If the idea of bonds conjures up images of the savings bonds you got as graduation or birthday gifts tucked away in some drawer, it is time to broaden your thinking. Bonds are an important part of your portfolio. Although they can be dreadfully complex, investors need only master a few basics to start investing in bonds.
U.S. Treasuries are by far the most popular bonds because they have the backing of the federal government and have been easier to buy than other bonds. But you may also choose other government bonds, such as municipals or agency bonds; corporate bonds; or offerings such as inflation-indexed or zero-coupon bonds.
To choose a bond, first determine your goal for the investment and how long you intend to hold it. Then select a bond based on the following features.
Every bond has a term, which is the length of time until the bond matures. The maturity date is the specific date on which the bond's principal will be repaid. Maturities range from one day to 30 years. Bonds (and bond funds) are classified by terms. Short-term notes have maturities up to four years; intermediate-term bonds and notes have maturities from 5 to 12 years; and long-term bonds are those maturing after 12 years. (The same categories are used with bond funds.)
Although bonds are not set to mature until the end of their terms, some bonds can come due sooner. A bond may have a call provision that allows the issuer to repay the principal before the maturity date. Issuers may "call" a bond at any time. A company may, for instance, call a bond when interest rates drop substantially, making it less expensive for it to pay the principal now then to wait until the bond matures. Bonds with call provisions typically pay higher rates than other bonds to compensate for the risk an investor is taking. Some bonds also have puts, which allow investors to cash out early.
Whether you buy short-term or long-term bonds depends on your investment goals. You may be willing to accept the lower returns provided by short-term bonds in order to find a safe investment. Or you may be willing to accept the risk that interest rates will rise and buy long-term bonds, which are most vulnerable to rate changes.
Many investors find intermediate bonds the best bet. Those bonds often have rates close to those of the riskier long-term bonds.
U.S. Treasuries are considered the highest quality because they are backed by the federal government -- and Uncle Sam is not likely to default. Bonds issued by state and local governments, as well as by corporations, vary in quality.
Issuers are required to describe the risks inherent in their bonds to all investors. Investors also rely on rating agencies such as Moody's and Standard & Poor that rate bonds as they are issued and track them over time. Each analyzes the finances of the issuer and awards a bond a letter rating, with AAA the highest. Bonds with ratings of BB and below are considered below investment grade. Also known as "high-yield" or "junk" bonds, these bonds are more risky but can bring higher returns.
How much you pay for a bond depends on its quality, market demand and interest rates, among other things. New bonds sell at prices close to their face values, but older bonds that are being resold will see wider fluctuations in price. If the current price is higher than face value, the bond is selling at a premium. If the price is lower than face value, the bond is selling at a discount.
The trick with bonds is to remember that yields move in the opposite direction as prices. So when the price of bonds rises, yield drops.
But just what are yields? Yields measure your rate of return. The most often quoted number is the current yield, the approximate rate of return over the next 12 months. Calculate it by dividing the bond's total annual interest payment by its current price. So a $900 bond with a coupan rate of 8 percent (which is $80 annually) has a current yield of 8.89 percent ($80 divided by $900).
But a more useful -- though more complicated -- measure is yield to maturity. Yield to maturity takes into account the present value of all future payments, so it includes reinvested dividends, as well as any gain or loss if you bought the bond at below or above face value. Ask your broker for this number when deciding on a bond.
Because maturity and yield are related, bond traders draw a yield curve between the yields on similar bonds of different maturities. A normal yield curve shows a steep rise between short and intermediate issues, which then slows between intermediates and long-term bonds. If you hear that the curve is steeper than usual, it means short-term bonds are yielding less than usual. If the curve is flat, it means that the difference between short- and long-term issues is relatively small. If the curve is inverted, short-term yields are actually higher and traders expect interest rates to fall. You can find the yield curve in major newspapers or financial web sites.
Rates are key to understanding how much your bonds will earn. Bonds pay interest that is usually fixed but can also be floating. Payments are made twice a year, so a bond with an 8 percent interest rate will pay 4 percent twice a year. Interest rates on floating bonds are reset according to changes in the government's set interest rates. Other bonds, known as zero-coupon bonds, pay interest only at maturity, along with the principal.
Changes in interest rates affect different bonds in different ways. Long-term bonds have more risk that rates will change by the time they mature.
Interest rates also affect the price of a bond. From the time it is issued until it matures, a bond's price will change. When interest rates rise, prices of outstanding bonds fall to price the already-issued bonds in line with the price of new issues. When interest rates fall, prices of existing bonds rises until their yield is low enough to match the lower rates of new issues. That means that the value of your bond can be higher or lower if you sell it before maturity (when your principal is guaranteed).
Also see: Why Buy Bonds?