The Retirement Corporation of America

How Bonds Work

BONDS ARE CALLED "fixed-income" investments because the amount of income the bond will produce each year is determined, or "fixed," when the bond is issued. Unlike dividends on stock, which can keep going up, year after year, the interest on bonds stays unchanged through the entire life of the bond.

Actually, the fixed-income label is somewhat misleading because there are three ways bonds can pay interest:

1. Some bonds indeed pay fixed rates. The overwhelming majority of bonds fall into this category.
2. Other bonds pay variable, sometimes called "floating," rates of interest. Their rates may be linked to some other interest rate or an index. That makes variable-rate bonds very similar to adjustable-rate mortgages.
3. Then there are so-called zero-coupon bonds. They are bonds that don't pay you a penny of interest until they mature.

Par Value

A bond's par value is the same as its face amount, or your principal. Most corporate bonds are sold in face amounts of $1,000 each. But most municipal bonds are issued in denominations of $5,000. Some kinds of bonds issued by the federal government or its agencies are issued in units as high as $25,000.

Price

The price of a bond is always quoted as a percentage of its par value. So, if you read that a bond costs $100, that means its price is $1,000. If you read that the price of bond is, say, $95, it costs $950, or 95% of its par value of $1,000. Whatever the quote, just add a zero to it to get the bond's dollar price.

Terms

How much interest a bond pays, when those interest payments will be made and the date by which the issuer promises to repay your principal are spelled out in the bond's indenture. This is a legally binding contract. The bond's trustee, usually an independent bank or trust company, acts on behalf of investors who buy the bond. The trustee is there to make sure the terms of the indenture are carried out by the issuer as promised.

Bonds and a company's preferred stock are both so-called senior securities. This means if the company runs into financial trouble, investors who hold these securities will be paid the interest they're owed before the company can pay any dividends to its stockholders.

Two Ways to Own Bonds

1. Registered bond. If you buy a registered bond, you can have it registered in your name or in "street name"—the name of the brokerage firm you used. If a bond is in your name, the interest is paid directly to you. If it's held in street name, the interest goes to your brokerage firm account. If you decide to own a bond in street name, set it up so your interest payments go straight into a money-market account. That way, your money will keep earning interest until you decide to invest it elsewhere.

2. Bearer bond. If you buy a bearer bond, your bond is the same as cash. If it is stolen, or somehow gets misplaced, anyone can clip the interest coupons on the bond when they come due and take them to the bank that's been designated the paying agent by the issuer. The only bearer bonds that are around anymore are municipal bonds that were issued before 1983. Since then, all municipals have been issued in registered form.

So that's the nuts-and-bolts about bonds. Now let's zero in on how bonds repay their owners. Remember, while we call bonds "fixed-income" securities, they actually come in three different flavors.

1. Fixed-Rate Bonds. The majority of bonds pay a fixed interest rate. The coupon rate is the interest you'll get, expressed as a percentage of the bond's par value. For example, if a bond has a par value of $1,000 and a coupon rate of 10%, it will pay you $100 a year in interest. Most bonds pay interest twice a year. So, if you owned this bond, you'd get a check every six months for $50.

•  When to Buy Fixed-Rate Bonds. They are good choices if you're looking for stable income for the life of a bond. Just remember, they leave you vulnerable to the possible ravages of inflation, however. The best advice for most investors is to buy intermediate fixed-rate bonds. They yield nearly as much as long-term, fixed-rate bonds, but their prices are much less volatile.

2. Adjustable-Rate Bonds. The interest rate on most of these bonds is reset periodically to track the rate some other investment is paying. But the rate on a few of these bonds is tied to changes in some kind of index. The interest on many adjustable-rate bonds is linked to the rate of newly issued Treasury securities. It might be short-term Treasury bills. Or, it might be longer-term Treasury bonds.

Owning an adjustable-rate bond is great when interest rates are rising. But it's not so great when interest rates are falling. The best choice are Treasury inflation-indexed securities—issued in 5, 10 and 30 year maturities. They pay rates, which are adjusted every six months in line with changes in the consumer price index. When these securities are issued, the market sets the basic rate. After that, the U.S. government credits holders with additional interest every time the consumer price index goes up. The adjustments are made every six months. Unlike fixed-rate bonds, they guarantee that inflation won't erode the purchasing power of your investment. Your total return on these securities is the beginning rate you get plus any increases in the inflation rate over the life of the bond.

All Treasury securities pay the lowest rates of any bonds because they are absolutely the safest investments you can make. They are backed by the full faith and credit of the U.S. government, which is the strongest in the world.

•  When to Buy Adjustable-Rate Bonds. Inflation-protection Treasuries are the ticket if you want to make sure that a dollar of income from your bond will buy as much tomorrow as it does today.

3. Zero-Coupon Bonds. They get their name from the fact that they have no coupon rate. As noted earlier, you don't get any interest at all from these bonds until they mature. At that point, you get your principal back plus all the interest that has accrued, but hasn't been paid out to you, over the bond's life. As it accrues, the interest on zero-coupon bonds keeps compounding semiannually.

What's nice about zeros is they eliminate one of the big problems of owning bonds—how to keep the interest earning at the same rate as your principal. You don't get the same certainty with regular bonds. They pay you your interest in cash every six months and it's up to you to reinvest that money the best you can. That can be a big problem if interest rates have fallen since you bought your bond. Another potential problem: Your interest payments may not be large enough to do anything more than put them in a money-market fund. There you're bound to earn less on your money than you would in bonds.

What isn't nice about zeros is that you're taxed every year on the interest that's building up in your bond, even though you don't get it until the bond matures. To avoid those taxes, put zeros in your IRA or other tax-deferred retirement account. Or, if you do use zeros to save for a child's college, put them in the child's name.

Zeros are always issued at a big discount to their face value. For example, you might buy a zero with a face amount of $20,000 maturing 20 years from now for about $5,000. But when the bond matures, you would get $20,000. That's a compound yield of about 7%. The difference is your accrued interest. Because zeros are issued at big discounts, they always sound like great bargains. But the important thing is how much you're going to earn on your investment. So, you should always ask your broker how much the bonds are priced to yield—after sales charges.

•  When to Buy Zero-Coupon Bonds. Investing in zeros is a good idea when you know you will need a big chunk of money at a certain time. That makes them a wise choice if you're saving for a child's education, for example. Don't buy zeros if there's a chance you might have to sell them before they mature. When interest rates rise, the prices of zero-coupon bonds fall faster than the prices of other bonds.