Bonds are essentially I.O.Us used to lend money to whatever entity you are purchasing the bond from including the federal government, state and local municipalities, corporations, mortgage- and asset -based securities and foreign government bonds. In exchange for the use of your money, they agree to pay a given interest rate. It sounds simple, but there is a lot to learn about making the most of your bond investment. Begin by using the following checklist when researching your purchase:
- Is the bond convertible or "straight."
- What is the rating? A bond is only as good as the underlying financials of the issuing entity.
- What - if any - special features are in play? Pay attention to call risk and don't count your profits before maturity.
- What is the yield, maturity date, coupon rate and tax status?
- Consider the "call risk". The call risk is when a bond issuer "calls" the bond and then creates a new issue at a lower rate. This is of particular importance when interest rates are falling.
Every portfolio has a place for bonds. Don't automatically assume they are less risky than stocks, or that their rate of return is less. The bond market is highly volatile and capable of bringing as much - or as little - stability versus risk as desired. Bonds are simply another form of investing and diversification. Keep in mind there are different types of bonds as well. For example, convertible bonds are those that can be converted into a specified amount of equity in the company at specific times of the lifecycle. Because they are bonds that have the option of being converted into stock, they tend to trade at a lower rate of return.