How bonds work

In Lesson 7

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Top things to know Why bonds? How bonds work Types of bonds Sizing up risks Buying bonds

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Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects. When you buy a bond, you are loaning your money for a certain period of time to the issuer, be it General Electric or Uncle Sam.

In exchange, the borrower promises to pay you interest every year and to return your principal at "maturity," when the loan comes due, or at "call" if the bond is of the type that can be called earlier than its maturity (more on this later). The length of time to maturity is called the "term."

A bond's face value, or price at issue, is known as its "par value." Its interest payment is known as its "coupon."

A $1,000 bond paying 7 percent a year has a $70 coupon (actually, the money would usually arrive in two $35 payments spaced six months apart). Expressed another way, its "coupon rate" is 7 percent. If you buy the bond for $1,000 and hold it to maturity, the "yield," or actual earnings on your investment, is also 7 percent (coupon rate divided by price = yield).

The prices of bonds fluctuate throughout the trading day as, of course, do their yields. But the coupon payments stay the same.

Say you don't buy the bond right at the offering, and instead buy from somebody else in the "secondary" market. If you buy the bond for $1,100 in the secondary market, though, the coupon will still be $70, but the yield is 6.4 percent because you paid a "premium" for the bond.

For a similar reason, if you buy it for $900, its yield will be 7.8 percent because you bought the bond at a "discount." If its current price equals its face value, the bond is said to be selling at "par."

The bottom line: There are many ways of expressing a bond's return, but "total return" is the only one that really matters. This includes all the money you earn off the bond: the annual interest and the gain or loss in market value, if any.

If you sell that $1,000 bond with the $70 coupon for $1,050 after one year, your total return is $120, or 12 percent -- $70 in interest and $50 in capital gains. (Prices are usually expressed based on a par value of 100, so when you sell that bond for $1,050 the price would be quoted as 105.)

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