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Investing in bonds and bond mutual funds was often an afterthought while the bull
market in stocks roared ahead during the 1990s. But the subsequent market downturn in 2000 and 2001
demonstrated the risks associated with investing in the stock market.
Investors should now be well aware that stock values can fall as dramatically as they can rise.
The fates of many high-tech companies in the early 2000's has made this fact extremely clear.
Bonds on the other hand have historically been less volatile than stocks but do not provide the
same opportunity for growth that stocks do.
Nevertheless, for the average investor, having some portion of your portfolio invested in
bonds or bond mutual funds is a wise idea because a diversified portfolio serves to reduce your
overall investment risk - the risk that your portfolio will decline in market value. And that
is the purpose of this section - to discuss bonds and, in particular, bond mutual funds.
As background, think of a bond as an IOU - an amount borrowed by the issuer to be repaid to
the bondholder (the investor) with interest typically over a fixed period of time. Also referred
to as debt obligations, the amount borrowed is known as the principal or face value and, since
the interest bondholders receive every year typically does not vary, bonds are known as fixed-income
securities.
Bonds are subject to what is called credit risk - the risk the issuer will default on payments
due bondholders. Bond investors should also be aware of interest-rate risk - the potential for
market value declines resulting from a rise in interest rates. For example, if you hold a bond
paying 6% and rates rise to 8%, the market value of your bond will decline because currently issued
bonds are paying higher interest rates. On the other hand, if rates decline to 5%, the value of your
bond rises.
There are three major categories of bonds that investors purchase:
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Bonds issued by the U.S. government and its agencies - The U.S. Treasury issues Treasury bills
which have maturity dates ranging between 90 days and one year. Treasury notes come with maturities
of one to ten years and Treasury bonds have maturity dates ranging between ten and thirty years.
The agencies that issue securities are numerous and have varied purposes. Examples include the
Federal National Mortgage Association, Federal Home Loan Bank, Federal Home Loan Mortgage Corporation,
Farmers Home Administration, Student Loan Marketing Association, Small Business Administration, etc.
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Corporations - Initially established with capital provided by their owners and investors who purchase
stock issued, corporations also issue bonds to borrow additional money from investors.
As we all know, corporations can fail and become insolvent. If you are a bondholder of a failed
corporation, you may lose some or all of your investment. Thus, if you're a safety conscious investor,
ignore the temptation to simply look for bonds with the highest interest payments or yield. Do pay
attention to the corporation's credit quality, which is a function of the corporation's ability to pay
its bondholders in a timely fashion. In general, the lower the credit quality, the higher the yield.
Stated differently, the higher the yield the higher the risk.
Bonds are assigned ratings by rating agencies such as Moody's Investors Service, Inc., Standard & Poor's
Corporation, Duff & Phelps and Fitch's Investors Service. They analyze the financial strength of each
bond's issuer. For example, Standard & Poor's classifies quality bonds, considered investment grade,
as AAA, AA, A or BBB. Lower ratings such as BB, B, CCC, etc. are considered speculative investments.
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Municipal bonds - When you think of municipal bonds, you typically think of bonds issued by a city.
But this is a generic term that refers to bonds issued by a city, county, state, school district, park
district, etc. Municipal bonds are issued to construct roads and bridges, schools, libraries, airports,
water and sewer systems, sports stadiums and so forth. Revenues to pay the bondholders come from taxes
or other revenues such as user charges.
One attractive feature about municipal bonds: the interest they pay is free from federal income
taxes. In most cases, bondholders who are also residents of the state in which the bonds are issued
do not have to pay state or local taxes on the interest income either.
Municipal bonds do occasionally default. Remember that Orange County, California filed for
bankruptcy in 1994. Thus, it's also wise to pay attention to the credit ratings assigned to municipal
bonds before buying them.
Investors can further protect themselves by purchasing what are known as insured bonds. Major
insurers of municipal bonds include Financial Security Assurance, Inc., Municipal Bond Investors
Assurance Corporation, Financial Guaranty Insurance Company, etc. These insurers 'step up to the
plate' so to speak in the event of issuer default and make payments to the bondholders.
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