So you want to know more about bonds. Not the spy, nor the chemical, emotional, or blood-brother type either. But rather the financial investment tools that come in so many shapes and sizes. Best start off with the basics. Bonds offer a safety cushion against the rollercoaster action of the stock market. They help balance anyone’s portfolio.
A bond is a form of a loan between its issuer and whoever purchases it. In most cases the issuer is the government (Federal, State, or local) or a public company. Buyers are typically investors, whether they are private or corporate. They earn interest with a guarantee of full payment by a set maturity date.
Considered fixed income investments, bonds make regular interest payments till the date they mature. The longer you have to wait for that maturity date the more likely the price of the bond will be affected. Therefore the longer maturity dates usually pay the highest interest.
Types of Bonds
US Government Securities-the safest and most secure and therefore offering the lowest return
o Treasury bonds-maturity date over 10 years in denominations from $1,000 to $1million-no longer issued, but still available secondhand with government backed insurance in tact
o Treasury notes-maturity date of 2, 3, 5, or 10 years in denominations of $1,000-sold at public auction periodically via either a competitive or non-competitive bid-competitive means you will get the bond, non-competitive means you might not-red tape to confuse the masses-the interest rate on the note is set at the auction-a competitive bid states what rate you will accept-a spin of the dice, but a way to insure you don’t get stuck with a rate too low to live with
o Treasury Inflation Protested Securities(TIPS)-maturity date of 5, 10, or 20 years-in denominations of $1,000-also sold at auction-with the added extra of being adjusted for inflation every 6 months-at maturity the bond pays the adjusted principal or the original face value, whichever is higher
o Treasury bills-maturity dates of 4 to 26 weeks make these arguable not bonds, but they work the same way
Mortgage backed securities
A few terms you’re likely to encounter in the bond market and their explanations for those of you who haven’t memorized a dictionary:
Callable-means the issue can pay it back in full before the maturity date-a way for the issuer to save money by refinancing if interest rates have fallen significantly enough
Convertible bonds-means that the bond can actually be converted into shares of a company’s stock
Coupon-or coupon rate-is the interest paid by the bond, not a discount of any kind
Current yield-is how much the bond is currently paying out in income
Discount-a bond can be sold for less than its face value
Par-when a bond sells below its face value it is said to be selling below par
Real rate of return-a ratio of the interest you earn and the market value of the bond
Speculative-means higher risk and lower grade normally for higher return
Yield to maturity-is the income you will get if you hold on until the bond matures while reinvesting all interest
Maturity dates can range from one to ten years
Credit quality rates range from the highest government insured bonds to the lowest and most risky “junk” variety.
Interest on the loan is usually paid semi-annually, with bond prices varying on a daily basis, when interest rates rise bond prices drop and vice versa.
Chose shorter term bonds when interest rates are rising and long term bonds when interest rates are falling-assuming you’re expecting the trend to continue
Most bonds come with broker commissions when purchased except US Treasury securities-contact the federal reserve for more details
Bond funds, purchased through a mutual fund company, can help avoid sales commissions, but do normally come with annual maintenance fees
Capital gains taxes apply if you resell your bond for a profit short term rates apply if held for under 12 months, long term rates for longer
Remember to focus on the after-tax return-bond interest is taxed as regular income with the following exceptions
o US Treasury bonds, bills, and notes are exempt from state and local taxes
o Municipal bonds are usually exempt from federal, state, and local taxes for the state residents within the state the bond is issued from.