What are Bonds? Definition & Types

These four bond types also feature differing tax treatments, which is a key consideration for bond investors. Bonds have historically been more conservative and less volatile than stocks, but there are still risks. For instance, there is a credit risk that the bond issuer will default. There is also interest rate risk, where bond prices can fall if interest rates increase. If a bond has a call provision, it may be paid off at earlier dates, at the option of the company, usually at a slight premium to par. A company may choose to call its bonds if interest rates allow them to borrow at a better rate.

These regular payments are also known as the bond’s interest rate or “coupon rate”. When the bond matures, the bond’s face value is paid back to you, the investor. Companies can issue corporate bonds when they need to raise money. For example, if a company wants to build a new plant, it may issue bonds and pay investors a stated interest rate until the bond matures.

Current Yield

Because the investor is closer to obtaining the face value as the maturity date nears, the bond’s price moves toward par as it ages. Treasurys offer a lower rate because there’s less risk the federal government will go bust. A sketchy company, on the other hand, might offer a higher rate on bonds meaning in finance bonds it issues because of the increased risk that the firm could fail before paying off the debt.

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This means they are unlikely to default and tend to remain stable investments. Corporate bonds are issued by companies looking to raise capital, such as to build out new facilities. Issuing these bonds often allows companies to obtain financing at a lower interest rate than if they took private loans, such as from banks. The risk and return levels for investors vary significantly based on the company’s creditworthiness. Maturities, also called durations, often correlate with an investor’s risk/return appetite.

1. But some have floating rates as well, though they involve higher risk.
2. As such, this yield is most useful for investors concerned with current income only.
3. Agency bonds are issued by departments within the federal government or government-affiliated organizations, like Freddie Mac.
4. The funds so accumulated by the issuer can be used to pay off debts, initiate new projects, or meet other financial requirements.
5. That said, buy-and-hold bond investors don’t necessarily need to worry as much about interest rate risk.
6. This can help confirm that your bond choices align with your financial goals and risk tolerance.

Other key bond terms

Bonds come in many forms, each with unique characteristics and advantages. With so many choices available, it’s essential to understand the sometimes subtle but important differences among the most common types. Net Asset Value (NAV) returns are based on the prior-day closing NAV value at 4 p.m. NAV returns assume the reinvestment of all dividend and capital gain distributions at NAV when paid.

However, they may carry a call risk, meaning the issuer can repay the bond before its maturity date. YTM is the internal rate of return of an investment in a bond if the investor holds the bond until maturity and if all payments are made as scheduled. YTM evaluates the attractiveness of one bond relative to other bonds of different coupons and maturity in the market. When buying new issues and secondary market bonds, investors may have more limited options. And understanding bond prices can be tricky for novice investors. You invest in bonds by buying new issues, purchasing bonds on the secondary market, or by buying bond mutual funds or exchange traded funds (ETFs).

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Callable bonds also appeal to investors, as they offer better coupon rates. Municipal bonds, or munis, are bonds issued by local governments. Contrary to what the name suggests, this can refer to state and county debt, not just municipal debt. Municipal bond income is not subject to most taxes, making them an attractive investment for investors in higher tax brackets. Importantly, bonds are an essential component of an investment portfolio’s asset allocation, helping absorb some of the uncertainty and volatility of equity markets.

Further, bondholders have a stake in a business as they are entitled to the interest and repayment of principal on maturity. This privilege makes them more secure than stocks as an investment. However, unlike equity holders, they are not owners and have no claim in the company’s profits.

Higher-rated bonds, also known as investment-grade bonds, generally hold a rating of  « Baa » or « BBB » or above, based on the rating agency. This means the bond is viewed as less risky because the issuer is more likely to pay off the debt. Most bonds pay regular interest payments, known as coupon payments. The amount paid is based on the face value of the bonds — i.e., the amount invested — multiplied by the interest rate, i.e., coupon rate. For example, a $1,000 bond with a 5% coupon rate pays $50 per year.

Banks and other lending institutions pool mortgages and « securitize » them so investors can buy bonds that are backed by income from people repaying their mortgages. Examples of MBS issuers include Ginnie Mae, Fannie Mae, and Freddie Mac. Mortgage-backed bonds have a yield that typically exceeds high-grade corporate bonds.

They can be a solid asset to own for individuals who like the idea of receiving regular, fixed-income because bonds pay interest at predictable rates and intervals. Certain kinds of bonds, such as municipal bonds, also offer tax breaks. Municipal bonds, also called munis, are issued by states, cities, counties and other non-federal government entities. Similar to how corporate bonds fund company projects or ventures, municipal bonds fund state or city projects, like building schools or highways. High-yield means they have a lower credit rating and offer higher interest rates in exchange for a higher risk of default. Investment-grade means they have a higher credit rating and pay lower interest rates due to a lower risk of default.