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Bonds

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Bonds


Bonds or bond funds?

Bonds are generally sold in $10000 lots, making it hard to diversify, so a bond fund may be a better idea.


Relation to interest rates

If interest rates rise, bond prices fall, especially long term ones.


Types of bonds

Taxable or tax-free ?

State and municipal bonds are tax-free in the state of issuance. Buy only tax-free bonds unless you are in the lowest tax bracket. Else, put them in a 401(k) which is tax sheltered for income from bonds. If grade AA bonds yield 7.5% and tax-free bonds yield 5.3%, the difference is about 30%, and if the investor is in a tax-bracket over 30%, tax-free bonds are a good idea. State and Municipal bonds are not always safe by the way. Choose AAA, AA, or A rated.

Government

The most common type of bonds are US Savings Bonds. Series E and H are very safe and give a good return. H pay interest twice a year, E do not pay interest, but are bought at 75% of the price and mature to 100% in 5 years. Interest is subject to federal tax, not to state tax. Tax on E bonds is paid annually or when the bond is disposed of. There is no other investment that(1) gives this much assurance (2) gives you money back at any time (3) gives circa 5% interest for 10 years. The right to cash in bonds at cost-price or more allows you to benefit from rising interest rates by selling low interest ones and buying very high coupon ones in turn.

Corporate

Corporate bonds are subject to fed and state tax. One can get 7-8% for a 25 year bond. High yield, or junk, bonds carry a higher risk, but nowadays, there are junk bond funds, which can diversify out some of the risk.

Don't forget that sometimes an ordinary bank savings account yields as much as bonds.


No call provisions

A call provision means that the company can buy back the bond at a predetermined low price when market value of the bond increases, which is not desirable. Find bonds that are non-callable (non-convertible) for many years.

More on convertible bonds

More information on bonds:

http://www.aaii.com/bonds/
http://money.cnn.com/magazines/moneymag/money101/lesson7/
http://www.investinginbonds.com