There are three kinds of bonds: U.S. Treasury bonds, corporate bonds and municipal bonds. There are three elements you must look for when purchasing a bond, and each of these types has all three elements. Depending on the particular bond, other important features should be considered. A bond is properly referred to as the (name of company) (coupon rate) due (maturity date), for example, "Big Cheese 5.5 percent first mortgage bonds due May 15, 2045."
The most important element of a bond is its credit rating. Moody's and Standard & Poor's rate bonds according to their likelihood to continue to pay timely interest and principal until maturity. U.S. Treasury bonds are considered the most secure bond investments because the Treasury can print money to pay interest and principal on their bonds. Investment-grade corporate bonds and municipals are rated from a high of AAA to BBB or Baa, with any lower ratings considered risky investments.
Bonds all have maturity dates when your principal will be returned. Principal is the $1,000 face value of each bond. Maturities on bonds range from 10 years to as long as 50 years or more. Bonds with under 10-year maturities are called notes. When a bond is issued, its coupon rate is set according to its credit rating and the number of years to maturity. As the number of years to maturity diminishes over time, the interest rate required by the market will change.
The coupon rate is set when the bond is first issued. It represents the total amount of interest paid annually. Interest is paid every six months, but the total amount paid over the year is the annual interest rate. If the bond coupon is 5.5 percent, it will pay $55 each year per each $1,000 face-value bond. The coupon rate and the interest rate are different. When the market price of a bond is par, or $1,000, its interest rate is the same as its coupon rate. If market interest rates rise, the bond's interest rate rises and its price declines below $1,000, making it a discount bond. If market interest rates drop, the bond's interest rate drops and its price increases, making it a premium bond.
Other Important Features
Other important features to note about any bonds you are considering are call dates, convertible provisions and whether they are mortgage bonds or debentures. A redemption -- or call -- provision means that if interest rates have dropped since the bond was issued, the company is likely to pay you your principal early so it can issue a new bond at a lower coupon rate. You don't have to buy the new bond, but your original holding will be called away from you. A convertible bond can be converted to stock at a certain point and a certain price as described in the bond prospectus. It is also important to note whether the bond is an unsecured debenture or a mortgage bond, secured by company assets. A secured bond usually carries a higher credit rating because it gives you a senior right to proceeds of the company in case of liquidation.
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