What is a "bond"?

October 4, 2007, Author

(This post is a part of the series on Basics of Finance and Investing.)

Like money market, a bond market is a debt instrument issued by both the US government and corporations to borrow fund from public. But there are two differences: a bond market has longer term maturity, and bond returns are not always fixed (and so it is not totally correct to categorize them as fixed-income securities).

Following are the common bond market instruments.

Treasury Notes and Bonds

“T-note” and “T-bond” in short, these are government debt securities (like T-bill in money market) sold in denominations of $1000 or more. Maturity of a T-note is up to 10 years, and T-bonds mature between 10 and 30 years. Interests are paid semi-annually based on the specified annual rate. For example, at 4.5% annual rate, a $1000 T-note will pay you $22.5 every 6 months. Because they are backed by the government, these securities are safe investments.

Municipal Bonds

These are issued by the state and local governments, and the interest earned is exempt from the federal income tax and state tax in the issuing state. This makes them an attractive investment choice for people in high income category (they pay higher tax). But you must pay tax on any capital gain (increase in the bond value) at maturity.

To see the tax advantage of municipal bonds, suppose the interest of a taxable security is i, and your income tax bracket is t. Your after-tax earning is then i(1-t). So, if you pay 35% tax on your income, then 4.5% interest of a T-note (which is taxable) reduces to a little over 2.9% after tax. Compared to this, a municipal bond that pays 3.5% tax-free interest is quite attractive. This is also why someone coming into lot of money suddenly (like winning a lottery) finds investing in municipal bonds a good choice.

Corporate Bonds

Corporate bonds are a mean by which corporations borrow fund directly from investors. As in T-notes and T-bonds, these too pay interest in semi-annual installments and return the principal at maturity. The important difference is that a corporate bond has relatively higher risk of defaulting (in the event of the issuing firm facing bankruptcy).

Callable bonds are those that can be bought back by the issuing firm at a stipulated call price. Convertible bonds allow the bondholder to exchange each bond for a specific number company stocks.

Mortgage-backed securities

These securities, as the name suggests, are built on a pool of mortgage loans that are securitized and sold in secondary markets. Investors earn from the cash inflow as more and more loans are paid off. Because the mortgage lender collects the interest and principal payments from borrowers (home-owners) and pass them to the investors, these securities are also known as pass-throughs.

They are issued by the Government National Mortgage Association new window (GNMA, or Ginnie Mae), which is owned by the US government, and also by federally sponsored organizations such as the Federal National Mortgage Association (FNMA, or Fannie Mae), the Federal Home Loan Mortgage Corporation (FHLMC, or Freddie Mac) and Federal Home Loan Bank (FHLB).