Investing in Bonds

Understanding the basics behind investing in bonds will help you decide whether this type of investment is right for you. Bonds are investment securities that represent debt obligations between the bonds' issuers, who are the borrowers, and investors like you, who are the lenders. In other words, bonds are essentially the IOUs of the corporate and government financial worlds. Generally speaking, bonds pay a fixed rate of interest to investors on a regular basis. Because investors view those interest payments as income, they often refer to bonds as "fixed-income" investments.

Not everyone who invests in bonds purchases individual bonds directly from the issuers. It's also possible to invest in bonds by investing in bond mutual funds. Bond mutual funds are professionally managed portfolios that typically include a diversified mix of different bonds. As a result, they may offer greater protection against the risk of loss than a portfolio made up of just one or two types of bonds.

Investment bonds
In order to understand how investing in bonds works, you must understand the meaning of a bond's face value, price and yield.

A bond's face value is equal to the amount of money the investor will receive when the bond is repaid at maturity, or when the IOU comes due. For example, if you purchase a $1,000 bond from a bond issuer who promises to repay the loan in five years, you can expect to receive $1,000 back after five years. In the meantime, you'll receive interest payments at the bond's stated interest rate.

Bond yields
A bond's yield is its annual rate of return to the investor. Yield is expressed as a percentage and calculated using the price you paid for the bond and its interest rate. If you buy a bond at face value and hold it to maturity, its annual yield will be the same as its interest rate. However, bonds are frequently resold by their original investors to other investors. Depending on interest-rate trends in the overall economy, bonds may be sold for more or less than their original value.

For example, if interest rates rise, new bonds will likely pay higher interest rates than older bonds. On the other hand, if interest rates fall, new bonds might pay lower interest rates than older bonds. In the former scenario, the price of older bonds would fall because the newer, higher-interest bonds would be more attractive to investors. Those older bonds would then likely be resold for less than their face value. In the latter scenario, the older bonds would be considered more valuable, and would likely fetch a price that's higher than their face value.

So if you buy a bond at less than face value, your yield will be higher than the bond's stated interest rate. And a bond purchased at a price higher than its face value will produce a lower yield.

Sound complicated? It's really not. Here's how it works: If you buy a $1,000 bond at face value that's paying 5% interest and hold it to maturity, your annual yield would be $50, or 5%. That's because $50 is 5% of the price you paid. However, if you pay $500 for a $1,000 bond paying 5% interest, your annual interest payment would still be $50, but the yield would be 10%, because the $50 interest payment is 10% of the price you paid.

Therefore, when purchasing bonds, it's important that you consider not only their stated interest rates, but also their selling prices and, by extension, your likely yields.

Types of bonds
Corporate bonds are issued by companies. The interest rates on corporate bonds are determined largely by the issuing company's creditworthiness, or the risk that the company will default on its interest and repayment obligations. Higher interest rates are designed to compensate investors for the added risk of investing in bonds issued by companies with poor credit ratings. Lower interest rates typically indicate that a company is financially stable, and therefore less of a credit risk. Because investors in bonds typically want to avoid risks, they are often happy to receive lower interest payments in exchange for greater peace of mind.

Government bonds and government agency bonds, as their names imply, are issued by the government or government-related organizations, such as the U.S. Treasury or Ginnie Mae, respectively.

Municipal bonds are issued by municipalities, such as cities and towns. Municipal bonds are unique, because they pay interest that is exempt from federal and, in some cases, state and local taxes.

Regardless of which bonds you have in your portfolio, remember that it's a good idea to review your fixed-income investments at least once each year to determine whether they're still appropriate for your needs.