Make someone else's debt work for you

Beyond common and preferred stocks is the wonderful world of bonds.These are debt instruments that companies issue to finance large projects and future growth. Rather than sell equity ownership in the company, they secure financing by obtaining loans from investors in return for regular interest payments. These payments are often referred to as coupons because historically they were physically detached from the bond when a payment was made. Today this is done electronically.

There are three main classes of bonds. Government bonds, or treasury bonds, are issued by a federal government. Bonds issued by a stable government like the United States are extremely safe; there is practically no risk of the lender defaulting. Municipal bonds are issued by city governments. These are also very low risk, but it can happen that cities go bankrupt if they're mismanaged. Corporate bonds are issued by private corporations. These carry higher risk, as we all know what can happen to private companies, especially if they overextend their debt loads. However, corporate bonds also give higher yields, since interest rates vary directly with risk. Very stable companies will issue bonds at lower interest rates than those with shakier credit quality.

The reasons for investing in bonds are preservation of capital and a predictable stream of income. Because bonds include an agreement by the company to repay the principal at maturity, they are perceived to carry less risk than stocks.However, all bonds (including those issued by the U.S. Treasury) do have their downside and it's important to keep that in mind when doing your research.

Some risks to keep in mind:

  • Interest rates affect the price of bonds. When rates rise, prices go down and when rates drop, prices go up. Every movement in price changes the yield you can expect from your bond. Therefore, the greater the time to maturity, the greater the interest rate risk.
  • When your investment reaches maturity, there is the possibility that you will be reinvesting the proceeds at a lower rate of interest, reducing the income it will produce in the future. This is referred to as reinvestment risk.
  • Let's say you hold a long-term bond that matures in 10 years. What will be the value of both the interest payment and the principal at maturity? The answer to this question is unknown. However, we do know that both the principal and interest will be worth less in today's dollars. Inflation risk is a key consideration when investing in bonds.
  • The bond market as a whole can decline, bringing the price of the individual security down with it. This is what's called market risk.
  • Some bonds have a call option allowing the borrower to repay the loan prior to maturity. In many instances they do so because interest rates have dropped and they want to obtain financing at these new levels. The investor must now reinvest those funds at a lower rate of interest which reduces the income they'll receive. Thus, it's referred to as the call risk.

Are bonds a good investment for your portfolio? Most financial advisors would answer yes because they help balance the risk ofthe stocks portion of your portfolio. As you age and get closer to retirement, the more appropriate fixed-income investments become.

A good rule of thumb is to take your age and subtract it from 100 and whatever that number is should be the percentage of your portfolio in stocks. So if you are 60, you would have 40 percent in stocksand 60 percent in bonds and cash. However, this is simply a guideline. Your specific situation may call for a different asset allocation model.

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