Bond Investment 101

Investing in bonds provides necessary stability to a conservative portfolio. However, bond investing doesn’t have to be only about risk avoidance. Successful market experts such as Bill Gross have a long history of investing in bonds to make money rather than to avoid losing money. Much like stock investors rely on some basic concepts, bond investors have some easy-to-understand measurements they track to create successful investment strategies.

What is a bond?

A bond is an obligation between a company or government and a lender. Buyers of bonds own the right to collect a debt from the company or government issuing the note. Like a mortgage, bonds have a pay-off date, interest rate, and may have periodic payments of interest or principal until the debt is repaid.

Length of the bond

The day the issuer must repay the loan is called the maturity date. This may be as far away as thirty years, but is often five or ten years. When deciding on which bonds to buy, investors review contract terms to know the length of time until funds are repaid. Investors classify bonds as short term, intermediate term, or long term obligations. Most analysts categorize intermediate term bonds as those between one and 15 years long. Short term bonds are loans of less than one year while long term bonds have maturities longer than 15 years.

Although investors often sell bonds on the open market before the maturity date, they can be assured that the issuer will repay by the maturity date to avoid defaulting on the loan. The issuer repays the same amount originally borrowed, plus any interest due, but this may not be the same amount of money that the investor originally paid for the note. Many investors buy bonds on the open market for prices different than the amount originally borrowed.

Early repayment

The first date that a company may repay a bond is known as the call date. These are important to investors for a variety of reasons. Persons investing cash to receive a stream of interest payments want to make sure that they won’t have their funds returned quickly, forcing them to find a new bond. Investors hoping for capital gains will purchase a fund near the call date below the repayment amount, hoping to make some quick money. Any investor purchasing debt beyond the call date knows that a company may repay the loan at any time.

How to tell what a bond is worth

The amount of money that the company originally borrowed is called the par value. Most bonds count their debt in $100 increments, although preferred stocks—actually a form of bond—have a par value of $25. By knowing the par value of a bond, the investor can quickly learn if there is the opportunity for a capital gain or risk of loss. If the bond is trading above the par value, the prudent investor knows that the company will return less than the current price when repaying the debt.

This concept of par value is lost on some neophyte investors. Enamored with dividends, some investors only ask the size yield a bond pays. It’s possible that a bond will pay a seven percent dividend, only to still have this money lost when the bond is repaid, simply because the bond was purchased above par value.

Taxes and Bonds

Because stock dividends are paid at a lower rate than normal income, tax-adverse investors will sometimes opt to buy stocks instead of bonds. However, some bonds have tax benefits that a prudent investor should explore before accepting the additional risk of the stock market.

Municipal bonds are tax free loans to city governments. If you live in the same state as the municipality issuing the debt, your money is state and federally tax free. Municipal bonds issued in other states are federally tax free, but are susceptible to state income taxation. Older investors should know that municipal bond income is computed when finding whether an individual will pay tax on Social Security. This may make municipal bonds less attractive persons receiving Social Security payments.

Bonds may be held in an IRA and many variable annuities offer attractive tax-deferred bond investments. These shelters protect investors from some of the tax created by taxable bond investments in a portfolio.

Should new investors buy individual bonds?

Bonds trade in more obscure ways than stocks, so it’s difficult for a new investor to find information about many types of available bonds. Online brokers often allow investors to review bond prices, maturity dates and yields before purchasing, but you may need to visit several brokers before settling on a bond that fits the goal.

Mutual fund or annuity bond funds are attractive options for new investors or those who don’t have the time and energy to track individual bonds. Mutual fund buyers don’t have to worry about par value, call dates, maturity dates or yield on individual bonds. Instead, bond fund buyers can request a prospectus from bond funds of interest and compare funds by length, yield, manager tenure, star rating, and size.

Bonds are an attractive investment for people seeking income from their investments, but who don’t want the risks of the stock market. This doesn’t mean that bonds are risk-free. Investors should always read the company’s credit rating closely before investing. Buying a bond is similar to loaning money to a friend. You’ll want to know their ability to repay before parting with hard-earned dollars.