The Retirement Corporation of America

Reviewing The World Of Bonds

HERE'S THE "60-SECOND" lesson about bonds.

•  Nature of the investment: You are a lender to the borrower—a company, a city or state, or even Uncle Sam. You hand over your money and get an IOU back, which promises to pay you a set rate of interest for a fixed period of years, and to repay your loan in full when that period has ended. You will always get repaid in full if you hold the bond until it matures. If you must sell before then, you may be able to turn a profit—but, depending on market conditions, you might have to sell at a loss.

•  Risk: Low to moderately high.

•  Reward: Moderately high, provided you don't get yourself into a situation where you must sell at a loss.

•  Role in your retirement savings: To provide a steady stream of income to your retirement savings accounts; also to provide a less-volatile offset to your investment in common stocks.

Why Bond Prices Fluctuate

It's easy to see why stock prices fluctuate. Perception in the marketplace, adjusted earnings, and other factors affect the overall value of the company—hence the price an investor will pay to buy its shares. But why would bond prices fluctuate? It all depends on when you buy the bond, and what's happening in the bond marketplace when you decide to sell.

You could buy a bond when it is newly issued by paying the face value (usually $1,000). The interest rate on the bond would be the yield earned on your money. An 8 percent bond would pay you $80 a year interest for each $1,000 you paid—an 8 percent yield on your investment.

Once a bond is sold, it starts trading just as stocks do—bought and sold at whatever price investors can agree on. What has the greatest influence on bond prices is what other interest rates are doing.

•  If the interest rate on a brand-new bond is now 10 percent, nobody would pay $1,000 to buy your 8 percent bond. You'd have to cut the price to about $800 to deliver the same 10 percent new bonds are yielding. If you decide to sell now, you will take a loss of $200.

•  But say the rate on a brand-new bond is only 6 percent. You'd be foolish to sell your 8 percent bond for $1,000. Investors should be willing to pay a lot more to buy your bond with that rich 8 percent yield. If you decide to sell now, you could make a nice profit.

•  No matter what price you paid when you bought the bond, it will always pay off at face value when it matures, never less.

Defining the Bond Market

Here are the three main categories of bonds:

•  Treasury securities: They are issued by Uncle Sam to help pay for the running of our government, and to help keep up with the national debt. They are backed by the taxing power of the U.S. Government. That makes them the safest securities in the world. They are further broken down by:

- Treasury bills: Government securities that will mature in one year or less.

- Treasury notes: Government securities that will mature in between one and 10 years.

- Treasury bonds: Government securities that will mature in 30 years.

- One feature of Treasury securities is that all the interest they pay is usually exempt from state and local taxes. Another feature is that you can eliminate the middleman, and buy directly from Uncle Sam, through a program called Treasury Direct. Your bank should be able to explain how it works. If not, call the nearest Federal Reserve branch (listed in the government pages in the phone book).

•  Municipal bonds: They are issued by various units of local government—cities, states, school districts, etc.—to pay for the running of these units of government, and to pay for the roads, schools, and public works that are essential to our lives. The interest is exempt from federal income tax plus state and local taxes, if they are issued by the jurisdiction in which the purchaser resides.

•  Corporate bonds: They are issued by corporations throughout the country (and overseas as well) to raise capital, and to pay for whatever new facilities the business needs to keep competitive. You don't get any tax breaks on corporate bonds, but they tend to pay a higher rate of interest than Treasury or municipal bonds.

Finally, there are some sub-categories of bonds:

•  Convertible bonds: They pay a set rate of interest like bonds, but can be converted into common stock at some point in the future. They can be very complicated investments. But once you master them, you can earn a nice interest rate. Then if the price begins to move, you can convert the bond into common stock. Because of the interest payment, the price of the conversion is less volatile than the price of the underlying common stock. Also, due to the conversion feature, the price of the bond is more stable than a comparable bond that isn't convertible. The best way for the average investor to buy convertible bonds is in a mutual fund.

•  High-yield, or "junk", bonds: Bonds are rated, from AAA (best quality credit) on down. Anything below BB (or Ba, if it is rated by Moody's Investors Service), is considered a "junk" bond. Junk bonds pose a higher risk of default than high-quality bonds. However, they pay far higher rates of interest, too. The best way for the average investor to buy junk bonds is in a mutual fund.

•  Zero-coupon bonds: Some bonds pay interest every six months. Zero-coupon bonds, as the name implies, pay no interest. Your return comes from buying them at a discount and holding them until you are repaid at face value when they mature. Most common Zeros are in Treasury securities. They are not very complicated to buy. Any broker can handle the trade. For technical reasons, they are best suited for tax-sheltered retirement accounts.

Summing up bonds: You buy stocks because, over time, they offer the highest total return of any investment. You buy bonds because, over time, they offer more stability, and a greater certainty of earning money, than stocks. You buy stocks AND bonds because together they offer a higher potential return than just buying bonds, with less risk than just buying stocks.