Bond Basics | Municipal Bonds



BOND BASICS

WHAT IS A BOND?
 
A bond is essentially a loan made to a company or a government body. The lender and the borrower enter into an agreement under which the lender will receive periodic interest payments and ultimately will get back the amount lent (the principal). The duration of the agreement, known as the maturity, can vary from days to decades. What makes a bond different from other loans is that it is a security that can be bought and sold and has a value that fluctuates. Debt securities with a maturity of 13 months or less are known as notes; the maturity of bonds is most often 30 years.†
 
 
WHAT ARE THE MAIN TYPES OF BONDS?
 
The three main categories are:
  • corporate
  • Treasury (issued by federal government)
  • municipal (issued by state or local government)

Municipals, which are the focus of this website, are also known as tax-exempt bonds, because the interest paid to the investor is typically not subject either to federal income tax or to state and local taxation (though some states exempt only interest from in-state bonds). There is a much smaller category of taxable municipal bonds, which we discuss below.


 

HOW ARE BONDS SOLD?

There are two main markets for bonds:
  • primary market: bonds sold for the first time
  • secondary market: the resale of bonds some time after their initial offering

When bonds are first offered (the usual term is issued), they are not sold directly to the public by the borrower (known as the issuer). Instead, they are brought to market by an underwriter, an intermediary (usually an investment bank or syndicate of investment banks) that brings together bond sellers and bond buyers. See below for more details on the underwriting process.

In the secondary market, bonds are generally not sold in exchanges like stocks. They are traded through a huge network of independent dealers. Buying and selling bonds is much less straightforward than trading shares of stock. Dealers vary in what type of bond they can provide, and pricing varies from dealer to dealer, since dealers set their own markup. Extensive price information is not readily available. Most municipal bonds trade infrequently; thus commission costs can be high.
Bonds have traditionally been sold in units of $1,000 (the face value is known as the par value), though municipals today are typically sold in denominations of $5,000.
Individuals who own bonds directly tend to be affluent investors, though a somewhat larger population invests through bond mutual funds. Until about two decades ago, bondholders were sent certificates containing coupons that had to be removed periodically and submitted to receive interest payments. Investors were known informally as coupon clippers. Today, interest payments are transmitted electronically to the bank account of the holder of record. The interest rate, however, is still frequently referred to as the bond’s coupon.
Not all bonds have traditional coupons. There is a category of bonds known as zero coupon, which do not pay interest periodically; instead, the interest accumulates until the maturity date. There are also variable-rate demand obligations, which are long-term bonds with variable short-term interest rates (and a feature that allows the holder to redeem the securities at different intervals).
 
 
WHO BUYS BONDS?
 
Buyers of bonds are primarily large institutional investors such as pension funds, insurance companies, banks, corporations and mutual funds. It is essentially a wholesale rather than a retail market. For the most part, the bond market is not designed for individual investor, though municipals are held more widely than corporate bonds and Treasurys.
 
 
HOW ARE BONDS PRICED?
 
The par value of bond is its value at the maturity date; in other words, the amount the investor would be paid when the bond comes due. When a bond sells at less than par, it is said to be selling at a discount; if it sells at more than par, it is called a premium bond.
Bond prices are quoted in two parts—the bid and the ask. This would, for example, be stated as 98 bid/100 ask (meaning you would get 98—equivalent to $980 on a $1,000 bond—if you are selling, or pay 100—or $1,000—if you are buying). The difference is the market spread. The dealer may quote a wider spread to get a bigger commission.
The size of the spread reflects the bondís liquidity; i.e., the ease and cost of trading it. A narrow spread reflects high demand and low risk, meaning that the dealer could resell it without difficulty. The spread usually ranges from one-half of one percentage point to four percentage points. Commission costs are closer to actual market spread for new issues, higher in the secondary market.
 
 
WHY BOND PRICES FLUCTUATE
 
The term yield is used to refer to the rate of return on a bond. This will vary from the coupon rate once a bond starts trading in the secondary market and ends up with a price that differs from the par value. If a bond has a fixed coupon interest rate (which is most commonly the case), the price of the bond has to adjust to keep the bondís yield in line with market conditions (particularly changes in interest rates) and changes in credit quality. Generally, interest rate risk has been the more important factor.
For example, if a bond was purchased initially with a coupon of 4% and prevailing interest rates have subsequently risen to 6%, the holder will have difficulty finding a buyer, given that someone could purchase a newly issued bond paying the higher rate. The buyer would have to reduce the price to reflect the change in prevailing interest rates and would thus take a loss on the principal. In the past few years, interest rates tended to move downward, meaning that bond prices increased. The fundamental principle is that interest rates and bond prices move in opposite directions, though the degree of movement tends to be greater in bonds of longer maturity.
 
 
WHAT ARE OTHER RISKS ASSOCIATED WITH BONDS?
 
Most bonds have call provisions, which allow the issuer to retire all or a portion of the bond issue before the stated maturity date at a set price, usually above par. Despite this premium, bondholders who retain the bonds until maturity will not receive all the interest they expected when they bought the bond. If interest rates have fallen compared to the coupon rate, a reinvestment of the principal in a new bond will yield less than the original bond would have provided.


Updated: June 2004

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