When you buy bonds, you are lending your money to a federal or state agency, municipality or other issuer, such as a corporation. A bond is like an IOU. The issuer promises to pay a stated rate of interest during the life of the bond and repay the entire face value when the bond comes due or reaches maturity. The interest a bond pays is based primarily on the credit quality of the issuer and current interest rates. Firms like Moody’s Investor Service and Standard & Poor’s rate bonds. With corporate bonds, the company’s bond rating is based on its financial picture. The rating for municipal bonds is based on its financial picture. The rating for municipal bonds is based on the creditworthiness of the government or other public entity that issues it. Issuers with the greatest likelihood of paying back the money have the highest ratings, and their bonds will pay an investor a lower interest rate. Remember, the lower the risk, the lower the expected return.
A bond may be sold at face value (called par value) or at a premium or discount. For example, when prevailing interest rates are lower than the bond’s stated rate, the selling price of the bond rises above its face value. It is sold at a premium. Conversely, when prevailing interest rates are higher than the bond’s stated rate, the selling price of the bond is discounted below face value. When bonds are purchased, they may be held to maturity or traded.
U.S. savings bonds
U.S. savings bonds are government-issued and government-backed. Unlike other investments, you can’t get back less than you put in. Savings bonds can be purchased in denominations ranging from $50 to $10,000. There are different types of savings bonds, each with slightly different features and advantages. Series I bonds are indexed for inflation. The earnings rate on this type of bond combines a fixed rate of return with the annualized rate of inflation.
If you have paper U.S. savings bonds, you can register them online at TreasuryDirect, www.treasurydirect.gov. Then, you won’t have to worry about losing the paper copy.
Treasury bills, bonds, notes and TIPS
The bonds the U.S. Treasury issues are sold to pay for an array of government activities and are backed by the full faith and credit of the federal government.
- Treasury bills are short-term securities with maturities of three months, six months or one year. They are sold at a discount from their face value, and the difference between the cost and what you are paid at maturity is the interest you earn.
- Treasury bonds are securities with terms of more than 10 years. Interest is paid semi-annually.
- Treasury notes are interest-bearing securities with maturities ranging from two to 10 years. Interest payments are made every six months.
- Treasury-Inflation Protection Securities (TIPS) offer investors a chance to buy a security that keeps pace with inflation. Interest is paid on the inflation-adjusted principal.
Bills, bonds and notes are sold in increments of $1,000. These securities, along with U.S. savings bonds, can be purchased directly from the U.S. Department of the Treasury through Treasury Direct at www.treasurydirect.gov.
Some government-issued bonds offer special tax advantages. There is no state or local income tax on the interest earned from Treasury and savings bonds. And in most cases, interest earned from municipal bonds is exempt from federal and state income tax. Typically, higher income investors buy these bonds for their tax benefits.