Bonds are loans that investors make to corporations and governments. The borrowers get the cash they need while the lenders earn interest. Every bond has a fixed maturity date when the bond expires and the loan must be paid back in full, at par value. The interest a bond pays is also set when the bond is issued. The rate is competitive, which means the bond pays interest comparable to what investors can earn elsewhere. As a result, the rate on a new bond is similar to current interest rates, including mortgage rates. Municipal bond rates are an exception because their yields are free from federal taxes. Income from municipal bonds may be subject to state and local taxes and may be subject to the Federal Alternative Minimum Tax. Ordinary income and capital gains if any, will be subject to applicable state and local taxes.
The three different kinds of bonds are Corporate Bonds, U.S. Treasury Bonds, and Municipal Bonds.
Corporate Bonds are used 1) to raise capital to pay for expansion, or modernizations; 2) to cover operating expenses; and 3) to finance corporate take-overs or other changes in management structure.
U.S. Treasury Bonds are marketable, fixed-interest U.S. government debt securities with a maturity of more than 10 years.
Municipal Bonds are used 1) to pay for a wide variety of public projects such as schools, highways, stadiums, sewage systems and bridges; and 2) to supplement their operating budgets. States, cities, counties and towns issue bonds.
Investors can buy bonds issued by U.S. companies, by the U.S. Treasury, by various cities and states and various federal, state and local government agencies. Many overseas companies and governments also sell bonds to U.S. investors. When those bonds are sold in dollars rather than the currency of the issuing country, they are sometimes known as “yankee bonds.” The advantage for individual investors is that they don’t have to worry about currency fluctuations in figuring the bond’s worth.
The life or term of the bond is fixed at time of issue. It can range from short-term (usually less than one year), to intermediate term (two to ten years), to long-term (ten to thirty years). Generally speaking, the longer the term the higher the interest rate that’s offered to make up for the additional risk of tying up money for such a long period of time. A graph showing the interest rates paid on short-term and long-term bonds is called the yield curve.