Codename: Bond Basics

SchoolhouseRock - Tyrannosaurus Debt

TOUR GUIDE: And this is the U.S. Treasury. It sells Treasury Bonds, bills, and notes, and savings bonds to finance the debt. The U.S. government promises to pay the owner interest plus the value of each bond at a future date.

Up to a few days ago, if you asked me what a bond was, I would tell you it was a way to make some interest on your money through the federal government and you can either buy bonds at face value or at half face value. That about sums up my knowledge.

Being a bit of a self-taught person I decided to learn more about bonds than what I understood for the last 30 years. And here is a basic understanding of that research (very basic).

What: Essentially, bonds are a way of taking loan out from a citizen bank with interest for the life of the bond. We citizens, are the banks investing in our governments; city, state, corporate and federal government. We can buy short term bonds or long term bonds and when the bond matures they will pay the face value plus interest accrued.

Who: Bonds are held not just by the federal government but also by municipalities (state, cities and local governments), corporations and mortgages. They are rated from AAA, AA and A down to B and lower by companies such as Moody's, Standard and Poors, Fitch, and Weiss Reports who look at the credit worthiness of the governments and corporations putting out their hand for a loan.

Why: Buying bonds, specifically those such as the EE, I or bond fund are the easiest way to put your money away for a stable investment over the long term (greater than 10 years). If purchasing bonds individually, remember, the letter grade above is constantly changing, is one of the primary determinants of value. Should a formerly rock-solid bond received a lowered rating, its value will slide accordingly since bonds trade on the open market just as stocks do. A bond that pays significantly more interest than a similar bond maturing at about the same time is riskier.
Downside: Some corporate bonds have an option to call in their bonds early. So if you paid for a 10 year bond and were expecting a certain level of investment when it matures but the corporation calls in the the bond early at year 5, you can lose some of that much needed interest that you were counting on  down the road.

How: Sometimes buying bonds is best left to the professionals by way of the bond fund option via IRA, 401k, 403b investments where you can pick up bonds that are bought for mortgages, corporations and governments (local and worldwide). If you go that route than professionals will monitor credit worthiness, bonds that have been called and interest rate trends.

Another way and a more common form is to pick up EE and I savings bonds offered through the federal government.  EE bonds have a fixed rate of interest (feb. 2011 - .60%) and I bonds have a fluctuating interest rate based on inflation (feb. 2011 - .74%). With interest rates varying over the years, you could have bonds with interest rates anywhere from .60% to 6%.

If you don't want to lose some of your interest earned through bond funds you can purchase the bonds individually, through a brokerage house like E-trade. You will have to stay on top of the calls on bonds and you may have some losses if you sell at the wrong time. The advantage is that you know what you own and have more control with lower average fees.

Where: To learn more about the intricacies of bond buying; I suggest the following -
Investopedia: Bond Basics
Motley Fool: Buying Bonds
Kiplinger: Understanding Bonds

Also, Mint.com has a wonderful InfoGraphic - What is a Bond - if pictures, multiple colors and arrows help you understand (like myself).