Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 11)

Bonds

by

Charles Lamson

Bonds are an important investment tool worthy of our consideration. We will look at them in more depth in later posts and show you ways to use them effectively.

Bonds are a loan to a governmental unit or corporation. They normally do not have any ownership rights. Bonds are used to finance a variety of projects for the government and corporations.

U.S. Treasury Bonds

The U.S. government borrows money through bonds it auctions off or issues. U.S. government bonds are the safest investment you can make. Bonds are backed by the "full faith and credit" of the U.S. government and are free of state income tax.

If the only consideration is safety, these bonds are your best investment. However, as we will learn in a later post, this safety comes with a price. The yields are at the bottom of the stack.

U.S. Treasury Bonds are sold in a variety of denominations starting at $1,000, and are actually called three different names depending on the length of maturity:

• Treasury bills mature within one year
• Treasury notes mature between one and ten years
• Treasury bonds mature in more than ten years

U.S. Bonds play an important role in our economy for several reasons. First, the federal government uses bonds to finance the difference between what it collects in taxes and its expenses. Secondly, many Americans are more intimately touched by the market for U.S. Treasury Bonds. Many commercial loans and residential mortgages are tied to the U.S. Treasury Bond rate. When that rate goes up, so does the interest consumers pay on a variety of loans.

Other Governmental Bonds

A number of other governmental agencies issue bonds for a variety of reasons, including financing mortgages and student loans. State and municipal governments issue bonds to finance highway construction, dams, and other large projects. These bonds are usually free from federal income tax and state income tax in the state where they are issued.

Corporate Bonds

Companies issue bonds to finance operations and to make large acquisitions. The interest paid by corporate bonds is fully taxable by local, state, and U.S. governments.

They are priced in part on the creditworthiness of the company. Junk bonds offer very high yields, but have a corresponding high risk of default.

Some corporate bonds can be called, which means the company can buy them back before maturity. This can play havoc with your plans if you are not careful. For example, you often buy a bond to meet a known upcoming expense (college tuition). If the bond is called before maturity, you will have to buy another bond to replace it. If the bond market has exploded since you bought the original bond, you may find yourself short of money to buy a replacement.

Other corporate bonds are convertible bonds, meaning under certain circumstances they can be converted into stock in the company.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 59-60*

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