How Bonds Work

IF You are thinking about investing in bonds, you have a vast smorgasbord of choices. You can buy ordinary, individual bonds, just like Mother and Dad did, or you can buy into whole portfolios in the form of a bond fund or a unit trust.

A bond is a long term IOU, and it pays a fixed rate of interest. Usually, you collect your interest checks every six months. Then when the bond comes due, your capital is repaid in full. So you can choose to tuck your bond away in a safe deposit box and collect regular interest payments until the bond matures. But it is precisely those far off maturity dates and the fixed interest rates that make bonds risky.

Say you buy a new 30 year corporate bond at its face value of $1,000. Say also that it pays 10% interest, so you collect $100 a year every year until the date when the bond matures, or comes due. But if long term interest rates in the meantime rise say, to 20% your bond will fall in value. It will be worth only about $500 in the open market, because that is the amount that makes your $100 annual return equal to a 20% yield. If you had to sell your bond to raise money before it matured, you would lose cash.

On the brighter side, however, if interest rates fall below 10%, your fixed interest bond is obviously worth more than $ 1,000. That is because an investor would have to pay more than $1,000 in the market to buy a bond that would yield the guaranteed $ 100 a year that you collect. You may want to speculate in bonds if you think that interest rates will fall, thus pushing prices up.

When you buy a bond, you should consider six factors: First, there is the so called coupon rate. That is the fixed dollar amount of interest you collect. Second is the maturity date. That is the date when you will be paid the face value of the bond, usually $ 1,000. The third factor is the current yield, which is the coupon rate divided by the current market price. For example, if the rate on the face of the bond is 9% and the bond is selling for $900, the current yield is 10%. Fourth is the yield to maturity, which combines the current yield with the price you paid for the bond if it was more or less than the face value. Fifth is the tax status. The interest paid on bonds issued by government bodies is usually exempt from certain taxes. Finally, there is the quality rating AAA or B minus, for example which tells you the financial soundness of the issuer.

Most investors should stay with bonds that have a quality rating of AAA or AA. Indeed, U.S. Treasury securities, which are guaranteed by the federal government, are even safer than AAA corporate or municipal bonds.

But adventurous buyers might consider lower quality issues. A bond rated BBB offers a yield two or three percentage points higher than one rated AAA. And yields for so called junk bonds which are rated BB + or lower are still richer. These low rated bonds have heavier risks. While few bond issuers have ever defaulted on the principal, interest payments could be deferred or the bond's quality rating could be lowered further, and that would depress the price.