Bonds are tradable IOUs that offer to repay the purchaser the amount invested (principal) plus a fixed or floating interest rate by a nominated maturity date. They are issued by different levels of government (federal, state and local) and larger corporations to raise capital for growth or development and priced at $100=face value.
Bonds are part of fixed income assets - those with a nominated rate of return - and most state a coupon or interest rate plus their issue price, also called par. So at a price of $100 and a coupon of 6% the issuer is offering to pay the bond holder $6 annually for the bond's life (up to 30 years) plus the original issue price on maturity. Collectively, bonds and other tradable IOUs are called debt and considered the counterpart to equity.
In the secondary market buyers judge their return as yield by calculating the bond's interest rate compared to its current market price, which drops if demand for the rate offered is low, increasing the yield. This in turn can make the bond more appealing, raising the price of the bond and decreasing its yield.
The best known and most widely-held bonds are those issued by the federal government, usually called Treasury bonds or Treasury notes. They offer a fairly low rate of interest but are considered amongst the safest investments in the financial world because they are backed by the U.S. government. The federal government issues electronic and paper versions of EE-series bonds, which pay a fixed interest rate (most recently 3%) and I-series bonds, whose interest rate is indexed to inflation, and both are sold in denominations ranging from $25 to $10,000 . Treasury-bond holders are exempt from paying local and state taxes on their earnings and can defer their federal taxes until the bond matures.
State and local governments issue municipal bonds, also called "munis", which usually offer a slightly better return than treasuries with a slightly risk that the issuer will default, or not pay their obligation on maturity. Munis generally offer better tax advantages than treasuries because their income is exempt from federal taxes and state taxes if the holder lives in the state of issue.
Corporate bonds usually offer higher yields than government bonds because companies are considered riskier investment vehicles than governments. Larger corporations' bonds that receive high ratings from agencies like Standard & Poors are considered the least risky. These bonds, also called "gilts", usually offer lower yields than smaller-company bonds that receive lower ratings, often called junk bonds. Corporate bond buyers purchase debt in a company while stock investors buy equity.
Bonds for investors
Investors of all sizes purchase government bonds mainly because their risk of default - especially for treasuries - is very low and so the investor's principal and return can be considered safe. They are especially popular during periods of economic downturn or uncertainty when other securities like stocks are performing poorly. Investors looking to reduce their overall tax burden also purchase government bonds for their tax benefits.
Corporate bonds, while somewhat riskier, offer investors the advantage of a slightly higher yield than Treasuries and munis without the risk of purchasing company stock. That's because if the issuing company declares bankruptcy, its obligations to its bond holders (debtors) take precedence over those to its equity-holding stockholders, making bonds attractive to the more risk-averse.
Bonds for traders
Although bonds receive less attention as a trading vehicle than stocks, bond traders mostly deserve their "Masters of the Universe" reputation first announced in Tom Wolfe's 1988 novel "Bonfire of the Vanities." Those traders generally preferred the potentially extreme volatility of junk bonds for short-term activity, but nowadays Treasuries are also popular for their combination of liquidity and volatility. They also allow traders to hedge and take longer-term positions on broader economic issues like interest rates and the credit market.
The usual vehicles for more active trading of U.S. treasuries, and the way most traders know them, are as derivatives contracts like options, futures and options on futures, on the bonds. These contracts effectively let traders predict the direction of key economic indicators by a fixed point in the future, such as six months from the contract's purchase. The exchange market for these contracts is dominated by the CME Group.