10/22/07
Contact:
Patricia Swanson, Human Development and Family Studies, (515) 294-2731,
pswanson@iastate.edu
Understanding Bonds
AMES, Iowa -- Two benefits of investing in bonds are that you will receive known
payments at specified times and you will have diversified holdings, assuming your other
investments are in, for example, stocks or real estate. But there are things to know if you
want to be a knowledgeable bond investor, says Pat Swanson, CFP® and families
specialist with Iowa State University (ISU) Extension's Invest Wisely Project
(www.extension.iastate.edu/investwisely).
"Bonds are fixed-income investments. You are a lender. You loan your money to a
government entity, corporation or a financial institution and receive regular interest, for
example, semi-annually, annually or at the time the bond is redeemed," Swanson
explains. "If a $1,000 bond pays interest of 6 percent, the holder of the bond will receive
$30 every six months or $60 annually."
The rate of interest paid on a newly issued bond is based on the current rate at the time of
issuance for bonds of a similar risk. This interest rate paid the bond holder remains the
same over the life of the bond. Once bonds are purchased their market value rises or falls
based on changes in interest rates in the market. This is no concern to the bondholder
planning to keep the bond until it matures.
"However, if the holder of the bond wants to sell the bond prior to its maturity date, the
holder may receive more or less than the face amount of the bond," Swanson says. "For
example, if you own a $10,000 bond paying 4.75 percent and the current interest rate is 4
percent, you may be able to sell your bond for more than $10,000. But if you had a bond
paying 3 percent and you wanted to sell it, you would be faced with selling your bond at
a discount or less than the maturity value."
"There is risk with bonds that can be minimized or reduced," Swanson says. "Don't buy
bonds with long maturities when interest rates are low. Stick to short-term (bonds that
mature in three years or less) and intermediate-term bonds (bonds that mature in 3 to 20
years). Purchase bonds with different maturity dates. Diversify across different bond
issuers. Check the credit worthiness of the bond issuer."
Swanson says the capacity of bond issuers to repay their debt is rated by various
commercial firms such as Moody's and Standard and Poor's. Bonds rated Baa to Aaa by
Moody's and BBB to AAA by Standard and Poor's are considered investment grade
bonds. Those with lower ratings are termed substandard grade. Because there is more
risk, the interest paid on these bonds is higher.
Federal government bonds are considered to have no default risk and therefore their rates
set the floor on rates for all other bonds. "An advantage of interest on federal bonds is
that you pay no state income tax on the interest earned. Likewise, interest on bonds
issued by states is not taxable by the federal government," Swanson says.
Corporate bonds are issued to raise capital for expansion or the ongoing operations of a
company. Because there is a higher risk, corporate bonds pay higher interest rates than
government securities, Swanson explains. A mortgage bond backed by specified assets of
a company, such as certain land and buildings, is the least risky corporate bond. The
highest risk corporate bond is a debenture, which is backed only by the company's future
earnings and its promise to repay.
"You also may have heard of agency security bonds from such organizations as Fannie
Mae, Freddie Mac and the Tennessee Valley Authority," Swanson says. "Although these
organizations are not technically backed by the Federal government, it is generally
understood the government wouldn't let them fail."
"Investors not having the resources to diversify their bond holdings or knowledge in this
area might want to consider bond mutual funds," Swanson concludes. In choosing a bond
mutual fund an investor needs to look at the fund's performance and charges. Studies
have shown that funds with lower management fees have out performed other funds. An
advantage of bond mutual funds is they may pay interest monthly or quarterly while
individual bonds usually only pay every six months. "This would be good for an investor
wanting a regular but not fixed source of income."
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The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web
resources for investors. It is funded by a grant from the Investor Protection Trust (IPT).
The IPT is a nonprofit organization devoted to investor education. Since 1993 the IPT has
worked with the States to provide the independent, objective investor education needed
by all Americans to make informed investment decisions. www.investorprotection.org.