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Investing in Bonds
Generally, “savers” and “investors” Loaner assets are certificates of de-
have different objectives for their posit, U.S. Treasury Securities,
money. “Savers” plan to use their Municipal Bonds, Corporate
money in the next 3–5 years, while Bonds, Convertible Bonds, Zero-
“investors” won’t need their money Coupon Bonds, Bond Unit
for five years or longer. Many “sav- Investment Trusts, Bond Mutual
ers” want liquidity or quick access Funds, Mortgage-Backed Securi-
to their money without penalty. ties, Collateralized Mortgage Bond Terminology
Bonds provide a desirable saving or Obligations, Fixed Annuities, Pre-
Face value or par value is the
investment vehicle for many rea- ferred Stock, and Guaranteed
value of the bond (amount of prin-
sons. Bonds tend to be safer than Investment Contracts.1
cipal) printed on the certificate and
stocks because if you hold bonds received at maturity. If interest
until the maturity date, you don’t What is a Bond? rates change and you need to sell
risk the principal. Plus, bonds can Bond A before maturity, the value
A bond represents a loan obliga-
provide a regular, steady source of you receive may change. If interest
tion of the bond issuer
income (typically, interest pay- rates increase, Bond A may sell at a
(government, corporation, or indi-
ments are received every 6 discount or less than the face
vidual) to the bondholder or
months). For the long term, inves- value. In this case, investors can
investor. In essence, the investor
tors need to be willing to “tie up” buy Bond B paying higher rates so
loans funds to the bond issuer in
money when investing in bonds. they are not as interested in this
exchange for interest payments for
However, bonds tend to have a Bond A. If interest rates decrease,
a set period of time. At the end of
lower return than stocks over the Bond A may sell at a premium be-
this time the borrower (bond is-
long term. cause other investors would be
suer) pays the investor (bond
holder/loaner) back the money willing to pay more for the higher
Owner vs. Loaner loaned. A certificate of deposit is interest rate on Bond A. See the ex-
Investment securities usually in- an example of a bond. A consumer ample on page 5 of this fact sheet.
volve two types of securities—those goes to the bank and gives the Coupon Rate (also known as cou-
where the investor is an owner or bank money. In turn, the bank pon, coupon yield, stated
those where the investor is a loaner. pays the consumer interest for the interest rate) is the interest rate
Owner securities include stocks, use of that money for a specified
real estate, equity unit investment period. Then, the bank uses that
1
money to invest in other projects, Investing for Your Future, A Cooperative Ex-
trusts, equity mutual funds, col- tension System Basic Investing Home Study
lectibles, business ownership, and such as, small businesses or home Course, February 2000, Rutgers Cooperative
commodities. mortgages. Extension.
This fact sheet is intended for educational purposes only. Mention of a proprietary product, trademark or commercial
firm in text or figures does not constitute endorsement by Ohio State University Extension and does not imply approval
to the exclusion of other products or firms. For specific advice, consult your financial or legal advisor.
MM-05-2001—page 2
printed on the bond certificate pare taxable and tax-free yields for
when the bond is issued. It usually different marginal tax rates. Refer Savings bonds can be bought
is stated as an annual fixed rate to the following web site: with small dollar amounts
typically paid every six months to http://www.bondmarkets.com ($25) and new inflation-in-
the investor. for this type of chart. dexed bonds (I-bonds) help
Maturity date is the day when the protect against inflation.
face amount of the bond must be Different Types of Bonds
repaid and the debt retired. The The following bonds are listed in
coupon rate remains the same until order of risk. Those listed first have
the maturity date. Bond maturities authorities) sell bonds to raise
the least risk.
may run from a few months to 40 money for a variety of purposes.
years. U.S. Government Bonds After U.S. Treasuries, municipal
The United States Treasury sells bonds are considered the safest.
A call feature allows the issuing Depending on the reason for sell-
bonds to finance the federal gov-
agency to pay the investor the face ing bonds, there are different types
ernment. Because the U.S.
amount for the bond and buy back of municipal bonds. In order of
government has never failed to pay
the bond before maturity. This al- safety, these bonds are: general ob-
its debt, these bonds are consid-
lows the issuer to then reissue the ligation, revenue, equipment,
ered to be some of the safest you
bond at lower interest rates. In the debenture. Bonds for private pur-
can buy. Savings bonds can be
event a bond is called, investors poses (sports stadiums, airports,
bought with small dollar amounts
may then need to reinvest their hospitals, industrial parks) may not
($25) and new inflation-indexed
money at lower interest rates as be income tax-exempt.
bonds (I-bonds) help protect
well. This results in reinvestment
against inflation. Information about
rate risk. Corporate Bonds
these bonds can be found on the
Default is the failure of the issuer Corporations sell bonds to raise
following web site:
of the bond to make payment on money for major projects. Corpo-
http://www.savingsbonds.gov
the interest or money borrowed. rate bonds pay higher interest
or call 1-800-722-2678. Consum-
Thus, the investor can lose money. because corporations cannot tax to
ers can also purchase some U.S.
raise money. Corporate bonds have
Tax-equivalent yield—If you are bonds through brokers and banks
no income tax advantages, thus,
buying municipal bonds for the or directly through the Federal Re-
usually have higher yields;
state in which you live, the interest serve Banks. In Ohio, there is a
whereas, U.S. Treasuries are not
may be free of federal, state, and Federal Reserve Bank in Cleveland.
taxed by state and local govern-
local income taxes. (You still may ment. Some municipal bonds are
have to pay capital gain taxes if you Mortgage-Backed Securities
Government agencies also sell free from federal income tax and
sell the bonds at a premium.) may not be taxed by state and local
These income tax-exempt bonds bonds. Listed in order of safety,
Ginnie Mae, Freddie Macs, and governments.
are appropriate for investors with
marginal tax rates of 28% or Fannie Maes are federal govern-
Specialty Bonds
higher. There are charts that com- ment agency home mortgages,
Variable rate bonds, CMOs2, con-
which are lower risk but not as low
vertible bonds, and zero-coupon
risk as U.S. Treasuries. These
bonds are some examples of spe-
bonds have uncertain maturities
cialty bonds. Zero-coupon bonds
because people pay back mortgages
are bought at a discount. At matu-
before the end of the mortgage. All
rity the face value of a zero-coupon
have irregular monthly payments
bond is more than the issued pur-
that may include both interest and
chased price. However, there are
principal.
no interest payments made to the
Municipal Bonds
State and local governments and 2
CMOs are collateralized mortgage obligations
government-related agencies and will pay back interest and a portion of prin-
ciple. These are sometimes included in
(schools, water, bridge, highway retirement plan options.
MM-05-2001—page 3
Bond Risks have two bonds maturing in 30 Individual Bonds vs. Bond
5. The risks associated with years and Bond A pays 5% in inter- Mutual Funds
bonds are tied to several factors. est and Bond B pays 15% in Investors have the choice of buying
There are interest-rate risk, interest, Bond A’s price will change individual or bond mutual funds.
credit risk, callability risk, rein- more dramatically than Bond B’s There are advantages and disad-
vestment rate risk, and inflation price. The principal value will have vantages of each way of adding
risk. The safest bonds are short- wider swings in its price if sold be- bonds to your portfolio.
term (less than 5 years) Treasury fore the maturity date. Junk bonds
Bills followed by other short-term and zero-coupon bonds will expe- Individual Bonds
government bonds. The riskiest rience wider changes in prices. Many investors purchase U.S. Sav-
bonds are long-term bonds (12 These changes in a bond’s price ings Bonds. These are a very safe
years–40 years), junk bonds, and will be reflected on broker state- investment but sometimes they do
high yield, or high return bonds. ments, but are only realized if the not keep up with the cost of infla-
a. The longer the maturity of bond is sold. tion. When buying municipal or
bonds, the greater the interest c. Ratings on bonds also reflect corporate bonds, you need to pur-
(coupon) rate risk while shorter assumed risk. Credit rating sys- chase several different individual
term bonds have less risk but lower tems help consumers make more bonds to protect against business
returns. informed bond purchases from and financial risk. This requires a
firms, individuals, and state and lo- large sum of money for a beginning
—Short-term bonds mature in investor. If you hold bonds to ma-
5 years or less. cal governments. Higher rated
bonds carry less risk while lower turity, you won’t lose the principal
—Intermediate bonds mature rated bonds (e.g., junk bonds or of individual bonds. For the begin-
between 5 and 12 years. high yield/high return bonds) have ning investor, a bond mutual fund
—Long-term bonds have matu- more risk. During good economic or a balance mutual fund (which
rity dates of more than 12 times, junk bonds are safer than holds both stock and bonds) is a
years. during poor economic conditions. good place to start.
Moody’s Bond Ratings and Stan-
Investors need to consider their Bond Mutual Funds
dard & Poor’s Bond Ratings
time frame to choose bonds that fit Risk in bond funds is determined
include investment grade or safer
their needs. If an 80-year-old buys by the credit ratings of the bonds
bonds as anything rated triple-B or
a 30-year bond, she faces interest held, the duration of the bonds
above—(Aaa,AAA; Aa,AA; A,A;
rate risk. Within 30 years interest held (or the average maturity), and
Bbb,BBB) while those ratings below
rates could change dramatically. If the variability of interest rates. The
the triple-B—(Ba,BB; B,B;
the bond pays 6% interest, and in- longer the average maturity, the
Ccc,CCC; Cc,CC; C,C; D) carry
terest rates climb to 12%, chances more risky the fund is or the
higher risk of default. Junk bonds
are you could lose money to infla- higher the duration, then the
and high-yield securities are below
tion and could be making more riskier the fund. Advantages of
the triple-B ratings and have higher
money elsewhere over 30 years. buying bond mutual funds are that
risk.
b. Risk is also associated with they:
d. Bonds can be called. Bonds
the coupon or interest rate on the —can reinvest dividends which
may have call dates that protect the
bond. Bonds with lower interest can’t be done with individual
issuer from paying high interest
rates will experience more fluctua- bonds,
rates if they can refinance and pay
tions in bond prices than bonds
lower rates. If you hold a bond, it —can invest small sums of money
with higher interest rates. If you
can be called back by the company and make small, regular contri-
issuing it. The company will pay butions,
The riskiest bonds are long- you a predetermined amount to do —can withdraw portions of
term bonds (12 years–40 this. You run the risk of having to invested money if forced to sell
years), junk bonds, and high reinvest your money at lower inter- bonds before maturity,
yield, or high return bonds. est rates. This is a type of
reinvestment rate risk. —can help investors speculate on a
decline in interest rates, and
MM-05-2001—page 5
See how much you understand. Choose which bond to buy. It is now the year 2001.
Answers to questions:
1. Bond A will pay $77.50 yearly for every $1000 purchased. With a minimum investment of $5000 you would re-
ceive $387.50. If you purchased bonds worth $10,000 you would receive $775 divided into two semiannual
payments. For Bond B the interest would be $86.25 for every $1000 owned. For the minimum of $5000, an inves-
tor would receive $431.25 a year.
2. Bond A matures on April 15, 2024, while Bond B matures on August 1, 2020. Both are long-term bonds which are
considered more risky than short-term bonds (matures in 5 years or less).
3. Bond A indicates it is insured and Bond B does not indicate any insurance. This insurance means if the company
issuing Bond A goes bankrupt, you will receive your principal back from the insurer.
4. Bond B is selling at a premium of $16.25 over a face value of $1000. Bond A is selling at a discount of $2.50 under
a face value of $1000. The reason for this is the interest rate or coupons on Bonds A and B. B pays a higher interest
rate while A is paying a rate lower than market rates. These are not newly issued bonds which sell at the face value.
5. Yes, both bonds can be called. Bond B can be called in 2005 at face value or $1000 for each $1000 invested. Bond
A can be called in 2004 at more than face value $1037.51 for each $1000 owned.
6. Yield to Maturity (YTM) on Bond A is 7.773% or more than the 7.75% interest paid. The reason for this is you
bought the bond at a discount so you paid less than $1000 and the $2.50 increase in value of the bond is added to
the interest you have received since that time. That discount increases the yield you will receive.
7. When this bond is called you will receive the face value of $1000 yet you paid a premium of $1016.25 so you have
lost $16.25. That loss is added to the interest paid 8.625% and it lowers your return to 8.116%.
8. It depends on how much risk you are willing to assume. Bond A is the safer bond, is insured, is highly rated, but
has a lower interest rate. It is a long-term bond and it is callable within a few years. Bond B has a lower credit rat-
ing, is not insured, but has a higher interest payment. If interest rates rise, the face value of this bond will drop. If
interest rates drop, this bond will sell at an even higher premium. Conservative investors will probably like Bond A,
while aggressive investors thinking that rates will drop within the next 4 years might speculate on Bond B hoping to
sell at an even higher premium.