I was speaking to a group of teenagers at a church recently about personal finance. I asked them if they knew what a bond was.
Several of the students looked down at their feet. Others just stared blankly. So, I asked the adults in the room if they knew what a bond was.
Again, blank stares and discomfort.
Since the beginning of the year, I've made it my mission to write about the basics of saving, spending and investing. The unfortunate truth is that many investors can't describe what it is they are putting their money into.
What is a bond
A bond is like an IOU. It's a debt. When you buy a bond, you're playing the banker, lending your money to some entity. In return for allowing a company or government to use your money, the bond issuer promises to pay you a certain interest rate during the life of the bond. You also get back your principal or the face value of the bond when it reaches the end of the agreed-upon term of the bond, called its maturity.
For example, a 10-year $1,000 bond with an 8 percent interest rate will pay $80 a year, in payments of $40 every six months. When the bond matures, the investor gets back $1,000.
Most people are familiar with a U.S. savings bond, which is issued by the federal government. But there are other bonds. A city might issue (sell) bonds to raise money to build a new football or baseball stadium.
Corporations issue bonds to raise money to build a new plant or expand their business.
Bonds issued by the Treasury Department and other government agencies are generally considered less risky than bonds sold by corporations. As a result, they often pay less interest than corporate bonds.
Why buy bonds or invest in a bond fund (funds managed by a professional investor who buys a portfolio of bonds)?
Bonds bring balance to your investment portfolio. That's why bonds are called fixed-income securities. You know the interest you will earn and the amount of cash you are supposed to get back, provided you hold the bond until maturity.
I use the word supposed because bonds are by no means risk-free. Companies and even local governments do go bankrupt, which can leave you holding a worthless bond.
Items to consider
There are a number of important things to consider when investing in bonds: maturity, interest rate and market fluctuations.
According to the Bond Market Assn., here are some of the facts you should know before buying a bond:
- Maturity. A bond's maturity refers to the specific date when your principal will be repaid. Bond maturities generally range from one day up to 30 years. Maturity ranges are often categorized as follows: Short-term bonds with maturities of up to five years; intermediate-term notes/bonds: five to 12 years; long-term bonds: 12 or more years.
- Interest rate. Bonds pay interest that can be fixed, floating or payable at maturity. Most bonds carry an interest rate that is a percentage of the principal amount. Some investors want an interest rate that is adjustable. So, they may buy a bond with an interest rate that is reset periodically based on the rate on Treasury bills. Then there are zero coupon bonds. This type of bond is sold at a substantial discount from its face amount. For example, a $20,000 bond maturing in 20 years might be purchased for about $5,050. At the end of the 20 years, you would receive $20,000. The difference between $20,000 and $5,050 represents the interest, based on an interest rate of 7 percent, which compounds automatically until the bond matures.
- Market fluctuations. "When you say the price of a bond can move in opposite direction of yield (the percent return your bond promises at any given price), you can see people's eyes glaze over," said Jon Teall, vice president of media relations for the Bond Market Assn. "But all that means is if you decide to sell your bond and interest rates have gone up or down, you may get a different price than what you paid for the bond." For example, let's say you have a bond paying 5 percent interest. But prevailing interest rates are now around 10 percent. Investors can buy bonds at the higher rate of 10 percent, so your bond may not be worth what you paid for it if you sell it. Conversely, if interest rates are low (like they are now) and you have a bond paying 13 percent interest, everybody and their mama would love to have your bond. You could sell that bond at a premium or for more than its face value. Just remember, the market price of a bond and its yield change in opposite directions when interest rates change.
Now you can understand why those teens and their parents gave me blank stares. There's a lot to know about investing in bonds.
For more information try www.investinginbonds.com. You also can order "An Investor's Guide to Bond Basics" by writing to the Bond Market Assn., Publications, 360 Madison Ave., New York, N.Y., 10017.