bonds with a comparable maturity this position briefly reversed itself for short-term UK bonds in December However, as the principal amount grows, the payments increase with inflation.
The United Kingdom was the first sovereign issuer to issue inflation linked gilts in the s. Receipt for temporary bonds for the state of Kansas issued in Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator income, added value or on a country's GDP.
Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc.
The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid.
As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first, the subordinated tranches later.
Covered bonds are backed by cash flows from mortgages or public sector assets. Contrary to asset-backed securities the assets for such bonds remain on the issuers balance sheet.
Perpetual bonds are also often called perpetuities or 'Perps'. They have no maturity date. Some of these were issued back in and still trade today, although the amounts are now insignificant. Some ultra-long-term bonds sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in i. Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond.
Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen. Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. Treasury stopped in , and state and local tax-exempt bearer bonds were prohibited in It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity are sent to the registered owner.
A government bond , also called Treasury bond, is issued by a national government and is not exposed to default risk. It is characterized as the safest bond, with the lowest interest rate. For that reason, for the major OECD countries this type of bond is often referred to as risk-free.
May 1, Municipal bond is a bond issued by a state, U. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
Unlike traditional US municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, the bond is tax-exempt within the US state where it is issued. Generally, BABs offer significantly higher yields over 7 percent than standard municipal bonds. As physically processing paper bonds and interest coupons became more expensive, issuers and banks that used to collect coupon interest for depositors have tried to discourage their use.
Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them. Bond Portfolio Vs. Stock Portfolio Stock prices generally go up faster than bond prices, but they're also usually riskier.
Bonds, which are loans to governments and businesses that issue them, are often called good investments for older investors who need to rely on steady interest income. Some bonds are riskier than others, and usually pay higher interest as a result, so it's good to make sure you understand the particular securities you invest in.
Advantages of Bonds Bonds offer safety of principal and periodic interest income, which is the product of the stated interest rate or coupon rate and the principal or face value of the bond.
Bonds are ideal investments for retirees who depend on the interest income for their living expenses and who cannot afford to lose any of their savings.
Bond prices sometimes benefit from safe-haven downloading, which occurs when investors move funds from volatile stock markets to the relative safety of bonds. Governments and businesses issue bonds to raise funds from investors. Bonds pay regular interest, and bond investors get the principal back on maturity. Credit-rating agencies rate bonds based on creditworthiness. Low-rated bonds must pay higher interest rates to compensate investors for taking on the higher risk.
Corporate bonds are usually riskier than government bonds. Treasury bonds are considered risk-free investments. You can download bonds directly through your broker or indirectly through bond mutual funds. You can also download U.
Treasury bonds directly from the department's TreasuryDirect website. Disadvantages of Bonds The disadvantages of bonds include rising interest rates, market volatility and credit risk.