A bond is an "IOU" for money loaned by an investor to the bond's
issuer. In return for the use of that money, the issuer agrees to
pay interest to the investor at a stated rate known as the "coupon
rate." At the end of an agreed-upon time period when the bond
"matures" the issuer repays the investor's principal.
Benefits and Risks of Bonds
Because bonds tend not to move in tandem with stock investments,
they help provide diversification in an investor's portfolio. They
also provide investors with a steady income stream, usually at a
higher rate than money market investments.1 Zero-coupon
bonds and Treasury bills are exceptions: The interest income is
deducted from their purchase price and the investor then receives
the full face value of the bond at maturity.
All bonds carry some degree of "credit risk," or the risk that
the bond issuer may default on one or more payments before the bond
reaches maturity. In the event of a default, you may lose some or
all of the income you were entitled to, and even some or all of
principal amount invested. To help measure credit risk, many bonds
are rated by independent entities such as Moody's and Standard
& Poor's (S&P). Ratings run from Aaa (Moody's) or AAA
(S&P) through D (for default), based on the rater's appraisal
of the issuer's creditworthiness. Aaa (Moody's) and AAA (S&P)
are the highest credit ratings. Ratings better than BBB (S&P)
and Baa (Moody's) are considered to be "investment grade."
Bonds that are rated below investment grade (that is, BB or
lower by S&P, Ba or lower by Moody's) are sometimes called
"junk" bonds.2 They may be appropriate for
investors who can withstand higher price volatility and default
risk while seeking increased investment cash flow potential.
Like stocks, all bonds can present the risk of price fluctuation
(or "market risk") to an investor who is unable to hold them until
the maturity date (when the original principal amount is repaid to
the bondholder). If an investor is forced to sell or liquidate a
bond before it matures, and the bond's price has fallen, he or she
will lose part of the principal investment as well as the future
An Inverse Relationship: Interest Rate Risk
Another risk common to all bonds is interest-rate risk. In
normal circumstances, when market interest rate levels rise,
existing bonds' market values usually drop (and vice versa),
although past performance does not assure future results. However,
interest rate risk's effect on market value may be a relatively
minor factor for income-oriented, buy-and-hold investment
strategies. That's because bondholders are generally entitled to
receive the full principal value of their bonds at maturity,
regardless of any short-term changes in market value that might
have been caused by fluctuations in market interest
Most Bonds Fall Into One of Four
- Government Agency
Types of Bonds
Bonds come in a variety of forms, each bringing different
benefits, risks, and tax considerations to an investor's portfolio.
Most bonds fall into four general categories: corporate,
government, government agency, and municipal.
- CORPORATE BONDS
Issued by corporations, these bonds may provide an investor with a
steady stream of income.
Risk Considerations: The primary risks
associated with corporate bonds are credit risk, interest rate
risk, and market risk. In addition, some corporate bonds can be
called for redemption by the issuer and have their principal repaid
prior to the maturity date. When bonds are called in a declining
interest environment, investors may not be able to obtain new bonds
that offer the same yield.
Tax Considerations: Interest earned on a
corporate bond is generally taxed as ordinary income at your
applicable federal and state income tax rates. If you sell or
redeem a bond for more than you paid, the difference would be taxed
as a capital gain.
- GOVERNMENT BONDS
Government bonds are issued by the U.S. Treasury and backed by the
full faith and credit of the U.S. government. They include
intermediate- and long-term Treasury bonds. Intermediate-term bonds
mature in three to 10 years, whereas long-term bonds generally
mature in 10 to 30 years.
Risk Considerations: Among the lowest risk of
all bond investments, these bonds have low credit risk because they
are backed by the full faith and credit of the U.S. government. A
government bond does present market risk if sold prior to maturity,
and also carries some inflation risk -- the risk that its
comparatively lower return will not keep pace with inflation.
Tax Considerations: Treasury bond interest is
fully taxable at the federal level but it is exempt from state and
local taxes. Gains on sale or redemption are also taxable.
- GOVERNMENT AGENCY BONDS
These bonds are indirect debt obligations of the U.S. government
issued by federal agencies and government-sponsored entities.
Examples of such organizations are the Federal National Mortgage
Association (FNMA or "Fannie Mae") and the Government National
Mortgage Association (GNMA or "Ginnie Mae").
Risk Considerations: Agency and entity bonds
are widely seen as having low credit risk due to their association
with government-chartered entities. But because these bonds
are not directly issued by the U.S. government, they are not
necessarily backed by its full faith and credit. In addition to the
risks inherent in government bonds, agency bonds run the risk of
going into default, although such an occurrence is generally
considered unlikely. Because of this added risk, however, these
bonds generally offer higher yields than government bonds.
Tax Considerations: These bonds are fully
taxable at the federal level and, in some cases, at the state and
local levels as well. Gains on sale or redemption are also
- MUNICIPAL BONDS
Municipal bonds, or "munis," are issued by a U.S. state, county,
city, town, village, or local authority to raise funds for general
use or particular public works projects.
Risk Considerations: Munis fall somewhere in
the middle of the credit risk spectrum. The risk of default can
vary depending on the creditworthiness of the issuer and the type
of debt obligation.
Tax Considerations: Perhaps the biggest
advantage of most munis is their ability to offer income potential
that may be income tax exempt. Gains on sale or redemption are
taxable. Income from some municipal bonds may be subject to the
alternative minimum tax.
Know the Risks Associated With
- Credit Risk -- The risk that a bond's issuer
will go into default before a bond reaches maturity.
- Market Risk -- The risk that a bond's value
will fluctuate with changing market conditions.
- Interest Rate Risk -- The risk that a bond's
price will fall with rising interest rates.
- Inflation Risk -- The risk that a bond's total
return will not outpace inflation.
Individual Bonds vs. Bond Mutual Funds
Individual bonds are typically issued with unit values ranging
from $1,000 to $100,000 apiece. As a result, many bond investors
find it impractical to assemble and manage a diversified bond
portfolio. One alternative to individual bond investment is bond
mutual funds. Using pooled investment resources, mutual fund
managers can create a diversified bond portfolio for investors.
Shares of these funds offer investors the opportunity to add a
fixed-income element to balance out a portfolio of other
Of course, diversification generally cannot assure a profit or
protect against a loss, and investments in mutual funds carry
specific costs such as management fees and operating expenses
(expressed as the annual expense ratio). Sometimes mutual funds
also incur sales commissions or redemption fees.
The wide variety of bonds may make them potentially suitable in
many investment scenarios. Discuss your goals with your financial
advisor, and together you can decide whether bond investing is
right for you.