Notes

by the end of this lesson, students will be able to:
compute and compare historical returns and fees of Treasury bonds and other bonds Sec 20-3
explain the connection between interest rates and bond returns Sec 20-1
evaluate the best and worst situations for investing in bonds Sec 20-2, 20-5
determine the risks and rewards of investing in bonds Sec 20-3
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reading guide
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Introduction
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A poster encouraging children to sell war bonds shows a Boy Scout lifting a sword for Lady Liberty.
By J. C. Leyendecker
This 1918 Liberty Bond poster was used to encourage citizens to purchase bonds to support their country in The First World War.
Historically, governments would go into debt to finance wars. The United States used Liberty Bonds to pay for World War I and other countries did the same. Bonds were often bought by patriotic citizens to fund military operations. Bond purchases were often seen as a way for all citizens, even children, to participate in the war effort. Today, bonds are used regularly to secure funding for many different things.
Why might investors pay money to governments or even corporations for a bond?
20-1 Bond Basics
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A bond is a promise by one entity, often a government, to pay the holder of the bond a certain amount of money at one or more specified times. Bonds can be structured in several ways, so knowing their basic terminology is useful. The principal of a bond is the amount on which the bondholder pays interest and typically must repay when the bond is redeemed. The interest rate is referred to as the coupon; it defines how much interest will be paid. The amount of money that an investor earns is referred to as the yield. The yield can be broken down in several ways. The way explored in this lesson looks only at the interest earned over the life of the bond. Maturity is the date of the final payment on a bond.
Principal, coupon, years to maturity, and yield are interrelated and can be arranged in several ways. For example, a bond with a $30,000 principal might come with a coupon of 6% and a maturity of 10 years. The bond will pay out $1,800 each year and, at the end of 10 years, repay the full principal. The owner of such a bond would earn a yield of $18,000. The formula below determines the yield for basic bonds:
Coupon × Principal × Years to Maturity = Yield

The coupon rates of bonds tend to move in the same direction as interest rates on loans and the prime rate. Generally, the longer a bond takes to mature or the riskier its issuing organization, the higher the coupon and the yield.
Bonds vs Ownership Investments
A bond does not represent ownership of any specific thing. Contrastingly, investing in real estate typically means the investor owns all or part of a tract of land. Unlike ownership investments, bonds are debt securities. They are obligations for the issuer to pay. They lack ownership rights.
This lack of ownership and control is offset by the fact that bondholders get paid first. With rare exceptions, if a company becomes insolvent and cannot pay its debts, bondholders are paid prior to any other investors who have claim on the money.
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20-2 Issuers of Bonds
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Historically, the biggest issuer of bonds is the U.S. Treasury. During World War I, the U.S. government faced a pressing need for funds to finance the war. The U.S. Treasury issued the first Liberty Bonds in 1917.
Following the war, the government could not fully fund the redemption of the Liberty Bonds as they matured. As a result, new securities were issued. Today, the U.S. Treasury issues new bonds to cover the maturation of old bonds and any budget deficits run by the current government. When tax receipts exceed government expenditures, fewer bonds are issued and the amount of debt decreases. When expenditures exceed tax income, more bonds are issued and the amount of debt increases.
Because treasury bonds are backed by the U.S. government, most investors believe they are the safest possible investment in the world. Investors think that the chances of the U.S. government being unable or unwilling to pay its debts, or defaulting, are essentially zero. As a last resort to ensure payment, the U.S. government could create more money through inflation to pay a bond. Other bonds tend to have their risks measured against bonds issued by the U.S. Treasury. Another benefit of U.S. Treasury bonds is that their income is only taxed at the federal level. Because of this low risk, Treasury bonds typically have the lowest coupons of any bond issued. Income from U.S. Treasury bonds cannot be taxed by state or local governments.
Like the federal government, state governments also issue bonds. State bonds can be used to pay for projects like highways and bridges. These bonds are generally considered safe because states typically have broad tax bases and substantial assets, like land, that could be sold to pay bondholders. State-issued bonds are not as safe as U.S. government bonds, however, because states cannot print new money to pay off the bonds.
Municipalities also can issue bonds to pay for investments, like a new sewer system. The taxes or fees paid by residents who use the sewer system then pay back the bonds. If the residents of a state buy bonds issued within their state, they pay no state, local, or federal taxes on their bond incomes. Municipal bonds can be riskier than state or federal bonds because cities have historically been more likely to default.
Corporate bonds are issued by corporations to raise capital to cover expected business costs. For instance, a corporation might issue bonds in order to build a factory and use the profits from that factory to pay off the bonds. Unlike government-issued bonds, corporate bonds require the bondholder to pay federal, state, and local tax. Corporate bonds also tend to be riskier, as corporations do not have the power to simply raise taxes. Offsetting these disadvantages, corporate bonds typically have higher interest rates.
All of the bonds examined thus far are types issued by American entities. Other countries, their municipalities, and their corporations also issue bonds. The rules for foreign bonds can be complex and are determined by the government of the issuer's country. Foreign bonds can allow for higher returns. Sometimes, they can be much riskier than American bonds.
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20-3 Bonds by Type
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Bonds also vary by type. Lenders may want different forms of repayment. Borrowers may find differing terms of bonds helpful for their own purposes. Below are the major types of bonds investors buy.
Fixed-rate bonds are bonds with a constant interest rate or coupon. The interest rate does not change after purchase. The bondholder receives fixed coupon payments. A fixed-rate bond of $1,000 with a 2% coupon will pay $20 interest directly to the bond holder each year.
In contrast, variable interest rate bonds have changeable coupons. A variable interest rate bond might track an index rate, like the prime rate, and pay slightly higher than that rate. For example, a flexible rate note might track the prime rate, a common interest rate for many loans. If the prime rate increases from 4% to 5%, then the coupon on the bond increases from 4% to 5%. Variable interest rate bonds give a higher yield than fixed-rate bonds when interest rates rise and a lower yield when rates fall.
One special type of variable interest rate bonds is known as Treasury Inflation Protected Securities, or TIPS. Each year, the principals on TIPS are adjusted for inflation. Annual inflation of 2% results in a 2% increase in principal value. This adjustment allows TIPS investors to protect themselves against loss of value from inflation.
A different type of bond is a zero coupon bond. Unlike other bonds, a zero coupon bond pays no interest over the life of the bond. Instead, the bond is sold for one value and redeemed for a higher value. For instance, a 20 year zero coupon bond with a face value of $10,000 might be sold for $5,000. No interest is earned over the life of the bond. However, after 20 years, the bondholder receives $10,000. Zero coupon bonds allow for easy saving calculations for predictable expenses. One downside of these bonds is that the IRS computes annual earnings assuming that zero coupon bonds gain value. Bondholders then have to pay taxes before receiving earnings.
Most bonds have fixed dates of redemption and terms of payment. Puttable and callable bonds do not. Puttable bonds allow for the bondholder to put the bond, or demand payment before the bond matures. Normally, this early payment results in the bondholder getting less income from the bond, but allows the bondholder more options. For instance, if interest rates rise the bond can be put and replaced with a bond that pays more. This type of bond is normally issued only when issuers do not have other options. Terms of specific puttable bonds vary widely.
Callable bonds are the opposite of puttable bonds. In a callable bond, the issuer can repay early. Issuers are protected from falling interest rates since they can pay off a high interest bond early and issue a new bond with a lower coupon. Often issuers have to agree to specific measures, like wage freezes, in order to get this flexibility. Making the bonds callable allows for the issuer to repay the bonds as soon as less demanding financing can be found.
A final special type of bond is a savings bond. Savings bonds are regular bonds that cannot be bought or sold after their initial sale. All other bonds can be sold by the holder to anyone else whenever a sale can be arranged. Savings bonds must be held by the bondholder until the bond matures, barring extraordinary circumstances.
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20-4 Risks of Bonds
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There are several risks when investing in bonds. While bonds are often among the safest investments a person can make, it is important to be aware of the risks of investing in bonds.
Default Risk
The most basic form of risk is default risk. As bonds are a promise to pay a debt, there is a risk that the issuer will be unable or unwilling to pay. If a company goes bankrupt, its assets, such as offices, are sold and the bondholders have first claim to this money. Bondholders lose their investment if the sale of assets cannot pay off their bonds. A less dramatic loss is sometimes termed a haircut. During a haircut, the bondholders and the issuer negotiate a lower rate of interest or even a principal reduction. Haircuts are done in the hopes of keeping the issuers from going broke and being unable to make any payments to their bondholders. This type of arrangement requires the consent of most bondholders or the intervention of a bankruptcy judge.
When buying government-issued bonds, it can be possible for the issuer to simply be unwilling to pay or to change the terms of repayment. Most government-issued bonds are backed by the promise that the government can increase taxes to pay back the bonds. Sometimes, taxes are not raised and the government denies the debt's validity instead. As a result, bondholders may either lose their investments or reduce the yield of their investments. Unlike with corporate bonds, government bonds can force investors to take a haircut without their consent. The government of Argentina forced bondholders to take losses in principal in 2005 in this fashion.
Default risk varies by issuer. The risk of default is considered lowest for Treasury bonds, as only once has the U.S. Treasury ever modified the terms of its bonds. As a last resort, the federal government can print more currency to cover the bonds.
State bonds tend to have the next lowest default risk. As states are large and can levy taxes easily, their bonds tend to be paid. While states cannot print money to pay their bonds, they can sell property and raise taxes. States currently are not allowed to go bankrupt by law.
Municipal and corporate bonds tend to have the highest risk of default. These issuers cannot raise new revenue as easily. Many municipalities and corporations have gone bankrupt. As default risk is highest, these bonds tend to offer the highest interest rates.

Default risk also varies based on the seniority of the bond. The closer a bond is to its maturation date, the less risk there is of default before it is redeemed. As bondholders can buy and sell bonds between themselves, buying bonds closer to their maturation date is generally less risky.
In most cases, the higher the default risk, the higher the yield there is on the bond. If there is not a good reward for the risk of buying the bond, buyers will simply invest elsewhere. To make investing easier, bonds are rated. Companies investigate bond offerings heavily and use math to predict how likely default is. A higher grade, such as "AAA," is a safer bond. These ratings are generally useful, but some issuers know that they can borrow more money for less if they have a high rating. This incentivizes bond issuers to artificially inflate their ratings. Wise investors begin by looking at bond ratings, not ending there.
Inflation Risk
Perhaps the biggest risk of investing in a bond is inflation. Due to inflation, the same amount of money can buy fewer things over time. Bondholders may find that even though they earn interest on the money they invest, they can buy less with the money they have after the bond matures than before they invested.
For example, George buys a bond for $10,000 with 2% annual interest. Over the five-year life of the bond, inflation runs 3% each year. Each year, George earns $200 for a total of $1,000 dollars in interest. When the bond is redeemed, George now has $11,000. Each year, inflation reduces what he can buy. What cost $100 last year now costs $103. Because inflation compounds each year, what George could buy for $10,000 now costs $11,593.
Bond value:
$10,000 × 5 × .02 = $1,000 in coupon payments
+ $10,000 principal
$11,000
Inflation effect:
Year 1
$10,000 × 1.03 = $10,300
Year 2
$10,300 × 1.03 = $10,609
Year 3
$10,609 × 1.03 = $10,927
Year 4
$10,927 × 1.03 = $11,255
Year 5
$11,255 × 1.03 = $11,593
Even though George made money on his investment, 3% annual inflation means he can purchase less today than when he bought the bond.
Inflation can destroy earnings of a bond. All bonds, except TIPS, suffer from inflation risk. The longer the term of a bond, the greater the inflation risk. Likewise, the closer the coupon of a bond to the inflation rate, the more risk there is that a sudden inflation spike will result in a negative real yield.
One strategy to mitigate the risks of inflation is to buy a ladder, or spread, of bonds maturing at different dates. In a ladder, the bondholder tries to have series of bonds that mature one right after another. As inflation increases, new bonds are bought, increasing the average coupon of the bonds in the ladder.
When managing risk in bonds, the best advice is often to diversify. TIPS can protect you against inflation but may offer lower returns than other bonds. Corporate bonds may offer higher returns but are more likely to default. Having a good mix lets the strengths of one bond type offset another's weaknesses.
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20-5 Analyzing Bonds
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To determine which bonds would make a good investment, some math is required. Recall the formula for the basic yield of a bond:
Coupon × Principal × Years to Maturity = Yield
The total value of a bond to be sold is given a value reflecting how much the buyer expects to earn on it. For a fixed-rate security, total value is given by the sum of the principal and the yield.
For variable yield bonds, each interest payment must be calculated separately. Instead of multiplying by the number of years, each payment is summed with the next to obtain the total yield. The yield for zero coupon bonds is simply the difference between the cost of the bond and the face value of the bond. Since these bonds are always sold for less than the face value, there is always profit.
Example bond value calculations:

This example was simplified from semi-annual to annual
and assumed no first year inflation adjustment.
A $5000 zero coupon bond with a purchase price of $4275
$5000
- $4275
$725 yield
Typically, these valuations are adjusted slightly downward based on the maturation date and actions in the bond market.
Calculating the yield for complicated bonds, lots of different bonds, or adjusting for inflation can be difficult. Most investors use bond calculators to compute yields.
Some simple rules of thumb for bond calculations are the rule of 72 and inflation discounting. Investors may choose to reinvest coupon payments into more bonds to get compound returns. Determining how long this type of investment will take to double is done by dividing the number 72 by the coupon. E.g. a coupon of 6% implies doubling in 12 years. This number is roughly the number of years an investor will need to buy and hold similar bonds to double their investment. To calculate how much real value bonds gain, subtract the annual inflation rate from the coupon. Neither of these rules will give exact answers, but they are close enough for many purposes.
When to Buy
Bonds are not always a good investment. If inflation is increasing, some bonds will have negative real returns. If interest rates are climbing, more responsive investments, like money market accounts, may earn more.
On the other hand, bonds are typically safe investments. Their returns may be lower, but they normally pay interest. Bonds also tend to allow for easy planning. If a large number of investments will need to be sold in a short period of time, bonds have stable values.
The most important things to consider regarding the purchase of bonds are the investor's risk tolerance, the performance of other investments, and how long the investments will be held. Investors with little appetite for risk should buy more bonds than those that are comfortable with risk. When other investments perform poorly, bonds become better investments. When the investment is for less than 10 years or so, bonds become a better investment. Typically, young investors buy few bonds. Older investors buy more bonds.
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Connections to History
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Bonds and the Making of America

By John Trumbull
Alexander Hamilton, 1806
One of the first acts of Congress was to issue bonds. During the Revolutionary Era, many expenses had been covered by bonds and promissory notes, written promises to repay whoever eventually owns the documents at some later, specified time. By 1788, many speculators no longer expected these bonds to be repaid.
In 1789, Congress established the Department of the Treasury. The first secretary of the treasury, Alexander Hamilton, crafted an ambitious plan to have the new federal government assume the war debts of the states. In order to finance this debt assumption, the first Treasury bonds were sold. This debt repayment was delayed until 1801.
Hamilton pursued this plan for several reasons. He wished to repair American credit in Europe so that it would be easier for Americans to borrow capital. He wanted the wealthy in the U.S. to have a direct, vested interest in the success of the new government. Hamilton also wished to provide a supply of easily tradable securities to increase currency circulation. Lastly, Hamilton wanted to establish a precedent for stable repayment of debts by the government.
As a price for assuming debts, a political bargain was formed. Hamilton could secure the votes needed to issue bonds only if he would support a southern capitol for the U.S. Instead of having the federal government in New York or Philadelphia, Hamilton supported a capitol located between the southern states of Maryland and Virginia.
Hamilton's move achieved his goals. Financing for early Americans became much cheaper. This financing allowed Americans to more easily expand westward, engage in international trade, and begin to industrialize the country. Federal debt assumption increased economic activity.
To this day, the federal government has defaulted, at most, once on its debts. During the Great Depression, Congress voted to no longer allow bondholders the option of redeeming their bonds in gold as was stated in the bond terms. Instead, the government forced bondholders to accept paper currency. Some jurists and academics hold that this decision was a default. Others hold that it was not.
The federal government has issued bonds and redeemed them since its inception. Bonds were one of the forces that knitted the country together.
Lesson Review
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Bonds are secure investments that allow the investor to earn interest. By lending money to a bond issuer, the bondholder trades money now for more money earned through interest later.
There are many types of bonds issued by many types of organizations. Bond types can differ in their coupon, principal, and time to maturity. Bonds issued by the U.S. Treasury, state governments, local municipalities, and corporations differ in their risks and in their typical coupons.
Some key types of bonds are fixed-rate bonds, variable rate bonds, TIPS, and zero coupon bonds. Fixed-rate bonds are the typical type of bonds that pay interest at an unchanging rate on a regular schedule. Variable rate bonds have fluctuating coupons. TIPS are a special class of variable rate bonds that protect the bondholder against inflation. Zero coupon bonds pay no interest. Instead, they are sold for less than their redemption value.
Homework
Part One
Respond to each question in a complete sentence. Each question is worth one point.
What is a bond?
What determines the yield of a bond?
What are the major risks for bondholders?
What advantage do TIPS have over other bonds?
Which type of bonds is typically taxed the least?
Describe an investor who would be wise to invest in bonds.
Part Two
In 2011, one of the bond rating agencies reduced the rating of Treasury securities. Use the internet to research this event. Do you think this move was justified? Why or why not? Explain your answer in two brief paragraphs.
Your teacher will use the following rubric to assess your answer. As you complete your answer, be sure that you have fulfilled each requirement to ensure that you achieve the highest possible score.
Category Description Point Value
Coverage The paragraphs should relate the reasons for the downgrade. 4
Argumentation The paragraphs should contain clear arguments as to why the student thinks the downgrade was or was not justified. 4
Grammar The paragraphs should be well written free of spelling and grammar mistakes. 2
TOTAL: 10