Basic Terms of Bonds
One of the key investment features of any bond is its maturity. A bond’s maturity tells you when you should expect to get your principal back and how long you can expect to receive interest payments. (However, some corporates have “call,” or redemption, features that can affect the date when your principal is returned. See “Understanding ’Call’ and Refunding Risk”.)
Corporate bonds, in general, are divided into three groups:
• Short-term notes – Maturities of 1-4 years
• Medium-term notes/bonds – Maturities of 5-12 years
• Long-term bonds – Maturities greater than 12 years.
Another important fact to know about a bond before you buy is its structure. With traditional debt securities, the investor lends the issuer a specified amount of money for a specified time. In exchange, the investor receives fixed payments of interest on a regular schedule for the life of the bonds, with the full principal returned at maturity. In recent years, however, the standard, fixed interest rate has been joined by other varieties. The three types of rates you are most likely to be offered are these:
• Fixed-rate: Most bonds are still the traditional fixed-rate securities described above.
• Floating-rate: These are bonds that have variable interest rates that are adjusted periodically according to an index tied to short-term Treasury bills or money markets. While such bonds offer protection against increases in interest rates, their yields are typically lower than those of fixed-rate securities with the same maturity.
• Zero-coupon: These are bonds that have no periodic interest payments. Instead, they are sold at a deep discount to face value and redeemed for the full face value at maturity. (One point to keep in mind: Even though you receive no cash interest payments, you must pay income tax on the interest accrued each year on most zero-coupon bonds. For this reason, zeros may be most suitable for IRAs and, other tax-sheltered retirement accounts.)