BOND · an IOU from a corporation, government, or agencyCOUPON RATE · the interest rate the issuer promises to payFACE VALUE · the principal repaid at maturity, usually $1,000MATURITY · the date the principal is repaidINVESTMENT GRADE · rated most likely to repay as promisedBOND · an IOU from a corporation, government, or agencyCOUPON RATE · the interest rate the issuer promises to payFACE VALUE · the principal repaid at maturity, usually $1,000MATURITY · the date the principal is repaidINVESTMENT GRADE · rated most likely to repay as promised
A bond is an IOU, just a much more formal one. This session covers what you're really buying when you lend money to a corporation, a city, an agency, or the federal government, and why bonds sit in a diversified portfolio right alongside stocks.
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Background
Lending Instead of Owning
A bond is like an IOU for a loan you've made to an institution, such as a government or a corporation. Similar to when you take out a car loan or a mortgage, when the government or a corporation borrows money from you, they do so for a certain period of time at a certain rate of interest.
When you purchase a bond you are lending money to the issuer, who can be a corporation, the government, or a government agency. In return for the loan, the issuer promises to pay you (the bond investor) a specific rate of interest known as the coupon rate. You are paid the interest on a predetermined schedule, usually quarterly, for the life of the bond. The life of a bond refers to the period of time the issuer has to repay the investor. The issuer also promises to repay the face value when the bond matures, also known as the principal or the par value. Most bonds are issued with a $1,000 face value.
This lesson focuses only on "investment grade" bonds: bonds rated highest by Moody's, Standard & Poor's, and Fitch, the main investment rating services in the United States. A bond rated investment grade is considered to have the least chance of missing an interest payment or failing to repay its principal.
Bonds are also called fixed-income investments because the investor knows the interest rate and the payment schedule before they buy. Bonds are often included in a diversified portfolio, alongside stocks, precisely because that income is predictable. There are four types of bonds most familiar to individual investors:
Corporate Bonds
A major source of corporate borrowing. Debentures, the most common type, are backed by the general credit of the corporation. Asset-backed bonds are backed by specific corporate assets, such as property or equipment.
Municipal Bonds
Issued by state and local governments. General obligation bonds are backed by the full faith and credit of the issuer. Revenue bonds are backed by the income generated by the specific project being financed.
Agency Bonds
Issued by government-sponsored but privately owned corporations (like Fannie Mae and Freddie Mac) and federal agencies (like Ginnie Mae and the Tennessee Valley Authority) to make loan money available or fund new projects.
U.S. Treasury Bonds
Backed by the full faith and credit of the United States government. When the government spends more than it collects in taxes, it issues Treasury notes, bills, and bonds to borrow the difference. Treasury bonds have the longest terms (10 years or more); Treasury bills have the shortest (under two years).
It is important to research bond investments. Maturity, redemption features, credit quality, interest rate, price, yield, and tax status all help determine a bond's value and whether it fits your investment needs. Ratings information is available from the rating services themselves, the financial press, or a broker.
Key Terms
Vocabulary
Tap a card to flip it and reveal the definition.
Default
Failure to pay principal or interest when due. Defaults can also occur for failing to meet non-payment obligations, such as reporting requirements, or when a material problem occurs for the issuer, such as bankruptcy.
Fixed-Income Investments
Investments that pay interest on a set schedule. This category includes corporate, municipal, agency, and U.S. Treasury bonds.
High-Yield Bonds
To attract investors, issuers of these bonds pay a higher rate of interest than investment grade bonds with the same maturity. Rated below investment grade, also called "junk bonds."
Issuer
An entity which issues, and is obligated to pay principal and interest on, a debt security.
Interest Rate
Compensation paid for the use of money, generally expressed as a percentage rate. Also referred to as the coupon rate.
Investment Grade Bonds
Bonds sold by a very reliable issuer, a government, large corporation, or government agency, that is most likely to repay the loan and the interest as promised.
IOU
Means exactly as it sounds, "I Owe You." An acknowledgement of a debt.
Maturity
The date when the principal amount of a security is payable.
Par Value
The principal amount of a bond or note due at maturity. Also referred to as face value.
Prepayment
The unscheduled partial or complete payment of the principal amount outstanding on a mortgage or other debt before it is due.
Principal
The face amount of a bond, payable at maturity. Also referred to as face or par value.
Trade Date
The date when the purchase or sale of a bond is transacted.
Zero Coupon Bond
A bond that pays no periodic interest at all. Instead, it is sold at a deep discount to its face value, and the investor's return is the difference between what they paid and the full face value they collect at maturity.
Balloon Payment
A large, lump-sum payment due at the end of a loan or bond's term, after a series of smaller regular payments. Most or all of the principal is repaid in that one final payment rather than spread evenly across the life of the debt.
Secured Bonds
Bonds backed by specific collateral the issuer pledges, such as property or equipment. If the issuer defaults, bondholders have a claim on that collateral, which is what makes an asset-backed corporate bond a secured bond.
Unsecured Bonds
Bonds backed only by the general creditworthiness of the issuer, not by any specific collateral. Corporate debentures are the most common example, they rely entirely on the issuer's reputation and credit rating.
Convertible Bonds
Corporate bonds that can be converted into a set number of shares of the issuing company's common stock. The holder collects bond interest until they choose to convert, giving them a way to benefit if the stock price rises.
Goals
Performance Objectives
By the end of this session, you will be able to:
Define the terms Bond and Investment Grade Bond.
Identify and define four types of bonds.
Understand bonds as an investment tool.
Materials for this session:
Fact Sheet 1 · Saul & Pepper
Activity Sheet 1 · About Bonds
Activity Sheet 2 · Choosing Bonds
Activity Sheet 3 · An Interest in Bonds
Springboard Activity
Fact Sheet 1: Saul & Pepper
Saul and Pepper have been friends since kindergarten. Both have good part-time jobs. Pepper deposits a portion of the money she earns in the bank each week. Saul, on the other hand, spends most of the money he earns on building his baseball card collection.
Recently, a rare 1975 Topps Mini George Brett rookie card went on sale for $100. This card would greatly enhance the value of Saul's collection, but he does not have the money to buy it. He asks Pepper to loan him $100. He signs an IOU to pay Pepper back her $100 plus 7% interest in one month, the time it will take him to save enough to repay her.
Saul and Pepper's friend John works at a supermarket. He has recently become good friends with Jackson, who works at the same supermarket. John likes Jackson because he is reliable and willing to cover shifts for him. One day, Jackson asks John to loan him $100. He promises to pay John back in three months with 7% interest, and signs an IOU agreeing to this.
Which IOU pays the most money, Saul's or Jackson's? Why?
JACKSON'SBoth IOUs pay 7%, but Jackson's runs for three months and Saul's runs for only one. Under simple interest, a longer term at the same rate earns more total interest, so Jackson's IOU pays more overall (roughly three times as much interest), even though the rate is identical.
Which IOU seems less risky? Why?
SAUL'SSaul's IOU is outstanding for a shorter time (one month versus three), so there is less time for something to go wrong, a job loss, an emergency expense, before repayment is due. Shorter maturities generally carry less risk than longer ones, all else being equal.
Do you think Pepper should lend Saul the money? Should John lend money to Jackson? Why?
DISCUSSION, NOT A FIXED ANSWERThis is meant to be discussed, not answered definitively. A reasonable case for lending: Saul and Jackson are known, trusted friends offering a real interest payment, similar to how an investor might trust a reliable issuer. A reasonable case for caution: neither borrower has demonstrated an ability to save (Saul spends most of what he earns; we know less about Jackson), so there is real risk of late or missed repayment, the same risk investors weigh before buying a bond from an unfamiliar or lower-rated issuer.
Activity Sheet 1
About Bonds
Part 1: What Is a Bond?
Bonds are issued by corporations, governments, and government agencies to raise large amounts of money. Just like any loan, the issuer agrees to pay back the money borrowed on a set date and agrees to pay interest.
Investors buy investment grade bonds because they are considered very safe. These issuers almost always pay the interest and the loan back as promised; bonds can take anywhere from a few weeks to thirty years to mature. Of course, just like a friend can refuse or be unable to pay all or part of an IOU, an issuer can default on a bond, but this is unlikely with investment grade bonds.
Example: you buy a U.S. Government 10-year Treasury bond on January 1st with a $1,000 face value. This means you have given the federal government a 10-year loan; on December 31st, ten years from now, the government will write you a check for $1,000 to repay the loan. If the bond's coupon rate is 5%, the government will also pay you $50 per year over the 10-year life of the bond. Interest on most bonds does not compound.
Q1
How is a bond like an IOU?
MODEL ANSWERBoth are a written promise to repay borrowed money. A bond states who borrowed the money (the issuer), how much (the face value), how they will compensate the lender for the use of the money (the interest, or coupon rate), and when they will pay it back (the maturity date), exactly the same information a personal IOU spells out.
Q2
Why is an investment grade bond considered a "safe" investment?
MODEL ANSWERBecause it is rated highly (by Moody's, Standard & Poor's, or Fitch) as being issued by a reliable government, large corporation, or government agency that is very likely to make every interest payment on schedule and repay the full principal at maturity. Safe does not mean risk-free, but it does mean the risk of default is considered low.
Q3
How can an investor make money by buying a bond?
MODEL ANSWERPrimarily through the interest (coupon) payments made on a set schedule for the life of the bond. An investor can also make money by selling a bond for more than they paid for it before it matures, if market interest rates or the issuer's credit quality move in the bond's favor.
Q4
Would you recommend your Stock Market Game team include a bond in your portfolio? Why, why not?
DISCUSSION, NOT A FIXED ANSWERThis is meant to be argued both ways. In favor: a bond adds diversification and a predictable, lower-risk income stream that can offset the swings of stock holdings. Against: bonds generally offer lower returns than stocks over time, and a short game window may not give a longer-term bond much chance to pay off relative to a stock that could move faster.
Part 2: Kinds of Bonds
Use the chart below to answer the questions that follow.
Corporate
Municipal
Bonds are a major source of corporate borrowing. The most common type, debentures, are backed by the general credit of the corporation. Asset-backed bonds are backed by specific corporate assets, such as property or equipment.
Millions of bonds have been issued by state and local governments. General obligation bonds are backed by the full faith and credit of the issuer. Revenue bonds are backed by the income generated by the particular project financed.
Agency
U.S. Treasury
Some government-sponsored but privately owned corporations (like Fannie Mae and Freddie Mac) and certain federal agencies (like Ginnie Mae and the Tennessee Valley Authority) issue bonds to raise funds, either to make loan money available or to fund new projects.
Treasury notes are an intermediate-term obligation of the U.S. Treasury, with a maturity of one to 10 years, paying interest semiannually. Treasury bills are short-term obligations with a maturity of one year or less, sold at a discount from face value.
Q1
A local government wants to build a new bridge to connect two parts of a growing city. Which type of bond would they issue? Why?
MUNICIPAL BONDA bridge is exactly the kind of local infrastructure project municipal bonds are issued to fund. If the bridge itself generates income, for example through tolls, it would likely be a revenue bond, backed by that toll income. If it is funded through general tax revenue instead, it would be a general obligation bond, backed by the full faith and credit of the local government.
Q2
A home mortgage company backed by the government wants to raise money for more first-time home mortgage loans. Which type of bond would the agency issue? Why?
AGENCY BONDA government-sponsored, privately owned mortgage company (like Fannie Mae or Freddie Mac) is the textbook example of an agency bond issuer, raising funds specifically to make more loan money available.
Q3
An investor wants the safest possible bond investment and plans to collect the interest for ten years. Which type of bond should they purchase? Why?
U.S. TREASURY (A 10-YEAR TREASURY NOTE)U.S. Treasury securities are backed by the full faith and credit of the federal government, making them the safest type of bond covered in this chart. A 10-year holding period matches a Treasury note exactly, since notes have maturities of one to 10 years and pay interest twice a year.
Q4
A large corporation wants to expand into Asian markets. They want to issue a bond and guarantee it with land holdings in Latin America. What type of bond would they issue? Why?
ASSET-BACKED CORPORATE BOND (SECURED)Because the bond is guaranteed by a specific asset, land, rather than by the company's general creditworthiness, it fits the asset-backed corporate bond category described in the background reading. This makes it a secured bond, since bondholders have a claim on that land if the company defaults.
Q5
A major corporation with a reputation for being trustworthy wants to issue a bond, using their credit rating rather than a specific asset to guarantee it. What type of bond would they issue? Why?
DEBENTURE (UNSECURED CORPORATE BOND)A debenture is a corporate bond backed by the general credit of the corporation rather than by any specific asset, which matches a company using its reputation and credit rating as the guarantee. Because no collateral is pledged, this is an unsecured bond.
Q6
An investor wants to support the increase of water power in America and would like to purchase a bond from the Tennessee Valley Authority. What type of bond would they purchase? Why?
AGENCY BONDThe Tennessee Valley Authority is named directly in the chart as a federal agency example, so a bond from the TVA is an agency bond.
Activity Sheet 2
Choosing Bonds
Use the chart below to recommend bonds to each investor.
Type of Bond
Terms
Risk
Interest
Tax Implications
Corporate
1 to 100 years
Low to high
Highest, linked to risk
Taxable
Municipal
1 to 50 years
Variable
Low, but linked to risk
Tax-exempt
Agency
1 to 20 years
Low to very safe
Medium
Some tax-exempt
Treasury notes
2, 5, & 10 years
Very safe
Low
Federally taxable only
Treasury bills
4, 13, & 26 weeks
Very safe
Low
Federally taxable only
Q1
Mr. Davis needs a very safe investment since he will retire in two years. Which bond(s) should he consider? Why?
TREASURY NOTES (2-YEAR)A 2-year Treasury note lines up exactly with Mr. Davis's two-year time horizon, and Treasury notes are rated "very safe" on the chart. Treasury bills would also be very safe, but their longest term is 26 weeks, well short of his two-year window, so he would need to keep reinvesting them.
Q2
Ms. Jones is a young investor willing to take the most risk that bonds have to offer. Which bonds should she consider? Why?
CORPORATE BONDSCorporate bonds span "low to high" risk on the chart, the widest and highest range of any bond type listed, and they pay the highest interest of the group, directly linked to that risk. That combination fits an investor willing to accept more risk for more return.
Q3
Mr. and Mrs. Peters want a tax-exempt investment. Which type of bonds should they consider? Why?
MUNICIPAL BONDSMunicipal bonds are the only type on this chart marked fully tax-exempt. (Agency bonds are only "some tax-exempt," so they are a weaker fit.)
Q4
Mr. Fredrick wants a short-term bond. Which bond should he consider? Why?
TREASURY BILLSTreasury bills have the shortest terms on the chart, only 4, 13, or 26 weeks, making them the clearest short-term option, alongside being very safe.
Activity Sheet 3
An Interest in Bonds
Bonds are fixed-income investments: the investor knows the interest rate and payment schedule in advance. Interest on most bonds is simple interest, not compounded, so each calculation below uses:
Interest = Principal × Rate × Time (in years)
You are investing $1,000.00
Q1
A treasury bond will pay 3% interest a year for 30 years. How much interest will the investor collect at the end of 30 years?
$900.00 interest$1,000 × 0.03 × 30 = $900.00.
Q2
A municipal bond will pay 4% interest a year for 10 years. How much interest will you collect?
$400.00 interest$1,000 × 0.04 × 10 = $400.00.
Q3
A corporate bond will pay 6% interest each year for 2 years. How much interest will you collect?
$120.00 interest$1,000 × 0.06 × 2 = $120.00.
Q4
Which investment would you most recommend to your SMG team? Why?
DISCUSSION, NOT A FIXED ANSWERBy total interest, the 30-year treasury bond wins ($900), but it ties up the money for three decades. The 10-year municipal bond earns less ($400) but is also tax-exempt, which matters more the higher an investor's tax bracket. The 2-year corporate bond earns the least in total ($120) but returns the money fastest and at the highest annual rate (6%), which may suit a short SMG game window better than total interest earned over decades would.
You are investing $3,000.00
Q5
The Ginnie Mae Corp issues a 5-year bond at 3% interest per year. How much money will you have after the bond matures?
$3,450.00 totalInterest = $3,000 × 0.03 × 5 = $450.00. Total at maturity = $3,000 principal + $450 interest = $3,450.00.
Q6
A treasury bill has a 9% interest rate for 27 weeks. How much will you have collected after the bill matures?
$3,140.19 total27 weeks is 27⁄52 of a year. Interest = $3,000 × 0.09 × (27⁄52) = $140.19. Total at maturity = $3,000 + $140.19 = $3,140.19.
Q7
A corporate bond will be issued for one year at a 6% interest rate. How much interest will you make on your investment?
$180.00 interest$3,000 × 0.06 × 1 = $180.00.
Q8
Which investment would you most recommend to your SMG team? Why?
DISCUSSION, NOT A FIXED ANSWERThe one-year 6% corporate bond earns the highest annual rate and returns the money soonest, useful if the team wants flexibility to reinvest. The 5-year Ginnie Mae bond earns less per year but is an agency bond, generally very safe, and locks in a predictable return for longer. The 27-week treasury bill sits in between: safest of the three, shortest of the longer options, and a solid choice if the team wants safety without waiting years.
You are investing $5,000.00
Q9
A city government is issuing a bond for 20 years at 3.5% interest per year. How much interest will you collect when the bond matures?
A large corporation is issuing a 1-year bond at 6.3%. How much money will you have collected after the bond matures?
$5,315.00 totalInterest = $5,000 × 0.063 × 1 = $315.00. Total at maturity = $5,000 + $315 = $5,315.00.
Q11
The treasury department is issuing a 20-year bond at 4.5% interest per year. How much money will you have collected after the bond matures?
$9,500.00 totalInterest = $5,000 × 0.045 × 20 = $4,500.00. Total at maturity = $5,000 + $4,500 = $9,500.00.
Q12
Which investment would you most recommend to your SMG team? Why?
DISCUSSION, NOT A FIXED ANSWERThe 1-year corporate bond at 6.3% is the clear winner by annual rate and speed of return, but it is a corporate bond, so its actual risk depends on that company's credit quality, which is not given here. The 20-year treasury bond at 4.5% is the safer, full-faith-and-credit choice and pays the most total interest of the three by far ($4,500), but it locks up the money for two decades. The 20-year municipal at 3.5% earns the least in this set but would be worth revisiting if tax-exempt status matters to the investor.
Application
Bonds in a Well-Balanced Portfolio
Bonds provide investors with safe, reliable returns, and they can also increase the diversification of a portfolio.
Task: create a list of reasons why you would include bonds as part of a well-balanced portfolio. Be sure to explain how different types of bonds would impact the portfolio differently.
Show a model answer
MODEL ANSWER
Bonds add a predictable income stream. Because the coupon rate and payment schedule are fixed at purchase, bonds smooth out returns that would otherwise depend entirely on stock price swings.
Bonds tend to reduce overall portfolio risk. When stock prices fall sharply, high quality bonds, especially U.S. Treasuries, often hold their value better, which cushions the portfolio.
Different bond types serve different goals within the same portfolio. Treasury bonds and notes add the most safety; agency bonds add safety with a bit more yield; municipal bonds add tax-exempt income for an investor in a higher tax bracket; corporate bonds add higher yield in exchange for taking on more issuer-specific risk.
Mixing bond maturities (short, medium, and long) diversifies the portfolio's timing too, so not all the money comes due, or is exposed to interest rate changes, at once.
Enrichment Activities
Bond Portfolio Strategies
Visit Investopedia at investopedia.com/terms/b/bond.asp to look up the following terms, then explain how each is used to build a fixed-income portfolio that meets the goals of the investors in Activity Sheet 2.
Laddering
Buying bonds with staggered maturity dates (for example, some maturing in 2 years, some in 5, some in 10) instead of one single maturity. As each "rung" matures, the investor reinvests it, which spreads out interest rate risk and provides a steady, recurring stream of cash coming due.
Barbell
Concentrating holdings at the two ends of the maturity range, short-term and long-term bonds, while holding little or nothing in between. This aims to combine the flexibility and safety of short-term bonds with the higher yield typically offered by long-term bonds.
Bond Swap
Selling one bond and simultaneously buying a different one, often to improve credit quality, adjust maturity, capture a tax loss, or take advantage of a change in interest rates, rather than simply holding the original bond to maturity.
How these connect to Activity Sheet 2: laddering could suit Mr. Davis (safe, timed around his two-year retirement) if he wanted more than a single 2-year note. A barbell could suit Ms. Jones if she wanted some corporate exposure for yield while still keeping a safe, liquid short-term piece. A bond swap is less about which investor and more about a strategy any of them might use later, to trade an existing bond for a better fit as their goals or the market changes.