Before adding bonds to your portfolio, it's important to know some basics about how they work and the significant variations that exist among bonds. What follows is an overview.
Bonds are essentially IOUs, issued by federal, state, and municipal governments as well as by corporations and governmental agencies. They are intended to raise revenue for a wide variety of activities. Governments issue bonds to finance the construction of infrastructure projects, such as roads, bridges, airports, public housing, and schools. Corporations use the proceeds of bonds to pay for the construction of new manufacturing facilities, research and development, and to expand into new markets.
Bond investors essentially loan money to the bond's issuer. In return, they receive interest payments at specified intervals plus a promise that the issuer will return the bond principal to investors when the bond's term ends on its maturity date.
A bond's interest rate (or "coupon rate") is an important consideration. Many bonds pay a fixed annual interest rate for the life of the bond. That rate is fixed at the time the bond is first issued and will not change. There are also floating rate bonds with interest rates that reset periodically.
Bonds with longer maturities generally pay owners a higher interest rate than bonds with shorter maturities. That higher interest rate is intended to compensate owners for the risk involved in holding longer term bonds.
The financial health of a bond issuer is typically assessed by a bond rating agency, such as Moody's or Standard & Poor's. Essentially, rating agencies scrutinize the overall financial soundness of a bond issuer and its ability to meet its obligations to bondholders. Bonds issued by companies or entities that are rated of the highest quality are likely to be considered less likely to default, whereas bonds rated lowest tend to be riskier investments.
The interest earned on corporate and many government bonds is taxable. However, bonds issued by municipalities pay interest that is generally exempt from federal income taxes. Interest payments on municipals may also be exempt from state income taxes in the state that issued the bond.
A callable bond is one in which the issuer reserves the right to redeem the bond prior to its stated maturity date. If the issuer takes that action, the bondholders may be unable to find comparable bonds paying similar interest rates. Because of that risk, issuers of callable bonds may have to pay an above-average interest rate to attract buyers.
This information is not meant as tailored investment or tax advice. Before building a portfolio that includes bonds, you may find it helpful to discuss your strategy with a financial professional.
Bonds can gain or lose value based on economic conditions and market events. Principal is not guaranteed.