Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 31)

Bonds (part A)

by

Charles Lamson

In this post we are going to look at bonds in greater detail than in previous posts, when I introduced you to some of the basics of "fixed income securities," as bonds are known.

The total worth of bonds owned by Americans is more than stocks and mutual funds. Bonds occupy a huge role in our economy and continue to be an attractive source for corporate financing, as well as for governments.

Types of Bonds 

In previous posts, we have touched briefly on different types of bonds. Now it is time to dig deeper for a better understanding of their strengths and weaknesses. The types of bonds we will be discussing are as follows:

• U.S. Treasury
• U.S. government agency
• Municipal
• Corporate

However, today's post will only cover U.S. Treasury and U.S. government agency bonds. In the next post, I will focus on municipal and corporate bonds.

PROCEED WITH CAUTION Bonds have some unique characteristics that make them well suited for many investors. However, they are not necessarily for everyone. A fixed yield and known maturity can be a positive tool in your investment arsenal.

U.S. Treasury Bonds

The U.S. government through the Department of Treasury issues debt instruments of various maturities to finance the day-to-day and long-term needs of the government. They come in three basic flavors:

• T-bonds have the longest maturities ranging from 10 to 30 years
• T-notes have mid-range maturities ranging from 2 to 10 years
• T-bills are short-term issues ranging from 90 days to 1 year

All of the Treasury issues come with the full backing of the U.S. government, meaning they are the benchmark for safety. The absolute assurance that they will be paid back comes with a price in the form of relatively lower interest rates.

The bond market watches these issues very closely because they represent the absolute in safety if held to maturity. When interest rates change on new Treasury issues, it usually signals a movement in interest rates on other issues.

JUST A MINUTE Brokers may charge relatively high commissions on bond sales. For the best rates, shop for brokers who specialize in bond sales.

The Federal Reserve Bank sells new issues at auction, but sales in the secondary market must be done through a broker.

New T-bonds and T-notes are issued in denominations starting at $1,000 and ranging up to $1 million. T-bills are issued in denominations of $10,000 and may be bundled for much larger investments.

T-bonds and T-notes pay periodic interest just like other bonds and are redeemable for face value at maturity. T-bills, on the other hand, are sold at a discount off the face value. The difference between the face value and the discount price is the interest. No interest payments are made; rather, the bills are redeemed at face value.

For example, a $10,000 T-Bill pays 5 percent interest. You would buy the bill for $9,523.81 and redeem it for the full $10,000 face value. The difference of $476.19 is your interest.

All three of the U.S. Treasury issues are exempt from state and local taxes, but not federal tax.

U.S. Government Agency

U.S. Government agency bonds are often used to finance mortgages provided under various government programs. The best known are Ginnie Mae (GNMAs), Fannie Mae (FNMAs), and Freddie Mac (FHLs) bonds. These bonds are taxable.

There are also bond programs that support student loans, loans to farmers, and other agencies. These bonds are reported in The Wall Street Journal under "Government Agency & Similar Issues." These bonds are exempt from state and local taxes.

Some of these issues may be rated by the standard rating services. They usually pay higher rates than Treasury issue, with just slightly more risk. Their maturities raise from 1 month to 20 years in some cases. Most are sold in very large denominations of $100,000 or more.

JUST A MINUTE U.S. government bonds feature lower yields than other bonds because of the absolute safety they provide. Agency bonds that are backed by mortgages may suffer during economic downturns when foreclosures rise.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 197-199*

END

PROCEED WITH CAUTION

Bonds have some unique characteristics that make them well suited for many investors. However, they are not necessarily for everyone. A fixed yield and known maturity can be a positive tool in your investment arsenal.

JUST A MINUTE

Brokers may charge relatively high commissions on bond sales. For the best rates, shop for brokers who specialize in bond sales.

JUST A MINUTE

U.S. government bonds feature lower yields than other bonds because of the absolute safety they provide. Agency bonds that are backed by mortgages may suffer during economic downturns when foreclosures rise.