Bond Investing Basics
October 5, 2009
Bond Investing Overview
Bond investments should probably be a part of most portfolios; across all ages, investing goals, and levels of risk tolerance. The problem is many people spend their time learning how to invest in stocks and aren’t aware of the benefits that investing in bonds can offer.
In general, investors spend very little time investigating the opportunities in bonds, and because of this can leave money on the table. Over the course of the next few articles, I’m going to share some details on the different types of bonds, some bond investing terms, and finally some bond investing strategies that you can implement in your portfolio.
Let’s start at the very beginning. A bond is a debt security. When an investor purchases a bond, they are lending money to the issuer of that bond. In return for the cash, the issuer gives you a document, or a “bond,” stating that they will return your money to you at a certain date, either the maturity of the bond or when it is “called.”Â
You will also receive a specific rate of interest for the life of that bond. Like stocks, most of them are traded electronically now, so you will not receive an actual “document,”Â but you will receive all of this other information.
Types of Bonds
There are many different types of bonds. They each have their own features and benefits. Which ones fit into your portfolio depend on what you are looking for.
Municipal Bonds – These are bonds that have been issued by states, counties, local municipalities and other government entities. They are used to finance the building of hospitals, highways, schools and other public projects that help that community. Many of these bonds offer both state and federal tax exempt income for residents of that state. For example, if you lived in Texas and purchased a San Antonio Hospital bond, the interest you earn from that bond will be tax-free. Not every bond offers this, so make sure you know what you are purchasing or consult a professional.
U.S. Treasury Securities – These encompass T-bills, T-bonds & T-notes. TIPS also fall under this category. These are securities issued by the U.S. Treasury and are backed by the “full faith and credit”Â of the U.S. government. These are considered to be the safest investment and have no “credit risk”Â in that the chances of not receiving your interest or principal back from the government are extremely small (trust me, if you don’t get paid, we all have a LOT more to worry about at that point).
Corporate Bonds – These are bonds that are issued by companies to help finance expansion other capital investment or cash flow. Investors have a much wider range of possibilities here, but also more risk. Whenever you invest in a bond, you always take on the chance that the company could go bankrupt or fold. It is important to know the credit rating of a specific bond and that company before you purchase the bond.
Mortgage-Backed/Asset-Backed Securities – When an investor purchases one of these, they receive a stake in pools of loans or other financial assets. As the loans, or other assets get paid off, the investor receives interest. These securities have come under considerable fire over the last two years. With the housing bubble and the implosion of several major financial companies, these types of investments were used too often, and in ways they were not made for.
These are the four major categories of bonds. Inside each of these are many more varieties of bonds and other debt securities. As always, make sure you do your due diligence when purchasing bonds. They have more moving parts than a stock. I’ll go over those moving parts in the next article on bond investing.
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