Corporations and governments are just like you and me -- every now and then, they need to borrow a little cash. By buying a bond, you spot them the money. And here's the good part: Unlike when you loan friends money, corporations and governments typically pay you back on time, with interest. For investors, the big appeal in buying bonds is predictability. They pay interest at a fixed rate for a fixed term and are generally considered a safer investment than stocks because those fixed payments limit the downside. But caveat emptor: if there's interest rate-uncertainty in the market, even bonds can get become a risky investment. Bond investing may seem complicated, but the basic idea isn't: You lend your money, you get fixed interest payments over the term of the loan, then you get your money back at the end. There are a great many types of bonds available to investors (the lenders in the equation): Treasury bonds, U.S. government debt securities; corporate bonds, debt securities issued by companies; municipal bonds, debt securities issued by local and state governments to fund municipal projects and such; convertible bonds, debt issued by companies that can be converted later into company stock; junk bonds, debt that offers higher interest rates because it is issued by companies that may default; and mortgage-backed securities, bonds backed by real-estate mortgage payments and guaranteed by agencies such as Fannie Mae ( FNM). The Investing Basics Getting Started With Bonds section has entries on all of these types of bonds; check them out for the specifics. But, in general, the various types of bonds work in the same manner. A company or government issues a bond with a fixed maturity date, which is when the bond comes due and the principal portion of the loan must be paid back in full. The term of the bond can be short term (less than a year), intermediate term (two to 10 years) or long term (more than 10 years). Typically, the longer the term, the higher the interest rate offered to investors. A bond's interest rate also varies depending on market conditions and the level of risk involved. Bonds are assigned bond ratings by agencies such as Standard & Poor's and Moody's Investors Service according to their risk levels.
A bond's principal amount is its face value -- usually $1000 or some multiple of $1000. Brand new bonds are sold at or near par, or 100 cents on the dollar of face value. Bonds pay lenders interest on the principal, usually twice a year; then, at the end of the term, investors get their principal back. The rate of the interest payments on the principal is known as the coupon. Since bonds make fixed payments, does that mean their value remains constant? No, for this reason: A bond's market value is also shaped by ever-changing economic conditions. A bond's interest rate doesn't change, but the rates being offered on new bonds do. So if an existing bond's interest rate is higher than the rates available on new bonds of comparable maturity and credit quality, investors will pay more to buy the bond. In this environment, you can sell a bond you bought at par at a premium. When the inverse occurs -- a bond's interest rate is lower than the rates on comparable brand-new bonds -- if you sell the bond the buyer will demand a discount. A bond's yield is its rate of return on a bond on an annualized basis. The price at which you buy a bond determines the yield you get. The less you pay, the higher the yield. The more you pay, the lower the yield.
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