What does ownership of a bond represent

Interest rate risk occurs when interest rates are rising. Most bonds have fixed-rate coupons, and as market rates rise, they may end up paying lower rates.

As a result, a bondholder might earn a lower yield compared to the market in the rising-rate environment. Being a bondholder is generally perceived as a low-risk endeavor because bonds guarantee consistent interest payments and the return of principal at maturity.

However, a bond is only as safe as the underlying issuer. Bonds carry credit risk and default risk since they're tied to the issuer's financial viability. If a company struggles financially, investors are at risk of default on the bond. For example, holding corporate bonds typically yields higher returns than holding government bonds , but they come with higher risk. This yield difference is because it is less likely a government or municipality will file for bankruptcy and leave its bondholders unpaid.

Of course, bonds issued by foreign countries with shakier economies or governments during upheaval can still carry a far greater risk of default than those issued by financially stable governments and corporations. Bond investors must consider the risk-versus-reward of being a bondholder. Risk causes bond prices on the secondary market to fluctuate and deviate from the bond's face value.

However, the investor who purchases the bond is taking the risk that the issuer will not fold or default before the investment's maturity. Potential bondholders can invest in government bonds or corporate bonds. Below is an example of each with the benefits and risks. Treasury bond T-bond is issued by the U. The U. Treasury Department issues bonds via auctions at various times throughout the year while existing bonds trade in the secondary market.

Considered risk-free with the full faith and credit of the U. However, the risk-free feature has a drawback as T-bonds usually pay a lower interest rate than corporate bonds. The year Treasury bond yield closed at 2. At maturity, in 30 years, they receive the full invested principal back. T-bonds can sell on the secondary market before maturity. BBBY has currently a discount bond as of April 05, The fixed bond—BBBY—has a rate of 4.

The value of the bond fell as BBBY had financial difficulty for several years. As a comparison, a year Treasury yield runs around 2. The BBBY offering is deeply discounted with a generous yield and a hardy serving of associated risks.

Should the company file for bankruptcy, bondholders could face losing their entire principal. Fixed Income Essentials. Corporate Bonds. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. Bond duration measurements help quantify and measure exposure to interest rate risks. Bond portfolio managers increase average duration when they expect rates to decline, to get the most benefit, and decrease average duration when they expect rates to rise, to minimize the negative impact.

The most commonly used measure of interest rate risk is duration. In reference to debt securities, a type of auction when a competitive bidding process establishes the interest rate on a security typically municipal or corporate bond. The lowest bid rate which all shares can be sold at par determines the interest rate. This is the rate paid for entire issue during a given period. A Dutch auction is also used in Treasury auctions, allowing each successful competitive bidder and noncompetitive bidder to be awarded securities at the price equivalent to the highest accepted rate or yield.

Differing from other types of Dutch auctions, Treasury accepts various prices, taking the highest bids first and working through progressively lower bids until an issue is completely sold. Most revolving ABS are subject to the risk of early-amortization events-also known as payout events or early calls.

A variety of developments, such as the following, may cause an early-amortization event: insufficient payments by the underlying borrowers; insufficient excess spread; a rise in the default rate on the underlying loans above a specified level; a drop in available credit enhancements below a specified level; and bankruptcy on the part of the sponsor or the servicer. The risk to bond investors that high-yielding bonds will be called early, with the result that proceeds may be reinvested at lower interest rates.

Statistical measures of current conditions in an economy. Economic indicators together provide a picture of the overall health of an economy or economic zone and how bond prices and yields might be affected. Economic risk describes the vulnerability of a bond to downturns in the economy.

For example, virtually all types of high-yield bonds are vulnerable to economic risk. In recessions, high-yield bonds typically lose more principal value than investment-grade bonds. If investors grow anxious about holding low-quality bonds, they may trade them for the higher-quality debt, such as government bonds and investment-grade corporate bonds. A provision that gives the issuer or bondholder an option, but not the obligation, to take an action against the other party.

The most common embedded option is a call option, giving the issuer the right to call, or redeem, the principal of a bond before the scheduled maturity date.

The majority of external emerging market bonds are government bonds. The official website provides free real-time access to prices of bonds and notes when sold or bought from customers, as well as prices paid in inter-dealer transactions and key bond data, such as official statements for most new offerings of municipal bonds, notes, college savings plans and other municipal securities.

Eurobonds are bonds that are denominated in a currency other than that of the European country in which they are issued. They are usually issued in more than one country of issue and traded across international financial centers. Supranational organizations and corporations are major issuers in the Eurobond market. The European Union Countries that use the Euro as the single currency and in which a single monetary policy is conducted under the responsibility of the European Central Bank.

In sharing a common currency, the member states of the European Economic and Monetary Union EMU are governed by the same monetary policy but this uniformity does not extend at the country level to alignment of all economic, regulatory and fiscal matters, including matters of taxation. These include poor management, changes in management, failure to anticipate shifts in the company's markets, rising costs of raw materials, regulations and new competition.

Another kind of event risk is the possibility of natural or man made disasters affecting an issuer's ability to repay its obligations. Events that adversely affect a whole industry may have a spillover effect on the bonds of issuers in that industry.

The net amount of interest payments from the underlying assets after bondholders and expenses are paid and after all losses are covered. Excess spread may be paid into a reserve account and used as a partial credit enhancement or it may be released to the seller or the originator of the assets. A bond with an option to exchange it for shares in a company other that the issuer. A fund that tracks an index, a commodity or a basket of assets. It is passively-managed like an index fund, but traded like a stock on an exchange, experiencing price changes throughout the day as they are bought and sold.

Bond ETFs like bond mutual funds, hold a portfolio of bonds and can differ widely in their investment strategies. Refers to those types of privately owned or privately used facilities which are authorized to be issued on a tax-exempt basis under the Internal Revenue Code. The Tax Reform Act of amended prior law to exclude the following types of facilities from those which can be financed on a tax-exempt basis: sports facilities; convention and trade show facilities; air and water pollution control facilities; privately owned airport, dock, wharf and mass-commuting facilities; and most parking facilities, among others.

The date on which principal is projected to be paid to investors. It is based on assumptions about collateral performance. The risk that investors' principal will be committed for a longer period of time than expected. In the context of mortgage- or asset-backed securities, this may be due to rising interest rates or other factors that slow the rate at which loans are repaid. This redemption is different from optional redemption or mandatory redemption in that it occurs under an unusual circumstance such as destruction of the facility financed.

A decimal value reflecting the proportion of the outstanding principal balance of a mortgage security, which changes over time, in relation to its original principal value. The interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. The target federal funds rate is set by the Federal Reserve Board's Federal Open Market Committee and is a principal tool of monetary policy. For more information, see www.

Calculated each day by the Federal Reserve Bank of New York by averaging the rate at which the five major commercial paper dealers offer "AA" industrial Commercial Paper for various maturities. The date on which the principal must be paid to investors, which is later than the expected maturity date.

Also called legal maturity date. A consultant to an issuer of municipal securities who provides the issuer with advice with respect to the structure, timing, terms or other similar matters concerning a new issue of securities. A municipal securities employee who is required to meet qualifications standards established by the MSRB. The individual is the person designated to be in charge of the preparation and filing of financial reports to the SEC and other regulatory bodies.

A mortgage featuring level monthly payments, determined at the outset, which remain constant over the life of the mortgage. A bond whose interest rate is adjusted periodically according to a predetermined formula; it is usually linked to an interest rate index such as LIBOR.

Refers to the structure which is established in the bond resolution or the trust documents which sets forth the order in which funds generated by the enterprise will be allocated to various purposes.

A security that is registered as to principal and interest, payment of which is made only to or on the order of the registered owner. Financial futures are a contract agreeing to buy or sell a specified amount of an underlying financial instrument at a specific price on a specific day in the future. The price is agreed to at the time of the contract.

Financial futures are usually of three main types: interest rate futures; stock index futures or currency futures. Because futures are complicated and risky, with the potential for losses not limited to your original investment, futures products are not suitable for many individual investors. In the municipal market, an agreement to purchase or sell the municipal bond index The Bond Buyer Bond Index for delivery in the future.

The value of an asset at a specified date in the future, calculated using a specified rate of return. Refers to the type of project proceeds or funds received from a muncipal bond issuance are used for such as government use, education, water, sewer and gas, health care. Pass-through mortgage securities on which registered holders receive separate principal and interest payments on each of their certificates. Ginnie Mae I securities are single-issuer pools.

Pass-through mortgage securities on which registered holders receive an aggregate principal and interest payment from a central paying agent on all of their Ginnie Mae II certificates. Ginnie Mae II securities are collateralized by multiple-issuer pools or custom pools, which contain loans from one issuer, but interest rates that may vary within one percentage point.

The issuance platform used by most GSEs when issuing "global" debt into the international marketplace or a particular foreign market. Has same credit characteristics as nonglobal debt but is more easily "cleared" through international clearing facilities. Also called good-faith check, if delivered as a check, or good-faith deposit. Financing entities created by Congress to fund loans to certain groups of borrowers, such as homeowners, farmers and students. Debt issued by government-sponsored enterprises GSEs —those financing entities created by Congress to fund loans to certain groups of borrowers such as homeowners, farmers and students.

Through the creation of GSEs, the government has sought to address various public policy concerns regarding the ability of members of these groups to borrow sufficient funds at affordable rates.

There are organizational differences among the GSEs although all are established with a public purpose. All GSE debt is not guaranteed by the federal government.

GSE-issued debt securities can be structured to offer investors fixed or floating interest rates. While the basic structures share many characteristics of non-structured fixed- or floating-rate debt, many variations are possible. A special-purpose vehicle set up to issue fixed-rate capital securities and use the proceeds to purchase debt of the parent company.

A commitment or investment made with the intention of minimizing the impact of adverse price movements in an asset or liability, offsetting potential losses. Due to the increased risk of default, these bonds are typically issued at a higher yield than more creditworthy bonds.

A type of inflation-adjusted security issued by the Treasury. Series I savings bonds pay interest according to an earning rate that is partly a fixed rate of return and partly adjusted for inflation. A market is illiquid when there is insufficient cash flowing to meet financial debts or obligations. In the context of bonds or other investments, illiquid refers to a bond or other investment that cannot be converted into cash quickly or near prevailing market prices.

Liquid investments or assets are defined as those that can be converted into cash quickly and without great impact on the price of the asset. Bond resolutions and trust agreements are functionally similarly types of documents, and the use of each depends on the individual issue and issuer. For any particular date and any particular inflation-indexed security, the Reference CPI-U applicable to such date divided by the Reference CPI-U applicable to the original issue date or dated date, when the dated date is different from the original issue date.

Tax-exempt bonds where the rate is periodically reset on a formula that incorporates an index, such as The Securities Industry and Financial Markets Association Municipal Swap Index. A security issued by a state, political subdivision or certain agencies or authorities, for certain specific purposes, but backed by the credit of a private enterprise. The rate of increases in the price of goods and services usually measured on an annualized basis.

For an inflation-indexed security, the principal amount of the security, derived by multiplying the par amount by the applicable index ratio.

Securities designed to protect investors and the future value of their fixed-income investments from the adverse effects of inflation. The delivery of a new issue by the issuer to the original purchaser, upon payment of the purchase price.

The price based upon yield to maturity stated as a percentage of par at which the account determines to market the issue during a set period of time, called the initial offering period. Members of the account may not offer any part of the issue at any other price during that period. Large organizational entities with significant amounts of money to invest such as insurance companies, pension funds, investment companies and unit trusts.

Institutional investors account for a majority of overall volume in the bond markets. The major insurers are identified by these symbols:. National Public Finance Guarantee Corp.

Radian Asset Assurance Inc. Syncora Guarantee. Compensation paid or to be paid to borrow money, generally expressed as an annual percentage rate.

Interest rates change in response to a number of things including revised expectations about inflation, and such changes in the prevailing level of interest rates affects the value of all outstanding bonds. An agreement where a party pays a premium up front or in installments to the counterparty.

If the floating interest rate exceeds a stated fixed rate during the time of the cap agreement, the counterparty will pay the difference, based on the notional amount. The cap rate is also called the strike rate. An interest rate cap can protect the purchaser against rising interest rates.

Interest-rate swaps are a derivative financial instrument which exchange or swap fixed rate interest rate payments for floating rate interest rate payments. Usually these swaps are an agreement between to parties to exchange one stream of interest payments for another over a set period of time.

Investors use interest-rate swaps for debt portfolio management; corporate finance; to lock in interest rates; and to manage and hedge risk. Interest-rate swaps have become critical to the bond markets. Initially interest-rate swaps helped corporations pay fixed rates and receive floating rate payments or vice versa depending on their business needs. But then, swaps were seen to reflect market expectations and sensitivity to interest rates and credit concerns via what an interest-rate swap reflects which is a desire to exchange loans-one that was borrowed at a fixed rate and the other at a floating rate tied to, most commonly, London Interbank Offered Rate LIBOR.

The graph plotting swap rates across available maturities became known as the swap curve. Swap rates suggest what the market expects the direction of LIBOR rates to be; and reflect the market's perception of credit quality. The swap rate curve is an important interest-rate benchmark for the bond markets and is commonly used in Europe as the pricing reference for all European government bonds. A primary derivative tax-exempt bond. The interest payable is based on a formula that has a ceiling rate less a specified floating rate index or bond.

The interest rate structure which exists when short-term interest rates exceed long-term interest rates. See ascending, or positive, yield curve. These bonds tend to issue at lower yields than less creditworthy bonds.

A security or tranche that pays only interest and not principal. IO securities are priced at a deep discount to the "notional" amount of principal used to calculate the amount of interest due. ISIN is the numbering code system set up by the International Organization for Standardization and used by internationally traded securities to identify and number each issue of securities. An ISIN code has twelve characters structured as follows: the first two characters of the ISIN are the country of origin for the security; the security identification number which is called the National Securities Identifying Number NSIN is the next 9 characters long; and a final character, called a check digit, is added to prevent errors and provide an additional verification for authenticity.

The NNA of the appropriate country administers the 9 digit security identification number. The issue description includes the name of the issuer of the bonds. If a municipal bond, the issuer is typically a state, political subdivision, agency or authority which borrows money through the sale of bonds or notes. Corporate bonds are issued by private corporations.

Underwriting accounts are headed by a manager. Ginnie Mae II pass-through mortgage securities collateralized by pools which are generally larger and contain mortgages that are often more geographically diverse than single-issuer pools.

Mortgage loans in jumbo pools may vary in terms of the interest rate within one percentage point. A Z-tranche that may start receiving principal payments before prior tranches are retired if market forces create a "triggering" event, such as a drop in Treasury yields to a defined level, or a prepayment experience that differs from assumptions by a specific margin.

Although jump Z-tranches are no longer issued, some still trade in the secondary market. For example, common stock is junior to preferred stock, which is junior to unsecured debt such as debentures, which is junior to secured debt. A technique for reducing the impact of interest-rate risk by structuring a portfolio with different bond issues that mature at different dates.

An opinion concerning the validity of a securities issue with respect to statutory authority, constitutionality, procedural conformity and usually the exemption of interest from federal income taxes if this relates to a municipal bond issue.

The legal opinion is usually rendered by a law firm recognized as specializing in public borrowings, often referred to as "bond counsel. A commitment, usually issued by a bank, used to guarantee the payment of principal and interest on debt issues.

A debt service schedule where total annual principal plus interest is approximately the same throughout the life of the bond. This entails a maturity schedule with increasing principal amounts each year.

A debt service schedule where total annual principal plus interest declines throughout the life of the bond. This entails a maturity schedule with the same amount of principal maturing each year, with a resulting smaller interest component each year.

This is also called declining debt service. A special type of tax-exempt private activity bond created to boost construction or renovation of residential property within the Liberty Zone in Lower Manhattan, New York, and commercial property within New York City primarily in the Liberty Zone following the September 11, terrorist attacks.

While the program expired at the end of , some in Congress are working to enact legislation to extend authority to issue the remaining Liberty Bonds through the end of The interest rate banks charge each other for short-term Eurodollar loans. LIBOR is frequently used as the base for resetting rates on floating-rate securities. A special-purpose company incorporated under special limited-liability company legislation enacted in many states and foreign countries.

This type of entity is structured as a "pass-through" and treated like a partnership for tax purposes. A bond secured by a pledge of a tax or category of taxes limited as to rate or amount.

A commitment by a bank to provide funds to a borrower, if certain conditions have been met, or if certain conditions do not exist. A measure of the relative ease and speed with which a security can be purchased or sold in the secondary market.

The period of time before a CMO investor will begin receiving principal payments. The obligation of an issuer of a corporate bond to pay a premium to an investor if the issuer pays off its bond before the final maturity.

The premium is based on a formula that compensates the investor for future coupon payments that it will not receive because the bonds have been called. The underwriter that serves as the lead underwriter for an account.

See also joint managers. A requirement to redeem a fixed portion of term bonds, which may comprise the entire issue, in accordance with a fixed schedule. Although the principal amount of the bonds to be redeemed is fixed, the specific bonds which will be called to satisfy the requirement as to amount are selected by the trustee on a lot basis.

For securities traded through an exchange, the last reported price at which a security was sold; for securities traded "over-the-counter," the current price of the security in the market. While investors are effectively guaranteed to receive interest and principal as promised, the underlying value of the bond itself may change depending on the direction of interest rates. As with all fixed-income securities, if interest rates in general rise after a bond is issued, the value of the issued security will fall, since bonds paying higher rates will come into the market.

Similarly, if interest rates fall, the value of the older, higher-paying bond will rise in comparison with new issues. Interest rate risk is also known as market risk. In the municipal market, with regard to Rule 15c, one of 11 specified events that must be disclosed to investors if they occur.

A debt security issued under a program that allows an issuer to offer notes continuously to investors through an agent. The size and terms of medium-term notes may be customized to meet investors' needs. Maturities can range from one to 30 years.

Duration adjusted to price and yield levels to represent percent change relationship of price and yield. A Triple-A-rated company that guarantees that all interest and principal payments on a bond will be paid as scheduled and that participates in no other line of insurance business. A revenue bond which, in addition to its primary source of security, possesses a structure whereby an issuer pledges to make up shortfalls in a debt service reserve fund, subject to legislative appropriation.

While the issuer does not have a legal obligation to make such a payment, the failure of the issuer to honor the moral pledge would have negative consequences for its creditworthiness. A legal instrument that creates a lien upon real estate securing the payment of a specific debt.

Mortgage-backed securities, called MBS are bonds or notes backed by mortgages on residential or commercial properties—an investor is purchasing an interest in pools of loans or other financial assets. As the underlying loans are paid off by the borrowers, the investors in MBS receive payments of interest and principal over time. The MBS market is for institutional investors and is not suitable for individual investors. An entity that originates mortgage loans, sells them to investors and services the loans.

A debt instrument representing a direct interest in a pool of mortgage loans. The pass-through issuer or servicer collects the payments on the loans in the pool and "passes through" the principal and interest to the security holders on a pro rata basis.

A security issued by a state, certain agencies or authorities, or a local government to make or purchase loans including mortgages or other owner-financing with respect to single-family or multifamily residences. Measure of credit risk of municipal bonds relative to risk-free securities, Treasuries.

Stocks are favored by those with a long-term investment horizon and a tolerance for short-term risk. Bonds lack the powerful long-term return potential of stocks, but they are preferred by investors who want to increase their income. They also are less risky than stocks. While their prices fluctuate in the market—sometimes quite substantially in the case of higher-risk market segments—the vast majority of bonds tend to pay back the full amount of principal at maturity, and there is much less risk of loss than there is with stocks.

Many people invest in both stocks and bonds to diversify. Deciding on the appropriate mix of stocks and bonds in your portfolio is a function of your time horizon, tolerance for risk , and investment objectives. Typically, stocks and bonds do not fluctuate at the same time. If seeing a stock price fall quickly would cause you to panic or if you are close to retiring and may need the money soon, then a mix with more bonds could be the better option for you.

If you're a young investor who has a lot of time, you can benefit in a weak market. You can buy stocks after their prices drop, and sell them when their prices increase again. Each person has their own financial goals. Try to keep them in mind when choosing which investments to make. The recommended portion of stocks and bonds in your portfolio changes depending on your circumstances. If you start investing when you're young, you can put a larger percentage of your portfolio in stocks because of the long-term reward, which will mitigate the risk of stock volatility.

As you get closer to retirement, you'll want to gradually shift toward more bonds to offset the growing short-term risk. If a company files for bankruptcy, it must pay back its debts before its shareholders. That means bondholders are in a better position to get paid back than investors when a company is in trouble. To buy stocks, you must set up a brokerage account, establish funds, and then begin trading. You can do this online, through a stockbroker, or directly from companies.

Bonds typically require a larger minimum investment and can be purchased through a broker , an exchange-traded fund, or directly from the U. Inverted curves are not usually very dramatic looking, but they can be. For example, here is the yield curve from September 14, The short answer is not much in terms of your own investing. It can help provide context for interest rates, and it's a useful tool for economists and portfolio managers. But the yield curve, no matter what shape it is, is not a critical consideration for long-term investment planning.

If you hold a broadly diversified bond portfolio, you'll probably have exposure to all parts of the yield curve. The hypothetical illustrations do not represent the return on any particular investment. All investing is subject to risk, including the possible loss of principal.

The degree to which the value of an investment or an entire market fluctuates. The greater the volatility, the greater the difference between the investment's or market's high and low prices and the faster those fluctuations occur.

Liz Tammaro: And from Jim in Washington, "So what is the difference between duration and average maturity? Which is a better measure of volatility to interest rate changes? Ron Reardon: That's a great question. We're throwing around these two terms maturities and duration. And they are different.

I won't go into the mathematics of it. There are different calculations. But the duration of a bond fund includes not just the maturity when you get your principal back, but it also takes into account when you get the cash flows back, right. So it takes into account the couponing of it as well. And that measure is actually the better measure of volatility or sensitivity—.

Ron Reardon: Exactly right. So and that's available on all our funds. So a longer-duration fund, or a longer-duration bond, will have more sensitivity to rates, a shorter-duration bond or bond fund will have less sensitivity to rates. But the thing to remember is that that duration I think is most helpful for investors in order to be able to compare that, that particular fund, or that portfolio, to other products to determine how much additional risk.

But really using that duration measure as a way to chart the—or come up with the risk of that fund relative to other funds I think is the most helpful.

Liz Tammaro: So as you're building your bond allocation and your bond portfolio you would be looking at a measure like duration to figure out which fund may be most appropriate for you and in your portfolio.

Chuck Riley: Right. And when we build portfolios, when I build portfolios for my clients, we focus on intermediate-term bonds, we find that that's the sweet spot. They have a duration of about five years, five to five and a half years. And we really feel that that's the sweet spot of bonds because you're getting almost all the yield, not all the yield, but you're getting a good portion of the yield that you would find in a long-term bond fund. But you're not taking as much risk and conversely you're getting a lot more income than you are from a short-term fund, but again you're not taking all that much more risk.

So it's really finding that balance. An intermediate-term is where we tend to think the sweet spot is. Liz Tammaro: And I think this is a related question that's coming to us from Bob: "I have read that if your time horizon is longer than the bond fund, or the bond's duration, you benefit in a rising-rate environment. Can you please explain the math behind this statement? Ron Reardon: Well, yes, but if you think about it, right, if you have a five-year investment horizon and as opposed to buying a five-year bond fund you buy a three-year bond fund.

The idea is that you get that money back sooner, you can then reinvest that money at the higher rate. So I think that's where the rule of thumb comes from. And I think that's fair. The thing to keep in mind though is that again we mentioned earlier that future paths of interest rates are already priced into the price of bonds today.

So what really is important not so much that you invest at a higher rate in three years' time if you buy that three-year bond fund, but that you invest in a rate higher than what the expectation was, right, at the time of your original investment.

And again this is just a difficult thing for most investors to really kind of come to a conclusion on. All investing is subject to risk, including the possible loss of the money you invest.

Diversification does not ensure a profit or protect against a loss. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.

For more information about Vanguard funds, visit vanguard. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.

Advisory services are provided by Vanguard Advisers Inc. VAI , a registered investment advisor. All rights reserved. Vanguard Marketing Corporation, Distributor. A bond's credit quality is usually determined by independent bond rating agencies, such as Moody's Investors Service, Inc. These agencies classify bonds into 2 basic categories—investment-grade and below-investment-grade—and provide detailed ratings within each.

A measure of how quickly and easily an investment can be sold at a fair price and converted to cash. Rebecca Katz: All right, so our first question is actually from Kathy in Urbana, Illinois, and Kathy says, "My question is really a request.

Would you please begin your discussion with an overview of muni bonds for those of us who have zero experience with them? Daniel Wallick: Sure. So, you can think of them as a contract between a local or state government and people that lend them money. And what state and local governments are trying to do typically is fund capital projects, and what we mean by capital projects are projects that take a lot of money, a lot of capital. And so that could be a road, or that could be a school, or that could be a hospital, or that could be an electric system, or that could be a sewer.

It could be any one of a number of things that just takes a lot of money. So what governments do, is they go out and borrow that money, pay for it up front to fund the project, and then repay that over a long period of time. Rebecca Katz: Okay, and I did mention that there's some tax advantages to munis.

Want to touch on that quickly? Daniel Wallick: Sure and so municipal bonds in particular since they affect state and local governments, they tend to have a tax advantage. So they're not subject to federal, state, or local taxes depending on the jurisdiction. And so there's this difference you'll see in the yields that accommodates for that difference in the tax impact. Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares.

For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax. We recommend that you consult a financial or tax advisor about your individual situation. Rebecca Katz: Okay, great.