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When the
government and companies want to raise
money (and they don't want to sell part
of the company by selling stock), they issue bonds that you can
buy. When you buy a bond, you are,
basically, loaning them money for a
specific amount of time... and they'll
pay you interest. Unless the
government or company goes belly up,
it's a safe bet that you'll get your
money back. So, for the most part,
bonds are pretty safe investments.
Some companies do
go bankrupt and billions of dollars of
bond investments are lost each year
though, so there is a rating system to
know how safe a bond is. The
safest is an AAA bond, then an AA bond,
then an A bond, then a BBB bond and so
on. Bonds with bad ratings
usually offer a higher interest rate to
lure you in. These are called
"junk bonds" and are not for the weak at
heart.
Bonds are similar
to CD's (certificates of deposit) in
that they have a set maturity date and
you get your principal back (usually,
anyway). Unlike CD's though, you
can sell a bond at anytime and they,
typically, yield a higher interest rate.
The only real
trick to bonds is that, when interest
rates go up, the yield (the interest you
make) on bonds goes down.
Because bonds are
safer than stocks and mutual funds, many
financial advisers say you should have a
chunk of your portfolio set aside for
them. How much? If you are
20, you should have 20% of your
portfolio in bonds. If you are 55,
you should have 55% of your portfolio in
bonds.
The older you get, the
safer you'll want your investments to
be. Whatever your age is, that's
the percentage of bonds you should have
in your portfolio.
Here are the main types of bonds:
Treasury Bonds:
Treasury bonds are issued by the U.S.
government. Obviously, they are
very safe (since the U.S. won't go out
of business - hopefully!) and will pay a little more
than CD's. One nice thing about
treasury bonds is that you don't have to
pay any state tax on the interest you
earn.
T-Bills are treasury bonds that mature
(end) in 1 year. T-Notes are
treasury bonds that mature in 1- 10
years. T-Bonds are treasury bonds
that mature in more than 10 years.
You can purchase treasury bonds straight
from the
Federal
Reserve, but it's a pain to do and a
bigger pain to try to sell them
yourself. It's the easiest to find
a good discount broker to buy and sell
treasury bonds.
Inflation-indexed Bonds:
This is a new type of U.S. government
bond. When interest rates go up,
they'll add that amount to your
principal (the amount you put into the
bond.) For example, say you bought
a bond for $1000 and the next year,
interest rates in our country went up
2%... They'd add 2% of $1000 to
your account... .02 x 1000 = 20...
So, they'd add $20 to your account.
Since inflation-indexed bonds have this
extra safety net, they pay a lower
interest rate.
Municipal Bonds:
Municipal bonds are issued by state and
local governments and are very safe.
You don't have to pay any federal tax on
these and, if you live in the state
that's issued them, you don't have to
pay state tax either. If you are
in a high tax bracket, these are
definitely the bonds for you.
Corporate Bonds:
Corporate bonds are issued by
companies... They are as safe as
the company is. Safe and solid
company = safe corporate bonds.
Shaky company = risky bonds. This
is where you really need that rating
system. Corporate bonds with bad
ratings are the ones you have heard
called "junk bonds." Yeah, they
offer a lot of interest, but the company
is likely to fail... and you'll lose
your money.
Convertible Bonds:
Convertible bonds are a type of
corporate bond. You can choose to
convert them to stock in the company.
Because of this, they offer a lower
interest rate than the nonconvertible
variety.
Mortgage Bonds:
Banks often sell their mortgages out as
bonds... So, you are really
loaning the bank money so they can loan
it out to someone else in the form of a
mortgage. Mortgage bonds are safe
because they are usually guaranteed by a
government agency like Fannie Mae (that's
a nickname for the Federal National
Mortgage Association.)
You can buy and
sell bonds through a discount broker
(same as stocks and mutual funds), but
you'll spend a ton of time deciding on
which ones to buy... And there are
a lot of ravenous sales people out there
who will talk you into things because
they'll make a big commission. The
easiest thing to do is to buy bond
mutual funds. These are mutual
funds that just specialize in bonds.
Then you can buy and not worry
anymore... Well, not much!
You can
search for bonds using our Google "safe
search" option. Or you can search for a different
topic on Finance FREAK. A new window will open
with your results.
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