LESSON 4: Investing in Bonds

Bonds vs. Stocks

When a government or corporation needs money to pay for a special project or

expansion, it can fund operations with cash saved in the organization or with cash
raised by selling securities. If the organization chooses to sell securities, it can sell
bonds. Bonds represent a promise made by the issuer to repay principal and interest to
the bondholder at prescribed intervals during a prescribed time period. When you
think bond, think loan. And think of yourself as the lender because you supply the
bond issuer with money that will usually be repaid to you as periodic interest
payments. Bonds mature when the prescribed time period elapses.

Bonds are more defined and stable than stocks. Whereas the life of a bond is time-
limited, your stocks can be passed on to your heirs and to your heirs' heirs for
generations after you buy them. Bond payments are also more fixed than stock
payments because the issuer promises a fixed interest payment at prescribed intervals.
Dividends, which are the cash payments made to owners of stocks, can rise and fall
unpredictably -- or even cease entirely -- for any given stock.

Unlike bond interest payments, the value of bonds can fluctuate just like stock values,
but the changes are less volatile and the reasons for those changes are different. Stock
values change as a result of market perceptions about the success of the stock issuer.
Bond values fluctuate in response to changes in the issuer's ability to repay and to
changes in the prevailing interest rates. For example, if a bond issuer suddenly
encounters reduced sales that restrict its cash flow and ability to fulfill its promise to
pay interest and principal to the bondholder, the market will treat the bond as a risky
investment. And rising interest rates suppress bond values, while falling rates pump
them up.

Governments back the payment of interest and principal with their taxing authority,
but corporations back bonds with the corporation's ability to earn money. Corporate
bonds are, therefore, generally riskier and pay higher interest than government issues.
When the market questions a bond issuer's ability to repay interest or principal, the
bond is called "junk." Junk bonds usually pay high interest to compensate buyers for
the high risk they assume when buying them.

Bond issuers can choose, before they issue their bonds, how to time repaying their
debt. Most bond repayment timing consists of bi-annual interest payments and
principal repayment when the bond matures. Alternatively, bond issuers can postpone
payments until maturity when they pay all interest and principal. Even if the bond
issuer selects either of these, a brokerage firm can buy the bonds and resell the cash
flows in different formats. For example, they can take the principal portion of a bond
and sell it at a deep discount and not pay any interest on it. Then they can take the
interest portion of the bond and sell that as a separate security that promises only
interest payments without any principal payment.

Types of Bonds:

Corporate Bonds

 Mortgage bonds -- Issued for the purchase of certain assets that are pledged as
collateral

 Equipment Trust Certificates -- Serial bonds secured by specific equipment

 Debentures -- Unsecured promissory notes

 Income bonds -- The indenture states that interest will be paid only if the issuer
earns the money to make interest payments

 Convertible bonds -- Can be exchanged for prestated number of issuer's common

stock

 Variable Interest bonds -- Pay interest rate tied to an indicator of prevailing rates
such as Treasury bills

 Zero-Coupon bonds -- Pay all interest and principal upon maturity; also known as
discount bond

 Euro-bonds -- Issued outside the United States and denominated in U.S. dollars

Government Bonds

 U.S. Treasury bills -- Zero-coupon issues with maturities less than one year

 U.S. Treasury notes -- Bonds with maturities from one to 10 years

 U.S. Treasury bonds -- Bonds with maturities greater than 10 years

 GNMA -- Mortgage pass-through bonds issued by the Government National

Mortgage Association, a U.S. federal government agency

 FHLMC -- Mortgage pass-through bonds issued by the Federal Home Loan

Mortgage Corporation, a U.S. federal government agency

 Collateralized Mortgage Obligations -- Fixed income securities created from

mortgage-backed securities (like GNMAs) designed to control risks

 General Obligation Municipal bonds -- Local or state government issue backed by

the taxing authority of the issuer, pay federally tax-free interest

 Revenue Municipal bonds -- Local, state or agency issues backed by the revenue
earned on the funded project

 Series EE and HH bonds -- Issued by the U.S. Treasury in small denominations to

appeal to individual investors

How to Value Bonds

Bond issuers promise to repay the face value of their bond. Face value is the amount
borrowed by the issuer, and is usually expressed in increments of $1,000, $5,000 or
$10,000. Since the bond market assesses prevailing and expected interest rates, the
interest paid on comparable issues and the issuer's ability to keep its promise, the
market might not value the bond according to its face value. If it considers the bond to
be a risky investment, it might only be willing to pay a percentage of face value,
which is called a discount. If the market thinks this issue is a great deal, it might pay a
premium for the bond.

The value of a bond is the "present value" of future interest and principal payments.
Present value is absolute cash payments adjusted for the timing of the payments. Since
a future payment is worth less than a payment made today, timing is important. If you
have to wait a year for a payment, you are losing the interest you could have earned by
investing in a bond with quarterly payments and then using those payments to invest
in something else. For example, say that you are considering buying a bond that pays
both interest and principal upon maturity one year from now. The absolute cash
payment will be $1,100 and today's market price, according to your broker, is $1,020.
You do some research and find bonds with the same maturity and risk that yield 5
percent. This little formula calculates the present value of the bond:

Future payment / (1 + yield)

If payment will not come for two or more years, the denominator (1 + yield) is raised
by an exponent equal to the number of years before payment. In the example above,
the present value is ($1,100 / (1 + .05) =) $1,047.62. Since the present value is greater
than today's market price, this bond is a bargain at the broker's quoted price of $1,020.
This formula can be applied to the future interest and principal payments of all bonds.

Evaluating Bond Performance

As we've seen in previous lessons, sound investment practice includes the periodic
evaluation of your investment performance. The two-step process below compares the
performance of individual investments, grouped into categories, with available
indices. An index is a group of bonds selected to represent a certain type of bond.
Examples of indices include high-grade (safe) corporate bonds and Treasury bonds.

In the first step of the process, you compare the performance of all bonds you own
with an appropriate index. If, for example, your high-grade corporate bonds earned 5
percent during the prescribed period, which is usually a year, and a good high-grade
corporate bond index earned 2 percent, you can conclude that your corporate bonds
are performing well.

The second step compares individual bonds with appropriate indices. This step
identifies high- and low-performing investments and helps you to decide whether you
should sell or stand pat.

The decision to sell is driven by the goals and preferences expressed in your
investment plan. If you don't have the time and expertise to do this kind of evaluation
yourself, mutual funds offer an outstanding and potentially lucrative alternative to
investing in individual bonds and stocks.