Bond Basics

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When you purchase a bond, you are in effect lending money to the bond's issuer. The issuer promises to pay you interest over the life of the bond and to repay your principal on the bond's maturity date.

Risks Associated With Bond Investing

Bonds have a reputation as being safer, more conservative investments than stocks. While generally true, an individual bond may carry even more risk than a given stock.

There are two primary risks associated with bond investing.

Credit risk is the risk that a bond issuer will fail to make promised interest or principal payments. When an issuer fails to make these payments, it is said to be in default.

To help investors gauge the levels of credit risk associated with the issuers of bonds, rating agencies such as Moody's and Standard & Poor's, analyze the financial health of bond issuers and assign ratings to them. Those assigned a rating of Baa or higher by Moody's, or BBB or higher by Standard & Poor's, are referred to as investment grade bonds. Those with lesser ratings are said to be "below investment grade" or in Wall Street jargon, high yield or junk bonds.

Just as your own personal credit rating affects the interest rate you pay when you borrow money, a bond issuer's credit rating affects its rates as well. The lower the credit rating of a bond issuer, the higher the rate it must pay to compensate investors for the additional risk.

As the rating agencies monitor the financial health of bond issuers, they will periodically issue upgrades or downgrades, reflecting positive or negative changes in the rating. These actions have a strong influence on the market value of the affected bonds.

Interest rate risk is the risk that interest rates will rise, causing the bond to be less valuable. When interest rates fall, the values of outstanding bonds generally increase. This risk is most relevant to those who plan to sell their bonds before maturity.

Assuming the issuer does not default, an investor who continues to hold the bond will receive the face value at maturity, making the intervening price fluctuations less meaningful.

Reinvestment risk is the risk that as interest rates change over time, the bondholder may not be able to reinvest the coupon payments at the original yield-to-maturity rate.

Issuers Of Bonds

The United States government issues three types of debt — Treasury bills, Treasury notes and Treasury bonds — distinguished by the length of time between issuance and maturity.

Because they are backed by the full faith and credit of the United States government, these securities are said to carry no credit risk whatsoever. Interest is exempt from state and local income tax but is subject to federal income tax.

Agencies refer to two distinct types of organizations — agencies of the federal government and government-sponsored enterprises. The latter are companies created by Congress to help serve a national need.

Most agency debt is created by bundling loans together. Agencies include:

• Government National Mortgage Association (GNMA) or Ginnie Mae.
• Federal National Mortgage Association (FNMA) or Fannie Mae.
• Federal Home Loan Mortgage Corporation (FHLMC) or Freddie Mac.

Of these, only Ginnie Mae debt is backed by the full faith and credit of the United States government. Although other agency securities do carry credit risk, many investors believe that risk is relatively small given the government's interest in their continued operations.

Companies issue corporate bonds to finance their operations, provide funds for new projects and to enable purchases of other companies.

State and local governments issue municipal bonds, which might be used to finance schools, roads, hospitals or stadiums.