average fixed-income fund gained 6.7% in 2003. The
top-rated Fidelity Advisor High Income Advantage bond fund
returned an impressive 42.3% by comparison.
What is a Bond?
A bond represents a loan obligation
of the bond issuer (government, corporation, or individual) to
the bondholder or investor. In essence, the investor loans funds
to the bond issuer in exchange for interest payments for a set
period of time. At the end of this time the borrower (bond
issuer) pays the investor (bond holder/loaner) back the money
loaned. A certificate of deposit is an example of a bond. A
consumer goes to the bank and gives the bank money. In turn, the
bank pays the consumer interest for the use of that money for a
specified period. Then, the bank uses that money to invest in
other projects, such as, small businesses or home mortgages.
Face value or par value is the
value of the bond (amount of principal) printed on the
certificate and received at maturity. If interest rates change
and you need to sell Bond A before maturity, the value you
receive may change. If interest rates increase, Bond A may sell
at a discount or less than the face value. In this case,
investors can buy Bond B paying higher rates so they are not as
interested in this Bond A. If interest rates decrease, Bond A
may sell at a premium because other investors would be
willing to pay more for the higher interest rate on Bond A. See
the example on page 5 of this fact sheet.
Coupon Rate (also known as coupon,
coupon yield, stated interest rate) is the interest rate
printed on the bond certificate when the bond is issued. It
usually is stated as an annual fixed rate typically paid every
six months to the investor.
Maturity date is the day when the
face amount of the bond must be repaid and the debt retired. The
coupon rate remains the same until the maturity date. Bond
maturities may run from a few months to 40 years.
A call feature allows the issuing
agency to pay the investor the face amount for the bond and buy
back the bond before maturity. This allows the issuer to then
reissue the bond at lower interest rates. In the event a bond is
called, investors may then need to reinvest their money at lower
interest rates as well. This results in reinvestment rate risk.
Default is the failure of the
issuer of the bond to make payment on the interest or money
borrowed. Thus, the investor can lose money.
Tax-equivalent yield—If you are
buying municipal bonds for the state in which you live, the
interest may be free of federal, state, and local income taxes.
(You still may have to pay capital gain taxes if you sell the
bonds at a premium.) These income tax-exempt bonds are
appropriate for investors with marginal tax rates of 28% or
higher. There are charts that compare taxable and tax-free
yields for different marginal tax rates. Refer to the following
web site: http://www.bondmarkets.com
for this type of chart.
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