Understanding Bonds and Their Risks

Key Points

» Benefits and Risks of Bonds
» An Inverse Relationship: Interest Rate Risk
» Most Bonds Fall Into One of Four Categories
» Types of Bonds
» Know the Risks Associated With Bonds
» Individual Bonds vs. Bond Mutual Funds
» Points to remember

A bond is an “IOU” for money loaned by an investor to the
bond’s issuer. In return for the use of that money, the issuer
agrees to pay interest to the investor at a stated rate known as
the “coupon rate.” At the end of an agreed-upon time period when
the bond “matures” the issuer repays the investor’s
principal.

Benefits and Risks of Bonds

Because bonds generally may not move in tandem with stock
investments, they help provide diversification in an
investor’s portfolio. They also provide investors with a
steady income stream, usually at a higher rate than money market
investments.¹ Zero-coupon bonds and Treasury bills are
exceptions: The interest income is deducted from their purchase
price and the investor then receives the full face value of the
bond at maturity.

Some bonds hold “credit risk,” or the risk that the bond issuer
will go into default before your bond reaches maturity. In that
case, you may lose some or all of the principal amount invested and
any outstanding income that is due. Bonds are often rated by
Moody’s and Standard & Poor’s (S&P). Ratings run
from Aaa (Moody’s) or AAA (S&P) through D, based on the
issuer’s creditworthiness. Aaa and AAA are the highest credit
ratings.

Despite their unpleasant name, junk bonds (so-called because of
their lower credit ratings) are fairly common investment vehicles.
They are most appropriate for investors who can withstand price
volatility in search of higher yields.

Like stocks, all bonds can present the risk of price fluctuation
(or “market risk”) to an investor who is unable to hold them until
the maturity date (when principal and interest are repaid to the
bondholder). If an investor is forced to sell or liquidate a bond
before it matures, and the bond’s price has fallen, he or she
will lose part of the principal investment as well as the future
income stream.

An Inverse Relationship: Interest Rate Risk

Another risk common to all bonds is interest-rate risk. When
interest rates in the economy rise, a bond’s price will
usually drop, and vice versa. Historically, bond investments have
been more stable than their stock counterparts. Moreover, because
bond investors are concerned primarily with receiving income
(instead of capital appreciation) from their bonds, they should not
be overly concerned with falling bond prices. Bond investors will
probably hold their bonds until maturity, intending to receive
their principal investment.

Most Bonds Fall Into One of Four Categories
Corporate Government Government Agency Municipal

Types of Bonds

Bonds come in a variety of forms, each bringing different benefits,
risks, and tax considerations to an investor’s portfolio. Most
bonds fall into four general categories: corporate, government,
government agency, and municipal.

CORPORATE BONDS
Issued by corporations, these bonds can provide an investor with a
steady stream of income at a generally higher rate than other
bonds.

Risk Considerations: Other than market and interest rate
risk, the primary risk associated with this type of bond is credit
risk. Another risk with some corporate bonds is that the bond could
be “called” by the issuer, who then repays the principal before the
maturity date; the debt is paid ahead of time, and the investor may
not be able to reinvest it at the same income stream.

Tax Considerations: All interest earned on a corporate
bond will be taxed as ordinary income at your usual income tax
rate. If you choose to sell a bond for profit, this “capital
appreciation” will also be taxed as a capital gain.

GOVERNMENT BONDS
Government bonds are issued by the U.S. Treasury and backed by the
full faith and credit of the U.S. government. They include
intermediate- and long-term Treasury bonds. Intermediate-term bonds
mature in 3 to 10 years, whereas long-term bonds generally mature
in periods of up to 30 years.Risk Considerations: Perhaps the lowest risk of all bond
investments, these bonds have little credit risk because they are
guaranteed by the U.S. government. A government bond does present
market risk if sold prior to maturity, and also carries some
inflation risk — the risk of its comparatively lower return
not keeping pace with inflation. This investment could lose value
over time.

Tax Considerations: Treasuries are fully taxable at the
federal level but are exempt from state and local taxes.
GOVERNMENT AGENCY BONDS
These bonds are indirect debt obligations of the U.S. government
issued by federal agencies and government-sponsored entities.
Examples of such organizations are the Federal National Mortgage
Association (FNMA or “Fannie Mae”), the Government National
Mortgage Association (GNMA or “Ginnie Mae”), and the Student Loan
Marketing Association (SLMA or “Sallie Mae”).Risk Considerations: Next to Treasury bonds, agency and
entity bonds are the second safest bonds in terms of credit risk.
Because these bonds are not directly issued by the U.S. government,
they are not necessarily backed by its full faith and credit. In
addition to the risks inherent in government bonds, agency bonds
run the risk of going into default, although such an occurrence is
highly unlikely. Because of this added risk, however, these bonds
generally offer higher yields than government bonds.

Tax Considerations: These bonds are fully taxable at the
federal level and, in some cases, at the state and local levels as
well.
MUNICIPAL BONDS
Municipal bonds, or “munis,” are issued by a U.S. state, county,
city, town, village, or local authority to raise funds for
particular public works projects.Risk Considerations: Munis fall somewhere in the middle
of the credit risk spectrum. The risk of default can vary depending
on the creditworthiness of the issuer and the type of debt
obligation.

Tax Considerations: Perhaps the biggest advantage of most
munis is their tax-exempt income status. Income accrues tax free at
the federal level and, in most cases, at the state and local levels
as well. Capital gains, on the other hand, are fully taxable.

Know the Risks Associated With Bonds
Credit Risk The risk that a bond’s issuer will go into default before a bond reaches maturity. Market Risk The risk that a bond’s value will fluctuate with changing market conditions. Interest Rate Risk The risk that a bond’s price will fall with rising interest rates. Inflation Risk The risk that a bond’s total return will not outpace inflation.

Individual Bonds vs. Bond Mutual Funds

Because individual bonds require initial investments ranging
anywhere from $1,000 to $100,000, many bond investors pursue their
goals through mutual funds. Providing the professional management
and diversification inherent to all funds, bond mutual funds can
offer a fixed-income element to balance out a portfolio of other
stock and money market investments. Investors should remember,
however, that bond funds do not mature; therefore, risk to
principal cannot be minimized by holding them to maturity as with
individual bonds. Also, although interest income and the principal
amount invested in government bonds is guaranteed, the funds that
invest in these bonds are not.

Although bonds are often listed second to stocks when it comes to
long-term investing benefits, their variety (and, in some cases,
their tax benefits) can be suitable to many investors. Discuss your
goals with your financial advisor, and together you can decide
whether bond investing is right for you.

Points to Remember

A bond is an “IOU” from an issuer to an investor.
A bond’s issuer agrees to repay the investor the principal
amount invested at the bond’s maturity date, along with
regular interest payments at the bond’s stated coupon
rate.
Bond risks include credit risk, market risk, interest-rate
risk, and inflation risk.
Most bonds fall into four general categories: corporate,
government, government agency, and municipal.
Some investors might best pursue their fixed-income goals
through bond mutual funds, although they should remember that while
government bonds guarantee principal and interest, the funds that
invest in them do not. Also, bond funds do not mature; therefore,
risk to principal cannot be avoided by holding the bonds to
maturity.

¹An investment in a money market fund is not insured or
guaranteed by the Federal Deposit Insurance Corporation or any
other government agency. Although the fund seeks to preserve the
value of your investment at $1.00 per share, it is possible to lose
money by investing in the fund.

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