A Primer for Investing in Bonds

A Primer for Investing in Bonds 

Bonds offer an opportunity to spread your risk

What Is a Bond?
A bond is basically a loan issued by a corporation or 
government entity. The issuer pays the bondholder 
a specified amount of interest for a specified time, 
usually several years, and then repays the bondholder 
the face amount of the bond. 
Bonds may belong in your investment plan for a 
number of good reasons: 
n Bonds can provide a predictable stream of relatively 
high income that you can use for living expenses or for 
funding other parts of your investment plan. 
n Bonds offer an opportunity to spread your risk. 
During a recession, for instance, prices of high-quality 
bonds may go up even as prices of stocks go down. 
(Of course, bonds can also lose value. See page 5.)
n Bonds can generate profits from capital gains.
n Bonds can provide valuable tax advantages. In 
particular, interest from most bonds issued by state 
and local governments and their agencies is exempt 
from federal income tax and may be exempt from 
local income taxes, too.
Note that the word safety doesn’t appear on this 
list. People often think that bonds are about the safest 
investment around. But as you’ll see, such a notion is 
not always correct.
How Do Bonds Work, Anyway? 
Bonds are IOUs issued by corporations (both domes-

tic and foreign), state and city governments and their

agencies, the federal government and its agencies, 
and foreign governments. They are issued for periods 
as short as a few months to as long as 30 years, occa-

sionally even longer.
When you buy a bond, you become a creditor of the 
issuer; that means the issuer owes you the amount 
shown on the face of the bond, plus interest. (Bonds 
typically have a face value of $1,000 or $5,000, 
although some come in larger denominations.) You 
get a fixed amount of interest on a regular schedule—
every six months, in most cases—until the bond ma-

tures after a specified number of years. At that time 
you are paid the bond’s face value. If the issuer goes 
broke, bondholders have first claim on the issuer’s 
assets, ahead of stockholders.
In most cases, you won’t receive the actual bond 
certificate. Bond ownership is usually in the form of 
a “book entry,” meaning the issuer keeps a record of 
buyers’ names but sends out no certificates. U.S. 
Treasury bonds, for instance, are issued only electroni-

cally or by banks and brokers in book-entry form. 
After bonds are issued, they can be freely bought 
and sold by individuals and institutional investors in 
what’s called the secondary market, which works 
something like a stock exchange. 
All bonds share these basic traits, but they come 
in a variety of forms. Let’s take a closer look.
Secured bonds are backed by a lien on part of a 
corporation’s plant, equipment or other assets. If the

corporation defaults, those assets can be sold to 
pay back bondholders. 
Debentures are unsecured bonds, backed only by 
the general ability of the corporation to pay its bills. 
If a company goes broke, debentures can’t be paid off 
until secured bondholders are paid. Subordinated 
debentures are another step down the totem pole. 
Investors in these don’t get paid until after holders of 
so-called senior debentures get their money. 
Zero-coupon bonds may be secured or unsecured. 
They are issued at a big discount from face value be-

cause they pay no interest until maturity, when the in-

terest is paid in a lump sum at the same time the bond 
is redeemed and you get your original investment 
back. However, tax on the interest is due in the year in 
which it accrues, as if you had received it, unless the 
bond is in an IRA or other tax-deferred account. 
Municipal bonds are issued by state or city govern-

ments, or their agencies, and come in two varieties: 
General obligation bonds are backed by the full 
taxing authority of the government that issues the 
bonds. 
Revenue bonds are backed only by the receipts 
from a specific source of revenue, such as a bridge or 
highway toll, and thus are not considered as secure as 
general obligation bonds. Interest paid on municipal 
bonds is generally exempt from federal income taxes 
and usually income taxes of the issuing state as well. 
Interest on “private purpose” municipal bonds—those 

that provide some benefits to private activities—may 
be subject to the alternative minimum tax, however.
Build America Bonds, issued in 2009 and 2010 
(and still available in secondary markets) are munici-

pal bonds that pay taxable interest at a higher rate 
than tax-free interest on other munis. BAB bonds are 
designed to appeal to pension plans, IRAs and other 
non-taxable or tax-deferred entities.
U.S. Treasury debt obligations that mature in a 
year or less are called Treasury bills and those that 

mature in more than one year to ten years may be 
called Treasury notes. Treasury securities that come 
due in more than ten years are called Treasury bonds. 
All are backed by the full faith and credit of the federal 
government, which is an ironclad guarantee that 
you’ll get your money back. Interest from Treasuries 
has a special sweetener: It is exempt from state and 
local income taxes. 
Agency securities are issued by various U.S. 
government-sponsored organizations, such as 
Fannie Mae and the Tennessee Valley Authority. 
Although not technically backed by the Treasury, 

A Primer for Investing in Bonds