A bond is essentially a loan that the bondholder, also known as the purchaser of the bond, gives to the issuer of the bond. Municipalities, Corporations, and governments issue bonds when they require capital for various things such as investments in highways, schools, clinics, and other similar projects.
Investors who purchase government bonds are lending money to the government. If a certain investor purchases a corporate bond, they are lending money to the corporation. Investors usually purchase bonds because the latter provides a fixed and predictable income stream. A bond pays periodic interest, also known as a coupon, very similar to a loan and repays the principal amount at a particular time, referred to as maturity.
Bond types
There are two main classes of bonds, corporate and government bonds. As the term suggests, that latter is safer as the governments rarely default.
Here are the types of bonds that both classes encompass:
- Corporate: debt securities that public and private corporations issue
- Municipal: debt securities that counties, states, cities, and other government entities issue.
Bonds are also classified based on the yield rate they offer. High yield bonds have a reduced credit rating that implies greater credit risk compared to investment-grade bonds and hence provides greater rates of interest in return for the greater element of risk.
However, bonds are still considered to be safer than shares as the holders can expect to receive a part of the issuer’s capital proportionate to the principal in case of default.
Key points
The following are the three main important features you must study when you consider a bond.
Maturity
Maturity is the date when the bond’s paramount or principal is paid to the investors, and the bond obligation of the organization comes to an end. Hence, it defines the bond’s lifetime. The maturity of a bond is the crucial point investors take into account when considering their investment horizon and goals.
Callability
An issuer can pay off some of the bonds prior to maturity. If there is a call provision in a bond, it might get paid off early, often at a little premium to par. An organization might decide to call its bonds if the interest rates enable them to borrow at a better rate. Since they provide better coupon rates, a callable bond appeals to investors as well.
Tax Status
While most of the corporate bonds are taxable investments, a few of the municipal and government bonds are exempt from taxes, meaning no taxation on capital and income gains. Tax-exempt bonds usually have reduced interest when compared to the bonds that are taxable. Investors should calculate the yield (tax-equivalent) in order to compare the return with those of taxable instruments.
