KENTUCKY CROSSWORDS

Consumer Investments

Bonds: A Brief Introduction

In the world of finance, a bond is a certificate that promises to pay back a loan of money at a predetermined rate of interest. In basic terms a bond is an IOU from the issuer, most commonly a government, municipality, or corporation. An investor in bonds is the lender and the bond issuer is a borrower. The investor can hold the bond and receive periodic interest payments, or sell the bond to a third party. The bond has a maturity date, which is the date when the original investment, the face value of the bond is to be returned to the bondholder.

Upon issue, bonds are sometimes sold directly to investors from the borrower, (i.e. corporation, government, or municipality), or offered to buyers through investment banks. Most bonds are negotiable financial instruments, meaning they can be bought and sold among investors in the markets.

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The interest that the bond issuer agrees to pay is known as the coupon rate, or simply "the coupon", from the outdated practice of attaching coupons to certificates that could be "clipped" and submitted to the issuer for interest payments. In the United States, the coupon rate, or interest rate is generally paid semiannually and expressed as a percentage of the face value. For example, a $10,000 bond with a 4% coupon rate would have a yield of $400, paid in two payments per year of $200 each.

Most bonds offer a fixed interest rate at the time of issuance and are thus affected by changing interest rates, inflation, and other factors in the economy. For example, a bond with a low coupon will become less valuable if interest rates rise enough so that an investor can profit more by investing in other securities or financial instruments. If we own a bond with a fixed interest rate of 4% and comparable bonds with a 5% yield become available on the market, the market value of our bond, that is what other investors would pay for it, will be reduced. On the other hand, if the interest rate falls to 3%, our bond with a 4% yield becomes more valuable on the secondary market. However, if we hold the bond until its maturity date, fluctuations in interest rates will not affect the overall investment.

The long-term value of bonds is also affected by the rate of inflation. Using the example above of the bond with a 4% coupon rate, let's suppose that the rate of inflation rises to 6% while we are holding the bond; the real rate of return would be a negative two percent (-2%) due to the decrease in the long-term purchasing power of our money.

There are also bonds available on the market that are called variable-rate, because the coupon they pay coincides with a benchmark interest rate, such as that earned on Treasury bonds. Thus, interest rates on these variable-rate bonds are adjusted to run concurrently with the benchmark rate.

All bonds do not pay interest. Zero coupon bonds are offered for sale at a substantial discount below face value because this type of bond pays no periodic interest. Instead, at the maturity date of the bond, the holder receives the full face value. In investor jargon, zero-coupon bonds are also referred to as discount bonds. US savings bonds are a commonly known example of a zero-coupon bond.

Callable and Puttable Bonds

Some bonds have what are known as call provisions written into the contract. If a bond is callable, the issuer has the right to buy the bond back a specified price after an allotted time. Many municipal bonds are callable, as are most corporate bonds; most Treasury bonds are non-callable. Investors may lose money if a bond is purchased for a price above its call price. Because callable bonds can limit the profit investors want to earn from a bond and are thus less preferred than non-callable ones, callable bonds generally high a higher yield. Educating ourselves thoroughly on what we are purchasing can help eliminate potential risk of loss from a callable bond. [See Corporate Bonds for reasons an issuer may want to call back a bond issue.]

The provisions of a puttable bond work just opposite from callable ones. Bondholders of puttables have the right to demand early repayment of the face value after a specified period of time, but are not required to do so; it's an arbitrary investment decision.

Disclaimer: Information on this Web site is intended for consumer informational purposes only.