Debt instruments represent a loan that must be repaid, typically with interest. Bank certificates of deposit, government backed treasury bills, municipal bonds and corporate bonds are types of debt instruments. The bond's price and the bond's yield are important factors to consider when investing in bonds.
There are three primary types of bonds available to individual investors: federal government bonds; municipal bonds; and corporate bonds. Federal bonds, such as U.S. Savings Bonds and Treasury Bonds, are considered the safest of all investments because they are backed by the United States government. Municipal bonds are issued by state or local agencies. These bonds have the advantage of paying interest that is free from federal income tax. Corporate bonds are issued by private and public corporations. These bonds typically pay a higher rate of interest than either federal government or municipal bonds.
Bonds typically have a face value that is stated on the bond; for instance, the face value of a $50 U.S. Savings Bond is $50. Electronic EE series U.S. Savings bonds are sold at face value, and redeemed at their face value plus interest. The price of the bond does not necessarily reflect the face value. Older, paper EE series bonds were issued at a discount of 50 percent of their face value, and are redeemed upon maturity at their face value, so a $50 savings bond cost $25 to purchase, but was redeemed on maturity for $50. Once a bond has been issued, it may trade on the open market for more or less than the issue price, depending upon such factors as prevailing interest rates, and changes in the credit rating of the issuing organization.
Bonds are typically issued with a stated interest rate, which may be fixed or variable. The interest rate represents the yield if the bond is held to maturity. Once the bond is issued, it may trade on the open market for more or less than its issue price. This fluctuation in price will affect the bond's yield. Bond prices are particularly sensitive to changes in the prevailing interest rates for similar investments. If the prevailing interest rates rise, the price of the bond will go down in order to maintain a competitive yield. In the same way, if the prevailing interest rates drop, the price of the bond will increase. The general rule of thumb for bonds is that bond prices move in the opposite direction of interest rates. The yield on a bond that is sold for a price other than its face value is determined by dividing the annual interest payment by the price of the bond. A corporate bond with a $1000 face value, that pays seven percent interest, would have a yield of $70, or seven percent. If prevailing interest rates rise, the price of the bond would drop to compensate. The bond may now sell in the open market for $930. It would still pay $70 per year in interest. Seventy dollars divided by $930 results in a yield of 7.53 percent.
Bonds may be very safe or very risky investments, depending upon the quality of the issuing organization. Investors can get a good idea of the safety of a bond by the rating assigned to it by an outside rating company such as Moody's or Standard and Poor's. Bonds rated AAA, AA, A or BBB by Standard and Poor's, and those rated Aaa, Aa, A or Baa by Moody's, are considered to be investment grade bonds. Bonds rated lower are considered "junk bonds." The higher the rating, the lower the yield. Bonds issued by agencies of the federal government are not rated by any ratings company, because they are backed by the full faith and credit of the U.S. government.
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