What Are Bonds?
A common question we get is 'What are bonds?' And in order to get a firm grasp on mutual funds it's important to understand
what bonds are since—along with stocks—bonds make up the foundation of many mutual funds.
Like stocks, bonds are issued by entities (so there's no confusion, the term 'entities' refer to both companies and governments
at the federal, state, and local levels) to raise money to fund certain projects. For example, your local government may issue
tax free municipal bonds in order to raise money for improvement on the roadways. Or, a corporation may issue corporate bonds to raise
money to build a factory. The United States federal government can even issue government bonds (treasury securities) to secure debt.
In essence, bonds are loans made by the investing public to entities. Unlike stocks, being a bondholder does not make you a
part owner of a company, it simply makes you one if its creditors instead. In other words, bonds are simply an 'IOU' to you from an entity.
How do bonds work?
When you borrow money from a bank, you are required to pay the bank back all of the money you borrowed PLUS a stated rate of
interest over a specified period of time.
This same principal works with bonds.
When a company or government needs to borrow money they don't necessarily just go straight to the bank. Instead, many times
they may borrow money directly from the general investing public by issuing bonds.
Like any other loan, the bond has a face—or principal—value (also known as par value) which the entity promises to pay the
bondholder after a specific period of time. For the use of the money, the entity will also pay a set rate of interest (known as the coupon rate) to the
bondholder as incentive to hand over their hard-earned cash for an extended period of time.
The amount of interest you receive on a bond is generally tied—in some respect--to the interest rates in the economy. The interest you
receive may be paid periodically (monthly, quarterly, or annually) over the life of the bond, or it may be paid to you in one
lump sum once the bond has reached its maturity date (the date that the entity is required to give you your money back).
Some bonds pay no interest--these are called zero-coupon bonds. While others are considered
high-yield bonds, which are very risky.
Some bonds even carry characteristics such as being callable or convertible.
