A bond is instrument that allows you to buy debt. It is a sort of corporate "IOU". Bonds are riskier than the previously mentioned investment vehicles but their ROR is accordingly higher.
One of the nice things about bonds is that their ROR goes up when interest rates go down. This means that bonds tend to become more valuable when other sorts of investments are becoming less so. In part for this reason, it is a good idea for investors to have some bonds in their investment portfolios.
Most bonds pay interest at regular intervals, like a savings account without the guarantee. Bonds can be issued many different entities-businesses, governments, etc.-and not all bonds offer the same benefits.
Two major companies issue bond grades: Moody's and Standard & Poor. These companies attempt to determine how much risk there is of the organization that has issued the bonds going out of business, and label each bond accordingly. Bond grades vary between AAA (a very good risk) on the good side to D (a very poor risk). The lower the grade assigned to a bond, the more likely it is that the bond issuer will default on payments.
Below is a list highlighting the different types of bonds that are available for sale:
- Government. Governments (states, towns and even the federal government) issue bonds in order to raise capital. Federal bonds are very secure because it is unlikely that the U.S. Government will go out of business. Government bonds come in a variety of denominations and maturities.
- Commercial. These are corporate bonds sold by companies to raise money. They are usually sold in $1,000 increments and can take up to 40 years to mature (become payable).
- Convertible Bonds. Some business issue convertible bonds. These bonds allow you to trade the bond in for a specified number of shares of stock, at a certain time, and for a specified price.
- Foreign Currency. These bonds are issued by foreign governments or corporations. Accordingly, they are subject to fluctuations in currency markets. Information about foreign bonds is more difficult to obtain and can be less reliable. Additionally, there can be a greater risk of default. Foreign currency bonds are available in varying denominations and maturities.
- Junk Bonds. The term "junk bond" is used to describe a corporate bonds that has been rated BB (Standard & Poor) or Ba (Moody's) or lower, indicating that there is a heightened risk for default. These are not investment grade bonds because the risk in owning them is too high, hence the name junk bonds.
- TIPS (Treasury Inflation Protection Securities). Bonds with fixed maturity dates are always subject to inflation risk. TIPS bonds are a type of (federal) treasury bond that fights inflation through periodic interest rate adjustments. The downside of TIPS bonds is that their flexibility comes at the cost of a lower overall ROR.
- Mortgage Backed. Mortgage Backed bonds use mortgages as collateral. Bond payments come from people paying their mortgages. Such bonds are usually issued by Fannie Mae or Freddie Mac. These bonds offer a higher ROR than do treasury bonds but do have the backing of the US Government and so are slightly less safe than treasury bonds.
- Zero Coupon. The term "coupon" indicates the interest rate a bond is set to pay you. This interest rate is fixed for most bonds but some offer variable rates.
A zero coupon bond is sold at a discount of the full face value, but does not pay out until it reaches full maturity. This is like buying a $100 bill from someone for only $85 dollars and then agreeing to keep the $100 bill for a certain period of time before you use it.