Bonds are essentially IOUs that are issued by borrowers to raise money from investors willing to lend them money for a period of time. When you buy a bond, you're lending to the issuer in exchange for a promise of regular interest payments and the return of the bond's face value when it matures.
The amount the bond will be worth at maturity, typically $1,000 per bond. This is the amount that will be returned to the bondholder when the bond matures.
The annual interest rate paid on the bond, expressed as a percentage of the face value. For example, a $1,000 bond with a 5% coupon rate would pay $50 in interest each year.
The date when the bond expires and the issuer repays the face value to the bondholder. Bond maturities can range from a few months to 30 years or more.
The actual return an investor receives on a bond, which may differ from the coupon rate depending on whether the bond was purchased at a discount or premium to its face value.
Issued by national governments. In the U.S., these include Treasury Bills (maturities of 1 year or less), Treasury Notes (1-10 years), and Treasury Bonds (10-30 years). They're considered among the safest investments but typically offer lower yields.
Issued by states, cities, counties, and other government entities. Interest income is often exempt from federal income tax and sometimes from state and local taxes as well, making them attractive for tax-sensitive investors.
Issued by companies to raise capital. They typically offer higher yields than government bonds to compensate for higher default risk. Quality ranges from investment-grade (lower risk) to high-yield or "junk" bonds (higher risk).
Issued by government-sponsored enterprises (GSEs) or federal agencies. Examples include bonds from Fannie Mae, Freddie Mac, and the Federal Home Loan Bank.
Issued by foreign governments or corporations, these can provide geographic diversification but may carry additional risks including currency risk.
Bonds are rated by agencies like Standard & Poor's, Moody's, and Fitch to help investors assess credit risk. Ratings range from AAA (highest quality) to D (in default). Bonds rated BBB- or higher are considered "investment grade," while those below are called "high yield" or "junk bonds."
Bond prices and interest rates have an inverse relationship:
This happens because when new bonds are issued with higher interest rates, older bonds with lower rates become less attractive, causing their prices to fall. The opposite occurs when rates decline.
The risk that rising interest rates will cause a bond's price to fall. Longer-term bonds have greater interest rate risk than shorter-term bonds.
The risk that the issuer will fail to make interest or principal payments as scheduled. Higher credit risk typically leads to higher yields.
The risk that inflation will erode the real value of a bond's fixed interest payments and principal.
The risk that an investor may not be able to sell a bond quickly at a fair price.
The risk that an issuer will redeem a bond before maturity, typically when interest rates fall, potentially leaving the investor to reinvest at lower rates.
Bonds typically serve several functions in an investment portfolio: