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 a lot more talk about math and economics than you’ll usually find at the local discount stock broker’s office.

But don’t be discouraged. Bonds aren’t as mysterious as they may appear. Here’s a list of the top 10 things to know about bonds. 

Bonds Aren’t All That Complex

Despite the numerous titles used to describe them – fixed-income securities, debt instruments, credit securities, etc. – bonds are nothing more than fancy IOUs in which the terms, pay-back date, and interest rate are carefully spelled out in a legal document. When you purchase a bond, you are in effect making a loan to the bond's issuer, who pays you interest for the use of your money.

Bonds Have a Reputation for Safety

And that reputation is well-deserved. But that doesn’t mean that bonds are risk-free. In fact, bond investors tend to worry about things that stock investors never worry about, like inflation and 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, swings in interest rates and the resulting swings in the bond’s price won’t matter. But if you sell your bond before it matures, the price it fetches will be largely related to the current interest rate environment.

Bonds Are More Complicated Than Stocks

Whereas stocks come in only a handful of varieties and are offered only by public corporations, bonds are sold by corporations, the federal government, government-sponsored agencies, cities, states, and other public authorities. Bonds also come in nearly endless varieties – from short-term notes to bonds that take 30 years to mature.

Bonds Come in Three Basic Types

As complicated 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 extremely 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.” Third, there are rather high-risk bonds, also sold by corporations, cities, and states. Those bonds are called below-investment-grade, or junk bonds.

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 continuum between the two. A number of Wall Street companies “rank” bonds by safety. These credit rating agencies, including Moody’s, Standard & Poor’s and Fitch Ratings, 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 assets types. Savvy investors can buy futures and options on bonds just as they can do on stocks. The bond market has also developed countless derivative investments. Of these, the best known are credit default swaps, which are used to protect investors from default risk.

Bonds Have Yield Curves

The key to understanding the bond market lies in understanding a financial concept called a yield curve, which is a graphical representation 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 bond aimed at providing tax-free returns. Cities and states issue municipal bonds, or munis, 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 aren’t for everyone.

Bond Funds Are Best for Beginners

Much of the bond market takes place in an opaque, unfriendly corner of Wall Street where small, retail investors are particularly vulnerable. The secondary market, or over-the-counter market, is not recommended for these investors. While things aren’t quite as shady as they once were, the lack of oversight by any major exchange means this market is no place to venture unless you’re willing to do a lot of researching and a lot of negotiating.

So for the vast majority of individuals considering a foray into debt investing, buying a bond mutual fund or ETF is the way to go. Bond funds are free of the liquidity risk of individual bonds. Investors can buy them in small quantities and use them to diversify their holdings (something that’s nearly impossible for anyone other than the wealthy to do with individual bonds). It’s pretty easy to find out what the fees and loads (sales commissions) on any fund may be. And there are many funds that don't, in fact, charge a load at all, and keep fees to a minimum.