| Bonds - Turning Debt Into Fixed Income | | | | of a company were lowered and you wanted to sell |
| Bonds are an often overlooked component of a | | | | one of its bonds that you paid $1000 for, your fellow |
| balanced investment portfolio. Bonds are almost | | | | investors in the market may only be willing to pay |
| always safer, and in certain economic cycles, bonds | | | | you $950. |
| typically outperform the stock market. Although | | | | But what most commonly has an impact on a bond's |
| they're not right for everyone, a solid understanding | | | | market value are changes in interest rates. Although |
| of bonds is important for every serious investor. | | | | the actual bond's interest rate is fixed, prevailing |
| The Basics | | | | interest rates elsewhere in the economy can radically |
| Whereas stocks represent ownership in a company, | | | | alter the value of a bond. |
| bonds represent the company's debt. When you buy | | | | If interest rates go up, the value of bonds go down, |
| a bond directly from General Motors, you are | | | | and vice versa. This is because no one would be |
| essentially lending the company money. For this | | | | willing to pay $1000 for a bond with a seven percent |
| reason, bonds are sometimes referred to simply as | | | | coupon when they could buy a new one with a nine |
| "debt." | | | | percent coupon for the same price. |
| If you buy a bond directly from its issuing company, | | | | Government Debt |
| the amount you pay for the bond is called its "face | | | | U.S. government bonds are the safest of all fixed |
| value" or "par value." Most bonds have a face value | | | | income securities. This is because all government debt |
| of $1000. | | | | is backed by the full faith and credit of the U.S. |
| Bonds also have a stated "term to maturity." This | | | | government. Essentially, this means that the federal |
| could be one, five, ten, or thirty years, or any other | | | | government can't go bankrupt, because it controls |
| duration imaginable. Disney actually issued 100 year | | | | the printing presses. |
| bonds not long ago. | | | | Municipal bonds are debt issued by cities and counties. |
| Every six months until maturity, bonds pay a set | | | | They aren't quite as safe as U.S. government |
| amount of interest called the "coupon rate". This | | | | securities, but they do have one major advantage - |
| term comes from the old days when people literally | | | | they are virtually exempt from all levels of taxation. |
| tore off and mailed in coupons that were attached | | | | As a result, municipal securities typically pay a lower |
| to their bonds in order to be sent back interest | | | | pre-tax coupon rate than federal government debt. |
| payments. Upon maturity, the issuers of bonds must | | | | For people in high income tax brackets, the tax |
| repay their holders the face value of the bonds.. | | | | savings are enough to offset the lower coupon rate, |
| If, for example, the coupon rate is seven percent on | | | | and thus municipal securities are often great |
| a $1000 face value bond, this means that the | | | | investment vehicles for the wealthy. |
| bondholder will receive interest payments of $35 | | | | Safe Investment T.I.P.S. |
| every six months ($70 per year) until the bond | | | | If you're a really risk-averse investor, then for you, |
| matures. | | | | TIPS may be the greatest thing the government |
| The amount of interest paid every six months | | | | ever invented. TIPS, or Treasury Inflation Protected |
| doesn't change, and for that reason bonds are | | | | Securities, are a unique variety of ultra-safe fixed |
| sometimes called "fixed income securities." | | | | income government debt securities. |
| Corporate Debt | | | | TIPS typically pay a very low interest rate, but they |
| Corporate bonds are the best known, and riskiest of | | | | mature at the inflation adjusted equivalent of the |
| all bonds. If a company goes bankrupt, for example, | | | | original face value. Furthermore, the semi-annual |
| its bondholders may receive a mere fraction of their | | | | coupon rate is also adjusted every six months. |
| investments. Credit rating agencies, such as S&P, | | | | For example, investing $100,000 into 20-year TIPS |
| assign ratings to fixed income securities ranging from | | | | may promise a coupon rate of just 2.5 percent. This |
| AAA to D. | | | | means that you would receive semi-annual interest |
| Bonds with credit ratings of BB and below are | | | | payments of $1250. |
| considered junk bonds, meaning that their issuing | | | | However, if inflation were measured at three percent |
| companies face a realistic possibility of defaulting on | | | | the first year after you purchased your TIPS, the |
| their debt. | | | | new coupon rate would be 2.575 percent, resulting in |
| Changes in a company's credit rating effects the | | | | semi-annual interest payments of $1287.50. What's |
| value of its debt. Although the face value always | | | | more, the $100,000 face value of the TIPS would |
| remains the same and the issuing company always | | | | appreciate to $103,000. |
| redeems bonds at their original face value, bonds can | | | | After 20 years of inflation adjustment, the face |
| also be traded between investors before they reach | | | | value of your TIPS will have multiplied by several fold. |
| maturity. | | | | Although you sacrifice the opportunity to realize |
| These trades are said to take place on the | | | | outsized gains, TIPS are the ultimate in safe |
| "secondary market." For example, if the credit rating | | | | investments, as even inflation risk is avoided. |