The term bond is commonly used to refer to any securities that are founded on debt. When you purchase a bond, you are lending out your money to a company or government. In return, they agree to give you interest on your money and eventually pay you back the amount you lent out.
The main attraction of bonds is their relative safety. If you are buying bonds from a stable government, your investment is virtually guaranteed, or risk-free. The safety and stability, however, come at a cost. Because there is little risk, there is little potential return. As a result, the rate of return on bonds is generally lower than other securities.
Why Consider Bonds?
It's an investing axiom that stocks return more than bonds. In the past, this has generally been true for time periods of at least 10 years or more. However, this doesn't mean you shouldn't invest in bonds. Bonds are appropriate any time you cannot tolerate the short-term volatility of the stock market. Take two situations where this may be true:
1) Retirement - The easiest example to think of is an individual living off a fixed income. A retiree simply cannot afford to lose his/her principal as income for it is required to pay the bills.
2) Shorter time horizons - Say a young executive is planning to go back for an MBA in three years. It's true that the stock market provides the opportunity for higher growth, which is why his/her retirement fund is mostly in stocks, but the executive cannot afford to take the chance of losing the money going towards his/her education. Because money is needed for a specific purpose in the relatively near future, fixed-income securities are likely the best investment.
Characteristics of Bonds
Bonds have a number of characteristics of which you need to be aware. All of these factors play a role in determining the value of a bond and the extent to which it fits in your portfolio.
Face Value/Par Value
The face value (also known as the par value or principal) is the amount of money a holder will get back once a bond matures. A newly issued bond usually sells at the par value.
What confuses many people is that the par value is not the price of the bond. A bond's price fluctuates throughout its life in response to a number of variables (more on this later). When a bond trades at a price above the face value, it is said to be selling at a premium. When a bond sells below face value, it is said to be selling at a discount.
Coupon (The Interest Rate)
The coupon is the amount the bondholder will receive as interest payments. It's called a "coupon" because sometimes there are physical coupons on the bond that you tear off and redeem for interest. However, this was more common in the past. Nowadays, records are more likely to be kept electronically.
As previously mentioned, most bonds pay interest every six months, but it's possible for them to pay monthly, quarterly or annually. The coupon is expressed as a percentage of the par value. If a bond pays a coupon of 10% and its par value is $1,000, then it'll pay $100 of interest a year. A rate that stays as a fixed percentage of the par value like this is a fixed-rate bond. Another possibility is an adjustable interest payment, known as a floating-rate bond. In this case the interest rate is tied to market rates through an index, such as the rate on Treasury bills.
You might think investors will pay more for a high coupon than for a low coupon. All things being equal, a lower coupon means that the price of the bond will fluctuate more.
Maturity
The maturity date is the date in the future on which the investor's principal will be repaid. Maturities can range from as little as one day to as long as 30 years (though terms of 100 years have been issued).
A bond that matures in one year is much more predictable and thus less risky than a bond that matures in 20 years. Therefore, in general, the longer the time to maturity, the higher the interest rate. Also, all things being equal, a longer term bond will fluctuate more than a shorter term bond.
Types of Bonds
Government Bonds
In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories:
Bills - debt securities maturing in less than one year.
Notes - debt securities maturing in one to 10 years.
Bonds - debt securities maturing in more than 10 years.
Municipal Bonds
Municipal bonds, known as "munis", are the next progression in terms of risk. Cities don't go bankrupt that often, but it can happen. The major advantage to munis is that the returns are free from federal tax. Furthermore, local governments will sometimes make their debt non-taxable for residents, thus making some municipal bonds completely tax free. Because of these tax savings, the yield on a muni is usually lower than that of a taxable bond. Depending on your personal situation, a muni can be a great investment on an after-tax basis.
Corporate Bonds
A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years.
Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The upside is that they can also be the most rewarding fixed-income investments because of the risk the investor must take on. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives.
Other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.
Zero-Coupon Bonds
This is a type of bond that makes no coupon payments but instead is issued at a considerable discount to par value. For example, let's say a zero-coupon bond with a $1,000 par value and 10 years to maturity is trading at $600; you'd be paying $600 today for a bond that will be worth $1,000 in 10 years.
Gilts UK
Gilts, or Gilt Edged Securities, are bonds issued by the UK Government which offer the investor a fixed interested rate for a predetermined, set time.
Investment in Gilts is best suited to people who desire a fixed, predictable income with a return of capital guaranteed.
While their value, like shares, are prone to fluctuation, Gilts are well-known for their security and are viewed as the safest of investments, hence their original name Gilt Edged Securities.
While stock has a redemption date, typically between five and twenty five years, it can be sold at any time for the present market price. Investors are not tied down and there are no penalties for selling the stock. By the time the redemption date is reached, the government will pay the investor the face value of the stock, which could be more or less that the original price, providing a capital gain (or loss).
Buying Gilts and Selling Stock
One can buy Gilts and sell Gilts on the stock market or by using the Bank of England’s postal dealing service. Gilt value is influenced by many factors, including inflation, other competing forms of investment and the time left until maturity.
Buying Gilts is, arguably, best done when interest rates and high and look likely to fall. When general interest rates fall, the value of the stock will rise and can be sold profitably. On the other hand, if market interest rates are low, then Gilt prices will be high and a loss could be anticipated if the stock is possessed to redemption.
Remember, always do your homework, you should research bonds just as you would stocks! | 
