What is an Index Bond?

Many wise investors use a portion of their savings to purchase financial securities called bonds. With this type of investment, an individual gives a financial institution or government agency cash in exchange for the bond. Usually, the security has a maturity date, which determines when the investor can return the bond to the financial institution in order to collect the original cost of the bond, plus any accrued interest. An index bond is a special bond for which the value is determined by the current index rate.

An index bond does not have a maturity date. If the index rate plummets, the value of the bond also decreases, but if the rate rises, the value of the security increases.

An open-ended index bond is one that can be moved around from area to area, such as in a 401k plan. A closed index bond can be purchased in limited quantities, usually 100 shares, and can only be moved through a licensed broker. In either case, the purchaser can decide whether the security should be tax-exempt or taxable. If it earns interest, quarterly payments are sent to the owner.

An index bond can be a risky investment because index rates can rise or fall without notice. A look at the Lehman ten-year bond index for the year 2006, for example, showed that the value slowly declined every month. Only an open-ended bond can be held for longer than ten years. A closed one must be handled by a broker, who receives a commission for any changes made. Therefore, many bondholders choose to keep the security a few years longer in hopes of seeing an improvement in the rates before selling.

There is a minimum $1,000 US dollar (USD) investment in this type of bond, and it can be purchased through approved federal agencies or brokers. A service fee payment must also be made at the time of purchase.