by Michael Sanibel

Created on: October 05, 2008   Last Updated: October 11, 2008

Bonds: A Sound Investment?

A bond is a form of debt security where the issuer (borrower) has the obligation to pay the holder (lender) a specified principal and interest (coupon) at a future maturity date. Bonds are generally issued for the purpose of raising external sources of funding to finance long-term projects and investments. A bond is essentially a loan, but it can be bought, sold, and traded like most securities.

Stocks and bonds are both marketable securities, but stockholders have an equity ownership stake in the company. Bondholders are merely lenders of capital funds, and do not retain any ownership in the company in exchange for their loan. In addition, the ownership interest of a stockholder is indefinite, and only expires when the stock is sold. The vast majority of bonds have a defined term at which point the bond is redeemed.

A common perception is that bonds are a safer investment than stocks or mutual funds. As a general rule, bond values rise when stock markets fall, but they are more sensitive to interest rate changes. Therefore, some investors use them as a hedge against their exposure in riskier markets. Bonds typically experience less volatility than stocks, and interest generated by corporate bonds is usually higher than dividends paid by the same company to its stockholders.

All bonds are not savings bonds, although that is what many people think of when they consider buying bonds. The most common is the United States EE Savings bond which is bought at half of its face value, and is worth full face value when it matures. They have a fixed rate of return and if redeemed in the first 5 years, you'll forfeit the last three months' interest. There is no penalty if they are redeemed after five years.

A surety bond is one issued on behalf of a second party, guaranteeing that the second party will fulfill an obligation(s) to a third party. Should the obligations fail to be performed, the third party will recover its losses via the bond.

The selling price or market value of a premium bond exceeds its par value, or the face amount repaid to the investor when the bond matures. In the secondary market, this occurs when interest rates have fallen since the bond was issued, making the bond more valuable to other investors.

Corporate bonds are debt securities issued by public and private corporations. They are normally issued to raise money for business expansion purposes. They are essentially a loan to the company and do not entitle you to an ownership stake.

Municipal bonds (or "munis") are popular because the interest income is exempt from federal income tax, and in some cases, state and local income taxes as well. They are debt securities issued by local governments for important public projects such as schools and highways that directly benefit the people who buy them.

A treasury bond (T-Bond) is a marketable, U.S. government debt security with a fixed-interest rate and a maturity of more than ten years. Treasury bonds make interest payments semiannually and the income is only subject to federal income tax. They are issued with a minimum denomination of $1,000 and are initially sold through auction. The term "government bond" applies to any bond sold by the United States government.

Learn more about this author, Michael Sanibel.
Click here to send this author comments or questions.