What Are Bonds?

A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are
lending money to a government, municipality, corporation, federal agency or other entity
known as an issuer.* In return for that money, the issuer provides you with a bond in
which it promises to pay a specified rate of interest during the life of the bond and to
repay the face value of the bond (the principal) when it matures, or comes due.

Bonds can be also called bills, notes, debt securities, or debt obligations. To simplify
matters, we will refer to all of these as "bonds."

Why Invest in Bonds?

Many personal financial advisors recommend that investors maintain a diversified

Key Bond Investment Considerations, part 1

Assessing Risk
All investments carry some degree of risk, which is linked to the return that investment
will provide. A good rule of thumb is the higher the risk, the higher the return.
Conversely, safer investments offer lower returns. There are a number of key variables
that comprise the risk profile of a bond: its price, interest rate, yield, maturity,
redemption features, default history, credit ratings and tax status. Together, these
factors help determine the value of your bond investment and whether it is an
appropriate investment for you.
Price
The price you pay for a bond is based on a whole host of variables, including interest
rates, supply and demand, liquidity, credit quality, maturity and tax status. Newly issued
bonds normally sell at or close to par (100 percent of the face, or principal, value).
Bonds traded in the secondary market, however, fluctuate in price in response to
 changing interest rates, credit quality, general economic conditions, and supply and
demand. When the price of a bond increases above its face value, it is said to be selling
at a premium. When a bond sells below face value, it is said to be selling at adiscount.
Interest Rate
Bonds pay interest that can be fixed, floating or payable at maturity. Most debt
securities carry an interest rate that stays fixed until maturity and is a percentage of the
face (principal) amount. Fixed rate bonds carry any interest rate that is established
when the bonds are issued (expressed as a percentage of the face amount) with
semiannual interest payments

Some issuers, however, prefer to issue floating rate bonds, the rate of which is reset
periodically in line with interest rates on Treasury bills, the London Interbank Offered
Rate (LIBOR), or some other benchmark interest-rate index.

The third type of bond does not make periodic interest payments. Instead, the investor
receives one payment at maturity that is equal to the purchase price (principal) plus the
total interest earned, compounded at the original interest rate. Known as zero coupon
bonds, they are sold at a substantial discount from their face amount. For example, a
bond with a face amount of $20,000 maturing in 20 years might be purchased for about
$5,050. At the end of the 20 years, the investor will receive $20,000. The difference
between $20,000 and $5,050 represents the interest, based on an annual interest rate
of seven percent, compounded semiannually, until the bond matures. Suchfuture
value calculations vary somewhat depending on the specific terms of the bond. Since all
theaccrued interest and principal are payable only at the bond's maturity, the prices of
this type of bond tend to fluctuate more than those of coupon bonds. If the bond is
taxable, the interest is taxed as it accrues, even though it is not paid to the investor
before maturity or redemption.

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Maturity
A bond’s maturity refers to the specific future date on which the investor’s principal will
be repaid. Generally, bond terms range from one year to 30 years. Term ranges are
often categorized as follows:
 Short-term:   maturities of up to 5 years
 Medium-term:   maturities of 5 - 12 years
 Long-term:   maturities greater than 12 years
Call Provision
Bonds may have a redemption – or call – provision that allows or requires the issuer to
redeem the bonds at a specified price and date before maturity. Since a call provision
offers protection to the issuer, callable bonds usually offer a higher annual return than
comparable non-callable bonds to compensate the investor for the risk that the investor
might have to reinvest the proceeds of a called bond at a lower interest rate.
Put Provision
A bond may have a put provision, which gives an investor the option to sell the bond to
an issuer at a specified price and date prior to maturity. Typically, investors exercise a
put provision when they need cash or when interest rates have risen so that they may
then reinvest the proceeds at a higher interest rate. Since a put provision offers
protection to the investor, bonds with such features usually offer a lower annual return
than comparable bonds without a put to compensate the issuer.
Conversion
Some corporate bonds, known as convertible bonds, contain an option to convert the
bond into common sotck instead of receiving a cash payment.
Principal Payments and Average Life
Certain bonds are priced and traded on the basis of their average life rather than their
stated maturity.
Yield
A bond's yield is the return earned on the bond, based on the price paid and the interest
payment received. Usually, yield is quoted in basis points, or bps. There are two types
of bond yields: current yield and yield to maturity (or yield to call).

Current yield is the annual return on the dollar amount paid for the bond and is derived
by dividing the bond’s interest payment by its purchase price. If you bought a $1,000
bond at par and the annual interest payment is $80, the current yield is 800 bps or 8%
($80  /  $1,000). If you bought the same bond for $900 and the annual
interest payment is $80, the current yield is 889 bps or 8.89% ($80  /  $900). Current
yield does not take into account the fact that, if you held the bond to maturity, you would
receive $1,000 even though you only paid $900.
Yield to maturity is the total return you will receive by holding the bond until it matures.
This figure is common to all bonds and enables you to compare bonds with different
maturities and coupons.
The Link Between Price and Yield
From the time a bond is originally issued until the day it matures or is called, its price in
the marketplace will fluctuate depending on the particular terms of that bond as well
as general market conditions, including prevailing interest rates, the bond's credit and
other factors. Because of these fluctuations, the value of a bonds will likely be higher or
lower than its original face value if you sell it before it matures. In general, when interest
rates fall, prices of outstanding bonds with higher rates rise. The inverse also holds true:
when interest rates rise, prices of outstanding bonds with lower rates fall to bring the
yield of those bonds into line with higher-interest bearing new issues. Take, for
example, a $1,000 bond issued at eight percent. If during the term of that bond interest
rates rise to nine percent, it is expected that the price of the bond will fall to about $888,
so that its yeild to maturity will be in line with the market yield of nine percent ($80 /
$888 = 9.00%)
The Link Between Interest Rates and Maturity
Changes in interest rates do not affect all bonds equally. Generally, the longer a bond's
term, the more its price may be affected by interest rate fluctuations. Investors,
generally, will expect to be compensated for taking that extra risk.
Money Market Funds
Money market funds refer to pooled investments in short-term, highly liquid securities.
These securities include municipal bonds, certificates of deposit issued by major
commercial banks, and commercial paper issued by corporations. Generally, these
funds consist of securities and other instruments having maturities of three months or
less. Money market funds may offer convenient liquidity, since most allow investors to
withdraw their money at any time.
Bond Unit Investment Trusts
Bond unit investment trusts offer a fixed portfolio of investments in government,
municipal, mortgage-backed or corporate bonds, which are professionally selected and
remain constant throughout the life of the trust. One of the benefits of a unit trust is that
you know exactly how much you will earn while you are invested because the
composition of the portfolio remains stable.