Investing in Bonds

Just like people need to borrow money for various reasons, so do large corporations, federal and state governments. However, for them not only is it difficult to raise large sums of money, but they have to pay back the amounts ultimately borrowed with interest.

Understanding Bonds

Bonds are one such security used by organizations to borrow large sums of money. Bond investing is one type of indebtedness that is sold to the public. The lender will have in his possession a document stipulating the amount lent pre-determined interest rate, period of repayment as well as other items such as the terms concerning the interest and loan.

Investing in bonds - By virtue of the amount of income the bond generates each year being fixed, bonds are typically known as ‘fixed-income’ securities. No matter who holds the bond or what the circumstances may be, a bond will generate the same amount of money. There are basically four kinds of bonds based on the seller of the debt.

The federal government – Treasuries are bonds sold by the Treasury Department of the U.S. Government. These are available in different maturity dates ranging from three months to thirty years. Treasuries include Treasury notes, Treasury bills, Treasury bonds, and inflation-indexed notes, all of which vary based on maturity and amount of interest paid. Treasuries are guaranteed by the U.S. government and are free of state and local taxes on the interest they pay.

State and local governments – In a move to avoid taxation on the people to raise funds, the federal government permits state and local governments to sell bonds that are free of federal income tax on the interest paid. State and local governments can also relinquish state and local income taxes on the bonds to facilitate investment in bonds.

Other governmental agencies – include Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corp. (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae). They sell bonds backed by the U.S. government for specific purposes such as funding home ownership.

Corporate bonds – Corporate bonds are debts sold by companies to the public. Although they carry high interest rates, they are usually attractive enough to lure investors to invest in them.

Before investing in stocks and bonds, there are essentially four aspects of a bond that one must be familiar with. It helps one to analyze the bond as well as compare it to other potential investments.

• Par Value is the original amount of money or the principal paid back to the investor by the borrower after maturity.
• Coupon Rate is the amount of interest that the bondholder will get. It is typically expressed as a percentage of the par value.
• Maturity Date is the ultimate time period when the bond issuer has to return the principal back to the lender or the investor.
• Yield of a bond - The yield of a bond is calculated by dividing the amount of interest it will pay over the duration of the year by the current price of the bond.

It is interesting to note that often bond yields differ from coupon rates. Bond prices have a tendency to fluctuate with changes in interest rates. If you hold the bond to maturity you are guaranteed to get your principal back, provided of course, the borrower does not default. However, if you sell your bond before it matures, you will have to sell it at the ongoing market rate which may be above or below your par value.

Yield to maturity is another form of yield that is used by investors given the market functionality of being able to buy a bond above or below par value. Yield to maturity includes interest payments you will receive during the tenure of the loan, and at the same time assumes that you will reinvest the interest payment at the same rate as the current yield on the bond. It also takes into consideration the difference, if any between the existing par value of the bond and the actual market price of the bond at the time.

Yield to maturity is essential when looking at zero-coupon bonds, a special type of bond that pays no interest until the maturity date. Here you receive the entire amount of principal back plus interest for the entire duration of the loan. Because zeros have no present yield, any yield you see associated with them is always a yield to maturity.

Buying bonds as an investment

Investing in bonds is generally considered safe. However, except those issued by the government, most bonds carry the risk of default if the borrower is unable to make the payments – both interest and principal. In an attempt to counteract this problem, and show how financially stable the issuer really is, the system of bond ratings was introduced. Developed by third parties such as Standard and Poor and Moody's, bond-rating services give bonds ratings based on the financial viability of the issuer. Since different companies have their own systems and standards for rating, it is important to get a high rating by the more important companies.

Business investing in stocks and bonds can be done through a brokerage, Treasury Direct and Mutual Funds.

Brokerage – It is the most common form of bond investing and you can use a full service broker to execute your trades. You will have to pay a commission for this service which varies widely with different brokers.

TreasuryDirect – This program was started by the Bureau of Public Debt in an effort to facilitate citizens to buy U.S. government bonds. Individuals can buy bonds directly from the Treasury without paying brokerage. Investors can establish a single TreasuryDirect account containing all their Treasury notes, bills, and bonds, and in return they will be issued period account statements. Besides getting electronic transfers of the principal and the interest, it allows you the transfer of bonds to and from your account.

Mutual Funds - One of the most popular ways to invest in bonds is through mutual funds. You can invest small amounts, sign up for an automatic investment plan and achieve instant diversification.

Other fixed income

Preferred Stock is a stock that is a cross between a stock and a bond. The reason it is called "preferred" stock is because certain preferred shareholders can claim the assets of the company in the case of a bankruptcy or liquidation. It means that they get any proceeds before common stock shareholders do. Preferred stock always carries a dividend. If these are not paid for some reason, they accumulate and have to be paid to the preferred shareholders before the others.

Real Estate Investment Trusts (REITs) are a specialized form of equity that allows investors to own a portion of a group of real estate properties. By virtue of these being granted special tax status by the Internal Revenue Service, REITs pay out at least 95% of their earnings in the form of dividends to shareholders, often offering healthy dividend yields of the same magnitude as bonds. Moreover, REITs can keep acquiring properties and if the value of these increase, so will the value of the equity thereby providing a nice hefty return.