AMES, Iowa -- Two benefits of investing in bonds are that you
will receive known payments at specified times and you will have
diversified holdings, assuming your other investments are in,
for example, stocks or real estate. But there are things to know
if you want to be a knowledgeable bond investor, says Pat Swanson,
CFP® and families specialist with Iowa State University (ISU)
Extension's Invest Wisely Project (www.extension.iastate.edu/investwisely).
"Bonds are fixed-income investments. You are a lender.
You loan your money to a government entity, corporation or a
financial institution and receive regular interest, for example,
semi-annually, annually or at the time the bond is redeemed," Swanson
explains. "If a $1,000 bond pays interest of 6 percent,
the holder of the bond will receive $30 every six months or $60
The rate of interest paid on a newly issued bond is based on
the current rate at the time of issuance for bonds of a similar
risk. This interest rate paid the bond holder remains the same
over the life of the bond. Once bonds are purchased their market
value rises or falls based on changes in interest rates in the
market. This is no concern to the bondholder planning to keep
the bond until it matures.
"However, if the holder of the bond wants to sell the bond
prior to its maturity date, the holder may receive more or less
than the face amount of the bond," Swanson says. "For
example, if you own a $10,000 bond paying 4.75 percent and the
current interest rate is 4 percent, you may be able to sell your
bond for more than $10,000. But if you had a bond paying 3 percent
and you wanted to sell it, you would be faced with selling your
bond at a discount or less than the maturity value."
"There is risk with bonds that can be minimized or reduced," Swanson
says. "Don't buy bonds with long maturities when interest
rates are low. Stick to short-term (bonds that mature in three
years or less) and intermediate-term bonds (bonds that mature
in 3 to 20 years). Purchase bonds with different maturity dates.
Diversify across different bond issuers. Check the credit worthiness
of the bond issuer."
Swanson says the capacity of bond issuers to repay their debt
is rated by various commercial firms such as Moody's and Standard
and Poor's. Bonds rated Baa to Aaa by Moody's and BBB to AAA
by Standard and Poor's are considered investment grade bonds.
Those with lower ratings are termed substandard grade. Because
there is more risk, the interest paid on these bonds is higher.
Federal government bonds are considered to have no default risk
and therefore their rates set the floor on rates for all other
bonds. "An advantage of interest on federal bonds is that
you pay no state income tax on the interest earned. Likewise,
interest on bonds issued by states is not taxable by the federal
government," Swanson says.
Corporate bonds are issued to raise capital for expansion or
the ongoing operations of a company. Because there is a higher
risk, corporate bonds pay higher interest rates than government
securities, Swanson explains. A mortgage bond backed by specified
assets of a company, such as certain land and buildings, is the
least risky corporate bond. The highest risk corporate bond is
a debenture, which is backed only by the company's future earnings
and its promise to repay.
"You also may have heard of agency security bonds from
such organizations as Fannie Mae, Freddie Mac and the Tennessee
Valley Authority," Swanson says. "Although these organizations
are not technically backed by the Federal government, it is generally
understood the government wouldn't let them fail."
"Investors not having the resources to diversify their
bond holdings or knowledge in this area might want to consider
bond mutual funds," Swanson concludes. In choosing a bond
mutual fund an investor needs to look at the fund's performance
and charges. Studies have shown that funds with lower management
fees have out performed other funds. An advantage of bond mutual
funds is they may pay interest monthly or quarterly while individual
bonds usually only pay every six months. "This would be
good for an investor wanting a regular but not fixed source of
The ISU Extension Invest Wisely
Project provides a series of newspaper, radio, and web resources
for investors. It is funded by a grant from the Investor
Protection Trust (IPT). The IPT is a nonprofit organization
devoted to investor education. Since 1993 the IPT has
worked with the States to provide the independent, objective
investor education needed by all Americans to make informed
investment decisions. www.investorprotection.org.