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Economy 101: Bonds

Bonds are a common form of investment. They are issued by governments or corporations as a way to raise money. By purchasing a bond, you are essentially lending money to the government or corporation, and they in turn, pay you interest for the loan.

A bondís face value is the amount on which interest is calculated, which is repaid when the bond reaches full maturity Ė that is, when the end of the loan period (term) is reached. Bonds are typically assigned a fixed interest rate.

Bonds can, however, be resold before they mature. When this happens, they are usually sold at whatever the prevailing interest rate is at that time, minus a transaction fee. Itís typically best to sell bonds when market interest rates are lower than the fixed rate on your bonds. If market rates are higher, buyers will be more interested in new bonds with better interest rates than yours.

Bond rating agencies, such as Standard and Poorís, categorize and rate bonds according to their tax status, issuerís credit quality, maturity term, and other features. Like stocks, bonds can be packaged into mutual funds, which can reduce risk through diversification: So, if one corporation in the fund defaults on its bonds, only a portion of the investment is lost.

Bonds versus Stocks

Unlike stock shareholders (see Stocks), who own a portion of the company and may have voting rights, bondholders donít have ownership or voting rights; but they do have a greater financial claim should the issuer go bankrupt. For that reason, and because their values tend to fluctuate less, bonds are usually considered a safer investment than stocks. Typically, when stock values decline in a poor economy, bonds become a more attractive investment; conversely, when stocks do well, bonds tend to decline in value.

Common Bond Types

Discount bonds, such as Treasury Bills, are purchased at less than face value. Then, at maturity, the bondholder is paid the full face value. There are no incremental interest payments.

Coupon bonds, issued with interest payment coupons attached, pay interest at specified intervals (quarterly, yearly, etc.), as well as the face value at the maturity date.

U.S. Treasury bonds are often considered the safest form of investment. They include: savings bonds, Treasury Bills (T-Bills), Treasury Notes, Treasury Bonds and Treasury Inflation-Protected Securities (TIPS).

Municipal bonds are issued by state and local governments. Interest income is often exempt from federal income tax and income tax in the issuing state.

Corporate bonds are issued either through a representative bank or by the company directly. They are often considered riskier than government-issued bonds and therefore usually pay higher interest rates. High-yield (or ďjunkĒ) bonds are issued by companies at the highest risk of failure.

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