Understanding Bonds

Many investors view bonds and bond mutual funds as conservative investments that provide a steady income and represent a minimal risk to principal. That’s because if you hold your bond until maturity, you get the full amount of your investment plus interest. (A bond is an obligation of its issuer to pay the interest and principal as promised.)

Zero-coupon bonds are very popular among parents and grandparents who are funding a child's education. A zero-coupon bond is issued at a discount from its par value (or face value). It only pays interest with principal at maturity or at the time the bond is called. Unlike other types of bonds, interest on zero-coupon bonds is not paid to you every six months; it is automatically reinvested or compounded at the agreed-upon rate at time of purchase. The combination of compounding and the discounted price means that a relatively small investment can multiply significantly before the bond matures. The longer the maturity length of the bond, the deeper the discount usually is.

In addition to being used to fund a college education, zero coupon bonds appeal to many individual investors who are planning for retirement. If placed in SEPs, IRAs or Keoghs, they are not subject to immediate taxation since these accounts are tax-deferred. By making an investment in a zero-coupon bond today, investors know exactly how much they will receive at maturity.

Municipal bonds are debt securities issued by public authorities (such as states or municipalities) to raise funds for building or repairing schools, highways, prisons, bridges, tunnels and other public works. The interest payments you receive on municipal bonds is free from federal income taxes. The higher your tax bracket, the more you will benefit by investing in “munis” and earning tax-free income.

If you live in a high income tax state you may also derive additional benefits from owning in-state bonds that are also state income tax-exempt.

Interest on bonds issued by the U.S. Virgin Islands, Guam and the Commonwealth of Puerto Rico are exempt from federal, state and local taxes in all fifty states.

Corporate bonds complement many investment portfolios especially retirement accounts and accounts with low marginal tax rates.

Many reputable companies raise capital by issuing corporate bonds to purchase or update equipment, build plants, and replace outstanding debt with lower cost issues. Credit rating agencies such as Moody’s and Standard & Poor’s (S&P) study the creditworthiness of the issuer of the bond, and assign a rating to that bond as a general guideline for investors.

Investment grade ratings used by agencies are:
Moody's S&P
Aaa AAA
Aa AA
A A
Baa BBB

These agencies revise their ratings when they feel the creditworthiness of an issue changes.

United States government securities are among the most\ secure of all income-producing investments. They are available in two forms: direct obligations of the U. S. government and those issued by various agencies which are indirect obligations of the U.S. government.

All bonds (U.S. Treasuries, federal agencies, zero-coupons, corporate and municipals) are subject to market fluctuations if you sell them before they mature. Investing in bonds has become more complex in recent years as the choice of taxable and tax-exempt bonds has expanded and volatility in bond prices and interest rates has increased. (Question 89 to 102)