July 23, 2008

Bonds 101, part 1 - Overview of bonds

What are bonds exactly?

Bonds are an investment vehicle where by you lend money to someone for a promise that they will pay you back with interest.

What kind of investment are they? When should you use them? Generally speaking bonds earn medium to low interest rates and have fairly low risk level. Bonds safer and less volatile than the stock market but a bit more risky and less liquid than saving in a bank or CD. Bonds are a good place to put money that you need to keep safe for a few years. If you are nearing retirement for example than bonds are a pretty good investment.

How do they work?
Bonds are issued for a set period of time given in years. Bonds come in various terms from a fraction of a year to 40 years. You buy the bond for a specific price, typically increments of $1000. The bond issuer will then pay the bond owner interest at specified intervals during the period of the bond. Then when the bond period is done and the bond 'matures' the issuer will return the principal face value to the bond owner.

What kinds of bonds are there?
Bonds fall into 3 main categories: treasury bonds, municipal bonds and corporate bonds. Treasury bonds are issued by the US government and are one of if not the safest investment in the world. Municipal bonds or 'munis' are issued by state and local governments and are typically tax free. Corporate bonds are issued by companies to generate capital. Junk bonds or speculative grade bonds are a type of corporate bonds with high risk of default.

What are bond ratings about? Bonds have ratings that indicate the quality of the risk. The better the rating the lower the risk of default. Bond ratings are like grades of A, B, C, So an A rating is better than a B rating. Main organizations that rate bonds are Moodys and Standard and Poors and Fitch. Moodys rates bonds as : Aaa, Aa, A, Bbb, Bb, B, Ccc, Cc, C. S & P and Fitch use AAA, AA, A, BBB, BB, B, CCC, CC, C. Anything below Bbb/ BBB should be avoided and is considered a 'junk' rating bond.

How do you buy/sell bonds? You can buy treasury bonds directly from the US government. Other bonds can be bought and sold through a broker such as Scottrade or Charles Schwab.

Sources of information:

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