How do bonds work?

Types of Bonds

­The U.S. government advertised its bonds heavily during World War II to help fund the war effort.
­The U.S. government advertised its bonds heavily during World War II to help fund the war effort.
National Archives/National Archives/Time & Life Pictures/Getty Images


­Businesses a­ren't the only entities that can issue bonds. Governments and municipalities sell them as well. Let's look at how these kinds of bonds differ.

Governmen­t Bonds: To fund programs, meet their payrolls and essentially pay their bills, governments issue bonds. Bonds from stable governments, such as the United States, are considered extremely safe investments. Bonds from developing countries, on the other hand, are more risky. The U.S. government issues its own bonds from the treasury and from several government agencies. Those maturing in less than one year are known as T-bills. Bonds that mature in one to 10 years are T-notes, and those that take more than 10 years to mature are treasury bonds. In some cases, you don't have to pay state or local income taxes on the interest they earn.

Municipal Bonds: Municipal bonds — also called "munis" — are issued by states, cities, counties and various districts to raise money to finance operations or to pay for projects. Munis finance things like hospitals, schools, power plants, streets, office buildings, airports, bridges and the like. Municipalities usually issue bonds when they need more money than they collect through taxes. The good thing about municipal bonds is that you don't have to pay federal income taxes on the interest they earn.

Corporate Bonds: Corporate bonds are issued by businesses to help them pay expenses. While corporate bonds are a higher risk than government bonds, they can earn a lot more money. There's also a much larger selection of corporate bonds. The disadvantage is that you do have to pay federal income tax on the interest they earn.

Especially when investing in corporate bonds, it's important to consider how risky the bond is. No investor wants to pour a lot of money into a low-yield bond if there's a 50-50 chance the company will go under. You can research the issuer's financial situation to see how solid its prospects are. This involves investigating things like cash flow, debt, liquidity and the company's business plan.

As fun as it sounds to research these things, most of us don't have the time or skills to analyze a corporation's financial situation accurately. Thankfully, there are organizations that do this work for us, like Moody's Investors Service and Standard & Poor's. Their experts research a company's situation and determine a bond rating for the company.

Every rating service has its own formula for measuring risk and its own kind of rating sc­ale. Typically, rating scales are spelled out in letter grades, where an AAA rating designates a safe, low-risk bond, and a D rating designates a high-risk bond. Safer bonds, like U.S. government bonds, are usually low-yield bonds. You can depend on getting a payout — but that payout will be small.

On the other side of the spectrum, you have what's not-so-affectionately known as junk bonds, which are low-rated, high-risk bonds. In order to entice investors into buying these risky junk bonds, the issuing companies promise high yields. If you buy a junk bond, there's no guarantee you'll ever see your money again. But if you do, you could get paid in spades.

Still unsure about some of the terms related to bond investment? Check out the glossary on the next page.