What is a Bond?

A bond is a form of debt. It is often called a fixed income investment. Fixed Income refers to an investment under which the borrower or issuer is obligated to make “fixed” payments on a “fixed” schedule. The payments are set at a particular figure and will not vary or rise with the rate of inflation. The Coupon Rate on a bond is the percentage paid by the issuer relative to the face value of the bond and usually on a semi-annual basis, depending on the terms of the bond. A bond is one of the three main generic asset classes, as well as stocks (equities) and cash equivalents.

Most simply, bonds are a form of borrowing money and then making interest payments back to the subject you borrowed money from. Governments and corporations will use bonds in order to borrow money. When an entity issues a bond, it asks for a certain investment of money. It then promises to pay back that investment, plus interest payments, over a specified period of time. Most bonds follow this same formula. You invest a sum of money, collect interest payments on it, and get your money back when the bond reaches maturity.

3 Primary Bond Types:

  1. Corporate bonds, and as the name implies, they are issued by corporations and are issued to help raise money for the business and any business related operations. Bonds that are issued by corporations tend to offer higher interest rates than other types of bonds, but that interest is subject to be taxed by the state and federal level.
  2. Municipal bonds or commonly referred to as “Muni Bonds” are issued by states and/or cities to raise money to pay for projects or offer public services. Issuing a Muni bond would be used for something like building a new bridge. There are two types of municipal bonds as well.
    1. General obligation bonds (GO Bonds) are backed by the full faith and credit of the issuer.
      1. A general obligation bond allows a city to do whatever is necessary to repay bondholders on schedule, for example sell assets.
    2. Revenue bonds are backed by the income streams tied to them.
      1. A revenue bond example would be issuing a revenue bond to build a toll booth and then all toll proceeds once built, would be used to pay back the bondholders of that revenue bond.
    3. Treasury bonds or T-bonds are issued by the U.S. Government. Treasury bonds will have a maturity of 10 years or more and are backed by the full faith and credit of the U.S. government. As you can imagine, they’re considered virtually risk-free as they’re backed by the U.S. government. Interest received from T-bonds are only taxed at the federal level, not state nor local taxes.

Bond ratings are the best way to evaluate bonds. A bond rating is a score of sorts that measures the financial strength of the entity issuing the bond. You may have heard of some of the rating agencies, they are 1. Standard & Poor’s, Moody’s and Fitch. Standard and Poor’s and Fitch use a similar rating system that ranks bonds from best quality to worst as follows:

Bond Ratings

Following the Letter rating system, numbers and symbols are added to even further break down a bond’s individual rating. Standard and Poor’s and Fitch use plus and minus signs, for example, a bond rated A+ is better than a bond rated A or A-.

Generally speaking, the higher a bond’s rating, the safer an investment it is. There is a term called Investment Grade bonds. An investment-grade is a rating that indicates that a municipal or corporate bond has a relatively low risk of default. When using Standard and Poor’s bond rating system, any rating above BBB is considered investment grade. Credit ratings for bonds below BB are considered low credit quality and are commonly referred to as “junk bonds.”

To summarize, bonds can contribute an element of stability to a portfolio, and help your diversification. They are a safe and conservative investment and provide a predictable stream of income, hence they are considered Fixed Income Investments. They are useful as a great savings vehicle for when you don’t want to put your money at risk.

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