The Basics of Bonds

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If you’re new to the world of bonds, it’s easy to be intimidated. Bond investing can be filled with  unusual lingo, strange concepts (think catastrophe bonds) and a lot more talk about math and economics than you’ll find at the local discount stock broker’s office.

Top Things to Know About Bonds

But don’t be discouraged. Bonds aren’t as mysterious as they may appear. Here’s a list of the top 10 things to know about bonds. 

  1. Bonds aren’t as complex as they may seem. Despite the numerous titles used to describe them – fixed-income securities, debt instruments, credit securities, etc. – bonds are nothing more than a fancy IOU in which the terms, pay-back date, and interest rate are carefully spelled out in a legal document.
  2. Bonds have a reputation for safety. And that reputation is well-deserved. But that doesn’t mean that bonds are risk-free. In fact, bond investors tend to worry about things that stock investors never worry about, like inflation and liquidity risk.
  1. Bonds move in the opposite direction of interest rates. When rates rise, bonds fall. And vice versa. If you buy a bond and hold it until it matures, swings in interest rates and the resulting swings in the bond’s price won’t matter. But if you sell your bond before it matures, the price it fetches will be largely related to the interest rate environment.
  2. Bonds are more complicated than stocks. Whereas stocks come in only a handful of varieties and are offered only by public corporations, bonds are sold by corporations, the federal government, government-sponsored agencies, cities, states, and other public authorities. Bonds also come in nearly endless varieties – from short-term notes to bonds that take 30 years to mature.
  1. As complicated as bonds may be, it helps to realize that all the bonds issued in the U.S. fall into one of three categories. First, there’s the extremely safe debt of the federal government and its agencies. Second, there are the safe bonds sold by corporations, cities, and states. Those two forms of bond are called “investment grade.” Third, there are the risky bonds sold by those same corporations, cities, and states. Those bonds are called below-investment-grade, or junk bonds.
  2. It’s easy to tell at a glance whether a bond is investment grade or junk (and where it falls on the continuum between the two. A number of Wall Street companies “rank” bonds by safety. These credit rating agencies, including Moody’s, Standard & Poor’s and Fitch Ratings, publish simple “grades” on all debt issues.
  1. The key to understanding the bond market lies in understanding a financial concept called a yield curve, which is a graphical representation of the relationship between the interest rate that a bond pays and when that bond matures. Once you learn to read curves (and calculate the spread between curves), you can make informed comparisons between bond issues.
  2. There’s an entire class of bond aimed at providing tax-free returns. Cities and states issue municipal bonds, or munis, to raise money to pay for schools, highways and a slew of other projects. And interest payments on the bonds are free of federal taxes. But despite the tax break, munis aren’t for everyone.
  1. The bond market is the basis of other, more complex markets. Savvy investors can buy futures and options on bonds just as they can them on stocks. The bond market has also developed countless investments. Of these, the best known are credit default swaps, which are used to protect investors from default risk.
  2. Much of the bond market takes place in an opaque, unfriendly corner of Wall Street where smaller investors are particularly vulnerable. The secondary market, or over-the-counter market, is not recommended for average investors. Things aren’t quite as shady as they once were. But it’s no place to venture unless you’re willing to do a lot of researching and a lot of negotiating. Thus for the vast majority of investors considering a foray into debt investing, buying a bond mutual fund is the way to go. Bond funds are free of the liquidity risk of individual bonds. Investors can use them to diversify their holdings (something that’s nearly impossible for anyone other than the wealthy to do with individual bonds.) It’s pretty easy to find out what the fees and loads (sales commissions) on any fund may be. And there are thousands of funds that don’t charge a load and keep fees to a minimum.