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What is a Bond?

Bonds are a core element of any financial plan to invest and grow wealth A bond is a loan you make to an institution. You can make the loan to the U.S. government, a state, a local municipality or to a company. Companies and governments need this money to finance projects like new buildings and roads.

When you lend money to the institution, the IOU they give you is called a bond. This IOU is their promise to repay both your principal (the amount you lend) and a fixed amount of interest for allowing them to borrow your money.

So what are we talking about in real terms? Say you were to lend someone $1,000 for 10 years and charge them 9% interest annually for borrowing your money. Well, if your loan is a bond, then the $1,000 you lent is the face value of the bond (also called "par value"); the yearly 9% interest payment is the coupon; and the length of the loan, 10 years, is the bond's maturity. At the end of ten years you will have earned $900 in interest and will get your initial $1,000 investment back.

You may have heard bonds referred to as "fixed-income securities." They got that name because, unlike when you purchase stock in a company, a bond issuer promises that you'll receive a predetermined amount of interest on your investment. When you purchase stock in a company, the company does not promise a return Ð'- of your initial investment, or an increase in the value of the stock or even the payment of a dividend. So maybe bonds aren't as sexy as stocksÐ'...but you can't argue that there isn't something attractive about financial predictability.

With the skyrocketing advances in the price of stocks in the late 1990s, many first-time investors raced to plunk their money down in any company ending with "dot com." Some became millionaires. Some went bankrupt. And some who diversified their money between stocks, bonds, and savings rode out the dot com crashes and are comfortably watching their money perform over the long haul. Although bonds will never be part of a "get rich quick scheme" for you, there are several great reasons that they should be included in your portfolio.

Why Invest in Bonds?

Many personal financial advisors recommend that investors maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. Because bonds typically have a predictable stream of payments and repayment of principal, many people invest in them to preserve and increase their capital or to receive dependable interest income. Whatever the purposeÐ'--saving for your children's college education or a new home, increasing retirement income or any of a number of other financial goalsÐ'--investing in bonds can help you achieve your objectives.

That's especially true for retirement planning. During the past decade, the traditional fixed-benefit retirement plans have increasingly been replaced by defined contribution programs, such as 401(k) plans. Because these plans offer greater individual freedom in selecting from a range of investment options, investors must be increasingly self-reliant in securing their retirement lifestyles.

The diversity of fixed-income securities presents investors with a wide variety of choices to tailor investments to their individual financial objectives. Whatever your goals, your investment advisor can help explain the numerous investment options available to help you reach them, taking into account your income needs and tolerance for risk.

The Benefits of Bonds:

Ð'* Financial Security Who doesn't like the sound of "financial security"? There's a reason that a bond is called a "fixed-income" security Ð'- not only are you highly likely to get back your principal but you can also count on receiving interest on your investment.

Ð'* Portfolio Balance & Diversification Bonds can be great financial "buffers." When the stock market is on a roller-coaster ride, bonds can help steady your pulse because they're a very safe financial tool to help balance the risk in your overall portfolio.

Ð'* Tax breaks Who doesn't want a tax break? One of the not so well known facts about bonds is that they're very often free from many taxes. For example, most bonds issued by state or local governments (also known as "municipalities" or "munis") are exempt from federal income taxes. All bonds issued by the U.S. Government (also known as "Treasurys") are exempt from state and local income taxes. Some municipal bonds ("munis") are free from all three Ð'- city, state and federal taxes Ð'- a condition known as being "triple tax free."

Ð'* Weighing the Risks Probably the first thing you've heard about investing is that it's never risk-free. True enough. And although highly-rated bonds are considered one of the safest ways to invest your money, you should still take the risks into account before making any decisions.

Ð'* Bankruptcy Bond issuers are not some mysterious "Wizard of Oz"-like entities. They're companies and units of government. And, sad to say, companies and sometimes even local governments can go bankrupt and default on their loans. Bonds with high credit ratings very seldom default and U.S. Treasury securities are considered essentially risk-free. But it's a fact to consider. Even bonds (except Treasurys) aren't risk free.

Ð'* Your bond is "called" Some bonds can be paid back early Ð'- what's known as your bond being "called." If you own a callable bond and it is called you will still be paid back your initial investment and any interest you've earned so far, but you will not receive the future interest you would have otherwise gained. From our example, let's say your 9% bond was called after 8 years. You would be repaid your initial $1,000 investment (the principal), plus the $720 you had accumulated in interest. However, you would not receive the additional interest you were expecting when you made your initial investment for 10 years. Most important, if the company decided to call the bond, chances are that interest rates are now lower and you won't be able to find a similarly rated bond paying as high as the original 9% interest you were receiving.

Ð'* Rising inflation If inflation rises, the interest you make on your initial investment will look low compared to bonds currently being issued. And with your money locked in a bond, you could lose some principal if you sell it