Money Essentials

The value of investing in bonds

Bonds are more predictable than stocks - but only barely so

Bonds at their best are basically boring, which is probably a virtue.

You loan money to a corporation or government agency, like the Treasury Department, and the borrower agrees to pay it back at a fixed rate of interest (sometimes known as the coupon) over a fixed period of time (the term or maturity).

Typically, the longer the maturity of a bond, the higher the coupon. For example, the spread between 5-year Treasury notes and 30-year bonds is often a full percentage point or two. Why? Because the longer the term of the bond, the longer its owner will be left earning a low rate if interest rates in general rise. The greater the risk, the greater the reward.

Similarly, the interest rate a bond pays is directly related to the riskiness of the bond. Treasury bonds, for example, are as close to a sure thing as you can get in the world of bonds, since Uncle Sam can always print more money to pay them off. (Even the feds aren't immune to the laws of economics, though. If the government ever did print lots of extra cash to pay off its bonds, that would cause inflation to soar and make the bonds worth less.)

At the other end of the spectrum, however, are low-grade corporate bonds, known as high-yield or junk bonds, which have coupons that are several percentage points higher because of the risk that the corporations that issue them might stumble. In between are investment-grade corporate bonds from large, blue-chip companies. The job of grading bonds comes from outfits like Standard & Poor's and Moody's, which rate the riskiness of most non-Treasury bonds.

One additional quirk to bonds: If they are issued by a state, county or city agency, their interest earnings are usually free from federal taxes. These municipal -- or muni -- bonds pay less than taxable bonds in nominal terms. But for investors in a high federal tax bracket, they often return more after taxes than comparable taxable bonds. If you happen to live in the municipality or state that issues the bond, it may also be exempt from state and/or local tax -- an added benefit. Similarly, bonds issued by the federal government are exempt from state and local taxes, but the tax rates are lower and the benefit is too.

Although bond prices tend to fluctuate less than stock prices, they aren't risk-free. If interest rates rise, bond prices will fall. Why? As new bonds paying higher rates become available on the market, the price of older bonds falls proportionately so that the interest they pay is the same as that of a comparable new bond. That's worth remembering in the current environment, in which interest rates in the United States have hovered around their lowest levels in decades.

Here's a simplified example of how it works: Let's say that you paid $1,000 for a 30-year bond that yielded 7% interest, or $70 a year. A year later, the rate for a comparable new bond falls to 5%, which means it yields just $50 a year. Your old bond is now going to be worth more, because investors are willing to pay more to get a $70-a-year income stream than they will to get $50 a year.

Since the interest rate of your bond is now 40% higher than normal, its new price will be about $1,400, or 40% more than you paid for it. And its yield? Exactly 5%, since $70 a year is 5% of $1,400. (Note: the equation is not quite that simple, since your bond now has only 29 years left to maturity and will be matched to other 29-year bonds, not new 30-year issues.)

Conversely, if rates jump from 7% to 9%, meaning new bonds are paying $90 a year interest, the value of your bond will fall to about $778 -- because your bond's $70 annual interest is 9% of $778.

Eventually, of course, when the bond matures, it will be worth $1,000 again. However, its value will move up and down in the meantime, depending on what interest rates do. The longer the time to maturity of a bond, the more dramatically its price moves in response to rate changes. That is, long-term bonds get hit harder than short-term bonds when rates climb, and gain the most in value when rates fall.

As a result, bond buyers tend to divide into two classes: investors (or speculators), who hope to make money thanks to a decline in interest rates that sends bond prices higher; and savers, who buy bonds and hold them to maturity as a way to earn a guaranteed rate of return.

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Updated 7/10/2012 with updated content, link - aross