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Bond Basics

As b as stocks have been throughout the 1990s, other investments also have specific roles to play in a diversified portfolio. And occasionally, when stocks take a breather, bonds can take center stage. Think of a bond as a loan. You loan your money to a government or a corporation and you expect certain things in return. Naturally, you expect a specific rate of interest, or yield, on your loan. You expect this yield to be paid regularly, perhaps every month or quarter. And you expect the full amount of the loan, or principal, to be paid back at the end of the period you have agreed to lend your money, the maturity date.

Why Invest in Bonds?

People invest in bonds for three main reasons:

  • Income - Regular interest payments provide steady income.
  • Safety - Bonds are generally more stable than stocks and are designed to return your principal if held to maturity.
  • Diversification - Because bonds may respond differently to market conditions than stocks, they can complement the stocks in your overall investment portfolio. Over time, a combination of stocks and bonds can produce competitive returns with less risk than a portfolio concentrated in a single investment.
The Risks of Bond Investing - Note, however, that bonds are not without risks.

  • Interest Rate Risk - The value of your bond can fluctuate depending on the interest it offers compared with the interest rates of other bonds. As interest rates rise, new bonds are issued and sold with higher rates than those already on the market. Suddenly your bond, with its lower rate, loses some of its luster, and value. When interest rates are declining, new bonds come on the market with lower rates. Suddenly, your bond is the belle of the ball with its now higher interest payments.
  • Credit Risk - A bond is only as dependable as the organization that issues it. If the issuer can't pay, you might not get your interest payments, or even your original investment, back.
  • Inflation Risk - If, over time, the rate of inflation runs higher than the yield your bond is earning, the value of your income stream could significantly diminish over time.
Different bonds and bond funds have different degrees of risk. A U.S. Savings Bond, for example, has little credit risk because the chances are slim that the U.S. government will go out of business. However, a U.S. Savings Bond may not significantly outpace inflation. Before investing in any bond or bond fund, be sure to weigh the various risks associated with it.

Glossary

    Here's a list of terms frequently used when discussing bond investing:

    Intermediate term: A bond that matures in between five and 10 years.

    Long term: A bond that matures in more than 10 years.

    Maturity: The time it takes for a bond to repay an investor's principal.

    Muni: Short for municipal bond. The income from these fixed-income investments is generally exempt from of federal taxes, and can be state and local tax-exempt, too.

    Short term: A bond that matures in less than five years.

    Tax-equivalent yield: The yield a taxable bond would have to pay to equal that of a tax-free bond.

    Yield: Rate of interest divided by the bond's purchase price.

    Zero-coupon bond: Bonds that pay no interest. The bonds are sold at a discount from their face value and investors can earn a capital gain on the bond upon maturity.

Questions & Answers:

Should I invest in bonds or bond funds?
There are advantages to both. Bond funds can offer low minimum investments, diversification, professional management and convenient access to your money. Individual bonds pay a fixed rate of interest and have a set maturity date when your principal will be returned to you.

This information is for educational purposes only and is not intended as investment advice.