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Everything you wanted to know about bonds, almost

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POSTED: March 21, 2008 5:00 a.m.
In the financial world, stocks tend to get most of the attention. But if you're going to make progress toward your long-term goals, you need to be aware of all types of investments, including bonds.
Many people, however, don't understand bonds. So, before you invest in them, familiarize yourself with the "bond basics." Here are a few:
Bonds are "debt" instruments. When you buy shares of stock, you're actually becoming an owner -- although one of many -- of a company. But when you buy bonds, you are, in effect, loaning money to whomever issues the bond -- a business or the government. If you hold the bond until it matures, you'll get your principal, or "par value," back (provided the issuer doesn't default) and, along the way, you'll receive regular interest payments. A bond's interest rate is known as the "coupon."
Bond prices fluctuate. Your bond's interest rate will not change over its life. However, the price of your bond can fluctuate, an important factor to keep in mind if you sell a bond before it matures. A bond's price will move in response to several variables, chiefly interest rates.
Bond investments are subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease and the investor can lose principal value. For example, suppose you own a $1,000 bond that pays 4 percent interest. If new bonds are issued at 5 percent, no one will pay you the full $1,000 for your 4 percent bond, so, if you wish to sell, you will have to offer it at a discount. Conversely, if market rates fall to 3 percent, your 4 percent bond will become more desirable, so you could sell it for more than the $1,000 par value.
Different bonds have different "ratings." If you buy a corporate bond, you'll have a choice between investment grade bonds -- those receiving the higher "grades" issued by rating agencies, such as Moody's or Standard & Poors -- and "junk" bonds -- those getting the lowest grades. The higher-quality bonds carry less risk of default but pay a lower interest rate than the "junk" bonds, which must offer the higher rates to attract investors. Generally speaking, you're probably better off avoiding the "junk."
Some bonds can be "called." A callable bond is a bond that can be redeemed -- or "called" -- by the issue before its maturity. If interest rates have declined since the bond was originally issued, companies will call bonds and reissue them at the lower, prevailing interest rate, thereby saving interest payments. As an investor, this could be cause for concern, because if your bond is called, and you wanted to reinvest the proceeds in a new bond, you'd likely have to accept a lower coupon rate. Consequently, you may want to look for a bond that offers "call protection," a promise that a bond can't be called before a certain time.
To determine if bonds are appropriate for your individual situation and, if so, what type of bonds see your financial advisor. By adding bonds to your portfolio, you may well give yourself a broader platform for success.

Cardella is a financial consultant with Edward Jones in Hinesville.
 

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