Bonds Made Easy

You know all the financial ratios and benchmarks you're supposed to master before you buy individual stocks? They're nothing compared with understanding the world of bonds. For instance: When prices go up, yields go down.... You want to buy short when interest rates are rising and buy long when rates are sinking.... A bond's coupon rate isn't necessarily the interest you'll collect.

Welcome to the complicated world of bond investing. Pull up a chair, and we'll try to make this simple.

Bond basics

Bonds are essentially IOUs written by corporations (corporate bonds) or state, local and federal governments (municipal, or muni, bonds). Both categories are also split between investment grade bonds and high-yield, or junk, bonds.

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When you buy a bond, you act as a creditor, and the business or government that issued the bond agrees to pay you its face value, plus interest. You can get that interest paid to you at regular intervals until the bond matures. The maturity date is when the bond issuer pays you back the principal, or the face value, of the bond.

Terms vary -- long-term bonds can mean a 20- to 40-year commitment, but they usually offer the highest yields. Intermediate bonds have maturities of three to ten years, and short-term bonds have maturities of less than that. Generally speaking, the shorter the maturity, the less the bond is affected by inflation and interest-rate changes. More about that in a minute.

The interest rate a bond pays is called its coupon rate, which is the income the bondholder receives expressed as a percentage of the bond's face value. But the coupon rate is not necessarily the bond's yield to maturity (the current yield and the capital gain or loss you can expect if you hold the bond to maturity). Of course, you can sell a bond to another investor before it reaches maturity.

The current yield is the annual interest payment calculated as a percentage of a bond's current market price. Remember, bond yields move in the opposite direction of bond prices. If the Federal Reserve lowers interest rates from 7% to 6%, for example, the bond you bought with a 7% coupon rate would be worth more in price than a new bond issued with a 6% coupon rate.

Not always a sure thing

Because they offer income, lots of investors think of bonds as a safe alternative to the stock market. But bonds aren't risk free.

Bonds seem attractive right now, given the stock market's tough couple of years. Investors are putting more money into the bond market, driving up prices (while holding down yields). Plus, the Fed has been cutting interest rates to stimulate growth. But once rates start heading up again, bond prices will fall.

Plus, since the 1930s, there has been about a one-half percent default rate on investment grade bonds, according to Moody's, a bond rating agency, On the other hand, high-yield bonds, sometimes referred to as junk bonds, had a 10% default rate last year. The yields on junk bonds are higher because investors expect to be compensated for the extra risk they assume. But the companies can go belly up.

Some bond strategies

If possible, reinvest the coupon rate rather than take the regular payouts, says Tony Crescenzi, chief bond market strategist for Miller, Tabak & Co. Say, for example, you bought a 10-year $10,000 bond with an 8% yield. If you reinvested the 8% year after year, you'd have $22,787 at maturity. If you took the 8% payouts, the bond would be worth only $18,400 at maturity, including the payouts.

If you're looking at two bonds with equal yields to maturity but one has a lower coupon rate, go with the lower if interest rates are headed down, says Crescenzi.

Whether you decide to buy long-term or short-term bonds depends on what your needs are and on market conditions. Lots of bond buyers ladder their bonds, or buy several with staggered maturity dates. You can time those maturities for when you know you'll need cash -- college tuition or retirement, for example.

In a weak economy like we have now, the Fed has been trimming rates to stimulate growth, and long-term bonds are the place to be while interest rates decline. On the flip side of that, short-term bonds are the way to go when interest rates are headed up because their prices are less sensitive to rate hikes (and you can get out of them quicker).

Right now investors might want to consider what Crescenzi refers to as the "sweet spot" of the bond market -- the lowest-rated investment-grade bonds. These companies typically carry an A or BBB bond rating, but their yields are higher than higher-graded bonds.

Crescenzi uses AOL as an example. The company's future is under scrutiny, and because of that, its bonds have come down in price. Companies like AOL and industries such as chemical, automotive, retail and rail will likely turn around when the economy starts expanding, and be able to generate the cash to make good on their obligations. But until that's more of a sure thing, you can buy them at a generous discount.

Better off with bond funds?

If you're considering buying bonds, though, bond funds are probably the way to go. The bond market is dominated by institutional investors, and the individual is often at a disadvantage. Individual bonds are hard to find, even for many good brokers; bond price quotes are even harder to come by, and interest rates aren't always as high as what the institutions get.

Plus, trading bonds can be pricey when you're on your own. When you buy a bond fund, you not only diversify your holdings and thereby lower the risk of default, but you also take advantage of an institution's ability to buy in bulk at a better price. Perhaps best of all, you get a pro who has already mastered all the intricacies that come with investing in bonds.