What are bonds? Bonds are securities issued by governments and large corporations, and sold to investors. Bonds are a way for the issuer to raise cash, and the buyer to earn interest by loaning out money.
The most familiar type of bond is the savings bond, but not all bonds are savings bonds. US Savings Bonds are sold to individuals through banks and payroll withdrawal, and on line from www.savingsbonds.gov. They can’t be resold, but can be cashed in after 5 years without penalty. There are two types of savings bond, the EE bond with a fixed rate and the inflation indexed I bond, which has a fixed part and an inflation adjusted part that adjusts every 6 months.
The Treasury also sells Treasury Bonds, T-Bills, T-Notes and TIPS. Treasury Bonds are sold at auction, pay interest every 6 months, and mature in 30 years. You will get your principal back then. They can be bought and sold in the secondary market if you do not want to invest for the full 30 years, but the price can vary depending on demand. T-Bills are sold for less than face value and mature within a year. T-Notes pay interest every 6 months, but have maturities of 2, 5, and 10 years. These bonds are safe, but the rates of return are generally below inflation. TIPS are inflation protected securities which can be resold.
These are not the only government bonds. State and local governments, and foreign governments, also issue bonds. Municipal bonds are issued by state and local governments. The interest is usually tax exempt from federal income tax. But beware, some municipal bonds are taxable, and gains and losses on the sale of the bond may be taxable. Bonds issued in other currencies have an additional risk of the exchange rate changing. They can be a hedge against the dollar going down, but if the dollar goes up your investment will shrink in value.
Corporate bonds are bonds issued by corporations to raise money, instead of getting a bank loan. They generally pay the highest interest, but are the least secure. There are many different corporate bonds, rated from AAA to “junk bonds”. Moody’s Investors Service and Standard & Poor’s rate municipal and corporate bonds. There is no complete guarantee of safety even on AAA bonds. You can also invest in bond funds. The advantage is you are buying into a diversified pot of bonds, so you are safer from an issuer defaulting on the bond. And your money is more liquid. But you are buying an asset with a share price that varies and has no fixed interest payments and no maturity date when you will get your principal back.
Bonds often pay a fixed coupon, or periodic interest payment. Premium bonds are old bonds with a higher interest rate being resold on the secondary market at a higher price than face value. Buyers will pay a premium to get the larger coupon payment. Discounted bonds are old bonds with an interest rate lower than bonds currently offer being sold for a lower price. So if interest rates on bonds go up, you will not be able to resell a bond with today’s low rates for full price.
Surety bonds not really an investment, they are a form of insurance. They are often required as part of getting a professional license. A contractor can buy a surety bond which will pay if the work in not done. A bail bond is also a surety bond, insurance the person will return to court.