I.

Introduction

Bond (finance), interest-bearing certificate sold by corporations and governments to raise money for expansion or capital. An investor who purchases a bond is essentially loaning money to the bond's issuer in return for interest. The investor can hold the bond and collect interest payments or sell the bond to a third party.

II.

How Bonds Work

A bond's principal, or face value, represents the amount of the original loan that is to be repaid on the bond's maturity date. The interest that the issuer agrees to pay each year is known as the coupon, a term derived from the obsolete practice of attaching coupons that could be redeemed for interest payments to the bottom of the bond certificate. The interest rate, or coupon rate, multiplied by the principal of the bond provides the dollar amount of the coupon. For example, a bond with an 8 percent coupon rate and a principal of $1000 will pay annual interest of $80. In the United States the usual practice is for the issuer to pay the coupon in two semiannual installments.

III.

Kinds of Bonds

A number of different kinds of bonds offer variations on this basic formula. Some types of bonds provide alternative interest structures. A zero-coupon bond does not make periodic interest payments. The bondholder realizes interest by buying the bond substantially below its face value. A floating-rate bond has an interest rate that is changed periodically according to an established formula. There also may be provisions that allow either the issuer or the bondholder to alter a bond's maturity date. A callable bond entitles the issuer to pay off the principal prior to the stated maturity date. Similarly, the owner of a putable bond can force the issuer to pay off the principal before the maturity date. A convertible bond gives the bondholder the right to exchange the bond for shares of the issuer's common stock at a specified date.

IV.

Issuing Bonds

Bond issuers can sell bonds directly through an auction process or use investment banking services. The investment banker buys the bonds from the issuer and then sells them to the public.

Corporate bonds are issued by private utilities, transportation companies, industrial enterprises, or banks and finance companies. These corporate bonds can be divided into two additional categories: mortgage bonds, which are secured by the issuer's assets, and debentures, which are backed only by the issuer's credit. Most companies try to establish a financial structure based on a combination of stocks, representing distributed ownership, and bonds, representing debt obligations. A company that raises funds by issuing bonds is said to be leveraged. Because bondholders are paid at a set rate regardless of profits, this approach increases the potential for profit to stockholders but also increases the level of financial risk.

The U.S. government issues bonds through the Department of the Treasury. These bonds, known as government securities, are backed by the unlimited taxing power of the federal government. Federal agencies and government-sponsored enterprises also issue bonds of their own. Generally, all of these federal bonds are considered to be among the safest investments.

Municipal bonds are issued by state and local governments and other public entities, such as colleges and universities, hospitals, power authorities, resource recovery projects, toll roads, and gas and water utilities. Municipal bonds are often attractive to investors because the interest is exempt from federal income taxes and some local taxes. There are two types of municipal bonds: general obligation bonds and revenue bonds. Like a government security, a general obligation municipal bond is secured by the issuer's taxing power. Revenue bonds are used to finance a particular project or enterprise. Income generated by the project provides funds to pay interest to bondholders.

V.

Investing in Bonds

From an investor's perspective, stocks offer a higher potential return if profits rise, but bonds are generally a safer investment. Stock dividends are paid out of company profits, while bond interest payments are made even if the company is losing money. If a corporation goes bankrupt, bondholders must be paid before stockholders. Nonetheless, risks are associated with investing in bonds. Because most bonds offer a fixed rate of return, a bond with a low coupon rate will be less valuable if interest rates rise to the point that the investor's money could be more profitably invested elsewhere. If the inflation rate rises in relation to the coupon rate, the value of the investor's return will be reduced.

The value of bonds also will vary due to changes in the default risk, or credit rating, of bond issuers. If the issuer of the bond is unable to make timely principal and interest payments, the issuer is said to be in default. Bonds issued by the U.S. government and by most federally related institutions are considered free of default risk. For other issuers, the risk of default is gauged by credit ratings assigned by four nationally recognized rating companies: Moody's Investor's Service, Standard and Poor's Corporation, Duff & Phelps Credit Rating Company, and Fitch Investors Service. Bonds that these rating companies place in the highest categories are known as investment-grade bonds. Bonds that are not assigned an investment grade rating are called junk bonds. These bonds have a higher degree of credit risk but also offer a higher potential yield.