Whether you are a seasonedinvestor or a beginner, you willprobably want to allocate yourassets so that some of the invest-ments in your portfolio generate asteady and reliable stream ofincome. For younger people, thatincome will balance out the peri-odic dips in a stock-dominatedportfolio; for those in retirement, itwill provide money to live on.Getting that steady income oftenentails investing in bonds. Bondsare debt instruments issued by acorporation or a government (fed-eral, state or municipal). Whenyou buy a bond, you are basicallybecoming a creditor to the bondissuer, who pays you regular inter-est and repays the initial invest-ment at a future date.

The value of bonds fluctuateswith inflation and interest rates.Susceptibility to these factors isfigured into the pricing of bonds.The more risk, the higher theyield. Investors demand higheryields for longer maturitiesbecause the longer you own bondsthe more risk you face from inter-est rate changes or rising inflation.

Another issue to consider isdefault risk. The credit quality of

companies and governments isclosely monitored by the twomajor debt-rating agencies—Standard & Poor’s and Moody’s.They assign credit ratings based onthe entity’s perceived ability to payits debts over time. Those ratingshelp determine the interest ratethat a company or government hasto pay when it issues bonds. Onceissued, the market determines theprice and resulting effective yieldof bonds.

Buying BondsBonds can be purchased

through many financial institu-tions, but the most cost-effectiveway to buy bonds is through thegovernment’s commission-freeTreasury Direct program(www.treasurydirect.gov), whichallows you to bypass brokers andtheir fees. An application to openan account may be obtained onlineby linking to the New York FederalReserve’s Web site or by contact-ing your nearest Federal ReserveBank or the U.S. Bureau of PublicDebt (202-874-4000).

Two- and 3-year notes are avail-able for a $5,000 minimum invest-ment, while 5- and 10-year noteshave $1,000 minimums. If forsome reason you need to sell thebonds in a Treasury Directaccount before they mature, youwill have to have them transferred

to a broker, who will charge about$50 per transaction. In addition,Treasury Direct accounts of$100,000 or more are subject to anannual $25 maintenance fee.

Types of BondsMost bonds are issued by one of

three groups: the U.S. government;state and local governments; orcorporations. These entities issuemany different types of bonds thatvary in terms of risk, reward andpracticality for your needs. Themost common bond types are dis-cussed below.

1. U.S. government bondsThe bonds issued by the U.S.

government are collectivelyreferred to as “treasuries.” They’regrouped in three categories: U.S.Treasury bills that mature in 90days to 1 year; U.S. Treasury notesthat mature in 2 to 10 years; andU.S. Treasury bonds that mature in10 to 30 years.

Treasuries are widely regardedas the safest bond investmentsbecause they are backed by “thefull faith and credit” of the U.S.government. Income earned fromtreasuries is exempt from state andlocal taxes. Interest rates for T-Billsclosely follow those for certificatesof deposit (CDs), which are issuedby banks. Bonds of longer maturi-ty tend to have higher interest

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INVESTING IN BONDS

Jason Johnson and Wade Polk*

*Assistant Professor and ExtensionEconomist–Management, and ExtensionProgram Specialist–Risk Management,The Texas A&M University System

rates (coupons) because the buyerassumes more risk. A 30-yeartreasury has longer to pay interestthan a 90-day T-bill or a 5-yearnote, but it is also at much morerisk of losing value because ofinflation or rising interest rates.

2. Agency bondsAgency bonds are issued by a

federal government agency or aprivately owned corporation that issponsored by the federal govern-ment. Agency bonds are consid-ered relatively safe and liquid.They have slightly higher yieldsthan treasuries, but these are offsetby brokerage commission costs,which run about 0.5 percent, or 50basis points. One type of agencybond is mortgage-backed bonds,which represent ownership in apackage of mortgage loans issuedor guaranteed by governmentagencies such as the GovernmentNational Mortgage Association(sometimes called Ginnie Mae),the Federal Home Loan MortgageCorporation (Freddie Mac) and theFederal National MortgageAssociation (Fannie Mae). Thesebonds usually require a minimuminvestment of $25,000. The pri-mary risk with these bonds is thatthe issuer may decide to pay themoff early. Even then, bond holdersget back their principal plus what-ever interest has been paid so far.

3. Municipal bonds (Munis)Municipal bonds are a step up

on the risk scale from Treasuries.Municipal bonds are issued bystate and local governments andcome in two types—general obliga-tion bonds or revenue bonds.General obligation bonds areissued to finance the building ofroads, schools and infrastructureand are backed by taxes collectedby the issuing government.Revenue bonds are riskier becausepayments are secured only by theincome of the specific project thebond is financing. Munis arebacked by the full faith and creditof the local issuing governmentand rarely default. Thanks to the

U.S. Constitution, the federal gov-ernment can’t tax interest on stateor local bonds. Additionally, alocal government will oftenexempt its own citizens from taxeson its bonds, so that many munisare safe from city, state and federaltaxes (sometimes referred to astriple tax-free).

4. Corporate bondsCorporate bonds are generally

the riskiest of all fixed-incomesecurities because companies—even large, stable ones—are muchmore susceptible than govern-ments to economic problems, mis-management and competition.However, corporate bonds can alsobe the most lucrative fixed-incomeinvestment, because you are gen-erally rewarded for the added risk.The lower the company’s creditquality, the higher the interestyou’re paid. Corporates come inseveral maturities: short-term (1 to5 years); intermediate term (5 to15 years); and long-term (longerthan 15 years). Companies usuallypay a fixed interest rate (coupon)every 6 months and redeem thebonds for face value when theymature. One risk is that some cor-porate bonds are “callable” by theissuer, meaning that the corpora-tion can, at its discretion, pay offits obligation at a stated price andstop paying interest. If interestrates decline and the value of thebonds goes up, the corporationmay call them, disrupting yourexpected income stream and cut-ting off a potential capital gain.Conversely, if interest rates rise,you are stuck holding a less valu-able security that is yieldingbelow-market rates.

5. Zero-coupon bondsZero-coupon bonds, also known

as strips, are fixed-income securi-ties that do not pay any periodicinterest, or “coupon,” like regularbonds. Instead, the bond is sold ata deep discount from its face valueand at maturity the bondholdercollects all of the compoundedinterest along with the principal.

There are many types of zerocoupon bonds, including federalgovernment bonds tied to treasur-ies, corporate and municipalbonds. Zeros are useful forinvestors who are looking for a setpayout on a given date, instead ofa stream of payments. People sav-ing for college tuition and retire-ment often invest in these bondsbecause maturity dates can be pre-determined according to incomeneeds. There is a tax drawback tozeroes unless you hold them in atax-deferred retirement account oran education IRA. You must paytaxes each year on the interest asit accrues, even though youhaven’t received the money.

6. High-yield or junk bondsHigh-yield or junk bonds are

debt obligations issued by emerg-ing companies or by establishedcompanies that have fallen onhard times. The term “junk”comes from their low quality (orcredit) ranking as determined bybond-rating agencies. High-yieldbonds are usually too speculativefor the average investor becausealthough the yields are high, soare the risks.

Bond FundsFor many investors the selection

of an individual bond is a daunt-ing task. That makes purchasing abond fund an attractive choice. Abond fund holds many differentbonds that are bought and sold byprofessional investment managers.Most funds buy bonds of a specifictype, maturity and risk profile, andoften pay out a coupon toinvestors monthly rather thanannually or semiannually like atypical bond. The chief advantageof a bond fund is that it is conven-ient and allows investors toachieve instant diversificationwithin their bond portfolio. It’salso true that when it comes tobuying corporate and municipalbonds, a professional managerbacked by a strong research organ-ization can make better decisionsthan the average individual

investor. The disadvantage of abond fund is that it’s not a bond.Unlike individual bonds, bondfunds have neither a fixed yieldnor a contractual obligation to giveinvestors back their principal atsome designated maturity date.Management fees are usually justover 1 percent, which instantlycuts into returns. Also, bond fundsdo not permit investors to precise-ly tailor their bond portfolios tomatch up maturities with theirincome needs.

Strategies for Coping with Interest Rate Risk

One way investors can balancerisk and return in a bond portfoliois to use a technique called ladder-ing. Building a laddered portfoliomeans buying a collection ofbonds with different maturitiesspread out over your investmenttime frame. For instance, in a 10-year laddered portfolio, you mightpurchase bonds that mature in 1,2, 3, 4, 5, 6, 7, 8, 9 and 10 years.When the first bond matures in ayear, you’d reinvest in a bond thatmatures in 10 years, thereby pre-serving the ladder (and so on foreach year). The rationale behindladdering isn’t complicated. Whenyou buy bonds with short-termmaturities you have a high degree

of stability, but because thesebonds are not very sensitive tochanging interest rates you have toaccept a lower yield. When youbuy bonds with long-term maturi-ties you can receive a higher yield,but you must also accept the riskthat the prices of the bonds mightchange. With a laddered portfolio,you would realize greater returnsthan from holding only short-termbonds, but with lower risk thanholding only long-term bonds. Byspreading out the maturities ofyour bonds you get some protec-tion from interest rate changes. Ifrates have fallen by the time youneed to reinvest, you’ll have tobuy a bond with a lower return,but the rest of your portfolio willbe generating above-marketreturns. If rates have risen, youmight receive a below-marketreturn on your portfolio, but youcould start to take care of that thenext time one of your ladderedbonds matures.

Strategies for Coping withInflation Risk

The U.S. Treasury is now offer-ing a new kind of Inflation-Indexed security, commonly calledan I-bond. It gives individual andinstitutional investors a chance tobuy a security that keeps pace

with inflation. When you buy anInflation-Indexed security, the U.S.Treasury pays you interest on theinflation-adjusted principalamount. Competitive biddingbefore a security’s issue deter-mines the fixed interest or couponrate. The security’s value is adjust-ed for inflation periodically, andthe principal you receive when itmatures won’t drop below the paramount at which it was originallyissued. At maturity, the Treasuryredeems your securities at theirinflation-adjusted principal amountor the par amount, whichever isgreater. Like other Treasury securi-ties, they’re safe and are guaran-teed by the full faith and credit ofthe U.S. government. Inflation-Indexed securities are exempt fromstate and local taxes, although fed-eral income taxes apply.

For further information:Eisenberg, Richard. The Money

Book of Personal Finance.Warner Books: New York, 1996.

Morris, Kenneth M. and Alan M.Siegel. The Wall Street JournalGuide to Understanding PersonalFinance. Lightbulb Press, Inc.and Dow Jones & Company,Inc.: New York, 1999.