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Before delving into the various types of bonds, it’s essential to understand some key terms associated with bonds:
This is the entity that borrows the funds. Issuers can be governments (federal, state, or local), municipalities, or corporations.
The maturity date of a bond is when the loan period ends, and the issuer must repay the bond’s face value to the bondholder.
Also known as par value, this is the amount the bond will be worth at its maturity and is the basis for calculating interest payments.
This rate determines the periodic interest payments made to bondholders. It’s expressed as a percentage of the bond’s face value.
Understanding the different types of bonds is crucial for investors as each type comes with its own risk and return profile:
These are issued by national governments and are often considered the safest type of bonds. They include Treasury bonds in the United States, which are backed by the full faith and credit of the government.
Issued by states, cities, or other local government entities, municipal bonds often provide tax-free interest payments, making them attractive to investors in higher tax brackets.
Corporations issue these bonds to raise capital. They typically offer higher interest rates than government bonds due to the higher risk of default.
Unique in that they do not pay periodic interest. Instead, they are sold at a deep discount to their face value and pay their full face value at maturity. The interest is the difference between the purchase price and the face value.
These corporate bonds can be converted into a predetermined number of shares of the issuing company’s stock. They provide a blend of bond and equity benefits.
Also known as junk bonds, these offer higher interest rates because they are issued by companies considered a higher risk of default.
Issued by foreign governments or corporations, these bonds can provide diversification but also carry additional risks, like currency risk.
Understanding the basics of bonds, including their key terms and the different types available, is essential for any investor considering bonds as part of their investment portfolio. Each type of bond offers a different balance of risk and return, and choosing the right mix can help investors achieve their financial goals while managing their risk tolerance.