What Is a Bond?

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental). A bond could be thought of as an I.O.U. between the lender and borrower that includes the details of the loan and its payments. Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations. Owners of bonds are debtholders, or creditors, of the issuer. Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually includes the terms for variable or fixed interest payments made by the borrower.

When you buy a bond, you are lending to the issuer, which may be a government, municipality, or corporation. In return, the issuer promises to pay you a specified rate of interest during the life of the bond and to repay the principal, also known as face value or par value of the bond, when it “matures,” or comes due after a set period of time.

What types of bonds are there?

There are three main types of bonds:

Corporate bonds are debt securities issued by private and public corporations.

Investment-grade.  These bonds have a higher credit rating, implying less credit risk, than high-yield corporate bonds.

High-yield.  These bonds have a lower credit rating, implying higher credit risk, than investment-grade bonds and, therefore, offer higher interest rates in return for the increased risk.

Municipal bonds, called “munis,” are debt securities issued by states, cities, counties and other government entities. Types of “munis” include:

• • General obligation bonds. These bonds are not secured by any assets; instead, they are backed by the “full faith and credit” of the issuer, which has the power to tax residents to pay bondholders.
  • Revenue bonds. Instead of taxes, these bonds are backed by revenues from a specific project or source, such as highway tolls or lease fees.  Some revenue bonds are “non-recourse,” meaning that if the revenue stream dries up, the bondholders do not have a claim on the underlying revenue source.
  • Conduit bonds. Governments sometimes issue municipal bonds on behalf of private entities such as non-profit colleges or hospitals. These “conduit” borrowers typically agree to repay the issuer, who pays the interest and principal on the bonds. If the conduit borrower fails to make a payment, the issuer usually is not required to pay the bondholders.

U.S. Treasuries are issued by the U.S. Department of the Treasury on behalf of the federal government. They carry the full faith and credit of the U.S. government, making them a safe and popular investment. Types of U.S. Treasury debt include:

• • Treasury Bills. Short-term securities maturing in a few days to 52 weeks
  • Notes. Longer-term securities maturing within ten years
  • Bonds. Long-term securities that typically mature in 30 years and pay interest every six months
  • TIPS. Treasury Inflation-Protected Securities are notes and bonds whose principal is adjusted based on changes in the Consumer Price Index. TIPS pay interest every six months and are issued with maturities of five, ten, and 30 years.