Bonds turn individuals into moneylenders. How so? Corporations, governments, and nonprofit entities need to borrow to keep running. They would prefer to borrow from investors than from banks. Individuals and large institutions like the idea of an investment that pays them a guaranteed amount at a guaranteed time. It’s a marriage made in heaven. Bonds are called “fixed-income” securities because the income stated on the bond won’t vary, even if it’s sold. No matter who owns the bond, they’ll earn the same amount.
Types of Bonds
Treasuries. The U.S. Treasury Department sells bonds in a variety of maturities (for a look at what the government sells, go to www.savingsbonds.com). U.S. government bonds are called Treasuries because they are sold by the Treasury Department. They are guaranteed by the U.S. government and are free of state and local taxes on the interest they pay.
- Quasi-government bonds. Sallie Mae, the nation’s leading provider of student loans, sells various securities to back those loans.
- Corporate bonds. Corporate bonds often pay more than government bonds because companies face more risk than governments.
- Municipal bonds. Munis aren’t Treasuries, but they’re public debt issued by municipalities to fund operating or capital expenditures. Munis are generally considered a safe investment in healthy economies when tax revenues adequately support the government issuing the bonds, but remember Orange County, California’s bankruptcy in 1994? The county treasurer invested more than $7 billion in public pension money in junk bonds, and when the market went south, so did all that money. The important point here is that the strength of the investment is only as strong as the government’s ability to pay its debts, so make sure the health of that debt is secure.
When evaluating a municipal bond investment, always check news reports on the city or county’s bond rating from Moody’s Investors Service (Moodys.com) or Standard & Poor’s (www. standardandpoors.com). There’s risk involved. Of course, there are also great tax advantages involved, since they are free of federal, state, and local income tax, which makes it easier to swallow the relatively low returns on these bonds.
Par value is what an investor will be paid once the bond matures if the investor keeps it that long. Essentially, it’s the principal. Coupon rate is an amount that bondholder receives and it is expressed as a percentage of the par value. Thus, if a bond has a par value of $1000 and a coupon rate of 10 percent, the person holding the bond will receive $100 a year. The bond will also specify when the interest is to be paid, whether monthly, quarterly, semiannually, or annually.
Maturity date is the date when the bond issuer has to return the principal to the lender (the person who purchased the bond). After the debtor pays back the principal, it is no longer obligated to make interest payments. Sometimes, companies call (buy them back before they mature) their bonds to wipe that debt off the books.
Figuring Out The Bond Yield
Current Yield = Annual Dollar Interest Paid x 100 Market Price
Commit the above formula to memory. This will allow you to compare the yield on a bond with the potential yield of other investments. Why not just refer to the coupon rate? Because that gives you an idea of return if you hold the bond to maturity. If you plan to buy or sell it now, current yield is a snapshot of reality.
How to Buy Bonds
Federal bonds can now be bought on the Internet at no charge, which is a big step forward. Again, go to vvww.savingsbonds.gov for an overview. Corporate and municipal bonds generally need to be purchased through an investment broker.