Identification

• Debt securities, also known as bonds, are the primary way to invest in debt. Issuing bonds is a way for corporations and government entities to borrow money. When you own bonds, the issuer of the bonds is in debt to you and is obligated to pay you interest and the face amount of the bonds when they mature. Bonds are marketable securities, meaning they can be quickly converted to cash by selling in the market. Debt securities can also be know as notes, bills or debt obligations.
  
  

Features

• Bonds are issued with a fixed face amount in multiples of $1,000 or $5,000 and a fixed rate of interest. The bond issuer pays the interest in semi-annual installments and repays the principal amount on the maturity date. The term of debt securities can range from a few months out to 30 years or longer. The interest paid on a bond is determined by the credit-worthiness of the issuer, the time to maturity and the tax status of the interest.
  
  

Types

• U.S. and foreign governments, corporations and municipal governments issue bonds. U.S. government debt, or Treasury debt, has maturities from 30 days to 30 years. Treasuries are considered to be the safest debt instruments and generally pay the lowest rate of taxable interest. Interest from Treasury securities is exempt from state income taxes. State and local governments issue municipal bonds. Municipal bonds are attractive because the interest paid is exempt from federal income tax. Interest from bonds issued in a tax payer's state of residence is also exempt from state income tax. Corporations borrow money by issuing bonds and pay a rate of interest based on the credit quality of the corporation. Corporate bonds are dividend into investment grade issues and non-investment grade, or junk bonds.
  
  

Function

• Investors can hold bonds directly or invest in bonds through bond mutual funds, closed-end funds, unit investment trusts or ETFs. Direct ownership should be limited to investors with a large enough portfolio to diversify across several bonds of $25,000 face amount or more. Mutual funds and closed end funds provide professional management to select the best bonds based on current market conditions. Unit investment trusts hold a diversified portfolio of bonds with a fixed maturity date. Exchange traded funds allow a low cost way to short term trade in the bond market.
  
  

Credit Risk

• Bond investors are subject to two primary kinds of risk, interest rate and credit risk. Credit risk is the possibility that the bond issuer will be unable to pay the interest and/or principal. Bond issuers are rated by Standard & Poors, Moodys and Fitch Ratings that indicate the credit quality of of the bonds. Treasury debt has the highest, the AAA rating. Investment grade bonds are those rated BBB or higher. Issuers with lower credit ratings must pay a higher rate of interest to borrow money. Investors weigh the chance of default against the interest rate to pick the quality of bonds they are comfortable with.
  
  

Interest Risk

• The majority of bonds are issued with a fixed rate of interest payment. The bond market then adjusts for changing interest rates by changing the price of bonds on the open market. Rising interest rates cause bond market prices to decline, and falling rates are good for bond values. Longer term to maturity bonds have greater price swings than short term bonds. Investors who think rates will increase should own short term bonds. This allows them to wait until maturity to receive the principal and reinvest the money at the new, higher rates. Declining rates dictate the ownership of long term bonds. As rates fall the long bond holder will still be earning the high rate attained at the time of purchase, or he can sell the bond at the current market price for a capital gain.