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Booyah Breakdown: Bond With Bonds

Coupons, maturity dates, dividend yield? The Breakdown explains it all.

Editor's Note: This is the first of a three-part Booyah Breakdown series on bonds

First, I'd like to wish all you hard-working, stressed-out, over-exhausted mothers a fabulous, well-deserved Mother's Day. I don't care what anyone says, it is by far the hardest job out there. Taking a company public is a cakewalk compared to making lunch and breakfast at the same time while trying to give an infant a bottle and help your oldest study for a test, all before 7:30 in the morning.

So while you're reinforcing the bonds that tie you with your mother this weekend, you might also want to reinforce your knowledge of bonds. It seems you can't read an economic report these days without having to get through a spattering of bond market data.

Treasuries were inching higher. The 10-year note was up 2/32 in price, yielding 4.63%, and the 30-year bond was adding 2/32, yielding 4.82%.

Huh?

The bond market, though generally a big enigma to most investors, is correlated to the equities market. As Frank Sinatra croons in his song

Love and Marriage

, "You can't have one without the other."

So the Booyah Breakdown is going to start to tackle the bond market today. Today we'll go over some bond basics, and next time we'll explain how bonds price and why the infamous yield curve is making some folks nervous these days.

All in the Family

There are a bunch of similar concepts among all bonds, so let's illustrate with a very commonplace example.

Your brother needs a $5,000 loan.

You have no desire to lend him money because you know you'll never see it again.

But this time he gets smart and offers you an 8% semiannual interest payment on your loan. And he swears on his custom-made motorcycle (no, I am not speaking from experience) that he'll repay your $5,000 in three years.

For some unknown reason, you decide to give him the benefit of the doubt and lend him the $5,000. In addition, you set up an automatic debit from his checking account to yours (because you got smart, too) for your $200 semiannual interest payment (annual interest would be $400 -- 8% on $5,000 -- but you need to divide it over two payments).

So you get your interest payments every six months and sure enough, three years later you also get your $5,000 back (apparently, he isn't willing to part with his bike).

Well, that's basically how the bond market works (without the motorcycle).

If you buy a bond, you're basically lending the issuer of the bond some money. He will then pay you some interest -- usually twice a year -- as your bonus for lending him money.

Now, no matter what kind of bond you buy, they all have a few things in common.

Every bond has a "face value," which is the principal portion of the loan. These days, its either $1,000 or $5,000. That's also the amount you generally pay upfront for the bond and it's the amount you'll get back from the issuer on the day your loan is over.

Now when your loan ends, the bond folks say your bond has "matured." (Just like your brother.) So let's say you buy a 10-year bond with a $5,000 face value. Your bond will come due -- or mature -- 10 years from the day it was issued. And on that final day, you'll get your $5,000 back.

These days, maturities can be as long as 30 years or as short as 2 years.

The interest you get on that bond is sometimes called your coupon payment. Years ago, bonds used to come with attached coupons that investors had to clip so they could redeem their interest payments. These days, it's all done electronically -- but old habits die hard so that interest payment is still called the "coupon."

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So a bond with an "8% coupon" pays 8% interest based on the face value of the bond, in two semiannual installments. Assuming a face value of $5,000, like in our example above, that's two $200 interest payments a year.

Bond, James Bond

Many folks presume that because bonds have maturity dates, they're pretty much guaranteed investments. And that's true in most instances, so it's no surprise that older investors who need secured money for retirement will invest in bonds. The same goes for the guy whose kid will be in college in five years or has a child getting married in the near future. When you know you need the money soon, you sometimes don't want to risk it in the equities market.

But as much as bonds are supposed to be the stable, low-risk portion of your investment portfolio, the world of bond investing is still rife with pitfalls.

That's because bonds have credit risk. If the U.S. government issues you a bond -- a Treasury bond -- then you can rest assured you're going to get your money back. But if you decide to buy a bond from a risky company, such as

GM

(GM) - Get General Motors Company (GM) Report

or

Ford

(F) - Get Ford Motor Company Report

these days, because it's offering a really high interest payment, you run the risk that the company is not going to have the money to give back to you when your bond matures.

Bonds also have interest-rate risk -- no surprise. Let's say you bought a bond with a 6% interest payment. But what if interest rates rise? Now there are bonds out there with 8% interest rates. So you're missing out on a higher interest payment.

That's why bonds with longer maturities, such as 10-year and 30-year bonds, have more interest-rate risk. The odds are good that interest rates will change over 10 years. But if you buy a bond that has a one-year maturity, the rates probably won't change that much during that 12-month period.

So you have to analyze two things: whether the issuer is going to be able to pay you in the end and whether your interest-rate risk is too much to handle.

Yield to the Yield

One final piece of jargon you need to be aware of: a bond's yield. In general, the yield of anything is its annual rate of return, expressed as a percentage.

So in the equities market, we look at a stock's dividend yield (check out this

previous Booyah Breakdown

for more on that), to see how much extra money we're going to make off the shares. The dividend yield is just the annual dividend payments divided by the stock's current share price. The higher the yield, the more money you're going to pocket.

Same is true in the bonds market. A bond's yield is essentially the value of its interest payments. So it's a good basis of comparison with other bonds.

But know that higher-yield bonds generally come with more risk. That's because the issuer knows that there's a chance he may default on the loan or that the bond's maturity is a long way off. So he pays you more -- in the form of an interest payment -- for taking a chance and helping him with his debt.

So now you've got some lingo down. Next time we'll talk about how bonds price and how their yields are determined. And then we'll tackle that infamous yield curve and discuss why it's making folks uneasy these days.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

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