Bonds

Bond Basics

• What they are: Debt securities where you lend money to an issuer (e.g., a corporation or government) in exchange for interest payments and the future repayment of the bond’s face value.
• Pros: Can be virtually risk-free (or low-risk); predictable income; better returns compared with other short-term investments; some bonds are tax exempt.
• Cons: Potential for default; selling before maturity can result in a loss. 
• How to invest: Over-the-counter (OTC) markets including securities firms, banks, brokers and dealers. Corporate bonds may be listed on the New York Stock Exchange. US government bonds can be purchased online at www.treasurydirect.gov.
• Tip: Interest payments from municipal bonds (“muni’s”) are exempt from federal taxes and sometimes state taxes as well.

A bond is an IOU issued by a corporation or government so it can finance certain projects and activities. When you buy a bond, you are giving a loan to the issuer for a certain amount of time. In exchange, the issuer pays you a set interest rate (the coupon rate) at regular intervals until the bond matures. When the bond matures, the issuer repays the full face value (or par value) of the bond. In general, the higher the bond interest rate, the higher the risk.

What types of risk are we talking about?

• Default risk: The possibility that the issuer will not be able to make interest or principal payments when they are due.
• Prepayment risk: The possibility that the bond will be paid off earlier than expected, in which case you lose out on any remaining interest payments.
• Interest rate risk: The possibility that interest rates will be different than expected. If rates decline, you risk prepayment if the firm exercises a call feature. If rates go up, you risk holding a bond with below-market rates (meaning you could be earning more somewhere else).

Tips for Picking Bonds

• Bonds come in different maturities and have different risk profiles. Consider your time horizon and risk tolerance. Are you willing to take on more risk to get higher rewards?
• U.S. Treasury bonds are considered one of the safest investments in the world.
• Investment-grade corporate bonds pay more than Treasuries, but have a higher risk of default.
• High-yield (“junk” bonds) have higher yields, but even more risk.
• There’s no federal tax on municipal bond income, and if you buy bonds issued by your own state, there’s no state tax either.
• Consider a bond fund if you want to diversify your bond investments.

For ideas about how to put a portfolio together, see 4 Steps to Building a Profitable Portfolio.