How bonds work

A bond is simply a loan you make to a corporation, municipality, or government agency. The borrower gets the cash it needs, while you, the lender, earn interest for the term of the loan. For the use of your money, the borrower promises to pay you a specific interest rate on a regular basis for a set period of time.

This information is formally spelled out in the loan agreement with:

• Amount of the loan (principal)
• Rate of interest (coupon)
• Payment schedule

For example, if you buy a $1,000 bond paying 5% interest annually for 20 years, you are entitled to receive $50 every year in interest payments for the period you hold the bond.

This steady, predictable stream of interest is why bonds are called fixed-income investments. Other fixed-income investments include: CDs, investment contracts, fixed annuities, mortgage-backed securities, and savings bonds.

A bond can be bought and sold in the open market, similar to a stock. When the bond matures, the borrower repays you the original purchase price of your bond. Prior to the bond's maturity, its market value will vary as interest rates in the economy rise or fall.

For example, using the same $1,000 bond paying 5%:

• If interest rates rise to 7%, the value of your bond will be worth less because investors want new bonds paying more; therefore, your bond will depreciate, losing resale value.
• If interest rates fall to 3%, your bond becomes more valuable than those issued after yours; this means the bond has appreciated and you could sell it at a premium.

This hypothetical example is for illustration only and is not intended to reflect the return of any actual investment. Investments do not typically grow at an even rate of return and may experience negative growth.

Maturity and duration

Maturity — the time until the loan is repaid — is a factor determining a bond's income, as well as its volatility. Bonds are categorized as:

• Short-term (usually two years or less)
• Long-term (10 years or longer)
• Intermediate-term (in between the two)

The risk of bonds varies with maturity because the possibility of gains and losses varies with the length of time interest and principal payments are exposed to market rate fluctuations.

Because the value of the remaining stream of payments varies with changes in interest rates, longer maturity bonds fluctuate more than shorter maturity bonds for a given change in rates.

This fluctuation is measured by duration, a more precise calculation of the "effective life" of an investment. Compared to maturity, which only deals with the date when the principal is finally repaid, duration also reflects the amount and frequency of all payments, as well as today's price. Duration is an estimate of a bond or bond fund's sensitivity to interest rate changes.

Interest rates

Credit quality is a major factor in determining a bond's stated interest rate. Independent rating agencies, such as Moody's Investors Service and Standard & Poor's Corp., rate bonds according to the issuer's financial health and ability to make interest payments and repay the principal in full at maturity.

Ratings are scaled from AAA (the highest rating) to D (the lowest rating). Bonds known as "investment grade" are generally those rated BBB or better using Standard & Poor's rankings. Below investment grade (also known as "high yield" or "junk bonds") are generally rated BB or lower.

Investment grade bonds tend to be safer and generally offer lower interest rates than below-investment-grade bonds. Issuers with lower credit ratings are perceived as more risky and must offer their bonds at a higher interest rate to attract investors.

Risks

Although the stock market is generally considered more volatile, bonds carry their own forms of risk. The most significant ones are interest-rate risk and credit-quality risk.

Generally, the higher the risk the larger the yield, or return, to the investor. For example, U.S. Treasury bonds, backed by the creditworthiness of the United States, pay lower yields than bonds issued by corporations with a less creditworthy reputation. When you accept high yields and low credit quality, you risk seeing the bond issuer default on their bond obligations.

Credit rating agencies try to define bond issuers by their ability to pay their bondholders on schedule. However, rating an issuer's creditworthiness is not an exact science and rating agencies can be wrong.

The biggest risk of a bond investment is if the issuer goes bankrupt, the loan may not get paid back at all. In bankruptcy cases, bank lenders have the first claim on any assets that the bankrupt company may have. But bondholders have a higher claim than stockholders, which is one reason bonds are generally less risky than stocks.

When interest rates rise, bond prices generally fall. This means that bonds — particularly longer-term bonds — are highly susceptible in economic climates with rising interest rates. If your investment portfolio is heavily weighted with bonds, you could watch your nest egg shrink significantly during some periods. If rates rise and you try to sell a bond before it matures, you will find that the bond's price on the open market has fallen below what you paid for it. You would lose some of your original investment if you sold before maturity.

Diversifying your bond portfolio

A bond mutual fund is a convenient way to invest in bonds and diversify your bond portfolio. Managed by experts who invest in many different bonds, a fund doesn't have all its money riding on one corporation or municipality, one interest rate, or one maturity. By investing in shares in the fund, you own a percentage of all the fund's investments. Shareholders make a profit by selling shares when the price has risen higher than what they paid for them.

The real advantage of investing in a bond fund is that you don't have to try to choose the bonds yourself. Professionals who are trained to analyze the quality of bonds choose them for you. They use analytical skills to find bond issuers who are likely to pay off the bonds on time, and who pay an interest rate in the meantime.

However, there are risks associated with investing in a bond fund rather than in bonds themselves. An investor can lose money by selling shares that have dipped below the purchase price. And a bond fund doesn't have a definite maturity, as a bond does. Consequently, bond fund investors are vulnerable to such market risks as rising interest rates. Also, bond funds charge annual management fees, while some impose initial sales charges or fees for selling shares.

Consider meeting with a financial advisor for help.