Investing Advice

Bonds

We have all heard of the term "stocks and bonds". You have a clear understanding of stocks now, but just what exactly is a bond?

Companies, cities, states, and the federal government borrow money from investors. They give the investor a piece of paper in exchange for their money that says when the money is going to be paid back, the amount that will be paid, and with some kinds of bonds, the interest rate. This piece of paper, the bond, is an IOU.

The term of the bond (how many years until it is due to be paid) is typically up to 30 years.

Some bonds pay interest along the way, which you collect by clipping coupons off the bond then presenting them to the organization that issued the bond, generally every 6 months. So if a bond pays 6%, 3% of the face value is paid to the bond-holder twice a year.

Other bonds, known as "zero-coupon", pay all the interest at the date the bond becomes due and payable (at maturity). An example of a zero-coupon bond would be a 20 year, $1,000 T-Bill that you buy for $250 then collect $1,000 in 20 years.

Since a zero is sold at a lower price than the face value of $1,000 (called a discount to par value), the interest that you earn is the difference between the discounted price and the face value of $1,000. Even though you don't collect the interest each year, the hypothetical amount is taxable in the current year.

A popular type of bond is issued by cities, counties, and agencies such as highway departments, water districts, hospitals, and school districts. Called municipal bonds, or "munies", they are exempt from federal taxes and also from local state taxes if the investor lives within the state where the bond was issued.

Revenue bonds are issued for specific projects such as a bridge. The money to pay the bond holders comes from the revenue generated by what is built with the money. Revenue bonds are generally considered to be safe, but their projects can go bust and default (not pay) on their debt. An example is the Washington Public Power Supply System, which in the 1980's defaulted on $2.5 billion worth of revenue bonds.

U.S. government bonds, notes, and treasury bills, are generally all referred to as treasuries. They pay a modest interest rate, but are attractive because, being backed by the U.S. government, they are the safest investment that you can make.

T-Bonds and T-Bills with values up to $10,000 are sold at a discount paying their full face value at maturity, which can be from 4 weeks to 25 years. U.S. treasury notes ($1,000 to $5,000 with maturities from 2 to 10 years) pay their interest by coupon.

Corporate bonds, with somewhat greater risk than those issued by government agencies, pay a higher interest rate to investors to lure them away from the ultra-safe treasuries.

The market value of your bond is based upon the number of months left until it matures, the face value of the bond, the bond's interest rate, current prevailing interest rates, and maybe most importantly, the credit rating of the institution that issued the bond.

Since bonds have a fixed interest rate, the market value of an existing bond goes up when current interest rates fall, and the demand for an existing bond, and so the market value, falls when interest rates go up. This is because when interest rates go up, new bonds are paying a higher rate. Why would someone want to pay full price for a bond paying 4% when they can buy a new bond paying 6% unless you agree to sell the bond at a lower price?

You calculate your bond's yield (the percent you are earning) by dividing the annual interest that you are earning by the price that you paid for the bond.

An investor does not have to wait the full term of the bond to sell it. Bonds are bought and sold on the open market through your stock broker.

Junk bonds, we've all heard of them, are issued by companies that need money and can't qualify for the needed loan from their bank or from business financing institutions. General Electric and McDonald's issue high-grade AAA corporate bonds, but when you clip the coupons every six months for 4 or 5% annual interest, it just doesn't seem like much. You're loaning money to these big companies for almost free.

With riskier low-grade bonds, you buy a zero-coupon at a very steep discount. Or you might buy a $1,000 bond for only $660 and collect a $50 check every 6 months until the bond is due in 8 years, yielding 18.6% to maturity.

An investor gambles with such bonds out of greed, taking the risk that the company may default and then only pay part (or none) of the money back.

Buying and selling low-grade bonds doesn’t take place on an organized exchange, but by a handful of dealers. Markups can be large, and bid prices can fall dramatically when you wish to sell.

Other Types of Investments Topics:

  1. Interesting Ways to Invest in Real Estate
  2. Real Estate Investment Trusts (REIT)
  3. Bonds
  4. Bond Ratings
  5. Closed-end Bond Funds

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