What Is a Bond?
People borrow money every day for all kinds of reasons. Much like people, large organizations such as corporations, the federal government, and state and local governments all need to borrow money occasionally. Unlike you and me, it is very difficult for these organizations to get as much money as they need just with the promise to repay it the next day. Instead, they have to agree not only to pay back the amount they borrowed, but also to pay a little extra in the form of a fee (interest) for the privilege of borrowing the money.
Bonds are a form of indebtedness that is sold to the public in set increments, normally about $1,000. In return for loaning the debtor the money, the lender gets a piece of paper that stipulates how much was lent, the agreed-upon interest rate, how often interest will be paid and the term of the loan.
Types of Bonds
Bonds are known as "fixed-income" securities because the amount of income the bond will generate each year is "fixed," or set, when the bond is sold. No matter what happens or who holds the bond, it will generate exactly the same amount of money.
There are four basic kinds of bonds, all defined by who is selling the debt. The first are bonds sold by the U.S. government and other government agencies. The second are bonds sold by corporations. The third type of bonds are those sold by state and local governments. The last type of bond investors might encounter are bonds sold by foreign governments, although these can be difficult for the individual investor to buy and sell outside of a mutual fund.
- The Federal Government - U.S. government bonds are called Treasuries because they are sold by the Treasury Department. Treasuries come in a variety of different "maturities," or lengths of time until maturity, ranging from 3 months to 30 years. Various types of Treasuries include Treasury notes, Treasury bills, Treasury bonds and inflation-indexed notes. These all vary based on maturity and amount of interest paid. The Treasury Department also sells savings bonds as well as other types of debt through the Bureau of the Public Debt. Treasuries are guaranteed by the U.S. government and are free of state and local taxes on the interest they pay.
- Other Government Agencies - Some government agencies and quasi-government agencies like the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac) and the Government National Mortgage Association (Ginnie Mae) sell bonds backed by the full faith and credit of the U.S. for specific purposes, such as funding home ownership.
- Corporate Bonds - Companies sell debt through the public securities markets just as they sell stock. A company has a lot of flexibility as to how much debt it can issue and what interest rate it will pay, although it must make the bond attractive enough to interest investors or no one will buy them. Corporate bonds normally carry higher interest rates than government bonds because there is a risk that the company could go bankrupt and default on the bond, unlike the government, which can just print more money if it really needs it. High-yield bonds, also known as junk bonds, are corporate bonds issued by companies whose credit quality is below investment grade. Some corporate bonds are called convertible bonds because they can be converted into stock if certain provisions are met.
- State and Local Governments (Muni's) - Because state and local governments can go bankrupt (such as Orange County, California), they have to offer competitive interest rates just like corporate bonds. Unlike corporations, though, the only way that a state can get more income is to raise taxes on its citizens, always an unpopular move. As a way around this problem, the federal government permits state and local governments to sell bonds that are free of federal income tax on the interest paid. State and local governments can also waive state and local income taxes on the bonds, so even though they pay lower rates of interest, for borrowers in high tax brackets the bonds can actually have a higher after-tax yield than other forms of fixed-income investments. Thus, tax-free municipal bonds (also known as "muni's") were born.
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