Bonds

Bond basics

When you buy a bond, you become a lender. The bond issuer is the borrower. The bond issuer might be a company, a city, a state, or a federal government agency. They may borrow for short periods to manage cash flow or cover operating costs, for example. They may also borrow money for longer-term goals such as to build new facilities or pay for new technologies. Cities or states may need to build bridges or provide other community services. One common way to borrow money is to issue a bond series and sell units of the series to the public.

Why own bonds?

Bonds are a good choice if you're looking to earn a steady income with the potential to beat inflation. Bonds are sometimes referred to as "fixed income" securities. They pay you interest based on a fixed rate for a specified period of time, thus earning you "fixed income."

If you are thinking of buying a bond, consider some of the following questions:

• How much will you earn?
• When will you be paid the interest?
• How long is the loan?
• How reliable is the borrower?
• How much do they want to borrow?

How much will you earn?
The amount that you earn will be based on the bond's face value, coupon rate and yield.

The face value, or par value, of a bond is the value of the bond at maturity, the date when the loan is paid off. A common face value is $1,000 per bond. It's important to keep in mind that the actual market price of a bond may be higher or lower than the bond's face value. A bond's market price can fluctuate over time, depending on a variety of factors including investor demand, interest rate movement, the bond's maturity date and the creditworthiness of the issuer.

A bond's coupon rate refers to the interest that will be paid based on the face value of the bond. A bond with a face value of $1000 and a 7% coupon will pay $70 a year in interest. Interest may be divided into quarterly, semiannual or annual payments, depending on the issuer and the individual bond.

If you purchase a bond at face value, your coupon rate and actual earned yield will be the same. However, bonds are often sold at higher or lower prices than their face values. As a result, your actual yield can be different from the bond's coupon rate. Buying a bond at a discount, or less than its face value, results in a higher yield than the stated coupon rate. In contrast, buying a bond at a premium, or more than its face value, results in a lower yield than the stated coupon rate.

How safe is your bond?

When you buy bonds, you're taking a risk that borrowers with poor credit ratings may not repay their loans on time, or even at all. Two major services, Moody's and Standard & Poor's, rate the creditworthiness of bonds. Ratings are based primarily on the credit history and current status of the issuer.

The ratings use a letter system. They go by letters, like at school. The ones with only As in their rating are of high quality. The ones with a B in the rating are of medium quality (except for Moody's B rating, which is below medium quality). Bonds with a C are either low quality or extremely low quality.

Bonds are commonly labeled either "investment grade" or "junk" quality (often called "high yield" instead). The less creditworthy the borrower, the higher your risk is of not being repaid what you lend. For that reason, higher risk bonds usually provide a higher interest rate.

You can avoid the issue of creditworthiness entirely by investing in bonds issued by federal government agencies. Repayment of these loans is guaranteed by the Full Faith and Credit of the U.S. Government.

What do Bond Ratings Mean?

Moody's Bond Ratings

Aaa

Best quality, with the smallest degree of investment risk.

Aa

High quality by all standards; together with the Aaa group they comprise what are generally known as high-grade bonds.

A

Possess many favorable investment attributes; considered upper-medium-grade bonds.

Baa

Medium-grade bonds (neither highly protected nor poorly secured). Bonds rated Baa and above are considered investment grade.

Ba

Have speculative elements; futures are not as well-assured. Bonds rated Ba and below are generally considered speculative.

B

Generally lack characteristics of a desirable investment.

Caa

Bonds of poor standing.

C

Lowest rated class of bonds, with extremely poor prospects of ever attaining any real investment standing.

Standard & Poor's Bond Ratings

AAA

'AAA' is the highest rating assigned by Standard & Poor's. The bond issuer's capacity to meet its financial commitment is extremely strong.

AA

A bond rated 'AA' differs from the highest-rated obligations only to a small degree. The bond issuer's capacity to meet its financial commitment on the bond is very strong.

A

A bond rated 'A' is somewhat more affected negatively by changes in world and economic conditions than bonds in higher-rated categories. However, the bond issuer's capacity to meet its financial commitment on the bond is still strong.

BBB

A bond rated 'BBB' show signs of adequate financial protection. However, unfavorable economic conditions or changing circumstances are more likely to weaken the bond issuer's ability to meet its financial commitment.

'BB', 'B', 'CCC', 'CC', and 'C'

Bonds with these ratings are regarded as having significant risk, even though they may have some positive qualities. 'BB' indicates the least degree of risk and 'C' the highest.

D

A bond rated 'D' is in payment default.

Taxable or tax-free?
Depending on type of issuer and your state of residence, the interest you receive from a bond investment may be taxable or tax exempt. Generally speaking, all corporate bonds are taxable. Municipal and state bonds are typically tax exempt if you live in the same state where the issuer is located. Federal government bonds are not federally taxable but may be taxable at the state and local levels.

Do interest rates affect prices?
In short, interest rates and bonds work like a see-saw: when rates rise, bond prices tend to fall, and when rates fall, bond prices tend to rise. If the economy's interest rates rise, newly issued bonds will pay higher interest than the bonds you own. Typically, your older bonds will be worth less, and you'd have to sell them at a discount. If, however, the economy's interest rates drop, newly issued bonds will pay lower interest than the bonds you own. Then your older bonds will be typically worth more, and you'd be able to sell them at a higher price. If you hold a bond to maturity, you will not face these price changes.

Interest rates can also influence an issuer's decision to pay off the bonds early. Just as you can pay off a mortgage at any time without a penalty, many bond issuers have the ability to "call" in the bonds early. Typically, if interest rates drop significantly, a "callable" bond will get called. This allows the bond issuer to get rid of this high interest debt and borrow again at a lower interest rate.

How long are you willing to tie up your money?
Time also plays a big role in how much risk you'll be taking and how much interest will be paid. In general, the longer you're asked to lend your money, the higher the risk that something might go wrong, and therefore the higher the interest rate you can expect to earn. There are three main time-based categories:

• Short-term bonds (generally under 2 years).
• Intermediate-term bonds (generally 2-10 years)
• Long-term bonds (generally more than 10 years)

How can you manage risk?
To help manage these risks, many financial professionals recommend holding a variety of bonds with different maturity dates. As with stocks or most types of securities, you generally want to avoid holding a large bond position with a single issuer or type of bond. Bond mutual funds can also reduce risk because they invest in a pool of many bonds.

Types of bonds

In general, there are three main types of bonds:

• Municipal bonds
• Corporate bonds
• Government bonds

Municipal Bonds
These are issued by state and local governments or their agencies to pay for public improvements, reducing debt, or other public purposes. If you buy bonds issued by your home state, you will not have to pay state income tax or federal income tax (or city tax, if you have one). If you buy bonds issued by another state, you will not have to pay federal tax, but you will pay tax to your own state (and city if applicable).

Corporate Bonds
These are issued by corporations that want to raise money for their business ventures, ranging from balancing their cash flow to buying new equipment, building new facilities, or spending on new research.

Interest earned from corporate bonds is taxable, so they tend to pay higher rates than government or municipal bonds, which have some tax benefits. Corporate bonds are often considered appropriate investments for the bond portion of your retirement plan investments, because you get the higher interest and still aren't taxed until the earnings are withdrawn. A municipal or government bond will pay you less interest and already offers a tax benefit, so they offer less incentive to include them in your retirement portfolio.

Government Bonds
Government bonds are those issued by the federal government or one of its agencies. From a credit perspective, these are the safest of all investments because they're backed by the "full faith and credit" of the U.S. government; so unless the U.S. goes bankrupt, you're guaranteed to get your money back. Common types of U.S. government bonds include Treasuries and Savings Bonds.

Treasuries
Treasury bills, notes, and bonds are collectively called "Treasuries."

• Treasury bills (T-bills): These are short-term securities that mature in a year or less. You buy them at a discount price and at the end of the term, you're repaid the full price. The difference is what constitutes your earnings. These earnings are exempt from local and state income taxes, but must be reported on your federal tax return.
• Treasury notes: These are issued for the intermediate term, such as 2 years up to 10 years. Expect to earn a little higher interest rate than what you could get from a T-bill. Interest is paid every six months. Earnings are exempt from local and state income taxes but must be reported on your federal tax return. You can sell your Treasury note before it matures, if you wish.
• Treasury bonds: These are issued for the long-term, generally from 10 years to 30 years. Expect to earn a higher interest rate than what you could get from a T-note. Interest is paid every six months. Earnings are exempt from local and state income taxes but must be reported on your federal tax return. You can sell your Treasury bond before it matures, if you wish.

Savings Bonds
Savings bonds are government bonds designed especially for individual investors. As such, they can generally only be redeemed by their original owner, except in limited circumstances. Savings bonds include:

• I Bonds: These are savings bonds that help protect against inflation. They pay a fixed interest rate combined with a variable interest rate that's updated twice a year based on the current inflation rate.
• EE Bonds: Series EE savings bonds issued on or after May 1, 2005 earn a fixed rate of interest. They increase in value every month instead of every six months. Interest is compounded semiannually. If you cash them in before owning them for 5 years, you will be penalized the last three months of interest. Interest earned on Series EE bonds is exempt from state and local income taxes. You can defer federal income tax until you redeem the bonds, which will stop earning interest after 30 years. Since interest isn't taxed until you redeem a bond, your savings grow faster. EE bonds can also assist you with tax planning, as you have the flexibility to redeem the bonds on your own terms.
• HH bonds. HH bonds also earn a fixed rate of interest. Unlike EE Bonds, HH Bonds pay interest every 6 months until maturity or redemption, whichever comes first. The U.S. Treasury discontinued the HH series of bonds in 2004, but will continue to honor outstanding HH bonds still held by investors.