What is a Bond?
A bond is a debt commodity that an entity will issue in order to raise capital for a company, government, school district, or even for the building and development of apartment complexes. A bond is unlike stocks, mutual funds, and other investment opportunities in that it does not operate as ownership, or a security interest, in an entity. The way a bond works is that an entity will issue a bond for a face amount for purchase by an investor. At that point the entity has an obligation to, over time, repay the debt with interest. In this scenario a bond holder is not an owner of the entity but is rather a creditor of the entity. The entity is the debtor and is obligated to repay the bond, or loan, within the prescribed period; much like when you take out a mortgage you are indebted to the bank, or lending institution, that you borrowed the funds from.
Bonds have their advantages and disadvantages for both the entity issuing the bond and for the investor. Advantages for the investor are that they are not required to sell you an interest in the company. Especially with start up companies the entity will want to retain control and keep as much of the ownership of the company as possible. This will be done by issuing bonds. By doing so the company will be able to get the capital it needs to operate and expand the company while, at the same time, retaining complete ownership of the company. The disadvantage to this is that the company will be required to pay back the bond at regular intervals, and with interest. Whereas the issuance of stock, and other forms of capital, do not require any further obligations in paying the stockholder, a bond issuer is required to maintain repayment plans and if a company loses money it is still obligated to repay the bond, with interest whereas the investor in stocks sinks or swims with the company.
Another advantage to bonds is that the investment is stable. An investor in a bond will be assured of a specific return, unless the company goes bankrupt. If you purchase a fixed bond for $100 with a fixed interest rate of %10 over 5 years you will be virtually guaranteed that you will receive $110 at the end of the 5 year period. This is a sound investment for those who wish to invest casually or in investments that will allow them stability and peace of mind. The downside is that bonds, in the most part, do not have a high rate of return. Because of the stability and low risk of bonds they do not carry with them a high rate of return. However, this depends on a number of factors including the length of the bonds maturity; whether the bond issuer is an established company, government entity, or if it is a start-up or troubled institution; and the extent of the current market. For example, if IBM decides to issue bonds to investors it will most likely have low rate of return due to the stability of the company, and the, almost, guaranteed return on investment. In contrast, a start-up company, or troubled institution, that issues bonds to investors in the troubled economic climate of 2011 will have to offer a high percentage of interest on their return in order to convince investors to take a chance on the bond.
When looking at bonds you will want to know the basics defining certain aspects of a bond:
FACE AMOUNT: The amount that the bond is worth on its face.
ISSUE PRICE: Is the amount of money that the debtor pays for the bond. The issue price is not necessarily the amount that the bond is equal to. Often bonds are sold at a discount where a debtor will buy a $100 bond for $75. Upon maturity the debtor will receive $100 plus interest.
MATURITY DATE: This is the amount of time it will take for the bond to mature to the face amount. Bonds that have a maturity date of less than one year are not necessarily bonds and are referred to as Money Market Securities
COUPON: This is the amount that the debtor will receive on a semi-annual or annual basis, depending on the bond, The Coupon signifies the payment of the creditor to the debtor in compliance with the bond agreement.
Yield to Maturity
yield to maturity, also known as redemption yield of a bond is the internal rate of a return that an investor will receive upon the maturity of a privately or government issued bond. A bond does not give the debtor any interest in the institution but obligates the creditor to pay the debtor interest, in the form of a coupon, until the bond reaches its maturity.
Yield to maturity is calculated by an A.P.R. (annual percentage rate) but the interest is actually dispersed in a semi-annual basis in which the debtor will receive a coupon, consisting of the percentage of the face amount plus interest. For example, if a 10 year bond is sold with a face amount of $100 at 10% Yield to Maturity that means that every 6 months the debtor will receive a coupon of $5.50 (The $100 face amount + $10 (the interest accumulated over the 10 year life of the bond) / 24 (the number of coupons that are distributed over the 10 year period).
Yield to maturity rates depend on a number of factors including the current market rates, the length of the term and the creditworthiness of the issuer. Typically the longer the bond maturity length the higher the yield to maturity will be. On the same note, the more stable the issuer the less the yield to maturity rate will be. United State Treasury Bonds are considered to be one of, if not the most, stable bond an investor can purchase. The return on your investment is practically guaranteed and for that reason the coupon amount and the yield to maturity will be lower.
Types of Bonds
There are many different types of bonds that an investor can purchase. When investing in bonds you will want to, not only look at your expected return and interest, but also the stability of the bond, and how long it will take for the bond to reach maturity.
Municipal bonds allow an investing in bonds in your community. Your local government, school district, or other entity in your local community may issue bonds for the use of infrastructure. By investing in bonds that involve your local community it allows the investor to make a sound investment while, at the same time, giving the investor a sense of contribution to his, or her, municipality. Investing in bonds with your municipality are, not only stable investments, but are also exempt from most, if not all, state taxes. The downside of municipal bonds is that investing in bonds in your locality are expensive. Most municipal bonds require a minimum investment of $10,000 to $100,000. Another disadvantage is that the amount of money that you are expected upon your maturity date does not factor in for inflation.
Corporate bonds are another form of investing in bonds that is very popular. Investing in corporate bonds is the riskiest form of investing in bonds, however they yield at maturity, can be much higher than that involved with municipal, state and federal bonds. The downside to corporate bonds is that their is higher risk involved. Because a corporate entity is more likely to dissolve than a municipality or other government entity the risk will be higher. The more prone to dissolution the company the higher the risk, yet in the positive, the yield will be greater.
The most stable form of bond is the United States Savings Bond. A United States Savings Bond is almost guaranteed and they come in many different forms. The two most prevalent are the EE savings bond and the I savings bond.
The EE savings bond is characterized by a stable, long term investment. WIth EE savings bond the federal government will require a long term investment of 20 years in order for the bond to reach its maturity level. There are two types of EE savings bonds: paper EE savings bonds and electronic EE savings bonds. The most important distinction between the two is their return on investment. With a paper EE savings bond the investor will get a yield on return of the value he invested upon the maturity of the bond. This means that if you invested $5,000 then in 20 years you will receive a payment of $5,000 plus the interest accumulated over that period of time. In contrast, an electronic EE savings bond will require you to pay half of the value of the savings bond and upon its maturity you will receive the face value; essentially allowing you to double your investment. You are not required to keep your investment for the 20 year period in either form of EE savings bonds but their is a penalty for early withdrawal. The disadvantages to EE savings bonds are the long maturity length, and the fact that an individual is allowed a maximum of $25,000 of investment per year. EE savings bonds are exempt from state and local taxes but they will be used to calculate federal tax income. In addition, EE savings bonds do not adjust for inflation.
The other type of United States Savings Bond that is very prevalent is the I bond. An I bond is a U.S. savings bond where the yield on maturity is calculated as the fixed rate of return plus inflation. The I bond is periodically adjusted to factor in for inflation and the yield at the end of the maturity will be in a way that you will not lose money based on the inflation rate. One of the disadvantages of an I bond is that it is considered a zero coupon bond. The interest that accumulates over the lifetime of the bond is automatically re-invested into the I bond.