Basics of Bonds

A bond is simply a negotiable IOU or a loan. Investors who buy bonds are
lending a specific sum of money (the principal) to the bond issuer - a
corporation, a government, or some other borrowing institution - for a 
specified period of time (the term). Typically, the bond issuer promises 
to make regular payments of interest to the investor at a rate that is 
set when the bond is issued. This is why bonds are often referred to as 
fixed-income investments.

The term of a bond ends on the bond's maturity date, at which time the 
issuer repays to the investor the face amount listed on the bond. When 
a bond is held to maturity, its face amount is repaid in full. Before 
maturity, however, the value of a bond may often fluctuate. These continual 
changes in bond prices are influenced by many factors, including interest 
rate movements, supply and demand, changes in the financial health of 
bond issuers, returns offered by other investments, and the maturity 
date of a bond. 

Types of Bonds

Bonds can have considerable variations in maturity, and they may have a 
wide range of credit ratings. Bonds are issued by the federal government 
and its agencies, state and local governments, and corporations.

U.S. Treasury

Securities offered by the U.S. Treasury come in three forms:

U.S. Treasury bills, which have maturities ranging from 90 days to 1
year. 
U.S. Treasury notes, which have maturities from 1 to 10 years. 
U.S. Treasury bonds, which have maturities from 10 to 30 years.
Treasury securities are considered the safest of all debt instruments because
they are legally backed by the full faith and credit of the U.S. government.
This designation, which is the highest level of backing given on a U.S.
government security, means that the government pledges to use its full taxing
and borrowing authority, as well as revenue from nontax sources, to pay the
interest and repay the face amount of the security. Nonetheless, the market
prices of these securities are not guaranteed and will fluctuate daily just 
like the prices of any other bonds. Interest paid on Treasury bonds usually 
is exempt from state and local income taxes, but is not exempt from federal 
income taxes.

U.S. Government Agency

U.S. government agency bonds and securities are issued by agencies that are
owned, backed, or sponsored by the U.S. government. While some of those
bonds and securities are backed by the full faith and credit of the government,
others carry less formal guarantees.

The most common agency securities are mortgage pass-through securities such
as those issued by the Government National Mortgage Association (Ginnie
Mae), the Federal National Mortgage Association (Fannie Mae), and the
Federal Home Loan Mortgage Corporation (Freddie Mac). Mortgage
pass-through securities are backed by home mortgage loans. By purchasing
mortgage pass-through securities, investors are making mortgage loans to
homeowners through intermediary companies. Homeowners make monthly
mortgage payments to mortgage-servicing companies, and those payments flow
through to investors holding the mortgage pass-through security. Of these
agencies, only Ginnie Mae offers securities that are backed by the full 
faith and credit of the U.S. government. Nonetheless, bond market 
professionals believe that all of these securities have a very high 
credit quality, meaning that the issuing agency is very likely to pay 
the bond's interest and principal in full and on time. Indeed, these 
agency securities are regarded as equal or even superior to bonds issued 
by the most creditworthy corporate borrowers.

Other U.S. government agencies also issue securities, and investors should
carefully investigate the level of backing provided by the U.S. Treasury 
for those investments.

Corporate Bonds

Corporate bonds are issued by companies of varying quality and in various
maturities from short-term (between 1 and 5 years) to intermediate-term
(between 5 and 10 years) to long-term (more than 10 years). Most corporate
bonds are assigned a letter-coded rating by independent bond-rating agencies
such as Moody's Investors Service, Inc., and Standard & Poor's Corporation
to indicate their relative credit quality - the likelihood that the issuer 
will pay interest and principal in full and on time. 

Investment-grade bonds are issued by well-regarded companies and rated as
desirable investments. To be considered investment-grade, a bond must be
rated BBB or better by Standard & Poor's, or Baa or better by Moody's.
Corporate bonds with a lower rating or no rating are sometimes called
high-yield bonds because of the higher interest rates they must pay to 
attract investors. They are also sometimes referred to as junk bonds 
because the issuers are believed more likely to default that is, to fail 
to make full interest and principal payments as scheduled.

Municipal Bonds

Municipal bonds are issued by state and local governments to support their
financial needs or to finance public projects. Interest paid on municipal 
bonds is typically exempt from federal income taxes and, in some cases, 
from state and local taxes too. (However, capital gains earned on a municipal 
bond investment like capital gains on any security are subject to federal and,
possibly, state and local income taxes as well.) Like corporate bonds, 
municipal bonds come with a variety of ratings to reflect the fact that some 
state and local governments are financially stronger than others. Municipal 
bonds, which have maturities ranging from less than 1 year to 40 years, are 
also known as tax-exempt, or tax-free, bonds.