What Should I Know About the Bond Market?
A bond is
simply an I.O.U. from an issuing agency that certifies you have lent them
money.
All bonds
pay interest in some form or another, in the vast majority of cases, at a fixed
rate. Coupon bonds pay a fixed amount periodically based on the face value of
the bond. Zero-coupon bonds pay face value at maturity but are sold at a
discount, gradually rising in value as the redemption date approaches. "Original
Issue Discount" (OID) bonds are a hybrid between the two. The value of
zero-coupon bonds is subject to market fluctuation. Because these bonds do not
pay interest until maturity, their prices tend to be more volatile than bonds,
which pay interest regularly.
There are
four broad sectors in the economy that issue bonds. You need to be aware of all
of them, as the risk of each bond varies with the standing of the issuer.
The highest
quality bonds available in the market are U.S. government securities. These are
known as Treasuries. They are backed by the full faith and credit of the U.S.
government as to the timely payment of principal and interest.
Treasury
bills are the short-term debt obligations of the government. Their maturities
range from three months to one year. They are sold at a discount with the face
value paid at maturity.
Treasury
notes and Treasury bonds are the long-term debt obligations of the government.
All Treasuries are exempt from state and local taxes.
Certain
federal agencies, particularly those concerned with housing, such as the
Government National Mortgage Association (Ginnie Mae), issue bonds. They are
guaranteed by the issuing government agency so that investors will receive
timely payment of principal and interest payments even if homeowners do not
make their mortgage payments on time.
Ginnie Maes,
Fannie Maes, and Freddie Macs are the most commonly known and frequently traded
of agency-issued debt securities. Their yields are often slightly higher than
Treasuries, and they provide a good level of liquidity.
Municipal
bonds are issued by local authorities to finance capital projects and other
undertakings. They tend to be exempt from federal, state, and local taxes for
purchasers residing in their states and cities of origin. They are particularly
popular with investors looking to increase their tax-exempt incomes. They may
be subject to federal, state, or local alternative minimum tax. If you sell a
municipal bond at a profit, there are capital gains to consider.
There are
two broad types of municipal bonds. General obligation bonds have the least
risk, because the issuing authority has the power to levy taxes to support the
debt. Revenue bonds rely on the revenues generated by the project to meet the
debt obligations.
The extra safety-conscious
investor may wish to purchase insured municipal bonds, which are guaranteed by
an insurance company. This increased safety often comes at the expense of a
lower coupon rate.
The final
category consists of corporate bonds that tend to have a higher level of risk
than government securities with similar maturities. They compensate for the
risk by offering higher yields.
Before
investing in a bond, it is imperative to consult a reputable bond rating
service, such as Moody’s or Standard & Poor’s, which will help you
determine the level of risk of default in the bond issue you are considering.
The value of bonds will fluctuate with the changes in interest rates, and if
sold prior to maturity may be worth more or less than their original cost.
© 2005 Emerald Publications
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