Understanding Bonds

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 annually."

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 income."

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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.