So far, you've learned about interest paid by bonds under the simplest scenario, which is that you bought your bond at face value. And you've been thinking only about the interest paid by bonds, while assuming that your invested principal was exactly the same as the face value — the amount you get back when the bond matures. Because this face value is the same amount you initially paid for the bond, the only income you receive are the interest payments.

Yield Versus Interest

Buying a bond at a time other than at issue, and at a value other than face value, brings into play another bond term: the yield. Thinking of bonds as they were treated a hundred years ago will help make this concept clearer.

Before computers ruled the financial world, bonds were printed on paper. The front of the bond — its “face” — indicated how much the bond was worth. A bond with $1,000 printed across the front had a face value of $1,000. Printed across the bottom were the bond's coupons, literally clippable tabs that each represented one interest payment on the bond. The investor would clip the coupon off the bottom and present it to the issuer in return for the interest payment.

Since bonds were unchangeably printed on paper, their face value could not be altered, but changes in the market would still affect their value. Different interest rates on new bonds or the credit rating of the issuer could affect how much an investor was willing to pay for an old bond that someone was trying to sell her. The new investor would have a profit at maturity if she paid less than face value, or a loss if she paid more. This total value received — the bond's interest payments, plus or minus their market value — is called their yield.

The Old-Fashioned Way

Think about it this way. You buy a $1,000 bond with a 5 percent coupon rate. At the first six months, you clip the coupon, take it to the issuer, and they give you your coupon payment based on that face value and interest rate. Now let's suppose that you decide you want your money out of the bond right now and can't wait until it matures. You go to a friend and ask him to buy the bond from you. Your friend would like to help, but comparable bonds are now offering higher interest. It wouldn't be fair to your friend to pay you the full $1,000 face value for the bond and then only collect the lower interest than he could earn with a newer bond. So you offer to drop the price of the bond and take less than $1,000 for it. He pays you the lower price, he still collects his 5 percent interest payments, and when the bond matures he collects the $1,000 face value. Since he paid less than $1,000 for the bond, his total yield is his profit, plus the interest payments. This yield would be equal to the higher-interest new bonds we're paying other investors.

What if Rates Rise?

Of course, in this example, as interest rates increased, the price of your bond dropped in order to balance with the higher market-rate yield. If interest rates were falling, the situation would be reversed. Your 5 percent interest rate would be mighty attractive to someone who was looking at new issues at a lower rate. She would be willing to pay you more than face value to get her hands on the comparatively high coupons you own. At maturity, paying more than face value would bring their final yield down to the market rate.

Interpreting Your Account Statement

This dynamic — rising interest rates bringing bond prices down and falling rates sending bond prices higher — is important to remember when looking at your account statements. If interest rates have gone up since you bought your bond, the value of the bond will show lower on the statement. Don't despair; the nice thing about high-quality bonds is that you get your principal back if you hold it to maturity … no matter what happens with rates in the meantime.

Factoring the Tax Impact

Bond investors must consider two types of tax. Profit generated because you paid below face value creates capital gains tax when the bond matures. Interest paid by bond investments, with a couple of exceptions, is taxed as income.

Interest from Treasuries is exempt from state and local taxes, and interest on muni bonds is exempt from federal income taxes. If the muni you bought was issued by the state where you pay your taxes, the interest is state and local tax free. This is a great deal for investors in higher income tax brackets. But beware: if you're paying alternative minimum tax, you need to rethink your investment. Taxable bonds might be better in your case. You'll learn all about the alternative minimum tax in Chapter 16.

Could Taxable Bonds Be Better?

Munis and Treasuries have lower coupon rates than fully taxable bonds such as corporates and CDs. If you're not in the highest income brackets, don't be fooled by their tax-free status. It may be wiser to take the higher interest and pay the tax than to take the lower tax-free rate. Check the Resource section (Appendix B) for online calculators to help you figure the difference.