Bonds: A Primer

In this two-part series on bonds, we'll explain what bonds are and how to use them effectively in your investment portfolio.

What is a Bond?

A bond is really just a loan. To understand bond investing, think of yourself as a bank. You (as the bank) loan some money to an interested party (the bond issuer). In return, you receive a series of payments that repay the loan plus interest. You can loan money to the U.S. government by buying Treasury bonds, or to a corporation by buying corporate bonds. States, municipalities, and government agencies also raise money by issuing bonds. The structure of a bond varies depending on the respective needs of the lender (you) and the borrower (the bond issuer). Some bonds are repaid over a period of many years, while others are repaid in six months or less. The interest rate also varies, depending on the prevailing rates at the time of issuance and the riskiness of the cash flows.

Risk versus Return

Why should risk play a role in determining interest rates? If you're loaning money to the U.S. government, you are virtually assured of getting paid back. On the other hand, if you loan money to a corporation, the firm could go bankrupt and default on the loan. A rational investor would therefore only invest in corporate bonds if they offered higher interest rates then similarly-structured government bonds.

Junk Bonds

When companies with poor credit ratings issue bonds, they have to offer higher interest rates than financially stable companies in order to attract investors. These bonds are often called high-yield or "junk" bonds. A junk bond investor benefits from higher interest rates, but faces a significant risk of default by the bond issuer.

Cash Flow

Most bonds provide investors with a series of cash payments at pre-determined intervals. In the standard format, the investor receives an interest (or "coupon") payment every six months. At the bond's maturity date, the investor receives a "principal" payment equal to the original purchase price of the bond, along with the final coupon payment.

Zero-Coupon Bonds

A zero-coupon bond is simply a bond with no coupon payments. The investor purchases the bond initially and then receives no payments at all until the maturity date. At that time, the principal plus interest is repaid in one lump sum.

Next month, we'll discuss how to use bonds in an investment portfolio to achieve some important investment objectives.

December 1, 2000

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