Bonds can help balance your portfolio.
Bonds are debt investments. When you buy a bond, you’re really lending money, or principal, to a company or government for a certain term, or period of time. The company or government—known as the issuer—promises to pay you interest on the principal, just as you would have to pay interest if you borrowed money from a bank. And when the bond matures at the end of its term, you’re promised the principal back.
TYPES OF BONDS
Corporate bonds are issued by public companies to raise money for various purposes, from expansion to modernization. In general, these bonds pay higher interest than other bonds, but that interest is taxable unless you buy the bonds through a taxdeferred or tax-exempt retirement savings plan.
US Treasury bills, notes, and bonds are issued by themfederal government to raise money for running the country. Since they’re backed by the government’s ability to levy taxes rather than just by corporate profits, these bonds have less credit risk—and tend to pay somewhat lower interest—than corporate bonds. You have to pay federal income taxes on the interest, but not state or local taxes.
Municipal bonds, often known as munis, are issued by state and local governments to raise money for various projects and expenses. Most municipal bond interest is free of federal income tax. And if you buy munis from the state where you live, the interest you earn is tax free. But if you buy munis issued by another state, you have to pay state and local taxes on the interest.
Agency bonds are issued by various government agencies for specific projects. For example, Ginnie Mae, the Government National Mortgage Association, issues bonds to help finance affordable mortgages. Agency bonds tend to pay slightly higher interest than other government bonds because they pose a higher credit risk. But you don’t get the tax breaks you do with Treasurys or munis. The interest these bonds pay is often taxable on all levels.
Zero-coupon bonds, sometimes called zeros, work a little differently than most other bonds. You buy them at a deep discount, for a price way below their par value. For example, you might pay $11,000 for a $20,000 zero-coupon bond. You don’t receive any interest during the bond’s term, but when it reaches maturity you get the face value plus all the interest that accumulates over th years.
If you’re investing for a particular goal with a predictable time frame— a child’s college education, for example—the relatively low cost and big payout of zeros can make them a smart move.
But if you’re just starting to invest and you don’t have a definite goal for this portion of your investment portfolio, zeros may not be smart. You’d be tying up a lot of money for a long time, or risking a loss if you sell, since zero-coupon prices are volatile. And even though you don’t get any interest until the bond matures, you still have to pay taxes on it each year.
FOR WHAT IT’S WORTH
A bond’s par value is the amount that you lend the issuer and the amount that you get repaid at maturity. In most cases, par value is $1,000 except US Treasury issues, where it’s $100. But various market forces and investor attitudes can change bond prices just as they change stock prices. The only difference is that with bonds, these increases and decreases are always in relation to par value.
What happens to interest rates has the biggest single impact on what bonds are worth. As rates go up, the prices of existing bonds go down because they provide comparatively less income. For example, if interest rates increase from 5% to 6%, you’d get $10 more income per $1,000 investment on a new bond than on an existing bond. As a result, an older bond becomes less attractive to investors and its market price will drop below $1,000. When a bond sells below par, it is selling at a discount.
Similarly, if the interest rate drops, existing bonds paying the older, higher rate become more desirable because they provide more income. In that case, investors will pay more than $1,000, or what’s known as a premium, to own them.
BUYING TO HOLD
If you buy a bond when it’s issued and hold onto it until it matures, it’s one of the most straightforward investments you can make. You pay your money up front, and you know beforehand exactly how much you’re going to earn, and when you’ll get your principal back. This simplicity makes it a favorite with traditional investors.
Of course, investing this way makes you vulnerable to inflation. Since the interest a bond pays is usually fixed—one exception is inflation-indexed Treasury bonds—the amount you receive over time will buy less and less as time goes on. This becomes a particularly pressing problem with long-term bonds, which is one of the reasons they typically pay a higher rate than short-term bonds. After all, there’s got to be some incentive for tying up your money.
BUYING TO TRADE
You can also trade bonds actively through a broker on the secondary market. That means buying bonds that another investor is selling—or selling the bonds you own because there are investors who want to buy. Some investors regularly buy and sell bonds as they do stocks, trying to make money on price fluctuations and interest rate changes.