How Do Bonds Work?

In order to understand how do bonds work, it is important to note the two main aspects of a bond. These aspects are the face value and the coupon rate.

The face value of a bond is the amount for which you purchased the bond. When the bond matures, this is the amount of money that you will receive. For example if you purchased a bond with a face value of $1000, when the bond matures you will receive a principal payment of $1000. If you choose to cash in your bond before the date of maturation the amount you will receive will be less than the $1000 face value amount.

The other aspect of bonds is the coupon rate. The coupon rate plays a factor in determining how much interest you will receive from a bond. The coupon rate is the rate of interest that is payable on a bond yearly. This rate is determined at the time the bond is purchased and generally does not change. Basically, the higher the coupon rate the higher the interest payments received from the bond.

Primary Bond Types

Treasury Bonds

One of the most well known entities that issues bonds is the government. Bonds issued though the government are called treasury bonds. These bonds are issued to help the government pay off debts and to fund government activities. Of all the bonds, these have the lowest returns or yields. However, government bonds are exempt from local and state taxes and they are lower in risk if you hold them until they mature.

Agency Bonds

There are also agency bonds that are issued by government groups that support such industries as student loans and home loans. These bonds allow these particular governmental agencies to have the necessary funds to support their ventures such as providing credit to homeowners or students for loans. Agency bonds are also exempt from local and state taxes, but generally have a higher yield than treasury bonds.

Municipal Bonds

Municipal bonds are another option. These are issued by cities, counties and states in order to pay for municipal or public projects. These bonds are exempt from federal, state and local taxes. Depending on how much you make, the level of return on these bonds can be high.

Corporate and Mortgage Bonds

Corporate and mortgage bonds, on the other hand, are used by a particular offering institution to raise money for business activities or to offer mortgages. The level of risk associated with these types of bonds can be high. However, the yield or rate of return can also be substantial. If you are interested in purchasing these types of bonds it is recommended that you properly access the credit risk of the particular company via a rating agency. These are the main types of bonds that are available for purchase.

Bond Variations

There are some variations in how bonds work. Typically when you purchase a bond you can do so at various terms or maturity rates. As your bond matures, you have the option of purchasing an additional bond that will continue the process of allowing you to earn interest and increasing your final payout.

There are also callable and zero coupon bonds that offer dividends a bit differently than the traditional bonds. Callable bonds offer a higher coupon rate, which means greater interest returns, and these types of bonds allow the issuer of the bond to pay off the principal earlier. There are also the zero coupon bonds that can be purchased at a much discounted price but that do not offer periodic interest payments. With the zero coupon bonds you receive one lump sum payment that includes interest and the principal at the maturation date. Zero coupon bonds are best kept until they mature in order to reap the full benefits. Unlike other types of bonds, zero coupon bonds do require you to pay annual taxes on the accrued interest.