Get to Know Bond Investing
02/11/08 - 02:51 PM EST
Jonas Elmerraji
Bonds -- we've all heard of them, and how they can solidify and diversify 
our portfolios. But as an individual investor, how much do you really know about investing and trading bonds?
before you contact your broker.
First, What's a Bond?
One of the principal rules of investing is "know what you own." So then, what exactly is a bond?
Bonds are debt securities, which means that when you buy a bond, you're lending money to whomever issued it. This sets bonds apart from stocks, which are equity securities, and represent ownership in the company that puts them out. Also unlike stocks, bonds don't have to be issued by a company. Municipal, state and federal governments issue bonds to raise money, as do supranational organizations like the World Bank, and agencies like the Federal National Mortgage Association -- better known as Fannie Mae (FNM Quote - Cramer on FNM - Stock Picks)..
When you buy bonds, you get the same treatment as any other creditor out there. That means that you won't get a vote in the company like you would if you bought stock, but if you buy bonds from a company that goes bust , you'll get paid back before the company's shareholders will.
About 'Fixed' Income
As with any loan, bond issuers pay interest to you when you buy them. Bonds act a lot like interest-only loans because the issuer doesn't repay the principal until the end of the bond's life (known as the maturity date). The interest rate the bond pays (also known as the coupon rate) is based on a number of factors, including the market interest rate, time to maturity, and the bond's rating .
Because bonds pay out interest income to their owners on a fixed schedule, bonds are called fixed-income investments.
If you're buying a bond, don't be surprised if the price it sells for isn't the principal amount. Changing interest rates (among other things) can make a big impact on bond prices.
All things being equal, if you buy a $1,000 bond that pays 5% annually, it's not going to sell for as much if other bonds out there are paying 6% annually. In this case, the bond will sell for a discount . If the market rate is only 4%, though, that same bond will sell for a premium because investors will be able to get more interest than they otherwise would.
Rating and Identifying Bonds
When you buy a bond, you can think of yourself as a loan officer at a bank. So not all borrowers are going to be good credit risks, which is why you would probably look at the borrower's credit score before you let them walk out with they money (see "Why Mortgages Blew Up"). Likewise, looking at a bond's rating can give you an idea about the level of risk you're undertaking when you buy bonds.
Rating agencies like Standard & Poor's and Moody's give bond issuers a grade (called a bond rating) that tells investors how much risk might be involved in buying their bonds. Scales differ among raters, so be sure you know which one you're looking at before you use a bond rating for an investment decision. U.S. government bonds are considered some of the safest investments, as are those of large blue-chip corporations like Berkshire Hathaway (BRK.A Quote - Cramer on BRK.A - Stock Picks) or General Electric (GE Quote - Cramer on GE - Stock Picks).
Because bond issuers can come out with many series of bonds, bonds are often identified by the issuer's name, coupon rate and maturity date. For example, "CSCO 5.5 02/22/16" is a bond issued by Cisco (CSCO Quote - Cramer on CSCO - Stock Picks) that pays 5.5% and will mature on Feb. 22, 2016. In the professional world, bonds issues are usually identified by a CUSIP (Committee on Uniform Securities Identification Procedures), a serial number that's given to a security -- much like an ISIN (International Securities Identification Number).
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