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BONDS |
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Overview A bond represents a debt owed by the government, a corporation, or some other entity to you. In exchange for lending money, you are paid interest on the loan. You also want the original amount you lent paid back. The issuer of a bond makes these promises:
Every bond has a maturity date, which is when you are entitled to receive the face value (par value) of your investment. If you’re investing in a bond, you want assurances that you will be paid back in full and you’ll receive your interest on time. Some bonds are callable, however, which means the issuer can redeem them if certain conditions are met.
The Bond Market Investors can buy a bond:
The secondary market is where investors buy and sell bonds from each other, not from the issuer. When a bond is first issued, the interest rate it pays depends on a number of factors:
The interest rate on a bond stays the same until the maturity date, but its value goes up and down in the secondary market. The price of a bond in the secondary market depends on how its interest rate compares to similar bonds being issued for the first time. If the bond you own pays interest equal to the interest rate on a new bond of comparable quality, your bond will have a price equal to its face value. If the interest rate on your bond is less than the interest rate on a newly issued bond, your bond is less desirable. You must sell it at a discounted price. If the interest rate on your bond is more than the interest rate on a newly issued bond, your bond is more desirable and will sell at a premium. Here’s how it works:
For example, if you own a $5,000 bond paying 5 percent and interest rates drop to 4 percent, the value of your bond increases and you can sell it for more than the face value. However, if interest rates rise higher than 5 percent, your bond’s value decreases and you’ll need to sell it at a discount from the face value.
Types of Bonds There are three broad categories of bonds:
Government bonds Treasury securities are direct obligations of the U.S. government. A government security is one issued by the federal government or one of its agencies. Here are a few of the possibilities:
With Treasury securities, the federal government guarantees the principal and interest. Even though your principal and interest is guaranteed, the value of your bond may be worth less or more than you invested if you need to sell it before the maturity date. Corporate bonds Corporate bonds are issued because companies don’t always borrow from banks and often use bonds, instead, to raise money. The interest rate paid on a corporate bond depends on:
Just like individuals, some companies are a good credit risk and some are a bad credit risk. Here’s how it works:
As an investor, you must decide if it’s worth taking more of a risk for a higher interest rate. Municipal bonds A municipal bond is issued by a state, city, school district or public entity. Municipal bonds are usually exempt from federal income taxes. They may also escape state and local taxes. Municipal bonds pay less interest than taxable bonds of comparable quality. For example, a city that has financial problems must pay a high interest rate to attract investors, because it may default on its obligations to bond owners. Bond maturity Along with choosing which type of bond to invest in, you must choose among varying maturity dates. Bonds are sometimes classified according to how long it takes for them to mature:
Risks of Buying Bonds When you buy a bond, you face several risks:
If you don’t hold a bond until its maturity date, you must sell it in the secondary market. Your bond may be worth less than its face value if interest rates are higher than when you first invested in the bond. Your bond will also go down in value if the issuer’s financial condition has deteriorated. If you plan to hold a bond to maturity, it really doesn’t matter if the bond’s value fluctuates from day to day. Nevertheless, you still need to worry that the bond’s issuer may not be able to redeem the bond when it comes due or make your interest payments. Bond Ratings Just as your bank won’t lend you a dime until it sees your credit rating, you shouldn’t buy a bond until you see the credit rating of the entity that issued it. You shouldn’t risk your small fortune on bonds from issuers that have financial problems. There are three major rating services that evaluate the credit worthiness of bonds:
The Standard & Poor’s top rating is AAA. A bond with a BBB or higher rating is classified as investment-grade. If you were looking at Moody’s ratings, investment grade is Baa and higher. So-called junk bonds are rated lower than investment grade. They are also referred to as high-yield bonds, since the issuer must may more interest to entice investors to buy riskier bonds. Keep in mind the higher the yield relative to other investments with the same maturity, the more risk you are taking that the issuer will not make all of your interest payments and, even worse, will fail to repay the debt
Tips & Common Mistakes Tip: Invest in bond mutual funds As a new investor, you may be better off with a bond mutual fund, rather than buying individual bonds. As we will see in our discussion of mutual funds, you can enjoy a diversified portfolio with a small investment. Tip: Use the laddering strategy If you buy individual bonds, you can use a similar laddering strategy that we suggested for CDs. You take the amount you want to invest and split your purchase among bonds with different maturity dates. Your goal is for bonds to come due at regular intervals in case you need the money. If not, you can buy another bond at the prevailing interest rate or explore other investments. When you stagger your purchase of bonds, you’ve hedged your bets in the event that interest rates rise or fall dramatically. Tip: Reinvest your interest Remember that your return will be higher if you reinvest the interest paid out on the bond. Let’s say you buy a five-year bond for $1,000 that pays 6 percent. At the end of five years, you’ll have received $300 in interest, plus your original $1,000. If you reinvest the $300 in interest as you receive it, you’ll have another $38.23 in five years. Common mistake: Putting everything in bonds Typical bond investors are older and need income to live on in retirement. For younger investors who are years away from retirement, the stock market offers greater opportunities for long-term growth. Nevertheless, as you build a diverse mix of assets for your investment portfolio, bonds are worth considering.
Getting Started There are several ways to invest in bonds:
A bond mutual fund has the following benefits:
However, the value of your bond investment may go above or below the amount you invested. The classification of a bond mutual fund is based upon the type of bonds it purchases. Often categories overlap and the fund manager purchases a mixture of bonds, such as corporate and government bonds. You can even buy index bond funds that spread your investment among the entire bond market or certain kinds of bonds. Bond funds are also differentiated by whether they buy short, medium or long-term bonds. As an example, if you invest in a short-term bond fund, the money manager buys bonds that mature in a relatively short period of time. Because they invest in short-term bonds, short-term bond funds are less likely to drop in value due to rising interest rates. Short-term bond funds are a slightly riskier alternative to money market funds.
FAQs Am I better off buying tax-free bonds? Tax-free bonds make sense if you are in a high tax bracket. They normally pay lower interest rates than comparable bonds that are not exempt from federal taxes. Tax-free bonds rarely make sense for college students because:
How are savings bonds different from other kinds of bonds? Unlike Treasury securities, U.S. Savings Bonds are non-transferable. You can only buy them or cash them in through the issuer, the federal government. There is no secondary market for U.S. Savings bonds. Savings bonds are also taxed differently. For example, your interest may be exempt from taxes if you redeem your savings bonds to pay for tuition expenses.
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