Ah, bonds, so cuddly, so generous, so mysterious

PERSONAL FINANCE

Suddenly, bonds aren't so homely as before

April 29, 2001

SEVERAL years ago during the raging bull market, Greg Prost would attract attention at a cocktail party when tip-hungry investors heard he worked at an investment firm.

Once they learned he was a "bond guy," though, "they would move right along," says Prost, chief investment officer for Ambassador Capital Management in Detroit.

Bonds were considered too stodgy, too blue-haired, too yesteryear. Not any more. After the pummeling of stocks that began last year and continues today, investors have come to appreciate the stability that bonds can add to a portfolio.

During the first two months of last year, when stocks were still rushing to new highs, investors drained nearly $21 billion out of bond funds. This year, $17.6 billion dollars poured into bond funds in January and February.

"People have a better attitude toward bonds," Prost says.

Despite their newfound popularity, bonds still confuse many investors. Bonds have their own language, such as duration and yield to maturity. And, experts agree, the most puzzling concept for investors: Why does the price of a bond go down when interest rates go up?

"I don't think the average investor knows as much about bonds as they do about stocks," says Dick O'Brien, a senior vice president in brokerage Folger Nolan Fleming Douglas Inc.'s Hunt Valley office. "There is more written about stocks. Stocks are more interesting to most people."

If you now are more interested in bonds but are new to them, here are some of the basics.

Simply put, a bond is an IOU. Buy a bond and you are lending money to a corporation or government. The bond issuer promises to repay the principal on a certain date, called the date of maturity. In the meantime, you will be paid interest, generally twice a year.

The annual interest rate on your bond is called the coupon rate. So, a $1,000 bond paying an 8 percent coupon rate means you will receive $40 in interest income every six months.

That's how most bonds work. One exception is a zero coupon bond, which sells for far less than its face value and doesn't pay periodic interest.

The type of bond depends on the issuer. For example, the U.S. government issues Treasuries; state and local governments offer municipals; and corporate bonds come from companies. Agencies such as Federal Home Loan Bank and Farm Credit System issue agency bonds.

Investors like bonds' predictable income. They also tend to shift money into bonds or other conservative investments when they know they'll need the cash in a few years, O'Brien says.

But bonds carry risks. Rising inflation can eat away at the purchasing power of the bond's principal and income.

Rising interest rates, too, can reduce the price of your bond. Here's how:

Say, you buy a bond with a 7 percent coupon rate, and later decide to sell it before maturity. But by that time, interest rates have risen and new bonds pay 8 percent. Your lower-rate bond is less enticing, so to lure a buyer you must sell your bond at a discount, or less than you paid for it.

Falling interest rates, on the other hand, raise the price of existing bonds that have higher coupon rates. If rates fell to 6 percent, then your 7 percent bond looks attractive and an investor may pay a premium, or more than you paid, for the bond.

Bonds also carry the risk that the issuer will default and investors might not get their principal back.

Credit agencies, such as Moody's Investor Service and Standard & Poor's Corp., rate the probability of default. U.S. Treasury securities, backed by the federal government, get the highest-quality rating. At the low end are high-yield bonds, or junk bonds, that offer a higher interest rate to offset their higher risk of default.

"Stick with investment grade," or the higher-rated bonds, O'Brien says.

If you want to invest in junk bonds, some suggest doing so though a mutual fund that may own 50 or more bonds, thereby lessening the damage if one issuer defaults.

Bond funds never mature because the money manager routinely buys and sells bonds in the fund. Bond funds offer some advantages to small investors. A fund provides diversification, professional money management, generally smaller initial investments than an individual bond and often greater liquidity, meaning the shares can be bought and sold quickly.

Compare fees when choosing a bond fund because they can erode returns, experts say. Also, there's no guaranteed return of your initial investment if you sell fund shares at a bad time.

You can buy Treasuries directly from the government or through a brokerage or a bank. Other types of individual bonds are generally sold by brokers. What should you ask before buying?

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