Bonds Letters

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Most investors are aware that two of the general categories of investments are stocks and bonds. We at the Fool cover stocks quite a bit, but bonds remain a mystery to a lot of people, even those with substantial investing experience. With that in mind, here are five things all investors should know about investing in bonds.

Selena Maranjian: One key thing to understand about bonds is that they come in different sizes and flavors. Four key categories to be familiar with are government bonds, municipal bonds, corporate bonds, and junk bonds.

Government bonds are issued by the U.S. Treasury and include bills, notes, and bonds, with different maturities. (Bonds generally have maturities of 10 years or more, while notes fall in the two-year to 10-year range, and bills are short term.) They're backed by the full faith and credit of the U.S. government, which makes them safe -- which is why they typically offer lower interest rates than you can find elsewhere. These bonds are often bought by big institutions, and they help fund our government. The U.S. government also issues savings bonds, targeted at individual investors. Treasury bond interest and gains on sales are taxable on your federal tax return but free from state or local taxes.

Smaller governments, such as U.S. states and cities, generate needed funds by issuing municipal bonds, or "munis." These vary in their safety, according to the credit-worthiness of the issuing entity. Municipal bonds often feature tax-free interest, which makes them especially appealing.

Corporate bonds are issued, not surprisingly, by companies. Their interest rates vary widely, with the highest-rated companies, such as Johnson & Johnson and Microsoft, able to attract investors with relatively low rates and risky companies having to offer fat rates. The riskiest companies' bonds are deemed "junk" bonds. With the price of oil having collapsed this year and many energy companies struggling, plenty have seen their credit ratings drop, hurting their attractiveness if they want to issue bonds.

As you consider bonds for your portfolio, be sure to figure out which kind(s) will serve you best.

Matt Frankel: One thing you may not know about bonds is that there is more than one interest rate you need to pay attention to.

For starters, a bond's coupon rate refers to the stated interest rate paid based on the par, or face value of the bond. If a bond is issued with a $1,000 face value and a coupon rate of 5.5%, that tells us that the bond will pay interest of $55 per year.

Current yield tells us how much a bond yields based on its current market price. For example, if our $1,000 bond with a 5.5% coupon rate trades for $950, its current yield jumps to 5.8% since it still pays a $55 annual dividend.

Yield-to-maturity is another rate and tells you the total return the bond will produce if you hold it through the end of its lifetime, expressed as an annualized rate. This is different than the current yield because it takes into account the final payment. For example, if a bond with a $1,000 face value trades for $950, the extra $50 you'll receive at maturity serves to boost the bond's total return.

Finally, yield-to-worst tells you how much the bond will return based on a worst-case scenario. This is especially useful if your bonds are "callable," which means the issuer can choose to redeem them early. If you buy a bond for a premium, say, $1,100 for a bond with a $1,000 face value, and the issuer chooses to call the bonds early, you'll receive $100 less than you paid; this needs to be taken into account.

Dan Caplinger: Understanding bond ratings is an important part of the bond market. Specialized ratings agencies look at the financials of companies that issue bonds and then make a judgment about their ability to pay compared to other bond issuers. Top-rated bonds are AAA, followed by AA, A, BBB, BB, B, CCC, CC, C, and D. Various ratings agencies use different methods of further subdividing these categories, with one using plus and minus signs to distinguish while another uses numbers 1, 2, and 3 to signify the best, middle, and worst ratings in each broader letter-grade. The better the rating, the safer the bond, but higher-rated bonds typically pay lower interest rates than lower-rated ones.

One key boundary exists between BBB- and BB+ rated debt. At BBB- or above, bonds are called investment-grade, achieving enough safety to be suitable for risk-averse investors. At BB+ or below, bonds are classified as high-yield debt, referred to colloquially as junk bonds. By setting expectations of how likely a bond is to default and cost you your principal, bond ratings can be a useful tool to help you establish the risk level of your bond portfolio and avoid what can become costly mistakes.

Jordan Wathen: One thing you should know about bonds is that you don't always have to pay full price. Thanks to historically wide discounts, bond investors can buy bonds at a discount by purchasing closed-end bond funds.

The average closed-end bond fund is trading right now at discount of about 11%. In other words, some funds backed with $10 of bonds for each share are currently trading for less than $9 per share. This discount only serves to add to your yield while creating the potential for capital gains if the funds trade back to net asset value, which they historically have. 

It will take some diligence. Most closed-end funds come with a slightly higher fee, and some use leverage, which may not make them suitable for everyone. But deals like these are historically rare. If you're in the market for a new bond fund, you might want to consider a closed-end fund given their cheap prices. 

Jason Hall: Just as mutual funds are a core way that most people invest in stocks, bond-based mutual funds are the primary way most people own bonds. The thing is, owning shares of a bond fund can mean different results versus owning bonds outright.

If you own a bond, you have the option to hold it to maturity. If you do this, you'll get the guaranteed interest payments, as well as the full face value of the bond if you redeem it at maturity. You also have the option to sell if on the secondary market if you choose to, and get market value.

But if you're investing in bond funds, you're left to the whims of the fund manager's decisions.

This is important today as we enter into what looks likely to be an environment of steadily rising interest rates over the next few years, as the Federal Reserve looks to re-establish one of its most important tools for dealing with macroeconomic threats.

And since bonds lose value when interest rates rise and higher-yielding bonds are available to buy, there's a good chance that some bond funds may significantly underperform, and some could even be money losers for investors.

In summary, owning bonds outright may be a better way to preserve capital than bond funds once interest rates start creeping up, as long as you can hold the bond to maturity. 

Dan Caplinger has no position in any stocks mentioned. Jason Hall has no position in any stocks mentioned. Jordan Wathen has no position in any stocks mentioned. Matthew Frankel has no position in any stocks mentioned. Selena Maranjian owns shares of Johnson & Johnson and Microsoft. The Motley Fool owns shares of Microsoft. The Motley Fool recommends Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.