A bond is a debt investment. It represents a loan to the issuing organization. In exchange for the use of your money, the bond issuer agrees to return the face amount of the bond after a specified period of time plus interest, which may be paid periodically or upon maturity. The interest rate earned on bond investments is influenced by a number of factors including the type of issuer, the bond's credit rating, prevailing interest rates and maturity.
Type of Issuer
There are three primary types of organizations that issue bonds. U.S. government bonds are issued by agencies of the federal government. The interest on government bonds is taxable at the federal level, but is exempt from state income taxes. Municipal bonds are issued by governmental organizations at the state and local level. The interest on municipal bonds is typically exempt from taxation at the federal level. Corporate bonds are issued by non-governmental corporations. The interest on these bonds is fully taxable at the federal, state and local levels. Corporate bonds typically pay a higher rate of interest than comparable government or municipal bonds to offset the bondholder's tax liability.
U.S. government bonds are backed by the full faith and credit of the United States and are considered to be among the safest of all investments. Due to the safety of government bonds, they typically pay a lower interest rate than other comparable debt instruments. Municipal bonds and corporate bonds are rated by bond rating organizations such as Moody's or Standard and Poor's, based on their issuing organizations' ability to meet their debt obligations. Bonds that have a higher rating typically pay a lower interest rate than comparable bonds with a lower rating.
Prevailing Interest Rates
Bonds may be issued with a fixed or variable interest rate, based on the face value of the bond. Once a bond is issued, its market price will fluctuate in an inverse direction to prevailing interest rates. If prevailing rates increase, the market price of the bond must decrease to maintain a competitive interest payout. If prevailing rates decrease, the market value of the bond will increase.
A bond's interest rate is influence by its maturity, that is, the amount of time that the bond will continue to pay interest. Long-term bonds represent a greater risk to the investor than comparable short-term bonds, so the interest rate on these bonds tends to be higher than the interest rate on short-term bonds.
- The Securities Industry and Financial Markets Association: Understanding Interest-Rate Risk
- Securities and Exchange Commission: Bonds, Corporate
- Securities and Exchange Commission: Zero Coupon Bonds
- Securities and Exchange Commission: Savings Bonds
- The Securities Industry and Financial Markets Association: What Are Municipal Bonds?
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