Bonds Explained
Bonds are a version of a loan in which the investor receives interest until the bond matures, at which point the issuer repays the amount of the loan. As with almost everything in the financial world, though, bonds can become a lot more complex than they seem at first glance. There are three main types of bonds.
Typical Bonds
A typical bond has a face value, which is the value of the bond the investor will receive when the bond is mature. If the bond is retired before it reaches maturity, the investor may receive a small premium above face value. Investors sometimes pay more or less than face value for a bond, but when it is bought at face value, it is called "paying par."
A typical bond also has a coupon rate, which is the annual rate of interest. The higher the coupon rate, the more money the investor receives. These rates are generally set at the time of purchase and do not change, with the majority being paid semiannually. However, some bonds offer monthly or quarterly payments.
Callable Bonds
Callable bonds refer to any bond type which the issuer can repay earlier than the maturity date at a predetermined price. Callable bonds usually give higher coupon rates than other bond types. The risk with callable bonds is that, if the interest rate drops low enough, the issuer can pay off the callable bonds and issue new bonds at the lower rates. The bond's interest payments to the investor then cease. The investor can reinvest their funds, but they will have to accept the new lower coupon rate.
Zero-Coupon Bonds
Also known as "strips," zero-coupon bonds make no periodic interest. Instead, the investor pays a steeply discounted price and receives a single payment when the bond matures. This payment is the principal invested plus interest. Zero-coupon bonds are great for those who plan to save for a predetermined date. The major drawback is that you have to pay annual taxes on your interest, even though you do not actually receive the money until maturity.
