Bonds are a form of debt, and they are generally issued for periods of time longer than one year. Bonds are sold by national governments, local governments, municipalities, companies, and other institutions. When you buy a bond, you are lending money to the institution that is selling the bond. The seller of the bond agrees to repay the principal amount of the loan when the bond reaches maturity. For interest-bearing bonds, the seller also agrees to pay interest periodically, as specified in the loan contract.

To understand bonds, you must first understand the language of bonds. Below is a list of important bond terminology.

Bond Basics

• Holder: The investor who owns the bond.
• Issuer: The corporation or government agency that issues the bond.
• Price: The price for which the bond could be sold.
• Indenture: A document that outlines the terms of the loan agreement.
• Par value: The face value of the bond, or the amount returned to the bond holder when the bond reaches maturity.
• Coupon interest rate (interest rate): The percentage of the par value that is paid to the bond holder annually in the form of interest.
• Call provision: A provision that allows the issuer to repurchase a bond before its maturity date. The price at which the bond may be repurchased is set in the indenture.
• Deferred calls: A specification stating that call provisions cannot be exercised for a number of years. Deferred calls provide protection for the holder of the bond.
• Redemption: The process of cashing in a callable bond before its maturity date.
• Sinking fund: Money that is set aside annually by the issuer to pay off the issuer’s bonds when they reach maturity.
• Current yield: The total annual interest payment on a bond divided by the bond’s current price.
• Debt obligation: A term that is interchangeable with the term bond.

Bond Maturity

• Maturity date: The date on which the bond expires and the issuer must pay back the loan.
• Short-term bond: A bond that matures in one year or less.
• Intermediate-term bond: A bond that matures in two to ten years.
• Long-term bond: A bond that matures in ten or more years.

Types of Bonds

• Asset-backed bond: A bond from an issuer whose bonds are backed by specific assets, such as equipment, automobiles, or real estate.
• Baby bond: A bond with a par value that is less than $1,000.
• Bearer bond: A bond with an attached coupon that allows the bearer to claim interest payments upon surrender of the coupon.
• Book-entry bond: A bond that is registered and stored electronically (similar to stocks).
• Collateralized mortgage obligations (CMOS): More complex, specialized versions of mortgage-backed bonds.
• Debenture: A bond that is backed by the credit of the issuer.
• Discount bond: A bond that is sold at a discount to its par value. At maturity, the accrued interest combined with the original investment usually equals the bond’s par value.
• Junk bond (high-yield bond): A bond with a very low (or risky) bond rating, a higher interest rate, and a higher default rate. Junk bonds are almost always callable.
• Mortgage-backed bond: A bond that is backed by a pool (portfolio) of mortgages that are carried by the issuer.
• Zero-coupon bond: A discount bond that does not allow for a coupon payment and pays no interest until maturity.

Bonds with Conditions

• Callable bond: A bond where the issuer can force the investor to redeem this type of bond before the bond’s maturity date.
• Convertible bond: A bond that gives the holder the option of converting the bond into company stock instead of obtaining cash repayment.
• Floating-rate bond: A bond in which interest payments fluctuate according to a specific benchmark for interest rate and premium.
• Subordinated bond: A bond that will be paid only after the issuer’s other loan obligations have been paid.

Bond Ratings

• Bond rating: A measure of the default risk associated with a company’s bonds. Ratings are done by a bond-rating company and may range from AAA (from Standard & Poor’s) or aaa (Moody’s) for the safest bonds to D (Standard & Poor’s) or d (Moody’s) for the riskiest bonds. In general, the better the bond rating, the lower the interest rate the company will have to pay on its bonds.
• Default risk: The risk that a company will be unable to repay a bond.
• Bond-rating company: A private-sector company that evaluates the financial condition of a company that issues bonds—factors include the company’s revenues, profits, and debts. Bond-rating companies give each bond-issuing company a rating: this rating indicates the relative safety of the bonds offered by the bond-issuing company. Bond-rating companies usually rate only companies that offer corporate and municipal bonds.
• Downgrade: A situation in which a bond-rating company reduces the bond rating of a particular company, usually because of a company’s deteriorating financial condition. If a bond rating is downgraded, it is likely that investors who own the company’s bonds will have to reduce the price of their bonds (resulting in a lower return for the holder and a higher yield for the issuer) to make up for the increased risk.
• Upgrade: A situation in which a bond-rating company improves the bond rating of a particular bond, usually because of a bond-issuing company’s improving financial condition.