Bonds are also known as debt instruments, fixed income securities, and credit securities. A bond is actually an IOU contract where the terms of the bond, interest rate, and date of repayment are all particularly defined in a legal document. If you buy a bond at original issue, then you are literally loaning the issuer money that will be repaid to you at a certain time, along with periodic interest payments.
Bonds are all classified under one of three categories in the United States. The first of these are the highest rated, safest category of Federal Government debt and its associated agencies. Treasury bills and treasury bonds fall under this first category. The second types of bonds are bonds deemed to be safe that are issued by companies, states, and cities. These first two categories of bonds are referred to as investment grade. The third category of bonds involves riskier types of bonds that are offered by companies, states, and cities. Such below investment grade bonds are commonly referred to as simply junk bonds.
Bonds’ values rise and fall in directly opposite correlation to the movement of interest rates. As interest rates fall, bonds rise. When interest rates are rising, bonds prices fall. These swings up and down in interest rates and bond prices are not important to you if you buy a bond and hold it until the pay back, or maturity, date. If you choose to sell a bond before maturity, the price that it realizes will be mostly dependent on what the interest rates prove to be like at the time.
Bonds’ investment statuses are rated by the credit rating agencies. These are Standard & Poor’s, Moody’s, and Fitch Ratings. All bond debt issues are awarded easy to understand grades, such as A+ or B. In the last few years of the financial crisis, these credit rating agencies were reprimanded for having awarded some companies bonds’ too high grades considering the risks that the companies undertook. This was especially the case with the bonds of banks, investment companies, and some insurance outfits.
Understanding the bond markets is a function of comprehending the yield curves. Yield curves turn out to be pictorial representations of a bond’s interest rate and the date that it reaches maturity, rendered on a graph. Learning to understand and read these curves, and to figure out the spread between such curves, will allow you to make educated comparisons between various issues of bonds.
Some bonds are tax free. These are those bonds that are offered by states and cities. Such municipal bonds, also known as munis, help to raise funds that are utilized to pay for roads, schools, dams, and various other projects. Interest payments made on these municipal bonds are not subject to Federal taxes. This makes them attractive to some investors.