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."

calculator
Tax-equivalent yield converter
glossary
Glossary
take the test
Take
the test
more lessons
More Money Essentials
lessons
Features
They're hiring!These Fortune 100 employers have at least 350 openings each. What are they looking for in a new hire? More
If the Fortune 500 were a country...It would be the world's second-biggest economy. See how big companies' sales stack up against GDP over the past decade. More
Sponsored By:
More Galleries
These 10 food trends could dominate 2015 So long, kale. Here's what's expected to shake up the food industry next year. More
Beyond Russia: Geopolitical hot spots in 2015 Investors beware: These 5 global crises are likely to rattle the stock market and world economy. More
These 20 antique guns could fetch big bucks Morphy Auctions in Pennsylvania is putting nearly 1,000 old guns on the block. Here are just a few. More

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.