SECTION 4: BONDS
58: The fundamental law of bond investing. Bond prices fall when interest rates rise, and vice versa. Why? If you own a bond paying 6 percent and rates rise, someone can now buy one paying 7 percent, so your 6 percent bond is worth less.
59: If you hold individual bonds to maturity, you almost never lose your money. U.S. government bonds, or Treasuries, never default. Municipal bonds and investment-grade corporate bonds rarely do, with long-term default rates of less than 1 percent and 2 percent, respectively.
60: Selling a bond before maturity can be costly. Bonds are not like stocks -- they don't always trade every day, and there's not always a willing buyer around when you want to sell one. So if you have to unload a bond, you may have to accept much less than its current value.
61: How to ladder. In a bond portfolio, hold bonds of different maturities so that you have some coming due every couple of years. This allows you to take advantage of higher rates while limiting your risk.
62: You can lose money in a bond fund. Every day, the value of the bonds in a fund's portfolio fluctuates, depending on moves in interest rates and other factors. The fund's net asset value (its share price) changes accordingly. So when you sell bond fund shares, the price may be lower -- or higher -- than when you bought them.
63: The inflation-proof investment. The Treasury's inflation-indexed securities, known as TIPS, are guaranteed to keep pace with inflation. The value of your bond adjusts twice each year to match changes in the consumer price index -- so your interest payment rises too (even though the rate remains the same). You are taxed on the increase in the bond's value, so TIPS are best held in a tax-sheltered account like an IRA. Three mutual funds that focus on TIPS: Vanguard Inflation-Protected Securities, Fidelity Inflation-Protected Bond (both no-load) and Pimco Real Return Bond, sold through brokers with a 3 percent load. The Treasury's I Bonds offer similar protection.
64: How a zero-coupon bond works. Zero-coupon bonds do not pay interest; instead, you buy them at a steep discount to their face value. When the bond matures, you receive that amount, which is your initial investment plus interest. For example, you could pay $6,659 and get a $10,000 zero that yields 4.15 percent and matures in 10 years.
65: What zeros are good for. Zeros are useful when you want to have a specific amount of money at a set time in the future -- for example, for a child's education. One catch: You must pay federal, state and local taxes on the imputed or "phantom" interest that accrues each year, so it's best to hold zeros in a tax-sheltered account such as a Coverdell.
66: What junk bonds are. Bonds that receive low grades from credit rating agencies such as Moody's or Standard & Poor's are known as junk, or high-yield, bonds. Because they are riskier, they have to pay higher yields to attract investors. The best way to invest in junk bonds is through a mutual fund such as Fidelity High Income or Northeast Investors Trust.
67: Munis aren't the only bonds that get a tax break. Interest on municipal bonds is generally free from federal, state and local taxes. Treasury bond interest is not subject to state and local taxes, but it is subject to federal taxes.
68: How to tell if a muni is right for you. If you want to see whether you'd earn more money from a tax-exempt bond than from a taxable one, you need to know the tax-equivalent yield. Divide the tax-free yield by 1 minus your top tax rate. So if a muni pays 4.3 percent and your top bracket is 35 percent, you would earn the equivalent of 6.6 percent with a muni: 4.3 divided by (1-0.35) equals 6.6.
69: Don't put tax-free bonds into a retirement account. If you do, you turn a tax-free investment into a taxable one because you're taxed (at regular income tax rates) when you withdraw money from a tax-deferred account. This may seem obvious, but it's a common mistake, according to retirement plan experts.
70: Coupon. A bond's coupon or coupon rate is the fixed amount of interest you receive each year.
71: Par value. Also known as face value, it's the amount a bond issuer agrees to pay at maturity. Bonds often trade above or below par.