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Investing in Bonds and Bond FundsBonds have been around for centuries. From a legal and investment perspective, a bond is simply a loan made to an entity (corporation, government, etc.) for a specific term (5 years, 20 years) with a guaranteed interest rate tied to it, which will be paid monthly, quarterly, or annually. For example, the US Treasury is the largest issuer of bonds in the world - the famous US Treasury Bonds. Demand in the marketplace determines the interest rates on these bonds, and they are issued in various terms: 90 days, 1 year, 5 years, etc. Why do people invest in bonds? The main reason is for the safe, steady stream of income that the interest on the bond provides. If you own the bond, you know you will receive a return of X% per year while you hold it, and then will be paid back the full amount of the bond at maturity (when the loan is over and needs to be paid back).
Risks of BondsApart from the interest rate risk discussed above, the next biggest risk associated with bonds is the risk of default - that is the borrower not being able to repay the loan/bond when it comes due. This happens when a government or a corporation comes under financial duress and is unable to or refuses to repay the loan amount, or is able to pay only a portion of its actual value (ie, 33%). This has happened in the past with countries like Argentina - people who bought those government bonds lost a lot of money. Same thing with corporations - some company declares bankruptcy, and in the process writes off a lot of bond debt (bond holders have rights in bankruptcy court). To get around these risks, the investment community has created bond funds, essentially a pooling of many bonds into one big mutual fund, which when you buy into it, give you partial ownership over this big basket of bonds. That way, if a few bonds default, hopefully the remaining 97% are solvent and your default risk is much less. For most individual investors, you are almost always better off buying into a bond fund than buying individual corporate bonds. Moody's and Standard and Poors offer ratings of all bonds, you can have an idea as to its risk.Junk Bonds - High Yield BondsThe rate someone pays on the bonds they issue depends on their credit worthiness - how likely are they going to be able to repay the loan at its maturity? The US Government is considered the safest, most reliable issuer of bond debt, hence they have the lowest interest rate that they pay on that debt. With its taxing authority, it is almost inconceivable that the US would be unable to repay its debt, and so it is the most conservative choice in bond investing. Many corporations also have AAA credit ratings, allowing them to borrow and issue bonds at a low rate as well. Companies with less stellar reputations and financial resource are forced to borrow money at higher rates, otherwise investors will not buy their bonds. Since they are riskier, they pay a higher interest rate or yield. Junk bonds (high yield bonds) are corporate bonds that have failed to receive investment-grade quality ratings - most bonds fall into this category. Again, the safest way to invest in these is through a bond fund. These funds might pay 7% annual return while AAA corporate bonds might pay only 5.5%, but again the risk for default is higher.Another kind of bond is a zero coupon bond. Instead of paying annual interest, the zero coupon bonds pays NO interest, but is instead sold at a discount to the face value, so you might pay $650 for a 10 year $1000 bond. You pay $650 upfront, receive no interest over those 10 years, but then get back $1000 when the 10 year period is up. Buying BondsHow can I buy bonds? Where do I buy Treasury bonds? You can buy bonds and bond funds through your broker - Charles Schwab, ETrade, Vanguard, T Rowe Price, Fidelity, you name it. You can actually buy Treasury bonds direct from the US government by bidding in their weekly and monthly auctions (TreasuryDirect). Most investment advisors suggest you hold between 10-80% of your holdings in bonds or bond funds, depending on your age. Younger people with lots earning years ahead of them usually should hold more stocks and less bonds, and as you age you should hold more bonds and less stocks. Of course these are general rules, and each persons financial situation is different.
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