Many investors find bonds confusing. Part of the problem is that multiple terms are used to describe the same thing. We'll start with bond terminology. The equals signs below indicate equivalent terms.

• Bond = Debt Security = Fixed-Income Investment: A loan to a corporate or government entity. A bond is a financial product that pays you, the investor, a set amount of interest at specified time intervals in exchange for loaning a specific amount of money to a corporate or government entity for a prescribed period of time.
• Interest Rate = Coupon Rate: The percent of the loan amount that the borrower (company or government) pays you, the lender, on a periodic basis. The annual interest rate for a bond is analogous to the interest rate on an interest-bearing checking or savings account.
• Maturity Date = Term to Maturity: The date when the bond issuer must repay you, the bond holder, the full face value of the bond.
• Face Value = Par Value: The official bond price or value. The actual price you pay may vary depending on market conditions and broker commissions.
• Treasury Bill = T-Bill: Treasury bond with a maturity date of one year or less.
• Treasury Note = T-Note: Treasury bond with a maturity of 2 to 10 years.
• Treasury Bond = T-Bond: Treasury bond with a maturity of more than 10 years
• Zero-Coupon Bond: A bond that does not pay any interest until it reaches maturity.
• Bond Rating: An alphanumeric scale used to indicate the financial strength and stability of the entity issuing the bond. The lower the rating, the less the financial stability.

Bond Basics

For most bonds, you invest a sum of money by buying a bond, then over the life of the bond you receive interest payments from the bond issuer. When the bond maturity date rolls around, you get your money back. Bonds are typically issued in multiples of $1,000. Usually the bond issuer pays interest every six months.

Corporate bonds are issued by corporations which use the money to finance research & development or to expand their business. Interest on corporate bonds is taxable both at the state and federal level.

Corporate bonds generally offer higher interest rates than government bonds because corporate bonds are more risky. The primary risk is that the company will go out of business.

Municipal bonds, or muni bonds, are issued by state and local governments. When you hear your city is funding a new bridge or road project with a bond issue, this is what they are talking about. Interest earned on a municipal bond is exempt from federal taxes. If you purchase a municipal bond from a government entity in your state, you won’t owe any state taxes either.

Treasury bonds are issued by the U.S. Treasury. They are backed by the full faith and credit of the U.S. government. Treasury bonds are considered virtually risk-free. The interest you receive on a treasury bond is taxable at the federal level but is exempt from state taxes.

Bonds are not purchased in the open market the way stocks are bought and sold. To purchase a bond, you must go through a broker. The exception is treasury bonds. You can buy treasury bonds directly from the government at Treasury Direct.

Understanding Bonds

Next let’s look at how bonds are rated. Standard and Poor’s, Fitch, and Moody’s provide bond ratings which are widely-recognized in the financial industry. The higher a bond’s rating, the safer the investment.

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Standard and Poor's and Fitch use the following rating system which ranks bond quality from best to worse:

• AAA
• AA
• A
• BBB
• BB
• B
• CCC
• CC
• C
• D

Moody's uses a similar but slightly different system:

• Aaa
• Aa
• A
• Baa
• Ba
• Caa
• Ca
• C

Anything below BBB/Baa is considered a junk bond. Bonds with lower ratings offer higher interest rates compared to highly-rated bonds.

Bond Pros and Cons

Bonds are inherently less risky than stocks. With less risk comes less reward. Investment returns on stocks averaged 11-12 percent over the last 100 years. During that same time period, the average return on bonds averaged 5-6 percent.

Bonds: Pro

As pointed out, bonds are safer than stocks so we can put that in the Pro column. Bonds also provide a predictable source of income. If your goal is to generate cash without touching the principal or putting it at significant risk, bonds are a good option.

Bonds also serve to diversify your investments. It’s not a good idea to put all of your eggs into one basket. Better to scatter them around so if something goes wrong with one investment type it won't affect your other investments. This is especially true as you approach retirement. A few years out from retirement you should transition some of your stocks into bonds. Bonds are a good compliment to stocks because when stock values decline bond returns tend to increase.

Bonds: Con

Bonds yield a lower return than stocks, which is a con. Bonds tie up your money for extended periods of time, which is also a negative. Of course, it’s possible to unload a bond before it reaches maturity, but there are market factors and broker fees to consider. Ideally, you would keep a bond until its maturity date.

Anyone who watches the financial markets knows they can turn on a dime. One day the world is great and the next we’re all going to hell in a hand-basket. Bonds lock you into a set interest rate. What if you buy a 10-year bond that pays 3 percent interest and the next year interest rates on similar bonds increase to 4 percent? Imagine if stocks came with a 10-year commitment. What if you bought stock in Blackberry the day before iPhones were introduced? That’s what buying a bond can be like. The lack of flexibility goes in the Con column.

Conclusion

Placing part of your nest egg in bonds helps diversify your portfolio. Don't be put off by the terminology, owning bonds is a sign of a mature investor.

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