Some bonds pay interest along the way, which you collect by clipping coupons off the bond then
presenting them to the organization that issued the bond, generally every 6 months. So if a bond
pays 6%, 3% of the face value is paid to the bond-holder twice a year.
Other bonds, known as "zero-coupon", pay all the interest at the date the bond becomes
due and payable (at maturity). An example of a zero-coupon bond would be a 20 year, $1,000 T-Bill
that you buy for $250 then collect $1,000 in 20 years.
Since a zero is sold at a lower price than the face value of $1,000 (called a discount to par
value), the interest that you earn is the difference between the discounted price and the face
value of $1,000. Even though you don't collect the interest each year, the hypothetical amount is
taxable in the current year.
A popular type of bond is issued by cities, counties, and agencies such as highway departments,
water districts, hospitals, and school districts. Called municipal bonds, or "munies",
they are exempt from federal taxes and also from local state taxes if the investor lives within the
state where the bond was issued.
Revenue bonds are issued for specific projects such as a bridge. The money to pay the bond holders
comes from the revenue generated by what is built with the money. Revenue bonds are generally
considered to be safe, but their projects can go bust and default (not pay) on their debt. An
example is the Washington Public Power Supply System, which in the 1980's defaulted on $2.5 billion
worth of revenue bonds.
U.S. government bonds, notes, and treasury bills, are generally all referred to as treasuries. They
pay a modest interest rate, but are attractive because, being backed by the U.S. government, they
are the safest investment that you can make.
T-Bonds and T-Bills with values up to $10,000 are sold at a discount paying their full face value
at maturity, which can be from 4 weeks to 25 years. U.S. treasury notes ($1,000 to $5,000
with maturities from 2 to 10 years) pay their interest by coupon.
Corporate bonds, with somewhat greater risk than those issued by government agencies, pay a higher
interest rate to investors to lure them away from the ultra-safe treasuries.
The market value of your bond is based upon the number of months left until it matures, the face
value of the bond, the bond's interest rate, current prevailing interest rates, and maybe most
importantly, the credit rating of the institution that issued the bond.
Since bonds have a fixed interest rate, the market value of an existing bond goes up when
current interest rates fall, and the demand for an existing bond, and so the market value, falls
when interest rates go up. This is because when interest rates go up, new bonds are paying a higher
rate. Why would someone want to pay full price for a bond paying 4% when they can buy a new bond
paying 6% unless you agree to sell the bond at a lower price?
You calculate your bond's yield (the percent you are earning) by dividing the annual interest that
you are earning by the price that you paid for the bond.
An investor does not have to wait the full term of the bond to sell it. Bonds are bought and sold
on the open market through your stock broker.
Junk bonds, we've all heard of them, are issued by companies that need money and can't qualify for
the needed loan from their bank or from business financing institutions. General Electric and
McDonald's issue high-grade AAA corporate bonds, but when you clip the coupons every six months for
4 or 5% annual interest, it just doesn't seem like much. You're loaning money to these big
companies for almost free.
With riskier low-grade bonds, you buy a zero-coupon at a very steep discount. Or you might buy a
$1,000 bond for only $660 and collect a $50 check every 6 months until the bond is due in 8 years,
yielding 18.6% to maturity.
An investor gambles with such bonds out of greed, taking the risk that the company may default and
then only pay part (or none) of the money back.
Buying and selling low-grade bonds doesn’t take place on an organized exchange, but by a handful of
dealers. Markups can be large, and bid prices can fall dramatically when you wish to sell.
Other Types of Investments Topics:
-
Interesting Ways to Invest in Real Estate
- Real Estate Investment Trusts (REIT)
- Bonds
- Bond Ratings
- Closed-end Bond Funds
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