Bonds are debt instruments issued by a company or government entity to finance a certain aspect of its operation. When you invest in bonds, you are essentially lending money to the bond issuer, entitling you to receive interest on that loan.

The interest rate, set when the bond is issued, is known as the bond's coupon and is expressed as an annual percentage of the bond's face value. For instance, a bond with a face value of $1,000 and a 10% coupon will pay $100 per year, usually in semiannual installments.

You can invest in bonds with many different maturities, which allows you to plan for future expenses. For instance, if you know you will need funds to pay for a child's college education in 10 years, you can invest in a bond that will reach maturity (i.e., repay the principal) at the desired time.

Bonds and Interest Rates

Though the face value of a bond is also set, the price actually paid for a bond after its initial offering is not. Rather, bond prices tend to correlate inversely with interest rates. As interest rates rise (and therefore coupon rates of new issues rise), bond prices tend to drop because the higher coupon rates are more desirable. If a bond sells for less than its face value (for instance, a $1,000 bond sells for $950), it sells at a discount.

Conversely, if interest rates - and the coupon rates of new bonds - drop, an existing bond with a higher coupon becomes more valuable. Investors are then willing to pay a premium, or more than face value, for the bond.

Yields

The current yield is a measure of the bond's current worth. It is the ratio of the coupon payments to the bond's market price. For example, if a $1,000 bond with a 10% coupon (annual interest payments of $100) is currently selling for $950, the current yield is 10.526% [($100/$950) x 100].

Maturity

The maturity of a bond refers to the date when the principal will be repaid to the bond's owner. A bond's yield to maturity is the overall rate of return if it's held until maturity.

U.S. Treasury Bonds

U.S. Treasury bonds are direct obligations of the U.S. Government that are issued regularly to finance the national debt. They are guaranteed by the full faith and credit of the U.S. Government, for the timely payment of interest and principal if held to maturity. They offer competitive returns in a wide range of maturities and can be bought and sold in the most liquid secondary market in the world. In addition, the income from U.S. Treasury bonds is exempt from state and local taxes.

Municipal Bonds

Municipal bonds are tax-exempt debt obligations of states, cities, towns, municipalities, and other governmental entities. They are issued to build schools, tunnels and bridges; to finance infrastructure repairs or improvements; or for general purposes. The face value for each bond is generally $1,000 or $5,000, but can be as high as $100,000 in the case of notes.

Interest income derived from municipal bonds is generally exempt from federal income taxation. In most cases, interest income derived from municipal bonds issued within the investor's state of residence is exempt from state and local income taxes as well. However, some investors may be subject to the federal alternative minimum tax (AMT). You should consult with your tax advisor for more information.

If a municipal bond appreciates (gains in value) and you sell it before maturity, you may be subject to capital gains taxes.

Corporate Bonds

Corporate bonds are debt obligations issued by private and public corporations and are generally issued in multiples of $1,000 and/or $5,000 with varying maturities.

Companies use the funds they raise from selling bonds for a variety of purposes, from building facilities to purchasing equipment to expanding the business.

Interest from corporate bonds is generally subject to state, local and federal taxes.

Rating Bonds

Besides the possible rise and fall of interest rates, the main risk of investing in bonds is that the issuing institution will be unable to make principal and interest payments. Rating services, such as Standard & Poor's and Moody's, evaluate the issuer's credit to help you gauge this risk.

Advantages and Disadvantages