Money Essentials

Bond investing basics

Top 10 things you need to know about investing in bonds.

1. Bonds are fancy IOUs

Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects. When you buy a bond, you are loaning your money for a certain period of time to the issuer, be it General Electric or Uncle Sam. In return, bond holders get back the loan amount plus interest payments.

2. Stocks do not always outperform bonds.

It is only in the post-World War II era that stocks so widely outpaced bonds in the total-return derby. Stock and bond returns were about even from about 1870 to 1940. And, of course, bonds were well in front in 2000, 2001 and 2002 before stocks once again took charge in 2003 and 2004. By 2008, however, the bond market had far outpaced the stock market once again, and did so again in 2011.

3. You can lose money in bonds.

Bonds are not turbo-charged CDs. Though their life span and interest payments are fixed -- thus the term "fixed-income" investments -- their returns are not.

4. Bond prices move in the opposite direction of interest rates.

When interest rates fall, bond prices rise, and vice versa. If you hold a bond to maturity, price fluctuations don't matter. You will get back the original face value of the bond, along with all the interest you expect.

5. A bond and a bond mutual fund are totally different animals.

With a bond, you always get your interest and principal at maturity, assuming the issuer doesn't go belly up. With a bond fund, your return is uncertain because the fund's value fluctuates.

6. Don't invest all your retirement money in bonds.

Inflation erodes the value of bonds' fixed interest payments. Stock returns, by contrast, stand a better chance of outpacing inflation. Despite the drubbing stocks sometimes take, young and middle-aged people should put a large chunk of their money in stocks. Even retirees should own some stocks, given that people are living longer than they used to.

7. Consider tax-free bonds.

Tax-exempt municipal bonds yield less than taxable bonds, but they can still be the better choice for taxable accounts. That's because tax-frees sometimes net you more income than you'd get from taxable bonds after taxes, provided you're in the 28% federal tax bracket or higher.

8. Pay attention to total return, not just yield.

Returns are a slippery matter in the bond world. A broker may sell you a bond that is paying a "coupon" - or interest rate - of 6%. If interest rates rise, however, and the price of the bond falls by, say, 2%, its total return for the first year - 6% in income less a 2% capital loss - would be only 4%

9. If you want capital gains, go long.

When interest rates are high, gamblers who want to bet that they'll head lower should buy long-term bonds or bond funds, especially "zeros." Reason: when rates fall, longer-term bonds gain more in price than shorter-term bonds. So you win big - scoring a large potential capital gain in addition to whatever interest the bond may be paying. If rates rise, on the other hand, you lose big, too.

10. If you want steady income, stick with short to medium terms.

Investors looking for income should invest in a laddered portfolio of short- and intermediate-term bonds. For more on laddered portfolios, see our "Sizing up risks."

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