By Nancy Trejos
Washington Post Staff Writer
Sunday, November 2, 2008
Investing in bonds is as complicated as investing in stocks. There are many types from which to choose. You can invest in government, municipal or corporate bonds. Or you can buy into mortgage and asset-backed securities, zero-coupon, U.S. Treasury Inflation-Protected Securities or international bonds. Each bond will have different credit ratings, yields, maturities and other features. Each carries its own risks. We try to boil it down for you.
· What are bonds?
Put simply, they are IOUs. You're lending money to the U.S. government, a state or local government, a foreign government, a corporation -- any institution that sells bonds. In exchange, the issuer will pay you back the principal when the loan matures, or expires, plus whatever interest was agreed on. Bonds attract investors because they typically offer a steady stream of interest income plus repayment of the principal. Because they can be a vehicle for preserving capital, financial advisers often suggest that any portfolio contain a mix of stocks and bonds or other forms of fixed income.
· What should you consider when shopping for bonds?
No two bonds are alike. They come with a number of features that, depending on your time horizon and risk tolerance, may not be right for you. Here are some to think about:
1) Interest rates: They can either be fixed, variable or payable when the loan expires. Most are fixed. Variable rates change along with such indexes as the London interbank offered rate, or Libor. You can receive payments semi-annually or when the loan is repaid.
2) Maturity: A bond reaches maturity when you are repaid the principal of the loan. That can happen within days or years. Typically, bonds are divided into short-term notes (up to five years), intermediate notes (5 to 12 years) and long-term notes (12 to 30 years, sometimes even longer.)
3) Yield: This is the actual return you get based on the price you paid and the interest payments. You can look at the current yield, which is the annual return on what you paid for the bond. But a better judge of the worthiness of the bond is to calculate the yield to maturity, which determines your return if you hold onto the bond until it expires. Remember, the higher the yield, the greater the return but the greater the risk as well.
4) Redemptions: Sometimes, despite their stated maturities at the time you buy the bonds, these loans can terminate early or last longer than expected. Some bonds have "call provisions" that require the issuer to repay the principal before it matures. This typically happens when the interest rate drops. On the flip side, some bonds have "puts," which let the investor ask the issuer to buy back the bond before it matures. This usually happens when the investor needs cash or when interest rates have risen to a point where he or she can turn a profit.
5) Credit quality: This is a way to calculate risk. The safest bet would be U.S. Treasury bonds, backed by the "full faith and credit" of the U.S. government. The riskiest would be below-investment grade, high-yield "junk" bonds. In the United States, the credit quality of governments and companies is monitored by the ratings agencies: Standard & Poor's, Moody's and Fitch Ratings. Lower-quality companies or governments will sell bonds with higher interest rates. So remember, the higher the interest rate and the lower the quality, the riskier the investment but the greater the opportunity for reward.
6) Taxes: You don't have to pay state or local income tax on the interest from U.S. Treasurys. That is often the case with municipal bonds as well. There is no federal income tax on most munis. Why would someone turn down a tax-exempt investment, you might ask? It all depends on your tax bracket. You should seek help from an adviser to determine whether you could actually earn more from a taxable bond.
7) Price: This fluctuates with market conditions, credit quality, and interest rates especially. The rule of thumb is this: When prices fall, the yield rises.
· What are the different types of bonds?
There are several types. Most bonds are issued by the U.S. government and its agencies, state and local governments or corporations. Let's take a look at these.
1) U.S. government bonds: You can buy either bills (maturities range from 90 days to a year), notes (2 to 10 years) or bonds (10 to 30 years). They are considered the safest bets. The U.S. government probably won't default on this loan because it can always raise tax revenue to pay back its debt obligations. Another plus: Any income you earn is exempt from local and state taxes. The downside is that because they are not as risky an investment, their interest rates are lower. Of the types of Treasurys you can get, the longer-term ones will have the highest interest rates simply because you have to wait longer to get repaid.
You can also get bonds from government-backed agencies such as the Tennessee Valley Authority and Sallie Mae. They have higher yields but are generally only available through brokers who charge commissions.
2) Municipal bonds: State and local governments issue these bonds to pay for school construction projects, water and sewer upgrades, etc. In exchange for investors' backing, the federal government won't tax the interest on these bonds. Many municipalities also will exempt investors from state and local taxes on these bonds. Because of this, the yield is usually lower than that of a taxable bond. And munis, as they are called, carry some risk. Cities can go bankrupt, after all.
3) Corporate bonds: These offer higher interest rates than government bonds, but buying them typically requires you to go through a broker and pay a commission. Many corporate bonds are also callable, meaning the company can pay off the debt early. Furthermore, corporations, unlike governments, are more likely to go bankrupt. Hence, the lower the credit quality, the higher the interest you're paid.
· How do you buy bonds?
You can buy individual bonds or bond funds. Most bond transactions are done through a full-service or discount brokerage. You can also get an investment adviser to sort it out for you. Keep in mind that the broker or dealer will probably include a mark-up. You can protect yourself from this by finding out the latest quote on a bond. This is easily done on the Internet.
The best way to buy U.S. government bonds is to go to http://www.treasurydirect.gov or to contact your nearest Federal Reserve Bank. Through the government's Treasury Direct program, you can buy these bonds without paying commission.
If you don't want to go through the hassle of buying individual funds, try a bond fund, which offers you diversification. The fund managers are constantly trading bonds depending on market conditions, so there are no maturity dates. You can withdraw your money whenever you want. But because the trading is constant, the value of your investments could be higher or lower when you pull out.
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