A bond is a debt security, similar to an IOU. Borrowers issue bonds to raise money from investors willing to lend them money for a certain amount of time.
When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it "matures," or comes due after a set period of time.
Investors buy bonds because:
Companies, governments and municipalities issue bonds to get money for various things, which may include:
There are three main types of bonds:
Bonds can provide a means of preserving capital and earning a predictable return. Bond investments provide steady streams of income from interest payments prior to maturity.
The interest from municipal bonds generally is exempt from federal income tax and also may be exempt from state and local taxes for residents in the states where the bond is issued.
As with any investment, bonds have risks. Bond investors are relying on the issuer’s ability to pay interest and repay principal. If the issuer has financial problems or defaults, the bondholders could wind up with losses.
Other risks include:
Call risk. The possibility that a bond issuer retires a bond before its maturity date, something an issuer might do if interest rates decline, much like a homeowner might refinance a mortgage to benefit from lower interest rates.
Inflation risk. Inflation is a general upward movement in prices. Inflation reduces purchasing power, which is a risk for investors receiving a fixed rate of interest.
Liquidity risk. This refers to the risk that investors won’t find a market for the bond, potentially preventing them from buying or selling when they want.
Interest rate risk. Interest rate changes can affect a bond’s value. If bonds are held to maturity the investor will receive the face value, plus interest. If sold before maturity, the bond may be worth more or less than the face value. Rising interest rates will make newly issued bonds more appealing to investors because the newer bonds will have a higher rate of interest than older ones. To sell an older bond with a lower interest rate, you might have to sell it at a discount.
With the exception of U.S. Treasury debt, bonds typically are not bought directly from the issuer but through an intermediary known as the underwriter.
Unlike stocks, bonds are not traded on an exchange; instead the underwriter buys them from the issuer and resells them to investors in the over-the-counter (OTC) market. Each bond is given a CUSIP number, similar to a ticker symbol, which is a uniform method to identify the security.
Usually, bonds are sold in the OTC market in $5,000 denominations. However, the prices are quoted as if the bonds were traded in $100 increments. Since bonds may be sold at a premium or a discount to the par value, that number is not always $100. Thus, a bond quoted at 97 refers to a bond priced at $97 per $100 of the face value of the bond. This bond is selling at a discount.
Another way to purchase bonds is through bond funds. These are a type of mutual fund that invests primarily in bonds. Depending on its investment objective and policies, a bond fund may concentrate its investments in a particular type of bond. Bond funds can be purchased directly through investment companies or through a broker or adviser.
All investments have fees. Bonds bought by investors normally include a markup, which consists of the broker-dealer’s costs and profit. An additional commission may be added if a broker-dealer has to locate a specific bond rather than selling one from the firm’s inventory. Each firm establishes its own prices, within regulatory guidelines, which will vary depending upon the type of bond, size of the transaction, and service the firm provides.
Corporate bonds are securities and, if publicly offered, must be registered with the SEC. The registration of these securities can be verified using the SEC’s EDGAR system. Be wary of any person who attempts to sell non-registered bonds.
Most municipal securities issued after July 3, 1995 are required to file annual financial information, operating data, and notices of certain events with the Municipal Securities Rulemaking Board (MSRB). This information is available free of charge online at www.emma.msrb.org. If the municipal bond is not filed with MSRB, this could be a red flag.
MSRB Investor Guide 2012
Bond Funds and Income Funds
Callable or Redeemable Bonds
Financial Industry Regulatory Authority (FINRA)
Information on CUSIP numbers
Late Payment of Interest on Bonds
Municipal Securities Rulemaking Board (MSRB)
MSRB Electronic Municipal Market Access (EMMA)
The Securities Industry and Financial Markets Association (SIFMA)