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MM-05-2001
Investing in Bonds
Generally, “savers” and “investors” Loaner assets are certificates of de-
have different objectives for their posit, U.S. Treasury Securities,
money. “Savers” plan to use their Municipal Bonds, Corporate
money in the next 3–5 years, while Bonds, Convertible Bonds, Zero-
“investors” won’t need their money Coupon Bonds, Bond Unit
for five years or longer. Many “sav- Investment Trusts, Bond Mutual
ers” want liquidity or quick access Funds, Mortgage-Backed Securi-
to their money without penalty. ties, Collateralized Mortgage Bond Terminology
Bonds provide a desirable saving or Obligations, Fixed Annuities, Pre-
Face value or par value is the
investment vehicle for many rea- ferred Stock, and Guaranteed
value of the bond (amount of prin-
sons. Bonds tend to be safer than Investment Contracts.1
cipal) printed on the certificate and
stocks because if you hold bonds received at maturity. If interest
until the maturity date, you don’t What is a Bond? rates change and you need to sell
risk the principal. Plus, bonds can Bond A before maturity, the value
A bond represents a loan obliga-
provide a regular, steady source of you receive may change. If interest
tion of the bond issuer
income (typically, interest pay- rates increase, Bond A may sell at a
(government, corporation, or indi-
ments are received every 6 discount or less than the face
vidual) to the bondholder or
months). For the long term, inves- value. In this case, investors can
investor. In essence, the investor
tors need to be willing to “tie up” buy Bond B paying higher rates so
loans funds to the bond issuer in
money when investing in bonds. they are not as interested in this
exchange for interest payments for
However, bonds tend to have a Bond A. If interest rates decrease,
a set period of time. At the end of
lower return than stocks over the Bond A may sell at a premium be-
this time the borrower (bond is-
long term. cause other investors would be
suer) pays the investor (bond
holder/loaner) back the money willing to pay more for the higher
Owner vs. Loaner loaned. A certificate of deposit is interest rate on Bond A. See the ex-
Investment securities usually in- an example of a bond. A consumer ample on page 5 of this fact sheet.
volve two types of securities—those goes to the bank and gives the Coupon Rate (also known as cou-
where the investor is an owner or bank money. In turn, the bank pon, coupon yield, stated
those where the investor is a loaner. pays the consumer interest for the interest rate) is the interest rate
Owner securities include stocks, use of that money for a specified
real estate, equity unit investment period. Then, the bank uses that
1
money to invest in other projects, Investing for Your Future, A Cooperative Ex-
trusts, equity mutual funds, col- tension System Basic Investing Home Study
lectibles, business ownership, and such as, small businesses or home Course, February 2000, Rutgers Cooperative
commodities. mortgages. Extension.
This fact sheet is intended for educational purposes only. Mention of a proprietary product, trademark or commercial
firm in text or figures does not constitute endorsement by Ohio State University Extension and does not imply approval
to the exclusion of other products or firms. For specific advice, consult your financial or legal advisor.
MM-05-2001—page 2
printed on the bond certificate pare taxable and tax-free yields for
when the bond is issued. It usually different marginal tax rates. Refer Savings bonds can be bought
is stated as an annual fixed rate to the following web site: with small dollar amounts
typically paid every six months to http://www.bondmarkets.com ($25) and new inflation-in-
the investor. for this type of chart. dexed bonds (I-bonds) help
Maturity date is the day when the protect against inflation.
face amount of the bond must be Different Types of Bonds
repaid and the debt retired. The The following bonds are listed in
coupon rate remains the same until order of risk. Those listed first have
the maturity date. Bond maturities authorities) sell bonds to raise
the least risk.
may run from a few months to 40 money for a variety of purposes.
years. U.S. Government Bonds After U.S. Treasuries, municipal
The United States Treasury sells bonds are considered the safest.
A call feature allows the issuing Depending on the reason for sell-
bonds to finance the federal gov-
agency to pay the investor the face ing bonds, there are different types
ernment. Because the U.S.
amount for the bond and buy back of municipal bonds. In order of
government has never failed to pay
the bond before maturity. This al- safety, these bonds are: general ob-
its debt, these bonds are consid-
lows the issuer to then reissue the ligation, revenue, equipment,
ered to be some of the safest you
bond at lower interest rates. In the debenture. Bonds for private pur-
can buy. Savings bonds can be
event a bond is called, investors poses (sports stadiums, airports,
bought with small dollar amounts
may then need to reinvest their hospitals, industrial parks) may not
($25) and new inflation-indexed
money at lower interest rates as be income tax-exempt.
bonds (I-bonds) help protect
well. This results in reinvestment
against inflation. Information about
rate risk. Corporate Bonds
these bonds can be found on the
Default is the failure of the issuer Corporations sell bonds to raise
following web site:
of the bond to make payment on money for major projects. Corpo-
http://www.savingsbonds.gov
the interest or money borrowed. rate bonds pay higher interest
or call 1-800-722-2678. Consum-
Thus, the investor can lose money. because corporations cannot tax to
ers can also purchase some U.S.
raise money. Corporate bonds have
Tax-equivalent yield—If you are bonds through brokers and banks
no income tax advantages, thus,
buying municipal bonds for the or directly through the Federal Re-
usually have higher yields;
state in which you live, the interest serve Banks. In Ohio, there is a
whereas, U.S. Treasuries are not
may be free of federal, state, and Federal Reserve Bank in Cleveland.
taxed by state and local govern-
local income taxes. (You still may ment. Some municipal bonds are
have to pay capital gain taxes if you Mortgage-Backed Securities
Government agencies also sell free from federal income tax and
sell the bonds at a premium.) may not be taxed by state and local
These income tax-exempt bonds bonds. Listed in order of safety,
Ginnie Mae, Freddie Macs, and governments.
are appropriate for investors with
marginal tax rates of 28% or Fannie Maes are federal govern-
Specialty Bonds
higher. There are charts that com- ment agency home mortgages,
Variable rate bonds, CMOs2, con-
which are lower risk but not as low
vertible bonds, and zero-coupon
risk as U.S. Treasuries. These
bonds are some examples of spe-
bonds have uncertain maturities
cialty bonds. Zero-coupon bonds
because people pay back mortgages
are bought at a discount. At matu-
before the end of the mortgage. All
rity the face value of a zero-coupon
have irregular monthly payments
bond is more than the issued pur-
that may include both interest and
chased price. However, there are
principal.
no interest payments made to the
Municipal Bonds
State and local governments and 2
CMOs are collateralized mortgage obligations
government-related agencies and will pay back interest and a portion of prin-
ciple. These are sometimes included in
(schools, water, bridge, highway retirement plan options.
MM-05-2001—page 3
investor. The value of the bond in- Laddering
creases each year. Even if the 2. When buying several bonds,
interest is not received by the in- buy at different maturity levels.
vestor, the interest is taxable as This is known as laddering. For ex-
current income (unless zeros ample, buy a 2-year bond maturing
qualify as tax-free bonds). in 2003, a 3-year bond maturing in
2004, 4-year bond maturing in
How to Buy Bonds 2005, and a 5-year bond maturing
in 2006. When the 2-year bond
When buying bonds, consider five
matures in 2003, buy another
factors: your investment objective,
bond maturing in 2007. That way
laddering of bond (spreading out
you will have a bond maturing in any premium paid for the bond
maturity), diversification, bond
each year and if you need money, when called and the premium or
yield, and bond risks. Bonds pro-
you won’t need to sell a bond at a discount paid for bonds when pur-
vide income through interest and
reduced price (discount) before chased. It may be higher or lower
some safety of the principal in-
maturity. than the yield to maturity. As an in-
vested.
vestor, you are required to return
Diversification bonds when called. A bond might
Investment Objective
3. Bonds can provide diversifica- be recalled if the bond issuer could
1. Bonds should fit your invest-
tion to an investor’s holdings. refinance the debt at lower interest
ment objective which is income
Stocks and bonds tend to move in rates.
and safety of principal. If you are
opposite directions. When the
looking for long-term growth, c. Duration will compare bonds
stock prices go up, bonds go
bonds do not match your objec- with different coupons and differ-
down; when bonds go up, stocks
tive. However, if your objective is ent terms to maturity. It reflects the
go down. Over the long haul, this
safety of principal and you want to average time it takes to collect a
low correlation between stocks and
earn current income from your bond’s interest and principal repay-
bonds permits a portfolio to even
money, bonds would match your ment. This is a weighted average
out the highs and lows and can re-
objective. For example, a major ob- that encompasses the total amount
sult in an overall higher return.
jective of someone over 70 is to of the bond’s payments and their
live off his/her investments and not Bond Yield timing and then standardizes for
lose money in case he/she may 4. Compare the yields of bonds the bond’s price.3 Higher duration
need money for health care. Al- to see the best return. indicates bonds more sensitive to
though this individual may live 30 interest rate changes. Bonds with
more years, a portion of his/her re- a. Yield to maturity is one way to shorter duration reduce risk associ-
tirement money might be invested compare bonds on the basis of ated with interest rates.
for growth in stocks but a majority time. This yield measures the
bond’s return when purchased (at If Bond A has a duration of 5.4
should probably be invested for in-
par, discounted, premium) and years and Bond B has a duration of
come in bonds that mature at
held to maturity. The change in 6.2 years, the second bond has
different times so the principal
current income generated by the more risk. So, a conservative inves-
would be available without loss.
bond (interest) and as well as any tor will want Bond A with the
change in its principal when it is lower duration and a more aggres-
held to maturity is “yield to matu- sive investor, interested in
rity.” However, this yield does not capitalizing on the bond’s price
indicate which bonds are more fluctuations, will desire Bond B
likely to have price fluctuations with the higher duration. Dura-
and may not provide the best com- tions can be used to compare bond
parison of bonds with different mutual funds to see which funds
maturities and different coupons. will have more volatility if interest
(See “duration” below.) rates change.
b. Yield to call expresses the re- 3
Mayo, Herbert. Investments: An Introduction.
The Dryden Press, 1993.
turn to the call date considering
MM-05-2001—page 4
Bond Risks have two bonds maturing in 30 Individual Bonds vs. Bond
5. The risks associated with years and Bond A pays 5% in inter- Mutual Funds
bonds are tied to several factors. est and Bond B pays 15% in Investors have the choice of buying
There are interest-rate risk, interest, Bond A’s price will change individual or bond mutual funds.
credit risk, callability risk, rein- more dramatically than Bond B’s There are advantages and disad-
vestment rate risk, and inflation price. The principal value will have vantages of each way of adding
risk. The safest bonds are short- wider swings in its price if sold be- bonds to your portfolio.
term (less than 5 years) Treasury fore the maturity date. Junk bonds
Bills followed by other short-term and zero-coupon bonds will expe- Individual Bonds
government bonds. The riskiest rience wider changes in prices. Many investors purchase U.S. Sav-
bonds are long-term bonds (12 These changes in a bond’s price ings Bonds. These are a very safe
years–40 years), junk bonds, and will be reflected on broker state- investment but sometimes they do
high yield, or high return bonds. ments, but are only realized if the not keep up with the cost of infla-
a. The longer the maturity of bond is sold. tion. When buying municipal or
bonds, the greater the interest c. Ratings on bonds also reflect corporate bonds, you need to pur-
(coupon) rate risk while shorter assumed risk. Credit rating sys- chase several different individual
term bonds have less risk but lower tems help consumers make more bonds to protect against business
returns. informed bond purchases from and financial risk. This requires a
firms, individuals, and state and lo- large sum of money for a beginning
—Short-term bonds mature in investor. If you hold bonds to ma-
5 years or less. cal governments. Higher rated
bonds carry less risk while lower turity, you won’t lose the principal
—Intermediate bonds mature rated bonds (e.g., junk bonds or of individual bonds. For the begin-
between 5 and 12 years. high yield/high return bonds) have ning investor, a bond mutual fund
—Long-term bonds have matu- more risk. During good economic or a balance mutual fund (which
rity dates of more than 12 times, junk bonds are safer than holds both stock and bonds) is a
years. during poor economic conditions. good place to start.
Moody’s Bond Ratings and Stan-
Investors need to consider their Bond Mutual Funds
dard & Poor’s Bond Ratings
time frame to choose bonds that fit Risk in bond funds is determined
include investment grade or safer
their needs. If an 80-year-old buys by the credit ratings of the bonds
bonds as anything rated triple-B or
a 30-year bond, she faces interest held, the duration of the bonds
above—(Aaa,AAA; Aa,AA; A,A;
rate risk. Within 30 years interest held (or the average maturity), and
Bbb,BBB) while those ratings below
rates could change dramatically. If the variability of interest rates. The
the triple-B—(Ba,BB; B,B;
the bond pays 6% interest, and in- longer the average maturity, the
Ccc,CCC; Cc,CC; C,C; D) carry
terest rates climb to 12%, chances more risky the fund is or the
higher risk of default. Junk bonds
are you could lose money to infla- higher the duration, then the
and high-yield securities are below
tion and could be making more riskier the fund. Advantages of
the triple-B ratings and have higher
money elsewhere over 30 years. buying bond mutual funds are that
risk.
b. Risk is also associated with they:
d. Bonds can be called. Bonds
the coupon or interest rate on the —can reinvest dividends which
may have call dates that protect the
bond. Bonds with lower interest can’t be done with individual
issuer from paying high interest
rates will experience more fluctua- bonds,
rates if they can refinance and pay
tions in bond prices than bonds
lower rates. If you hold a bond, it —can invest small sums of money
with higher interest rates. If you
can be called back by the company and make small, regular contri-
issuing it. The company will pay butions,
The riskiest bonds are long- you a predetermined amount to do —can withdraw portions of
term bonds (12 years–40 this. You run the risk of having to invested money if forced to sell
years), junk bonds, and high reinvest your money at lower inter- bonds before maturity,
yield, or high return bonds. est rates. This is a type of
reinvestment rate risk. —can help investors speculate on a
decline in interest rates, and
MM-05-2001—page 5
interest rates to rise which then Federal Reserve Bank, Cleveland,
Bonds are a good way to diver- causes bond prices to fall. OH or call 1-800-943-6864
sify a portfolio and help to meet • Bond prices can be quite volatile http://www.savingsbonds.gov
investors’ income objectives. because market interest rates vary
after a bond is issued. Garman & Forgue, Personal Fi-
nance. 6th Edition, Houghton
—can achieve diversification for a • Bonds over the long term have
Mifflin Company, 2000.
small amount of money. lower returns than stocks.
Bond funds provide flexibility in • Bond prices may swing 20% or
Quinn, Jane Bryant. Making the
buying and selling for small inves- more if selling bonds before ma-
Most of Your Money. Simon &
tors. If you want all your capital turity. Speculators might see this
Schuster, 1997.
back, then buy individual bonds. as an opportunity but conserva-
Fees are a factor in bond mutual tive investors will need to ignore
price changes if planning to hold The Bond Market Association, 40
funds, so carefully read the mutual Broad Street, New York, NY 10004-
fund prospectus to identify the fees to maturity.
2373.
charged. Bond mutual funds do • Individual bonds do not com- http://www.bondmarkets.com
not guarantee a return of the pound their interest. However, http://www.investingbonds.com
money invested. this is possible with bond mutual
funds.
Advantages and Disadvantages of Invest- Other OSU Extension fact sheets in this
ing in Bonds4 • Taxes will be owed on capital series:
gains/losses (selling before matu- MM-01 Start with Mutual Funds
Advantages of bonds are:
rity) and interest unless the MM-02 Financial News You Can
• Bonds pay higher interest rates bonds are tax-exempt. Use
than savings accounts.
• Diversification is hard to achieve MM-03 IRA—Individual Retire-
• Bonds usually offer a relatively (unless investing in bond mutual ment Account
safe return of principal. funds) because at $1000 for each
bond, many different types of MM-04 Retirement Planning
• Bonds often have less volatility
(price fluctuations) than stocks, bonds would be needed.
especially short-term bonds. Written by: Ruth Anne Mears, Ph.D.,
In conclusion, bonds are a good .P.,
C.F C.F .C.S., Family and Consumer
• Bonds offer regular income. way to diversify a portfolio and Sciences Extension Agent, Licking
• Bonds are sold in small dollar help to meet investors’ income ob- County, Ohio State University Exten-
amounts (U.S. Savings Bonds— jectives. See how much you sion, January 2001.
$25, $50). understand by trying to answer the
questions about the example on Visit Ohio State University Extension’s
• Bonds need less careful attention page 6. WWW site “Ohioline” at:
in management than other alter- http://ohioline.ag.ohio-state.edu
native investments.
Additional Resources All educational programs conducted by
Ohio State University Extension are
• Bond interest from municipal available to clientele on a nondiscrimina-
bonds can be exempt from federal Investing for Your Future, A Coop- tory basis without regard to race, color,
income taxes and possibly from erative Extension System Basic creed, religion, sexual orientation, national
origin, gender, age, disability or Vietnam-
state and local income taxes. Investing Home Study Course, Feb- era veteran status.
ruary 2000, Rutgers Cooperative Keith L. Smith, Associate Vice President
Disadvantages of bonds are: Extension. Can be obtained from for Ag. Adm. and Director, OSU Extension
• Bonds offer no hedge against in- OSU Extension. Ask for Bulletin Hearing impaired readers may request
information about educational topics by
flation because inflation causes 884. This bulletin is also available calling TDD #1-800-589-8292 (in Ohio) or
online at: 1-614-292-1868 (outside Ohio). For those
4
Quinn, Jane Bryant. Making the Most of Your with physical disabilities, special arrange-
http://www.investing.rutgers.edu ments for participating in educational
Money. Simon & Schuster, 1997, Chapter 25, programs can be made by contacting
How to Use Bonds. 1-614-472-0810.
MM-05-2001—page 6
See how much you understand. Choose which bond to buy. It is now the year 2001.
Description Price Callable YTM or YTC Rating
Bond A $997.50 04/15/04 7.773% AAA/Aaa
7.75% due 04/15/24 @103.751 YTM
Semiannual Interest Payments
MBIA Insured
(Min. $5000 principal)
Bond B $1016.25 08/01/05 8.116% A/A
8.625% Due 08/01/20 @100.00 YTC
Semiannual Interest Payments
(Min. $5000 principal)
Comparing the above two bonds:
1. How much would you receive in interest payments for the year for Bond A and Bond B?
2. What are the maturity dates of Bond A and Bond B?
3. Which bonds are insured—Bond A and/or Bond B?
4. Which bond is selling at a premium and which bond is selling at a discount?
5. Can these bonds be called and if so, when? When they are called, do you get the face value?
6. If the coupon rate on Bond A is 7.75%, why is the yield to maturity (YTM) 7.773%?
7. If the coupon rate on Bond B is 8.625%, and it sold for a premium, why is the yield to call (YTC) 8.116%?
8. Which bond would you buy?
Answers to questions:
1. Bond A will pay $77.50 yearly for every $1000 purchased. With a minimum investment of $5000 you would re-
ceive $387.50. If you purchased bonds worth $10,000 you would receive $775 divided into two semiannual
payments. For Bond B the interest would be $86.25 for every $1000 owned. For the minimum of $5000, an inves-
tor would receive $431.25 a year.
2. Bond A matures on April 15, 2024, while Bond B matures on August 1, 2020. Both are long-term bonds which are
considered more risky than short-term bonds (matures in 5 years or less).
3. Bond A indicates it is insured and Bond B does not indicate any insurance. This insurance means if the company
issuing Bond A goes bankrupt, you will receive your principal back from the insurer.
4. Bond B is selling at a premium of $16.25 over a face value of $1000. Bond A is selling at a discount of $2.50 under
a face value of $1000. The reason for this is the interest rate or coupons on Bonds A and B. B pays a higher interest
rate while A is paying a rate lower than market rates. These are not newly issued bonds which sell at the face value.
5. Yes, both bonds can be called. Bond B can be called in 2005 at face value or $1000 for each $1000 invested. Bond
A can be called in 2004 at more than face value $1037.51 for each $1000 owned.
6. Yield to Maturity (YTM) on Bond A is 7.773% or more than the 7.75% interest paid. The reason for this is you
bought the bond at a discount so you paid less than $1000 and the $2.50 increase in value of the bond is added to
the interest you have received since that time. That discount increases the yield you will receive.
7. When this bond is called you will receive the face value of $1000 yet you paid a premium of $1016.25 so you have
lost $16.25. That loss is added to the interest paid 8.625% and it lowers your return to 8.116%.
8. It depends on how much risk you are willing to assume. Bond A is the safer bond, is insured, is highly rated, but
has a lower interest rate. It is a long-term bond and it is callable within a few years. Bond B has a lower credit rat-
ing, is not insured, but has a higher interest payment. If interest rates rise, the face value of this bond will drop. If
interest rates drop, this bond will sell at an even higher premium. Conservative investors will probably like Bond A,
while aggressive investors thinking that rates will drop within the next 4 years might speculate on Bond B hoping to
sell at an even higher premium.
