BOND BASICS

Most investors have some knowledge of the generic investment class known as bonds. Many, however, may not realize that this term actually refers to a wide array of instruments with varying degrees of risk and reward potential.

What Is A Bond?
A bond is a security that represents a debt on the part of the issuer (the borrower) and a loan on the part of the bond’s purchaser (the lender). Bonds are generally issued by businesses and public entities that seek outside investors to finance major expenditures to keep their organizations operating effectively. Most bond agreements require that the borrower periodically pay interest payments to the lender and, on a specified date, repay the principal amount that was borrowed.

Although there can be significant differences among individual bond issues, there is some basic terminology that help you better understand this important asset class.

Types of Bonds
There are many categories of bonds. Some of the most common are:

Corporate bonds, issued by corporations, are traded on major exchanges and their prices are published in most newspapers.

Government bonds are issued by the U.S. Government and backed by the full faith and credit of the government. What many fail to recognize however, is that the market value of U.S. government bonds is not guaranteed. Like other bonds, their value will fluctuate with changing interest rates.

Government agency bonds are issued and backed by individual U.S. government agencies, such as the Federal Home Loan Bank or the Federal Land Bank. Although these agencies have high credit ratings, their bonds are not supported by the full faith and credit of the U.S. government.

Municipal bonds, on the other hand, are issued and backed by a state, city, or other political entity to raise funds needed to support general governmental needs or finance special projects, such as the building of roads, schools, parks, etc.

An important advantage of government and municipal bonds is the potential for federal tax savings, which can be particularly beneficial to those who fall within a high federal tax bracket. Consult your tax advisor for details concerning a specific issue and the impact such an investment might have on your tax burden.

Maturity vs. Duration
A bond’s maturity is the date on which the issuer is scheduled to repay the bond’s principal amount to the lender. Maturity length or “duration” refers to the number of years and months until the bond is scheduled to be redeemed. Bonds issued with maturities of five years and less are generally classified as short term; issues of five to ten years are generally considered intermediate term; and long-term bonds are those issued with maturities of more than ten years.

Bond Funds vs. Individual Bonds
First-time bond investors may want to consider investing in a bond mutual fund, rather than individual bond issues, because it offers professional management and the opportunity to invest in a diversified pool of several fixed income securities with different durations and rates of return. Such funds generally specialize in a particular kind of bond. There are, for example, long-term municipal bond funds, U.S. government bond funds, high yield bond funds, etc. Read the prospectus carefully before you invest to ascertain the investment policy of a particular fund.

Mutual fund shareholders purchase and redeem shares at any time based on the average market value of all the bonds in the fund. Therefore, upon redemption, mutual fund shares may be worth more or less than they were when purchased. Owners of individual bonds have the option of holding that bond until maturity and collecting all the promised principal and interest payments (as long as the issuer does not default on any of those payments). An investor who redeems an individual bond prior to maturity will generally do so at the current market value, which may represent a gain or loss on the initial investment, based on the current interest rate environment.

For example, let’s assume you purchase a ten-year corporate bond paying 5.5% and, within a year, interest rates rise and new ten-year bonds are paying 7%. The only way you can take advantage of the higher interest rate is to sell your bond and buy a new one. But in order to sell a bond earning 5.5% in an environment where investors can buy bonds earning 7% interest, you would most probably have to sell your bond at a discount. (Note that these returns are hypothetical, and do not represent the return of any particular investment.)