Bonds are a type of debt instrument in which a creditor agrees to loan some money to a debtor for a period of time in exchange for interest and a return of principal. Corporations issue bonds to cover short-term expenses and fund expansions and mergers.
If a corporation goes bankrupt, claims of bondholders take precedence over stockholders as creditors have to be made whole before individuals with ownership stakes in the company can receive any money from the sale of its assets. Governments around the world issue bonds to pay for day-to-day administrative costs and to finance long-term projects such as the construction of roads.
Federal Government Bonds
The United States federal government issues a variety of different bonds some of which investors can buy on the secondary market. Short-term bonds known as Treasury bills mature in less than a year, Treasury notes mature after ten years and Treasury bonds last for 30 years.
The federal government also issues zero coupon bonds which are sold at a discount to the face value and do not pay interest but when the bonds mature the bondholder receives the full face value. The prices of federal bonds are set at auctions as are the rates paid and ultimately both are based upon supply and demand.
Municipal Bonds
State, city and other local governments in all 50 states issue two types of bonds: general obligation bonds and revenue bonds. General obligation bonds are backed by the full faith of the government that issued them.
Tax revenues are actually used to pay bondholders who own GO bonds and these bonds are usually sold to raise funds for schools, law enforcement and other basic services. Revenue bonds are sold to finance income generating municipal projects such as the building of toll roads. Bondholders finance the project and receive interest payments that are based on revenue generated by the completed project. Revenue bonds are not backed by taxes so if the project goes bankrupt the municipal government do not settle the debt with tax money.
In many instances interest payments from municipal bonds are tax free because the Internal Revenue Service does not assess ordinary income tax on these payments. People who buy bonds issued by governments based in the state where they are domiciled do not usually have to pay state taxes on the interest. However some bonds such as private activity bonds are not tax-exempt because even though municipalities issue the bonds, the proceeds pay for private projects such as low income housing.
Mortgage Backed Bonds
Most mortgages written in the United States are sold to government sponsored Freddie Mac and Fannie Mae. These companies package together mortgages and divide these bundles of mortgages into mortgage backed bonds. Investors who buy the bonds receive interest payments that are contingent on borrowers making timely payments on the underlying mortgages.
Mortgage backed bonds have various degrees of risk and bonds paying the highest interest rates are tied to sub-prime mortgages which have higher than average default rates.
Bonds Versus Certificate of Deposit Accounts
Certificate of Deposit accounts are another type of debt instrument that involve creditors lending money to banks or credit unions for a specified period of time in exchange for interest. CDs are federally insured up to $250,000 whereas bonds are not.
However if a bank fails, the Federal Deposit Insurance Corporation can sell its CD accounts to another bank which does not have to honor the interest rate that the failed bank agreed with the CD account holder. CDs are generally not marketable and account holders pay penalties to break terms early whereas most bonds can be sold on the secondary market.
References
- Bankrate: Investing in Bonds
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