What Should I Know About the Bond Market?

A bond is simply an I.O.U. from an issuing agency that certifies you have lent them money.

All bonds pay interest in some form or another, in the vast majority of cases, at a fixed rate. Coupon bonds pay a fixed amount periodically based on the face value of the bond. Zero-coupon bonds pay face value at maturity but are sold at a discount, gradually rising in value as the redemption date approaches. "Original Issue Discount" (OID) bonds are a hybrid between the two. The value of zero-coupon bonds is subject to market fluctuation. Because these bonds do not pay interest until maturity, their prices tend to be more volatile than bonds, which pay interest regularly.

There are four broad sectors in the economy that issue bonds. You need to be aware of all of them, as the risk of each bond varies with the standing of the issuer.

The highest quality bonds available in the market are U.S. government securities. These are known as Treasuries. They are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest.

Treasury bills are the short-term debt obligations of the government. Their maturities range from three months to one year. They are sold at a discount with the face value paid at maturity.

Treasury notes and Treasury bonds are the long-term debt obligations of the government. All Treasuries are exempt from state and local taxes.

Certain federal agencies, particularly those concerned with housing, such as the Government National Mortgage Association (Ginnie Mae), issue bonds. They are guaranteed by the issuing government agency so that investors will receive timely payment of principal and interest payments even if homeowners do not make their mortgage payments on time.

Ginnie Maes, Fannie Maes, and Freddie Macs are the most commonly known and frequently traded of agency-issued debt securities. Their yields are often slightly higher than Treasuries, and they provide a good level of liquidity.

Municipal bonds are issued by local authorities to finance capital projects and other undertakings. They tend to be exempt from federal, state, and local taxes for purchasers residing in their states and cities of origin. They are particularly popular with investors looking to increase their tax-exempt incomes. They may be subject to federal, state, or local alternative minimum tax. If you sell a municipal bond at a profit, there are capital gains to consider.

There are two broad types of municipal bonds. General obligation bonds have the least risk, because the issuing authority has the power to levy taxes to support the debt. Revenue bonds rely on the revenues generated by the project to meet the debt obligations.

The extra safety-conscious investor may wish to purchase insured municipal bonds, which are guaranteed by an insurance company. This increased safety often comes at the expense of a lower coupon rate.

The final category consists of corporate bonds that tend to have a higher level of risk than government securities with similar maturities. They compensate for the risk by offering higher yields.

Before investing in a bond, it is imperative to consult a reputable bond rating service, such as Moody’s or Standard & Poor’s, which will help you determine the level of risk of default in the bond issue you are considering. The value of bonds will fluctuate with the changes in interest rates, and if sold prior to maturity may be worth more or less than their original cost.

As interest rates rise bond prices fall. The opposite is also true, and interest rates fall, bond prices will rise. Since the value of bonds will fluctuate with the changes in interest rates, if they are sold prior to maturity it may be worth more or less than its orginial cost.