The ABCs of Bonds

Did you know that the federal government wants to borrow money from you? Bonds, a relatively safe and predictable investment, can be a key component of your diversified portfolio.

Sorry, baseball fans, we don't have the ABCs on slugger Barry. The bonds we're talking about are the kind you might see in your investment portfolio. Unfortunately, given Barry's dominance of the media's attention in recent weeks, you may know more about home run records than you do about bond investing. That's about to change.

It takes two

A bond is an official agreement between a borrower and an investor. The borrower can be the federal government, a federal agency, a state or local government, or a corporation. Governments borrow money to cover a revenue shortfall or to fund special initiatives, while businesses borrow money to expand or to recapitalize. The investor, also called a bondholder, can be an individual, a corporation, or an institution.

Let's say Smyth Corporation needs to borrow $20 million to build a new factory. Smyth has two choices: borrow from a bank, or borrow from investors. Either way, Smyth will have to pay interest on that borrowed money-just like you do when you take out a mortgage to buy a house.

Borrowers pay, investors earn

For various reasons, Smyth decides to borrow the money from investors. Since approaching investors individually isn't very efficient, Smyth issues a bond that can be sold to the public in small amounts. Individual investors might buy in for $1,000, while institutional investors might buy in for several million.

Before purchasing the Smyth bond, potential investors would evaluate the investment opportunity based on risk level and terms. Primary risk considerations would be Smyth's credit rating, as well as its current financial strength and future prospects. Terms include the interest rate, frequency of interest payments, and maturity date.

Once an investor purchases the Smyth bond, she'll start receiving regular interest payments. If she wants her money back before the bond matures, she can sell the bond to another investor.

Types of bonds, risk and return

Federally-issued or federally-backed bonds usually have the lowest returns because they're virtually risk-free. State or local government bonds are slightly more risky, so they usually offer investors tax-free interest to compensate for the risk.

Corporate bonds carry varying levels of risk. A bond issued by a company with uncertain financial strength and a low credit rating, for example, would be very risky. This is what's known as a junk bond, and investors won't buy in unless the rate of return is very high.

Considering this risk/return relationship, know that you can't hit one out of the park with a bond investment unless you take on significant risk. A more conservative option would be to go for the guaranteed base hit and watch your savings grow one step at a time.