If you are new to investing perhaps you are not familiar with bonds. Before you get started, you need to understand some of the risks associated with bond investing. Most people assume that all interest-bearing securities are completely risk free, but this is not the case. Even if you know a lot about investing, you may not be aware of some of the risk characteristics associated with bonds.

The most important thing to take into account is the interest rate. The Federal Reserve (also known as the Fed) meets every 6-8 weeks to evaluate the health of the economy. At each meeting, the Fed renders a decision regarding interest rates.

If inflation is rising, the Fed will need to raise interest rates to tighten the money supply. If inflation is moderate or contained, the Fed will likely leave rates unchanged. However, if the economy is slowing down and there is very little inflation or maybe even deflation, then the Fed might decide to reduce interest rates to create a stimulus for economic growth.

The reason why you need to consider present and future interest rate levels is because as interest rates increase, bond prices go down, and vice versa. If you are able to hold your bond until maturity, then interest rate movements do not really matter, because you will redeem the principal upon redemption. But often, investors have to cash out their bonds well before the maturity date. If interest rates have moved up since you purchased the bond, and you sell it prior to maturity, then the bond will be worth less than your initial investment.

You should also be aware of the claim status of the bond you are buying. Claim status refers to your ability to liquidate your investment in the event the bond issuer goes bankrupt. If you are buying a government bond, such as a Treasury Bill, claim status is irrelevant, because the odds of the Federal Government going bankrupt are slim and none.

If you are buying a corporate bond, however, there is always a chance that the issuer could go out of business. In the event of liquidation, bondholders are given priority over stockholders. However, there are often different classes of bondholders. Senior note holders can often claim against certain kinds of physical collateral in the event of bankruptcy, such as equipment (computers, machines, etc.). Regular bondholders can not always claim against physically collateral, and are next in line after the senior note holders.

Next, you should always check the three main features of the bond you are buying; the coupon rate, the maturity date, and the call provisions. The coupon rate is the interest rate. Most bonds pay an interest rate semiannually or annually. The maturity date is the date that the bond will be redeemed by the issuer; simply put, the maturity date is when the company must pay back to you the principal you loaned to them. The call provisions are the rights of the issuer to buy back your bond prior to maturity. Some bonds are non-callable, while others are callable, meaning that the company can buy your bond back before maturity, usually at a higher price than what you paid.

Finally, you should also understand that if economic conditions become more favorable after you a buy a bond, and interest rates start to go down again, the issuer will likely issue a lot more bonds to take advantage of the low interest rates, and will use the proceeds to try to buy back any callable bonds it issued previously. So, when interest rates go down, there is an increasing likelihood that your bond will be redeemed prior to maturity, if in fact the bond is callable.

You should invest in bonds. However, you should also take into account the risk factors we have covered. Your portfolio should contain a mix of corporate, federal, municipal, and even junk bonds (there is always a default risk associated with junk bonds, but they pay a huge interest rate). Talk to your broker about diversifying the kinds of bonds in your portfolio and you will reduce your overall risk and maximize your return.



Thanks to Jim Pretin for contributing this article to our Bonds blog:

Municipal Bond Interest Rates

If you are relatively new to investing, you probably have heard of stocks, but know absolutely nothing about bonds. They do not offer the same sex appeal as stocks. Movies such as Wall Street and Boiler Room have gotten many neophyte investors excited about the stock market, and not once are bonds even mentioned in these films. Bonds are somewhat perplexing; the terminology is a little confusing. This article will hopefully help you understand how bonds work and whether or not they sound like an appropriate investment vehicle for you.

Simply put, corporations, governments, and municipalities borrow money by issuing bonds for sale to the general public. Companies sometimes need additional monies to expand their business, while governments need money for infrastructure. And just like any other loan, the bondholders are paid an interest rate on their money. And, generally speaking, at the end of a certain term, the borrower has to pay back the face amount of that loan.

Interest payments are made at a predetermined rate and schedule. The interest rate is usually referred to as a coupon. The date on which the borrower has to pay back the principal is known as the maturity date. If the lender holds the bond until maturity, he or she will get their principal back. So, for example, if you lend a company $10,000 by purchasing a corporate bond, and it pays an 8% coupon and has a maturity date of 10 years from now, that means you will be paid $800 per year for the next 10 years, and then you will get back the entire initial investment on the maturity date.

Bonds are considered debt instruments, whereas stocks are equity. The reason why stocks represent equity, or ownership, in a corporation, is because stockholders are entitled to receive a portion of the earnings in a corporation, whereas bondholders are only entitled to receive interest payments on their loan. If the bond issuer goes bankrupt, bondholders have a higher claim on the assets derived from the liquidation of the company; stockholders are compensated only after everyone else if a company goes belly up, and sometimes get nothing at all.

There are basically 3 different types of bonds. Government bonds are issued by the federal government, and are considered the safest as is the debt of any country with economic stability. Municipal bonds are issued by local governments, and are also considered safe. More importantly, municipals are exempted from federal tax and often from state taxes as well, making them a very lucrative investment. Finally, there are corporate bonds, which can be risky, depending on the financial condition of the company that is doing the issue.

I hope this information has helped you become familiar with bonds. Try to set aside some money for investing and start while you are still young. The earlier you begin, the more money you can potentially make down the road. Carefully research the credit rating of the company when investing in corporate bonds, and go for municipals or government issues if looking for security.



Thanks to Jim Pretin for contributing this article to our Bonds blog:

Cashing In Savings Bonds