Investing Basics – How To Invest In Bonds

Bonds are tricky, in part because most are traded on an over-the-counter basis, which means they’re not listed on any organized exchange. And by their very nature, bonds are complex. Each one has four main features: its principal, or par value; its interest payment, or coupon; its maturity, or repayment date; and its yield, which says what you’ll earn at a given price and interest payment.

Complicating matters, not all bonds are bought at par (commonly $1,000 per bond). Some are issued, and most trade, at a discount or premium to their face value, in which case knowing the actual return you’ll get calls for another calculation: yield to maturity.

Many bonds also carry call provisions allowing the issuer to prepay, or call, the loan. Investors then need to know the yield to call, which reflects the estimated payouts if the bond is redeemed on the next call date.

The easiest way to buy bonds is to purchase new issues and hold them until maturity. That way you just sit back and collect the interest until the principal is repaid. Trading bonds, however, is more common–and involved. Traders seek capital gains by selling bonds before maturity in the secondary market, where prices move inversely to interest rates.

Generally speaking, the safer the investment, the lower the yield. Treasuries, backed by the government, are considered riskless. They carry the lowest markup, and you can even buy them without commission directly from Federal Reserve branches (for information, visit publicdebt.treas.gov). Treasury yields are published daily in the larger newspapers and on numerous Web sites.

Investors who want higher returns must work their way down the credit scale from investment grade corporate bonds (with ratings ranging from AAA to BBB) issued by companies with strong balance sheets to high-yield junk bonds rated BB or lower. Junk bonds pay more interest but come with greater risk of default.

Corporate bonds carry wide spreads between the bid and ask prices, which means an investor who pays $1,000 to buy a bond might get only $950 if he or she immediately sells it. To avoid the spreads, stick to newly issued bonds (which you can get at par) with the certainty that you’re getting the stated yield, and hold them until maturity.

High-income investors will fare best with municipal bonds, issued by state and local governments to finance such projects as hospitals and road improvements. Muni-bond income is exempt from federal taxes and often from state taxes if the bond is issued within your state. Those tax breaks are figured into a muni’s yield, which will be lower than that of other bonds.