A “Bond” is basically an I.O.U. When you buy bonds (also known as notes, bills, debt securities or debt obligations), you are lending money to the bonds’ “issuer.” The issuer can be a government, a corporation, an agency or some other entity. By selling the bond to you, the issuer is giving you an I.O.U., promising to pay interest periodically during the bond’s life (often semiannually) and then the principal (or “face value”) when the bond comes due (“matures”). While a bond is like a share of stock in that it is an investment vehicle, a bond is unlike a share of stock in a number of ways, such as: tending to be lower risk; tending to have higher trading costs; and tending to be owned through giant investors like pension funds, mutual funds or exchange-traded funds, rather than by individual direct purchase.
Individual direct purchase of bonds is rarer than individual direct purchase of stock. However, some individuals are interested in direct individual purchase of bonds for their portfolios.
First, there are several types of bonds sold by the U. S. Treasury, which issues these I.O.U.s backed by the federal government. The U. S. Treasury sells several types of bonds, including: Treasury Bonds, which pay interest every 6 months of the bond’s life and pay the principal back in 30 years; Treasury Inflation-Protected Securities (TIPS), which pay interest every 6 months of this security’s life, adjust the principal according to the Consumer Price Index and reach maturity in 5, 10 or 30 years, depending on which security is purchased; Savings Bonds, that come in I, EE and E series, depending on interest rates and maturities. The U. S. Treasury offers these and many more types of securities through the following links:
In addition, many funds specialize in Treasury securities, and those funds include:
PIMCO 1 – 3 Year U. S. Treasury Index Exchange-Traded Fund
There are numerous types of bonds apart from federal government bonds, a few of which are discussed here.
Secondly, there are Municipal Bonds, I. O. U.’s issued by state or local governments. These bonds can be backed by the state or local government’s taxing authority and/or by revenue from a particular entity, such as a toll road.
Third, there are several types of Corporate Bonds: Secured, because they are backed by one or more liens on one or more of the company’s assets; Unsecured (“debentures”), because they are backed only by the company’s general credit; Zero-Coupon, which pay no interest until maturity but are sold for far less than their face value; Convertible, because they can be converted into corporate stock; and Junk Bonds, usually issued by corporations with poorer credit ratings and therefore riskier but potentially significant returns.
Individuals interested in individual direct bond purchase should analyze several aspects.
Fourth, Elusive Pricing: daily prices of individual bonds are tougher to find than are daily prices of stock; however, information can be found here:
U. S. Treasury securities
Fifth, Risks: there are 3 types of risks commonly associated with bonds. There is Default Risk: as you have probably gathered by now, since they are I. O. U.’s, bonds can be pretty risky. You must consider the I. O. U. issuer’s ability to repay the interest and principal as promised. This risk, along with the relatively high cost of bond trading, leads many financial advisors to recommend individually directly buying only U. S. Treasury securities, leaving other types of bonds to purchase by pension funds or mutual funds. There is also Interest Rate Risk: the interest rate paid on a bond is typically fixed; therefore, changes in interest rates inversely affect bond prices: when interest rates rise, bond prices fall and when interest rates fall, bond prices rise. If you buy a bond at a set interest rate and interest rates rise, you will lose money by selling the bond while the interest rates are higher. A third risk is the Reinvestment Risk: will you be able to roll the returns from your bonds into another investment with an equal or better return?
Sixth, Fees: as mentioned previously, fees for bond trades tend to be higher than for stock trades and that expense can significantly reduce your returns from the bond. Therefore, financial advisers recommend leaning toward bonds with lower expense ratios and/or higher performance to compensate for the expense.
Seventh, Diversification: purchasing different types of bonds with different maturities spreads your risk over a long period of years and over a number of different issuers, lessening your risks.
Eighth, Life Stage: since bonds tend to be lower risk/lower return than stock, bond-heavy portfolios tend to be more or less desirable, depending on the buyer’s age and related needs: younger investors tend to have less bond investment while middle-aged investors have more and elderly investors tend to have the most (50% or more) of their investments in bonds.
DO’S AND DON’TS
DON’T be intimidated by the process or the people.
DO understand that a bond is basically an I. O. U., with principal and interest owed by the bond issuer to the bond purchaser.
DO buy several types of bonds from the U. S. Treasury, which can be purchased here:
U. S. Treasury
DO understand that there are also many funds specializing in Treasury securities, including:
a. PIMCO 1 – 3 Year U. S. Treasury Index Exchange-Traded Fund
DO understand that Municipal Bonds are sold by state and local governments.
DO understand that there are several types of Corporate Bonds, including:
b. Unsecured (“debentures”)
e. Junk Bonds
DO watch for elusive pricing, which can be at least partially remedied by analyzing:
a.U. S. Treasury securities
DO consider the 3 types of risks commonly associated with bonds, which are:
a. Default Risk
b. Interest Rate Risk
c. Reinvestment Risk
DO consider the higher fees of bond trading and the importance of lower expense ratios and/or higher performance to compensate for the expense.
DO diversify to spread risk over a number of issuers for a number of years.
DO consider the needs related to your stage of life when deciding the percentage of bond investment in your portfolio.
[Note from HandelontheLaw.com: This article is to be used as an educational guide only and should not be interpreted as a legal consultation. Readers of this article are advised to seek an attorney if a legal consultation is needed. Laws may vary by state and are subject to change, thus the accuracy of this information cannot be guaranteed. Readers act on this information solely at their own risk. Neither HandelontheLaw.com, or any of its affiliates, shall have any liability stemming from this article.]