what are bonds

What Are Bonds

Whar Are Bonds?

Bond is a type of loans that is designed to help governments or corporations raise money through the use of investors.

These certificates are generally used to allow these entities to borrow more money than is possible through other channels, such as through a bank.
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Role of Lender

Investors choose to purchase bonds, which state that the borrower has the obligation to pay back the Investor the original amount at a specific time and pay an annual interest (usually twice in a year).

A bond does not provide ownership in the entity that is borrowing the money, but instead places the investor in a creditor role. Therefore, buying a bond means lending money for a set period of time for a fixed annual interest rate.

Types of Bonds

There are different types of bonds available, including:

  • Corporate
  • Municipal
  • Government

Investors choose to purchase bonds, which state that the borrower has the obligation to pay back the Investor the original amount at a specific time and pay an annual interest (usually twice in a year).

A bond does not provide ownership in the entity that is borrowing the money, but instead places the investor in a creditor role.

Therefore, buying a bond means lending money for a set period of time for a fixed annual interest rate.

The face amount, or “”Par Value”, of each bond is always $1,000 unless otherwise specified.

Corporate Bonds

Corporate bonds are issued by companies and generally have higher yields due to the increased risk of default. As with most types of loans, corporate bonds are available as either secured or unsecured.

A Secured Bond is backed by the issuer’s assets, and is either Mortgage Bond, Equipment Trust Certificate or Collateral Trust Bond.

With each of these types of corporate bonds, if the borrower fails to repay the interest or is unable to return the principal before the end of the borrowing period, the backing assets are sold to repay the lenders that hold the bond.

The financial stability, reputation and overall good standing of the corporation back Unsecured Bond. This bond, which is known as Debenture, is essentially written promises that the company will pay both the interest and the principal by a specified time.

Despite Debentures are unsecured, there are issuers whose credit standing is so excellent, that their Debentures are safer than secured bonds of less creditworthy corporations.

Income generated by corporate bonds is taxed as an ordinary income.

Municipal Bonds

Municipal bonds are issued by counties, school boards, cities, states or other local governments.

These types of bonds are available as either General Obligation or Revenue Bonds and have records of a safety of principal that are nearly as great as those issued by the federal government.

  • GeneralObligationBondis backed by the issuer’s credit and good faith. Many of these bonds are secured by the potentially unlimited property taxes owed by the company, which means if the taxes aren’t paid, investors can recoup their investments through tax sales.
  • RevenueBondis commonly issued by entities that generate revenue, such as gas, sewer or electric utilities companies, airports, toll roads and bridges and other types of facilities that generate income. This income may be in the form of fees charged for services or through lease rentals. Revenue Bond often provides a higher yield than General Obligation Bond.

Municipal bonds are tax exempt from federal taxes and many states and local taxes. Municipal bond rates are lower than taxable corporate bonds.

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Government Bonds

Government Bonds are securities issued by federal governments and are safest than Municipal and Corporate bonds issued by issuers of that country.

There are four major types of Government Bonds issued by U.S. Treasury Department:

  • TreasuryBills are issued each week with maturities of 4 weeks, 13 weeks, 26 weeks, and 52 weeks. Treasury Bills pay no interest; they are issued at a discount from their “Par Value” and paid at maturity at “Par Value”. The difference between issued price and “Par Value” is considered an interest paid by these securities.
  • Treasury Notes pay semiannual interest as a percentage of stated “Par Value” (usually $1,000), mature at “Par Value” and are issued by intermediate maturities (2, 3, 5, 7 and 10 years).
  • Treasury Bonds pay semiannual interest as a percentage of stated “Par Value” (usually $1,000), mature at “Par Value” and are issued by long-term maturities (10-30 years).
  • TreasuryInflation Protection Securities (TIPS) are issued with a fixed interest rate, but the principal amount is adjusted semiannually by an amount equal to the change in the Consumer Price Index (CPI). The interest payment the investors receive every six months is equal to the fixed interest amount times the newly adjusted principal. TIPS are issued with maturities of 5, 10 and 30 years.

All Government Bonds are exempt from state and local income taxes ones the interest income generated but are subject to federal taxation.

Federal Agency Securities

Federal Agency Securities are issued by U.S. Government Agencies that have been authorized by Congress to issues debt securities to help meet financial needs.

There are the following major U.S. federal agencies:

  • Federal Home Loan Banks (FHLB)
  • Federal National Mortgage Association (Fannie Mae)
  • Government National Mortgage Association (Ginnie Mae)
  • Federal Land Bank (FLB)
  • Federal Intermediate Credit Bank (FICB)
  • Federal Farm Credit Banks Funding Corporation (FFCBFC)

Fannie Mae and Ginnie Mae is subject to federal, state and local taxation. However, interest received by the investor on securities issued by all of other mentioned above U.S. Federal Agencies is exempt from state and local income taxes but not federal income tax.

Credit Ratings

The credit rating of the corporation or government entity issuing the bond is an important consideration for potential investors as it provides insight into the ability to repay the debt.

These ratings fall into categories, which are Investment Grade or High-Yield. Popular bond rating firms like Standard & Poor’s use A and B letter designations to provide credit quality ratings for bonds.

High credit ratings are listed as AAA or AA, investment grade, average credit ratings are given A or BBB ratings, and low credit quality, high-yield bonds are rated using BB, B, CCC and consecutive labels to make the ratings easier to understand.
Bond Investing