HE-626, Reprinted Sept 1998. Fred Waddell Extension Family Resource Management Specialist, Associate Professor, Human Development and Family Studies, Auburn University. Originally prepared by Josephine Turner, Certified Financial Planner, Extension Program Specialist, Professor, Human Development and Family Studies at Auburn University

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Basics of Bonds

Bonds offer investors a range of opportunities, from earning stable but low returns to earning large returns by speculating on interest rate movements. A bond can be described as a long-term debt instrument; that is, it is a contract or IOU between an issuer (the borrower) and a bondholder (the lender).You, as the bondholder, lend money to an issuer who agrees to pay interest at a fixed rate (the coupon rate) on a set schedule, usually semiannually. The issuer also agrees to repay the principal par value, or face value, at the bond's maturity date, which can vary. Bonds that come due in 10 years or less are frequently called notes.

Bonds, then, are fixed income securities because the interest payments and the par value are specified at the time the bond is issued and fixed for the life of the bond. If you hold the bond until it matures (and if the issuer does not default on the bond), you know the future stream of payments to be received.

Example: John bought a coupon bond with a par value of $1,000 and a 10 percent coupon rate. The dollar amount of interest paid to John per year would be $100 (10 percent of $1,000), with interest of $50 ($100 divided by 2) paid every 6 months.

Yield

All bonds operate on the same basic theory, but they are not all equal investments. Some are riskier than others and therefore offer higher interest. How can you decide which bonds are good investments for you?

First, you need to be able to figure how to measure the yield, or return, on a bond. There are several measures investors use to determine yield.

Current yield is the annual return that a bond pays its holder. It is calculated by dividing the stated (coupon) interest per year by the current market price. For example, if you buy a bond with a stated coupon rate of 8 percent and the par value of the bond is $1,000, you should expect to receive $80 per year from the bond. But if the price of the bond changes to $1,100, the current yield changes. The interest per year ($80) divided by the new price of the bond ($1,100) results in a current yield of 7.3 percent.

Current yield is a more accurate measure of the return on a bond than the coupon rate because it takes into account the market price. However, it does not consider the difference between the bond's purchase price and the amount the bond can be redeemed for at par value.

Yield to maturity is the rate of return on a bond that is most often quoted by investors. This figure is the promised rate of return you will receive from a bond purchased at the current market price and held to maturity. Another way to describe yield to maturity is that it is simply the compound rate of return you would have to earn on a comparable investment to equal the total return you would get on your bond if you held it to maturity. Yield to maturity includes not just the interest payments you will receive, but also the net rise or fall in the price of the bond as it moves toward its $1,000 maturity date.

The coupon interest is the amount of the interest paid periodically to the holder. The amortized discount is the amount by which a bond sells below its par or face value divided by the number of years until the bond matures. The amortized premium is the amount by which a bond sells above its par value divided by the number of years until the bond matures.

Example: You want to purchase a bond with a par value of $1,000, a 10 percent coupon rate (and therefore a dollar amount of $100 per year since 10 percent of $1,000 is $100), a term to maturity of 10 years, and a current market price of $1075. Since current market price is $1075, the premium is $75. This $75 must be amortized over 10 years (the term to maturity).

Yield to maturity is most accurately calculated with a computer or calculator. You can approximately calculate yield to maturity using this formula:

Approximate yield to maturity	=	coupon interest + amortized discount, or - amortized premium divided by current market price + par value divided by 2
For Example:
Approximate yield to maturity	=	$100 - ($75/10) divided by ($1,075 + $1,000)/2
	=	$ 92.75 divided by $1,037.50
	=	.0892 or 8.92 percent

Now you can see that even though the stated interest on the coupon is 10 percent, the return promised to you over the life of the bond if you hold it to maturity is 8.92 percent.

There is one more point about yield to maturity that you should know. This rate assumes that you will reinvest all coupons received from the bond at a rate equal to the calculated yield to maturity. For the bond we discussed above, you must understand that you will receive that 8.92 percent yield to maturity only if the interest you receive is reinvested at the 8.92 percent rate. If you spend the interest as you receive it or reinvest it at a rate different from the 8.92 percent, the actual return you receive will be different from the promised yield to maturity.

Risk

The second thing you need to consider in determining whether bonds are the right investment for you is risk. Bondholders are promised a stream of interest payments and a repayment of the par value, but there are several sources of risk that could jeopardize these promises. A major risk facing bond holders, for example, is changing interest rates. When the market interest rate rises, the price of the bond you hold will fall.

For example, suppose you buy a bond for $1,000 with a coupon rate of 10 percent and a maturity of 20 years. Then let's say you need to sell the bond 5 years after you buy it. Suppose that, unfortunately, the market interest rate on bonds like the one you hold has risen to 12 percent. You will probably not be able to sell your bond with its 10 percent coupon rate for $1,000, since investors on the market now can buy new bonds at $1,000 that have a coupon rate of 12 percent. As a result, the price of your 5-year-old bond will decline below $1,000 so that the purchaser would receive the equivalent of a 12 percent coupon rate.

When interest rates fall, the opposite trend occurs and bond prices rise. Again, however, ups and downs in the interest rate do not affect investors who hold their bonds until maturity.

Another risk that should be considered in buying bonds is the default risk--that is, the risk that the issuer will fail to pay the specified interest payments or the principal at the promised time. In order to help investors evaluate the risk of default, bonds are rated by two major rating agencies, Standard & Poor's and Moody's. Standard & Poor's rates bonds AAA through D, and Moody's rates them Aaa through D. As bonds go toward D in ratings, they carry higher risk. Usually, when the risk is higher, the price of the bond is lower.

Another risk bondholders face is maturity risk. This means that the longer the term to maturity on a bond, the more risk there is in the investment (other things being equal). Investing in a bond for 30 years is riskier than investing in a 5-year bond simply because it is so much more difficult to predict the investing environment in 30 years. Bond investors who invest in longer term bonds usually wish to receive an additional premium for lending long term than for short term.

Still another risk to be considered is the call risk of bonds. Keep in mind that issuers often have the option of redeeming or "calling" a bond before the maturity date, typically after the first 5 years a bond is outstanding. For example, when interest rates fall, bonds paying higher coupon rates are likely to be called. The call risk should be carefully evaluated when you purchase a bond, because the call feature is a disadvantage to the investor who must give up the higher-yielding bond. You could also lose money when a bond is called if you bought the bond at higher than par value and then were forced to have it paid off at par value.

Finally, you should consider the liquidity risk of trading your bond. Liquidity refers to how easily and quickly a security can be sold again without reducing the price too drastically. For example, Treasury securities are quite liquid; corporate bonds are often less liquid.

Many professional investors recommend diversity as a key to success in any kind of investment. Diversity means mixing up your investment portfolio instead of buying just one kind of issue or denomination. One way to achieve diversity, if you decide to invest in bonds, is to invest in bond mutual funds, particularly if you have a limited amount of money to invest.

A mutual fund is an investment company that continues to sell its shares to investors after the initial sale that starts the fund. Owners of mutual fund shares can sell them back to the company anytime they choose. The mutual fund pools money from many investors and often invests in many different types of securities, offering an instantly diversified portfolio to the investor. The fund is administered by professional money managers. Mutual funds are the most popular investment vehicle for most Americans because of the convenience and diversification advantages.

Types of Bonds

Whether you opt for a mutual fund or take a do-it-yourself approach to selecting bonds, you should understand the various kinds of bonds and decide which best suits your goals.

U.S. Government Bonds

The U.S. government, in order to finance its operations, issues many notes and bonds. One of the major advantages of investing in U.S. government bonds is their relative safety. Whether the investment is a United States Treasury note, Treasury bond, or savings bond, the bond is backed by the U.S. government. With some securities, you will not be given a certificate of ownership. Instead, the Treasury electronically keeps a record of ownership.

A Treasury bill (or "T-bill") is a short-term security issued by the U.S. Treasury in 3-month, 6-month, and 1-year maturities. A T-bill does not pay interest over the term of the security but is issued at a discount (i.e., at a price lower than its face value). The return on the investment is the difference between the purchase price and the face value of the security when it is redeemed at maturity.

T-bills are relatively safe places to "park" large sums of money for a short time. An advantage of T-bills is that they are backed by the federal government. Also, they pay market rates of interest and tie up your money for only a short time. Interest paid on T-bills is exempt from state and local income taxes, and T-bills are fairly liquid investments. A disadvantage of T-bills is that they can be purchased only in large denominations. In addition, they are the lowest-yielding marketable securities.

A Treasury note is an intermediate-term coupon security issued by the U.S. Treasury. This means it is usually issued for more than 2 years but less than 10 years. A coupon security is a security that pays a fixed rate of interest semi-annually for the life of the security. The interest rate is set at the time the security is issued and is never changed. When you buy a Treasury note (sometimes called a "T-note"), the Treasury promises to pay interest and to return the principal at a specified future time (the date of maturity).

There are many advantages of investing in a T-note. Treasury notes are backed by the federal government. They pay market rates of interest and provide a steady stream of income. T-notes with maturities of more than 4 years have a minimum purchase price of $1,000, which is a bonus for some small investors. Moreover, interest received on T-notes is exempt from state and local income taxes.

A disadvantage of T-notes is that when inflation is rising and interest rates generally increase, the value of a T-note usually deteriorates. In addition, the selling price of a T-note on the secondary market may be below its face value if interest rates go higher than the rate the T-note is paying. The secondary market is the market for securities that have already been issued.

A Treasury bond is a long-term coupon security issued by the U.S. Treasury. A security is considered long-term if it is issued for 10 years or more. Because they are long-term, T-bonds typically yield a slightly higher rate of interest than instruments of shorter periods. Like T-notes, T-bonds are backed by the federal government. They have a very small call risk since they may be called only after 25 years. They are available for a minimum purchase price of $1,000, and interest received on T-bonds is exempt from state and local taxes.

As with a T-note, one disadvantage of buying a T-bond is that the market price of such a bond will decrease if interest rates go higher than its coupon rate. As we said before, this would be a problem if you needed to cash in the T-bond before maturity. In addition, the yield from Treasury bonds (or any investment considered relatively "safe") is lower than investments with higher risk.

United States Savings Bonds are probably the best known of the debt instruments issued by the U.S. government. Savings bonds were considered a poor investment in the 1970s when interest rates were climbing. In 1982, however, the Treasury changed the method of computing interest so that savings bonds became more competitive in the market.

The new bonds were the Series EE bonds and the Series HH bonds. Series EE bonds are bought for one half of their face value, and the return on the investment is the difference between the purchase price and the value of the bond at maturity. Series HH bonds are coupon-type securities and can be bought only by trading in older savings bonds or eligible new EE bonds. Series HH bonds can be obtained at Federal Reserve Bank branches or from the Bureau of Public Debt (see the Conclusion of this publication for the address).

Two advantages of savings bonds are that they are backed by the federal government and that interest earned on them is exempt from state and local income taxes. Series EE bonds can be bought for small amounts of money, and they pay a variable rate of interest, which is advantageous if interest rates rise. They can be purchased over-the-counter or by mail from most banks and savings institutions. Also, U.S. savings bonds cannot be called in by the Treasury.

A disadvantage of savings bonds is that they cannot be sold, given away, or used as collateral. In addition, Series EE bonds cannot even be redeemed for the first 6 months after they were bought, and they earn no interest if they are cashed in during the same calendar year in which they were bought.

Corporate Bonds

Many large corporations use corporate bonds to finance their operations. Bonds issued by corporations are riskier than those issued by the federal government, but their yields can also be higher.

There are several types of corporate bonds. A debenture is an unsecured bond, although the holders usually have first call on the earnings or assets of the issuer. Mortgage bonds are bonds that are "secured" by a legal claim to specific assets of the issuer in case of liquidation. A convertible bond is a bond that can be converted into a specified number of shares of the common stock of the issuer. A low-grade corporate bond (rated BB or lower) is known as a high-yielding bond or junk bond. These bonds have a high risk of default, but they sell at substantially higher yields than higher-graded corporate bonds. These are more risky, but they can pay larger yields to the sophisticated investor who understands how to invest in them.

When you buy corporate bonds, you should be careful to look at their ratings in Standard & Poor's and Moody's. You should also carefully consider whether and when the bond is callable--that is, whether the issuer may require you to sell your bonds back before they mature.

Finally, the interest rate risk, which applies to all bonds, is also a risk with corporate bonds. You can lessen your exposure to the risk of rising interest rates with floating rate bonds, on which rates are regularly adjusted to prevailing interest rate levels, and put bonds, which can be sold or "put" back to the issuer at face value during certain periods before they mature.

Municipal Bonds

Municipal bonds are debt obligations of state and local governments and state and local authorities such as school districts and airports. The interest on municipal bonds is exempt from federal income tax; moreover, if you buy bonds issued by your home state, the interest is usually exempt from state and most local taxes as well.

Municipal bonds generally can be divided into three categories. General obligation bonds are backed by the taxing power of the state and local governments that issued them. They are intended to provide capital to the entity that issued them.

Revenue bonds are sold to finance particular projects such as airports or water treatment plants. These bonds are backed only by the income from the project they are sold to finance, and taxpayers are not obligated to bail out these projects. Therefore, revenue bonds carry higher risk.

Finally, private purpose bonds are bonds issued by taxing entities on behalf of other entities such as hospitals, colleges, private corporations, and local businesses. The benefiting organization is the primary guarantor of these bonds. The issuing state and local governments are not backing these bonds in the same way that they back their general obligation and revenue bonds.

The advantages of municipal bonds include the fact that most are exempt from taxes. You should be aware, however, that you could be subject to a minimum federal income tax on some municipal-bond income. Typically, municipal bonds pay higher after-tax returns than T-bonds of the same maturity. Also, because many municipal bonds are rated, you can get a good idea of the relative security of the bond as viewed by the investment community.

On the other hand, however, municipal bonds are only as safe as the issuer. Municipal bonds can be more difficult to sell than a Treasury security. Small investors can find themselves at a disadvantage because municipal bonds usually sell in large denominations, although you can buy municipal bonds through a mutual fund. Finally, municipal bonds can be purchased only through dealers or through a fund, and a fee will be charged in either case.

Zero Coupon Bonds

Zero coupon bonds are bonds that are issued with no coupons, or interest, to be paid over the life of the bond. Instead, the purchaser pays a deep discount from par value and receives par value at maturity. The difference in the par value and the purchase price generates a rate of return.

For zero coupon bonds, the Internal Revenue Service states that you owe income tax on the interest that has accrued each year, even though you do not actually receive the cash until maturity. However, you can defer this tax if you purchase zero coupons as part of an IRA or Keogh plan. (See Extension publication HE-628 in this series, "Individual Retirement Accounts and Other Retirement Savings Plans," for an explanation of IRAs, Keoghs, and other retirement plans.)

There are many types of zero coupon securities. Some may be created by investment banker dealers who take a regular coupon bond and separate it or "strip it" into the principal and a series of short-maturity zero coupons that sell separately. This technique is used frequently with Treasury bonds. For example, a 20-year Treasury bond would become stripped into forty separate securities or coupons that mature every 6 months plus one zero coupon, which is the principal. One type of Treasury zero coupon bond is marketed under the name of Treasury Investment Growth Receipt, or TIGR. Another is the Certificate of Accrual on Treasury Securities, or CATS.

People often use zero coupon securities to plan for a specific investment goal such as a child entering college. Zero coupons do pay a lower rate of interest than other Treasury securities with similar maturities, however; and they may be difficult to sell. Finally, zero coupon bonds are extremely volatile. Because these bonds have locked in a specific reinvestment rate, they rise more rapidly in value when interest rates fall. Conversely, if interest rates rise, zeros fall in value more dramatically than bonds paying interest currently. But, as is always the case with bonds, interest rate fluctuations have no effect if you hold the bond to maturity.

Mortgage-Backed Securities

There is a wide range of debt obligations of the federal government that are not direct obligations of the U.S. Treasury. These are issued by federal agencies and federal government-sponsored agencies. Federal agencies are legally part of the federal government. These are fully guaranteed by the federal government and include such agencies as Government National Mortgage Association (GNMA, called "Ginnie Mae"), Tennessee Valley Authority, the U.S. Postal Service, and others.

Federal government-sponsored agencies are quasi-private institutions that sell their securities in order to finance specific purposes. These securities are not guaranteed by the government in the same way, but they are considered relatively safe because historically the U.S. government has not allowed any agency or government-sponsored corporation to default on a loan. Examples of government-sponsored agencies include the Federal National Mortgage Association (FNMA or "Fannie Mae"), the Federal Home Loan Mortgage Corporation, the Federal Home Loan Banks, and the Farm Credit Banks.

There are several differences between agency securities and the Treasury securities discussed earlier. Agency securities may not be purchased directly from the issuer; they are sold only through securities dealers. Agency securities are not usually as widely traded as Treasury securities, so the "spread" or difference between the price the dealer bids for the security and the price the dealer will sell it for is much wider than the spreads on Treasury securities. As a result, agency securities may be more difficult to sell.

Perhaps the best known of these types of agencies is "Fannie Mae." This agency offers a variety of securities, including instruments known as mortgage-backed securities. These are basically an investment in pools or groups of home mortgages. Each month as the mortgagor makes a mortgage payment on his or her home, you, the investor, receive interest and principal on the original amount you invested. If the mortgagor repays the mortgage, the payment of that amount is accelerated to you. Another example of a mortgage-backed security is the Ginnie Mae pass-through certificate, which is called "a Ginnie Mae."

While the government does not insure that the market for mortgage-backed securities will not fluctuate, it does guarantee that if the mortgagor defaults, the government will bear the loss. However, you can still lose money on mortgage-backed securities if you must sell them when their value is lower than the price you paid. Mortgage-backed securities investors also run the risk of getting their money back before they want it. For example, if interest rates decline abruptly and homeowners decide to refinance their mortgages at lower rates, you as the mortgage holder must face the problem of reinvesting the money.

There are other disadvantages to purchasing agency securities such as mortgage-backed securities. Interest earned on Ginnie Mae pass-through certificates, for example, is not exempt from state and local income taxes. Often the minimum denomination for these securities is high for the individual investor unless you invest in a previously issued security with a shorter maturity.

Another way to invest a smaller amount is to invest in a mutual fund that invests in agency securities.You should realize that there are risks in this strategy also, since the U.S. government does not guarantee such a mutual fund. However, these types of investments are popular with investors because they usually pay slightly higher yields than Treasury securities of the same maturity. They can be sound investments if you take the time to understand the workings of this type of security.

Conclusion

Bonds are a major financial asset, and investors need to understand how they work and what advantages they can offer. Investors should gather as much information about bonds as possible. This publication has given an overview of some basic points about bonds, but it is not a "how-to" manual. Your investments are too important to take chances with. Seek professional assistance in buying and managing bonds. For more information about specific corporate issuers, consult Standard & Poor's and Moody's financial information services, as well as financial publications. For more information about Treasury notes, bonds, and U.S. savings bonds, write: The Bureau of Public Debt, Department F, 1300 C Street SW, Washington, D.C. 20239-0001

References

Breitbard, Stanley H., and Donna S. Carpenter. The Price Waterhouse Book of Personal Financial Planning. New York: Henry Holt and Company, 1988.

Jones, Charles P. Investments: Analysis and Management. New York: John Wiley & Sons, Inc., 1988.

Miller, Lyn Orr. Government Guaranteed Investments. Consumer Guide Magazine Investment Series, Publications International, Ltd., 1986.

Stokes, Barrie Balzli, J. D. Personal consultation.

For more information, contact your county Extension office. Look in your telephone directory under your county's name to find the number.