Bonds: The Basics

Bonds have their own vocabulary, but it’s easy to master.

When you invest in a bond at the time it’s issued, or first offered for sale, you lend money to an issuer.

In return, you expect to earn interest the borrower pays for access to your capital and to have your principal, or investment amount, repaid when the bond matures at a specified future date. Interest is sometimes called the coupon, and the rate the bond pays is called the coupon rate.

Before 1983, bond buyers received certificates that detailed the terms of the loan. Originally, these bearer bonds had coupons that could be detached and exchanged for interest. Coupons are long gone, and certificates have mostly disappeared. Instead, book-entry bonds are registered electronically in your brokerage account. Interest is credited directly to your account, as is repayment of the principal when the term ends.

US SAVINGS BONDS

To many people, bonds mean the US savings bonds you buy through a regular savings program at your job or online at www.treasurydirect.gov, where you establish a TreasuryDirect account. Savings bonds share some similarities with bond securities. You earn interest on your investment principal and can redeem the bonds for cash at maturity.

But they also differ in several important ways. Savings bonds aren’t marketable, which means you can’t sell them to another investor, and there’s no secondary market where they are traded. You simply buy them and hold them until you cash them in. Or, you can buy savings bonds as gifts for other people.

You can find helpful information at www.treasurydirect.gov about how the different types of savings bonds work, the interest they pay, the way that interest is taxed, and the different ways to buy them. The site also explains how to use the interest you earn on eligible Series I and Series EE bonds to pay higher education expenses without owing any income tax on those earnings, provided you qualify based on your adjusted gross income (AGI).

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WHAT’S AVAILABLE

There are Series EE and Series I savings bonds, each with some distinctive features:

Series EE bonds. You buy electronic EE bonds at face value in any amount from $25 to $10,000, in increments of as little as one cent, and earn a fixed rate of interest for the 30-year life of the bond. Series EE bonds are guaranteed to double in value in 20 years.

Series EE bonds issued before May 2005 continue to earn interest to maturity at a variable rate, which is reset twice a year.

Series I bonds. You buy I bonds at par value and earn interest at a combination of a fixed rate and a rate that changes twice a year to reflect the current rate of inflation. Most I bonds are electronic, but you can use your tax refund to buy up to $5,000 in paper I bonds.

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DEFINING BOND TERMS

When an issuer offers a bond for sale, all of its details are spelled out in a prospectus or offering circular that’s filed with the SEC and available online at www.sec.gov/edgar or from your brokerage firm. It includes the information you need to make an informed decision.

Par value, or the dollar value of the bond at the time it is issued, is also the amount that will be repaid at maturity. Most bonds have a par value of $1,000.However, US Treasury issues have a par value of $100. Similarly, municipalities sometimes offer bonds with par values of $500, nicknamed baby bonds.

Interest rate is the fixed percentage of par value that is paid to the bondholder annually. For example, a $1,000 bond with a 4.5% interest rate pays $45 a year.

Term is the length of time between the date of issue and the date of maturity. The term helps determine the interest rate.

Maturity is the date the bond comes due and must be repaid in full. A bond may be bought and sold in its lifetime and re-registered in the new owner’s name. Whoever owns the bond at maturity receives par value.

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BEARERS STILL

Eurobonds are bearer bonds denominated in a major currency, such as pounds or yen, that are issued and traded in countries outside of the country whose currency is being used. They’re not registered with any regulatory authority, and the certificates can be traded or redeemed by the bearer. You’re not likely to own one, though, since they’re sold in very large denominations. Typical buyers are corporations and governments.