Bonds

The Pros and Cons of some Basic Investments

Bonds

A bond is a glorified IOU. 

When you buy a bond, you're simply making a loan. 

The seller of the bond, also called the issuer, is borrowing your money, and the bond itself is proof that the issuer, is borrowing.

The biggest seller of bonds in the world is Uncle Sam.  Whenever the US government needs extra cash (which these days is all the time), it prints up a new batch.

The government owes so much to so many that more than 15% of all the federal taxes goes to paying the interest.

The type of bond that young people are most likely to get involved in is the US Savings Bond.  Grandparents are famous for giving savings bonds as gifts to their grandchildren.  Over the years, the government pays back the money, plus interest - not to the grandparents, but to the grandchildren.

State and local governments also sell bonds to raise cash. So do hospitals, and airports, school districts and sports stadiums, public agencies of all kinds, and thousands of companies.  Bonds are in abundant supply. 

The main difference between bonds and CDs or Treasury bills is that with CDs and Treasuries, you get paid back sooner (the period varies from a few months to a couple of years), and with bonds you get paid back later (you might have to wait five years, ten years, or as long as thirty years).

The longer it takes for bonds to pay off, the greater the risk that inflation will eat up the value of your money before you get it back.  That's why bonds pay a higher rate of interest than the short-term alternatives, such as CDs, savings accounts, or the money market.  Investors demand to be rewarded for taking the greater risk.

All else being equal, a 30-year bond pays more interest than a 10-year bond, which in turn pays more interest than a 5-year bond, and so on.  The buyers of bonds have to decide how far out they want to go, and whether the extra money they make in interest, on say, a 30-year bond is worth the risk of having their money tied up for that long.  These are difficult decisons.

Stocks are riskier than bonds, and potentially far more rewarding. 

The good thing about a bond is that even though you miss the gain when the stock goes up, you also miss the loss when the stock goes down. 

That's why a bond is less risky than a stock.  There's a guarantee attached to it.  When you buy a bond, you know in advance exactly how much you will be getting in interest payments, and you won't lie awake nights worrying where the stock price is headed.  Your investment is protected, at least more protected than when you buy a stock.

Still, there are 3 ways you can get hurt by a bond.

1.  The first danger occurs if you sell the bond before the due date, when the issuer of the bond must repay you in full.  By selling early, you take your chances in the bond market, where the prices of bonds go up and down daily, the same as stocks.  So, if you get out of a bond prematurely, you might get less than you paid for it.

2.  The second danger occurs when the issuer of the bond goes bankrupt and can't pay you back.  The chances of this happening depend on who is doing the issuing.  The US government, for example, will never go bankrupt - it can print more money whenever it wants.  Other issuers can't always offer such a guarantee.  If they go bankrupt, the owners of the bonds can lose a lot of money.  Usually, they get something back, but not the entire investment.  And sometimes, they lose the whole amount.

When an issuer of a bond fails to make the required payments, it's called a default.  To avoid getting caught in one, smart bond buyers review the financial condition of the issuer fo a bond before they consider buying it.  Some bonds are insured, which is another way the payments can be guaranteed.  Also, there are agencies that give safety ratings to bonds, so potential buyers know in advance which ones are risky and which aren't.  A strong company gets a high safety rating - the chance of defauting on a bond are close to zero.  A weaker company that has trouble paying its bills will get a low rating.  You've heard of junk bonds?  These are the bonds that get the lowest ratings of all.

When you buy a junk bond, you're taking a bigger risk that you won't get your money back.  That's why junk bonds pay a higher rate of interest than other bonds - the investors are rewarded for taking the extra risk.

Except with the junkiest of junk bonds, defaults are few and far between.

3.  The third and biggest risk in owning a bond is:  INFLATION.  With stocks, over the very long term, you can keep up with inflation and make a decent profit to boot.  With bonds, you can't.