Learn What The Rich Know: Pillar 5.2 - The ABCs of Investing

PAPER SECURITIES

BONDS

A bond pays interest over a fixed period. An investor who buys a bond intending to hold it to maturity need not worry about fluctuations in the interest rate. However, for those who want to sell before maturity, current interest rates are crucial. In the bond market, lower interest rates in the marketplace raise bond prices, and higher rates lower them.

THE BOND MARKET

Bonds are traded in the over-the-counter (OTC) market. The OTC is not a place; it is a market of dealers who do business over the phone or by computer.

“Good debt is debt that someone else pays for you. Bad debt is debt you acquire with your hard-earned money.”

Types of bonds.

• U.S. treasuries. By purchasing a treasury, an investor lends money to the U.S. government for a specified amount of time in exchange for interest payments. Treasury notes mature in two, five, or ten years, and require a minimum investment of between $1,000 and $5,000. Treasury bonds mature in ten to thirty years and require a minimum investment of $1,000. Both notes and bonds pay interest semi-annually.

• Savings bonds. These U.S. government bonds are issued in denominations ranging from $50 to $10,000. Sold at a discount price, they are redeemed at face value at maturity.

• Municipal bonds. These are issued by state and local governments. Municipal bonds tend to pay less interest than taxable bonds. While the interest payment may remain steady, the price of the bond may rise and fall with changes in the markets.

• Corporate bonds. These are issued by companies that need to borrow money. Corporate bonds may be riskier than government bonds because businesses can go bankrupt.

• High-yield (junk) bonds. These are issued by corporations without solid sales and earnings records, or with a dubious credit rating. The chance that the investor will not be repaid is higher with a junk bond because of the issuer’s instability. To attract investors, the issuer offers a relatively high interest rate. The price of a junk bond is more likely to fluctuate than that of any other type of bond.

Bond ratings. A bond rating is a method of evaluating the possibility of default by a bond issuer. Bonds are graded periodically by analysts at companies that do evaluations,

Pros and cons of investing in bonds. Many bonds, especially government bonds, represent a safe, secure investment. If held for more than twelve months, profits on sales are capital gains and taxed at a maximum of 20 percent. Changes in the tax law could affect the investor’s tax liability. Over time, inflation can cause the fixed-rate interest payment as well as the principal to erode.

Tax-free bonds can be very attractive vehicles for the rich when they see the market about to change.