As falling interest rates shrink the yields on certificates of deposit, money-market and bank accounts, more people are turning to bonds to boost their returns.
In the first three months of 1992, $48 billion in new money flowed into bond mutual funds, compared with $21.6 billion in the same period a year earlier, according to the Investment Company Institute.
Bonds and bond funds may be appropriate for many people. Some bonds have tax-saving features; others can be converted into common stock of the issuing companies. However, as with any investment, consumers should have a basic understanding of how bond investments work.
Bonds involve much more than a way to obtain higher yields. In fact, focusing on yield alone could backfire.
Stock represents ownership in a company, but a bond is like an IOU from the issuer. That may be the U.S. government, a state or local agency, or a corporation.
The issuer agrees to pay back the full amount borrowed at a specified time, called the date of maturity. Meanwhile, the issuer agrees to a set rate of interest, generally paid twice a year.
Most bonds are negotiable, meaning they may be bought and sold before maturity. This benefits bondholders who need cash before the maturity date. But a bondholder may not receive the face value of the bond, particularly if interest rates have climbed.
Though bond yields may be attractive to investors now, there is a trade-off between yield and risk. Generally, the higher the yield, the higher the risk. This is called credit risk.
For example, U.S. government bonds pay relatively low interest rates because the chances of default are remote. But a company whose financial stability is shaky must pay a higher yield to entice investors to assume a higher credit risk. The term junk bonds describes these riskier bond issues.
Don't be too fixated on yield. A high yield is meaningless if the issuer defaults.
The relative risk of bonds can be determined by consulting publications from two ratings services, Moody's Investors Service and Standard & Poor's Corp. They can be found at many public libraries.
Another risk, called market risk, involves changes in interest rates.
For instance, suppose you buy a bond with a $1,000 face value that pays 10 percent, or $100, each year. Two years later, interest rates have climbed, and newly issued bonds pay 15 percent. How much can you get if you sell your bond?
A 15 percent bond is a better buy than your 10 percent bond, so the only way to find a buyer is for your bond to yield 15 percent. Because interest payments are fixed, the only way to do this is to lower the price of the bond to $667. At that price, a person who receives $100 a year in interest gets a 15 percent yield.
Remember that $667 is only the market price of the bond. You'll still get $1,000 should you hold the bond until maturity.
In another scenario, imagine that interest rates have fallen to about 5 percent since you bought your 10 percent bond. Because you're getting twice the prevailing rate, you can sell rTC your bond for much more than its face value of $1,000.
Some points to keep in mind: The examples are intended to keep the math relatively easy to understand, so the dramatic swing in interest rates used may not necessarily occur. Also, if your yield gets too good relative to the market, the issuer may "call," or redeem, the bonds before maturity.
However, the key lesson is that when interest rates rise, bond prices fall, and vice versa. Therefore, if you are used to a federally insured bank account in which the value of your investment is stable, be aware that bond investments will fluctuate.
Investors have 1,369 bond and income funds to choose from. Unlike individual bonds, a mutual fund has many bonds and constantly changes, so investors can't lock in a fixed yield.