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A Bonds Primer

By Joel Dresang

Bonds are a prudent part of a well-diversified investment portfolio, offering both income and relative safety. But all bonds are not alike, and, over time, their value can fluctuate with economic and financial conditions.

Top of the mind are bonds issued by the U.S. Treasury, which are considered stable types of bonds to have in a portfolio. Such securities help finance government spending and are fully backed by the U.S. government, which has never yet defaulted on its debt.

Treasurys come in various terms of duration, including bills of up to a year, notes that come due between two and 10 years, and bonds with maturities of 10 years and longer.

Generally, the longer you let someone else use your money, the more they should pay you in interest. The risk of locking in a higher rate on a longer bond is that you’d miss out on even more generous rates before the bond matures.

Municipal governments also issue bonds. Such investments can benefit a taxable account because the earnings on those bonds are generally federally tax free, and portions of them can be state tax-free as well. Some income from municipal bonds still could be subject to the alternative minimum tax.

Corporate bonds help finance acquisitions and expansion projects and often offer higher interest rates than Treasuries because of the increased risk that corporate issuers could default on their debts.

Global bonds are another option to blend in to a balanced portfolio. Such bond funds feature securities issued by foreign governments and companies based overseas. They can help diversify investments by including varying interest rates from around the world,although foreign securities also face risks associated with currency exchange rates, varying accounting standards and political instability.

Long-term investors have bonds to help even out the volatility of stock investments, to add stability and to moderate the risk in their holdings overall. Though bond values also go up and down over time, they historically react differently than stocks to the same economic conditions.

Diversity helps minimize risk in a portfolio, and just as a broad mix of bonds and stocks is wise, you also should have an arrayed holding of bonds from a variety of issuers and with a range of different maturities.

The annual interest earned as a percentage of your investment is called the bond’s yield. So if you pay $1,000 for a bond paying 3% interest or $30 a year, the yield is 3%.

If someone buys that same bond later for $950, still receiving $30 in interest, the yield rises to 3.16% ($950 divided by $30). If someone else buys it later for $1,050, the yield dips to 2.86%, reflecting the same payment on a costlier investment.

The value of bonds fluctuates on secondary markets after they’re issued.

Essentially, a bond’s value is based on how its yield compares to the prospects of other investment opportunities as well as the likelihood that the bond’s issuer will pay off the debt when it matures.

As interest rates rise, prices fall for bonds that were sold at lower interest rates. Bond prices also can fall if financial problems beset an issuing corporation or agency.

Joel Dresang is vice president of communications at Landaas & Company.

More information on bonds from the Securities Industry and Financial Markets Association

initally posted April 14, 2010

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