Everything you ever wanted to know about bonds
What is a bond?
When investing, you can lend your money, or own something, such as real estate. A bond represents a loan from you to the issuer. A variety of entities issue bonds to raise money. These entities include private corporations, school districts, hospitals, utilities, cities, and even the federal government. Investors purchase these bonds for a set amount of money (called principal), and the issuer promises to return that amount of money at a specified time in the future. In addition, for the use of this money, the issuer promises to pay the investor a set amount of interest over the life of the bond. Bonds do not represent ownership, but they do provide a fixed amount of income and return of the investor's principal if held to maturity.
How do bonds work?
When you invest in a bond, you loan the bond issuer a set amount of money, the principal, for a set amount of time. The issuer promises to repay your principal at the end of that time, which is called the maturity date, and to pay you a certain interest rate at regular intervals, usually twice each year. Typically, bonds with longer maturities pay higher interest rates.
Most bonds are rated according to their quality. This rating indicates the issuer's ability to keep its promise regarding timely interest payments and to return principal when due. All bonds are not equally safe, so it is important to check a bond's rating before investing.
Once you invest in a bond, you can sell it to another investor before it matures. The price you receive will depend on what interest rates have done since you bought the bond. If interest rates have risen and investors can buy new bonds paying higher interest rates than your bond is paying, you will receive less than you paid for the bond. On the other hand, if interest rates have declined and bonds are paying less interest than your bond, other investors will pay more for your higher-paying bond.
However, none of this matters if bonds are used as they are intended. Bonds are designed to provide long-term regular income to investors. Fluctuations in a bond's market value should not be of concern to investors who plan to hold their bonds to maturity.
What is a municipal bond?
Municipal bonds (commonly called muni's or tax-free bonds) finance public projects, such as buildings or improving schools and hospitals and updating sewer and water systems. Cities, counties, states, and special districts like schools or water and sewer districts issue municipal bonds.
At first glance, municipal bonds appear to pay less interest than taxable bonds or CDs. However, all municipal bonds are free from federal taxes, and some are free from state and local taxes as well. As a result, municipal bonds can actually offer higher after-tax returns. For instance, if you are in the 28 percent tax bracket, a taxable bond must earn 6.25 percent to equal the after-tax return of a tax-free bond earning 4.5 percent.
Different bonds offer different levels of investment risk. To help you evaluate the quality of a bond, bonds are rated. In addition, nearly one-third of municipal bonds issued today are insured to guarantee timely payment of interest and principal.
As with taxable bonds, municipal bonds can be sold prior to maturity; however, if interests have risen, you may receive less than you originally paid. If you hold the bond to maturity, you will receive exactly what you were originally promised.
Jason Haney is a local
investment representative with Edward Jones. He can be reached at (913) 441-9431.