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Bonds

Bonds, or fixed-income securities, are issued by many different types of entities-the U.S. Treasury, government agencies, municipalities and corporations. When you buy a bond, you are lending money to these organizations, which in turn use the money for such things as funding the federal deficit, improving schools and building factories.

While stocks do not guarantee any kind of return, bonds promise to return your original investment, or principal, plus interest. When you buy a bond, you can count on it for capital preservation and income, which makes them generally less risky than stocks.

Bonds are issued with a face value, or par value. If a bond is selling above its par value, it is selling at a premium. If a bond is selling below its par value, it is selling at a discount. The issuer of the bond promises to pay back the face value by a predetermined maturity date. In the meantime, the bond pays a set interest rate, or coupon. You can sell the bond at any time before it reaches maturity. Bond yields can be calculated two different ways. Current yield is figured by dividing interest income by the market price. Yield-to-maturity is the total return of the bond at maturity.

Bonds typically generate lower returns than stocks because they are safer investments, but there are still risks involved in owning them. The biggest one is interest-rate risk. Bond prices move inversely to interest rate changes. Credit risk is another concern. The credit quality of a bond indicates to what degree the issuer is able to pay the principal and interest.

Bonds are an important diversification tool, and they belong in most portfolios because they are uncorrelated to stocks-that is, when bonds are doing well, stocks tend to perform poorly and vice versa. Bonds are also useful if you need preserve capital and receive a regular income stream.

What are Treasury securities?

The U.S. Treasury is the largest issuer of bonds in the world, and they issue many different types of fixed-income securities. Treasury securities are backed by the full faith and credit of the U.S. government, making them one of the safest investments available. But, because they carry no credit risk, they also pay relatively lower interest rates. Interest payments from Treasury securities are exempt from local and state taxes but not federal income taxes.

TIP: You can buy Treasury securities through any registered broker, or you can buy them directly from the U.S. Treasury through TreasuryDirect at www.treasurydirect.gov or 800.722.2678.

Treasury securities are classified according to their maturities as bills, notes and bonds. They are all issued in face values of $1,000.

What other government bonds can I invest in?

Government agencies issue bonds in order to fund their programs, such as providing funds for loans to students and homeowners. These securities do not carry the full faith and credit of the U.S. government, so they pay a higher yield than Treasury securities in exchange for the additional risk of owning them. However, these bonds are still very safe. They are issued at or near par value and pay a coupon rate.

Government agencies that issue bonds include:

What are "municipal bonds"?

Municipal bonds, or "munis," are issued by state and local governments to pay for public projects, such as schools, streets, highways, hospitals and airports.

Municipal bonds are usually high-quality, but some municipalities have had disastrous fiscal problems in the past. Munis are graded by bond rating agencies on the issuer's ability to repay the bond.

The interest income from munis is exempt from federal income taxes. Some are also exempt from state and local taxes. However, munis pay a lower coupon rate compared to corporate bonds with similar ratings. The tax savings may make up for the lower rate, but usually only if you are in a higher tax bracket. As a general rule, municipal bonds make sense if you are in the 28 percent tax bracket or above.

In order to figure out if a municipal bond will pay you the same as a taxable bond, you must calculate the equivalent taxable yield. Divide the municipal bond's tax-free return by the compliment of your tax bracket, which is one minus your tax bracket, to arrive at the equivalent taxable yield.

What are "corporate bonds"?

Corporate bonds are issued by companies to expand and improve their operations. They are issued at or near par value, with maturities of 2 to 30 years. Most are fixed-rate bonds that pay the same coupon until maturity, but some are floating-rate bonds that fluctuate depending on other interest rates. Some corporate bonds are called zero-coupon bonds because they make no regular interest payment. Zero coupon bonds sell at a significant discount to face value and can be redeemed at face value plus interest at maturity.

Corporate bonds pay relatively higher yields because they carry much greater risk than government bonds and because the income from corporate bonds is fully taxable. The credit quality of corporate bonds is graded by bond rating agencies, such as Moody's and Standard & Poor's, on the issuer's ability to repay the bond. The higher the credit quality the lower the yield and vice versa.