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, you should make sure you remember the following 10 facts about bonds. 

Bonds Aren’t All That Complex

Despite the numerous titles used to describe them–fixed-income securities, debt instruments, credit securities–bonds are nothing more than 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, then returns your money when the bond reaches maturity (you could consider this the expiration date).

Bonds Have a Reputation for Safety

This safe reputation is historically well-deserved. However, this safe reputation doesn’t mean that bonds are risk-free. 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, swings in interest rates and the resulting swings in the bond’s price won’t matter (unless you're worried about yield to maturity—how much interest income you receive until it matures).

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 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 ultrashort-term notes (less than a year) 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” bonds. Third, there are rather high-risk bonds, also sold by the previous entities. These bonds are considered below-investment-grade bonds, 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 rating agencies include Moody’s, Standard & Poor’s, and Fitch Ratings and 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 can do on stocks. The bond market has also developed countless derivative investments. Bond derivatives, basically, are 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 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 bonds aimed at providing tax-free returns. Cities and states issue municipal bonds (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 Good for Beginners

The vast majority of individuals considering a foray into debt investing should consider buying a bond mutual fund or exchange-traded fund (ETF). Bond funds are free of the liquidity risk of individual bonds. Investors can buy bond funds in small quantities and use them to diversify their holdings (something that’s difficult to do with individual bonds, as it can become very expensive).

It’s fairly simple to find the fees and loads (sales commissions) on bond funds. There are many funds that don't load at all and try to keep fees to a minimum.

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 there is not as much oversight in the bund fund market as in other markets, the Securities and Exchange Commission is investigating options for providing more regulation.