FastFacts: Bonds

Bond basics: When you buy a bond, you're making a loan to a corporation, the federal government, or state or local governments, for such things as factories, highways, and schools. In exchange for the use of your money, you earn interest and the promise of repayment of your principal on a set date.

Bond ratings: Bonds are rated according to their credit quality, a standard measure of the financial strength and creditworthiness of the bond issuer. As a general rule, higher-quality bonds pay lower interest rates, while lower-quality bonds pay higher rates to attract investors. Bond ratings aren’t meant to measure whether a bond is a good investment or not, but rather, how likely its principal will be paid if you hold it to maturity. The private agencies that rate bonds use a combination of letters A through D to estimate risk. For example, AAA or Aaa is the highest quality bond, while C or D rated bonds are in default of payment.

Bonds & interest rates: A bond's value is closely tied to movements in interest rates, so if you sell a bond before it's due, you'll receive its current value, which could be more or less than you paid for it. Bond values increase when interest rates fall, and decrease when interest rates rise. That's because if an older bond's interest rate is higher than the rate being paid on newly issued bonds, buyers are willing to pay more for it to get the higher interest. Conversely, if an older bond's interest rate is lower than the rate paid by newly issued bonds, its price will fall to attract buyers.

How a bond's value reacts to interest rate changes depends in part on its maturity. In general, bonds with longer maturities are more sensitive to changes in interest rates, so their market prices can fluctuate significantly. To compensate investors for this added risk, longer-term bonds generally pay higher yields.