The Basics of Bonds

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If you’re new to the world of bonds, it’s easy to be intimidated. Bond investing can be filled with unusual lingo, strange concepts (think catastrophe bonds), and as much talk about math and economics as you’ll find at your local stock broker’s office.

Don’t be discouraged. Bonds are neither as mysterious nor confusing as they may appear. As you learn about the world of bond investing, keep in mind the following facts and you'll reach pro status in no time.

Bonds Are Simple in Nature

The lingo used to describe bonds can seem quite complex at first. You may hear them called debt instruments, fixed-income or credit securities, or a host of others, but despite the many titles used to describe them, bonds are nothing more than formal IOUs. In fact, they are like loans, in which the terms, pay-back date, and interest rate are spelled out in a legal document. When you purchase a bond, you are in effect making a loan to the bond's issuer, who agrees to pay you a set amount of interest for the use of your money. They invest this money, with the intent to make a profit in the market, then return your money when the bond reaches maturity. You can also think of this as the expiration date.

Bonds Are Known for Safety

Over time, bonds have been proven to be among the safest ways to invest your money. This safe reputation is historically well-deserved. But note, bonds are not without risk. In fact, bond investors tend to worry about risks that stock investors don't worry about, such as the risk of inflation or liquidity risk.

Bonds Move Opposite to Interest Rates

When interest rates rise, bond prices fall, and vice versa. If you buy a bond and hold it until it matures, the rate changes that occur in the meantime won't matter, so for the most part you won't need to worry about swings in interest rates and the resulting swings in the bond’s price.

On the other hand, if you sell your bond before it matures, the price it fetches will be largely related to the current interest rate.

The yield to maturity (YTM) rate accounts for the full return that you can expect to receive if you keep a bond until its end date. Even if rates and prices change while you have the bond, the YTM might show up as a steady annual figure.

Bonds Are More Common Than Stocks

Whereas stocks come in only a handful of varieties and are offered only by public corporations, bonds are sold by a slew of parties. Public and private corporations, the federal government, government-sponsored agencies, cities, states, and many other public bodies, can all issue bonds. Bonds also come in nearly endless forms, from ultra short-term notes that mature in less than a year, to long-term bonds that take 30 years to mature.

Bonds Come in Three Basic Types

As varied as bonds may be, it helps to realize that all the bonds issued in the U.S. fall into one of three categories. First, there’s the very safe debt of the federal government and its agencies. Second, there are low-risk bonds sold by corporations, cities, and states; these are known as “investment-grade” bonds. Third, there are rather high-risk bonds, also sold by the same entities listed above. These bonds are often called "junk bonds" because they are considered to be below investment-grade.

Bonds Get Grades

It’s easy to tell at a glance whether a bond is investment-grade or junk (and where it falls on the spectrum between the two). A number of Wall Street companies rank bonds by safety. These rating agencies include Moody’s, Standard & Poor’s, and Fitch Ratings, and all publish simple grades on all debt issues.

Bonds Have Spin-Offs

While bonds themselves fall into three basic types, they often form the basis of other, more complex asset types. Savvy investors can buy futures and options on bonds just as they do on stocks. The bond market has also come up with countless derivative investments. These are types of securities derived from a bond's value; that security is then traded on the derivatives market.

One of the best-known derivatives is credit default swaps, which are used to protect investors from default risk. These are well known for their role in helping cause the 2008 financial crises.

Bonds Have Yield Curves

The key to knowing how to invest in the bond market lies in understanding a financial concept called a yield curve. This is a graphical model of the relationship between the interest rate that a bond pays and when that bond matures. Once you learn to read curves (and calculate the spread between curves), you can make informed comparisons between bond issues.

Bonds Can Be Tax-Free

There’s an entire class of bonds aimed at providing tax-free returns. Cities and states issue municipal bonds (called "munis" for short), to raise money to pay for schools, highways, and a slew of other projects. Interest payments on the bonds are exempt from federal taxes. They are also free from state and local taxes if an investor lives in the issuing municipality (in which case they're known as double- or triple-exempt bonds). But despite the tax break, munis come with a few quirks, and can vary by city. So before you dive head first, make sure you research your local muni bonds.

Bond Funds Are Good for Beginners

Most people who are just getting started in the market, or wanting to take a foray into debt investing, should look into buying a bond mutual fund or exchange-traded fund (ETF). These funds are professionally managed, and tend to be very safe for that reason.

Of course as with any account service, there will be fees. It’s fairly simple to find the fees and loads on bond funds. There are many funds that don't load at all and try to keep fees to a minimum. The costs may be worth the peace of mind you'll have in knowing your fund is free from the liquidity risk of individual bonds.

Another perk of bond funds is that they are diverse by default. You can buy bond funds in small amounts and use them to diversify your holdings; this is not easy to do with individual bonds, as buying many can be very costly.

A Warning About Bond Markets

Much of the bond market takes place in an opaque, unkind corner of Wall Street where small, retail investors are particularly vulnerable. The secondary market, or over-the-counter market, is not recommended for new traders either, as it can be complex and lacking in structure. While there is not as much oversight in the bond fund market as in other markets, the Securities and Exchange Commission is working on options to provide more regulation.