Most guys will tell you that bonds are safe investments for retirees and little old ladies; and most guys are wrong. Bonds offer an alternative to investing in stocks and (depending on the economy) may even outperform stocks. Having some bonds in your portfolio is a good way to make money and it's a great way to diversify.
Here's what you need to know before you invest in the bond market.
the basics
What is a bond?
A bond is just another word for a loan. When you buy a government or corporate bond, you're simply lending that entity money for a specified period of time. When the term of the bond ends, you get back the money plus the agreed upon interest.How does a bond work?
Unlike private loans, say the kind you make to your neighbor, there's a market for bonds. That means that at any given time, the price for a bond can fluctuate. Still, the face value remains the same, as does the rate (known as the coupon).
What changes through time is the yield, which is the total amount you would receive when the bond expires (coupon rate divided by price). But with the bond market changing, you have the chance to increase your yield by picking up discounted bonds (a bond selling below its face value).
A bond selling above its face value may still be a good buy, but remember that the yield will be less than what it would have been if you bought it at face value.
What types of bonds are available?
Bonds vary based on the issuer. The most stable bonds are U.S. government bonds or Treasury bills. These bonds are backed by the full faith and credit of the U.S. government, which means that they are not likely to default.Moving up the risk ladder, are municipal bonds. Local governments issue these bonds to finance public works projects. They tend to be low-risk and, therefore, are low-yield, but to help these governments raise money, many of these bonds are exempt from federal taxes (as well as state and local taxes for residents). That means that while you may not earn as much, you won't pay for your profits in tax.
Finally, there are corporate bonds. These bonds carry more risk but offer more reward. Corporate bonds are rated so you'll have an idea of relative risk, but like stock, even blue chips can go bust.
the risks
Inflation and interest rates
A major risk with bonds is inflation. Long-term bonds are particularly susceptible to inflation because interest payments are fixed (what might be a good rate today could be a lousy rate tomorrow). Likewise, changing interest rates affect bond prices.Typically, bond prices move against interest rates. For example: higher interest rates lower bond prices because the demand for the old bonds falls away with higher-yielding new bonds. Naturally, prices only matter to people who sell their bonds before maturity; although there is certainly an opportunity cost to be paid as well.
Calling a bond
Bonds differ from most private loans in one key aspect: the issuer sets the terms. Many issuers reserve the right to call the bond (these bonds typically offer a higher coupon). If a bond is called, the issuer need only pay back par value (face value) to the buyer. This usually happens when interest rates fall. While you can't always predict interest rates, you can ask about the likelihood of a given bond being called before you buy.The credit risk
Companies can and do go bust. Even local governments go bankrupt. When you loan money to a friend, there's a chance he might not be able to repay you. Bonds have that same risk. However, unlike stocks, bonds don't vanish if a company goes bankrupt; bond holders become creditors. But the likelihood of getting back even par value is slim to none.have a plan
Long-term or short term?
If you're buying your own bonds and not using a bond fund, you'll need to ask yourself what your goals are. If you want a steady stream of income, it's best to buy short-term bonds (the logic being that it's easier to predict interest rates in the short term). By contrast, those looking to increase their capital will do best by investing in long-term bonds (if their bet pays off).Diversify your bonds or consider a bond fund
Just like with stocks, it's important to spread your investments around. You don't want to be too heavy in any one sector (or, in this case, type of bond as well). You can do this on your own or you can look into a bond fund, which works in much the same way as a mutual fund for stocks.Ladder your portfolio
If you've ever bought a CD (Certificate of Deposit), you know about laddering. The goal is to give yourself money to reinvest each year on the theory that market conditions change. Thus, while some of your bonds might be taking a hit, others will be performing at their peak. You do this by buying bonds of varying terms, say from one year to 10 years. When the one-year bond expires, you put that money into a 10-year bond. As each bond expires, you reinvest it by filling the missing hole in your portfolio.get your bonds
Bonds are seldom as sexy as stocks. Most guys want to know what the (stock) market did on a given day. But bonds, depending on the type you buy, can be a better way of helping you achieve your financial goals.It may not be exciting to know that your money will likely earn 7% over the next 10 years, but when it's your money on the line, you may not want any excitement at all.
Resources:
http://money.cnn.com/pf/101/lessons/7/
http://moneycentral.msn.com/content/Investing/Buyingbonds/P39105.asp
http://www.fool.com/bonds/bonds01.htm
http://personal.fidelity.com/products/fixedincome/firisksoffixed.shtml.cvsr
Before you invest in any type of bond, it is important to know how bonds work. Bonds can be complicated to understand at first since there are many types of bonds and therefore many rules. It is also more important to understand how bonds work when you invest in bonds because people usually invest in bonds for the interest payments as well as redemption value which are something in the future. While when a stock goes down in value you know you are losing money, when a bond goes down in value, you may not be losing money but if you understand perfectly how your bonds work.