Bonds, also referred to as debt instruments, fixed income securities, and credit securities, represent a type of IOU contract in which the terms, interest rate, and repayment date are all explicitly outlined in a legal document. When you purchase a bond at its initial offering, you are essentially lending money to the issuer, who commits to repay the principal amount at a predetermined time while also making regular interest payments.
In the United States, bonds are categorized into three main types. The first category includes the highest-rated and safest bonds, such as those issued by the Federal Government and its associated agencies, including treasury bills and treasury bonds. The second category comprises bonds issued by corporations, states, and municipalities that are considered safe; both of these categories are collectively known as investment-grade bonds. The third category includes riskier bonds issued by companies, states, and municipalities, which are often called junk bonds or below investment-grade bonds.
The value of bonds fluctuates inversely with interest rates: as interest rates decrease, bond prices increase, and when interest rates rise, bond prices fall. These fluctuations are less significant if you hold a bond until its maturity date, but if you sell a bond before it matures, the sale price will largely depend on the prevailing interest rates at the time.
Bonds are rated by credit rating agencies such as Standard & Poor’s, Moody’s, and Fitch Ratings, which assign simple grades (e.g., A+ or B) to indicate the creditworthiness of the bond issuer. During the recent financial crisis, these agencies were criticized for assigning overly high ratings to certain bonds, particularly those issued by banks, investment firms, and some insurance companies, given the risks those entities were taking.
Understanding the bond market involves grasping the concept of yield curves, which are graphical representations of a bond’s interest rate plotted against its maturity date. Being able to interpret these curves and compare the spreads between them can help you make informed decisions about different bond issues.
Additionally, some bonds, particularly those issued by states and municipalities, are tax-exempt. These municipal bonds, often referred to as “munis,” are used to raise funds for various public projects such as road construction, school development, dam building, and other infrastructure initiatives. The interest payments from these municipal bonds are exempt from Federal taxes, making them attractive to certain investors seeking tax-advantaged investments.
