Bonds and
Bond Funds
Ready to loan some of your money to the government or a
corporation—in return for interest on your loan? Then you’ll want to
consider bonds. Also called fixed income securities, bonds are simply IOUs. In
return for your loan, the borrower (such as the government) agrees to make regular
interest payments for as long as you hold the bond. And when the bond matures,
after say 10 or 20 years, you can “cash in” the bond to get your original investment
back.
In this section, you can learn more about:
Different Types of Bonds
There are many different types of bonds, which are generally
classified by:
1) who
is issuing the bond;,
2) when
the bond matures; and
3) how
likely the issuer can meet its debt obligations.
1) The issuer. Bonds
are issued by a variety of different types of entities, including:
| Issuer |
Description |
U.S.
Government |
The bonds issued by Uncle
Sam are called Treasuries. They include:
• U.S. Treasury bills – maturities
from 90 days to 1 year
• U.S. Treasury notes – maturities
from 2 to 10 years
• U.S. Treasury bonds – maturities
from 10 to 30 years
|
| |
Treasuries are widely
regarded as the safest bond investments, because they are backed by "the
full faith and credit" of the U.S. government. So chances are you’ll
get paid back. Plus, the income you earn from them is exempt from state and local
taxes. But due to this high degree of safety and inherent tax advantages, Treasuries
generally provide lower interest income than other fixed income securities.
|
| |
Bonds of longer maturity,
however, tend to have higher interest rates because your money is tied up longer—and
as a result, assuming more risk.
|
Municipalities |
Municipal bonds are securities
issued by local governments such as cities, towns or special districts. An attractive
feature of these securities is that the interest on them is generally free from
federal income taxes and, in some cases, state and local taxes as well.
|
| |
Because retirement assets
are already tax-deferred, muni bonds are generally not offered in retirement plans.
|
Corporations |
Corporate bonds tend to
be the riskiest fixed-income securities because companies—even large, stable
ones—are much more susceptible than governments to problems. But corporate
bonds can also be the most lucrative fixed-income investment, since you are generally
rewarded for the extra risk you're taking. The lower the company's credit quality,
the higher the interest you're paid.
|
| |
Corporations, of course, want to keep their
credit ratings high. But all kinds of companies issue bonds. High-yield, or "junk,"
bonds, are riskier than higher quality bonds, but they can provide attractive
returns. |
Back to Top
 2)
The length of the bond’s maturity
Bonds are also categorized by how long you have to hold
the bond to get your principal back:
- short-term (1 to 5 years);
- intermediate term (5 to 15 years); and
- long term (greater than 15 years).
3) The credit quality of the issuer
 Bonds
are also categorized by how likely the company is to pay its debts over time.
Those ratings—expressed as Aaa, Aa, A, B, BB, BBB, etc.- help determine the interest
rate that the issuer has to pay its investors. Investment grade bonds are those
with the highest ratings; “junk” bonds are those with the lowest.
The lower a bond’s rating, the more risk that its issuer may default on the loan.
So the lower the bond’s quality, the more attractive the payoff needs to be.
Back to Top
Risks and Rewards of Bond Investing
 The
Risks
While you may find the income stream from bonds appealing,
you should also keep in mind that this stream of income could be interrupted.
- The issuer may default on the bond—so you may not
ever get repaid in full; or
- The bond may be “called” which means the issuer takes the bond
back before maturity—and forces you to reinvest your original principal,
most likely at a lower interest rate.
Bond prices also tend to move countercyclically to inflation. When investors
see prices rising, they may not want to be locked into the fixed returns of bonds.
So when inflation goes up, bond prices typically go down.
The Rewards
Bond investments are attractive because they offer a stable
source of income. Moreover, these income payments are usually higher than what
investors could earn on other more conservative investments like money markets
or certificates of deposits (CDs).
Want to learn more about bond investing?
Go to our article on Waking
the Bear.
Back to Top
|
Invest
Your Assets
