Bonds, types of bonds and how they work can get confusing. I’ll do my best to describe what I know about this area of investing. There are different categories of bonds that you can invest in. All bonds carry a maturity date and coupon rate. The coupon rate is the annual interest rate paid and can be compounded annually, semi-annually, monthly or daily while the maturity is when the bond expires. 5, 10 and 30 year maturities are common.
Most people are familiar with US government bonds, also called treasuries. If you bought a 10 year treasury in 2009, it means you bought a government bond that matures in 2019. This bond would pay you interest every year for ten years until it matures and the balance is returned to you in 2019. Other types of bonds include zero coupon bonds, municipal bonds “munies” and corporate bonds. Bonds also carry ratings. Triple A is the highest and considered very safe. Double A is next, then A. After A is triple B, double B, B, etc. And as the rating goes down, so does the safety of your investment.
Corporate bonds tend to offer higher coupon rates than treasuries because they carry more risk as a company can go bankrupt (i.e. GM) while the government can print more money to pay the bonds off.
Muni bonds are issued by local municipal governments to pay for school, road and service support or improvements. Municipal bonds are great investments because the interest you make on them is not taxed by the US government or by your state (if you buy munies from the state in which you reside) since they directly help local governments.
Zero coupon bonds are just what they’re called, they carry no coupon rate. Instead you pay a decreased price now for a lump sum payout at the end. If you bought a 5 year zero coupon bond today that will pay $1000 in 5 years, you might pay $800 today for $1000 in 5 years. The difference is you won’t receive any interest payments during those 5 years. It’s also important to note that some bonds require substantial minimum investments. You can check out the most updated rates, investment requirements and trade these through most online brokerages just like stocks and options.
The last important note about bonds is that the base price of bonds changes over time as interest rates change. The value of your bond will increase as interest rates fall and decrease as rates rise. This is because someone is willing to pay extra for additional interest they can no longer get from CD’s or savings accounts and vice versa. So while you’re getting you interest payments, the value of your bond can also increase and give you the opportunity to make a little more return if you sell early.