BONDS #1 - An Introduction

Tell someone you’re thinking of investing—and they will immediately assume that you are looking into stocks!

Not surprising, since the amazing rise in the stock markets, especially over the past five years, has dazzled investors and the media. But to ignore the advantages of fixed income investing is to miss out on one of the three “legs” of the traditional financial plan: a balance of stocks, bonds and cash.

Deciding how to balance these three investment categories is called asset allocation and is the single most important decision an investor will make. Not only is the balance a very personal reflection of one’s tolerance for the ups and downs in the value of one’s investments (volatility), but the allocation changes as a person grows from one stage of life to another and future financial needs change.

This is the first of a series of articles about fixed income investing written for readers of mfr.com. At the risk of alienating our more sophisticated readers, I will start with basic definitions and concepts, the usefulness and advantages of income-producing assets and some of the basic types of bonds available to individuals. Later, we will explore investment strategies and market conditions, especially as economic forces affect the attractiveness of the three main asset classes.

But first, who needs to know about bonds? Here are some examples:

· an individual with a 401k savings plan to allocate

· one with new financial responsibilities (such as college education) to plan for

· a person developing a retirement strategy

· the recipient of any lump sum payment (inheritance, insurance distribution) who wants to use it wisely in planning for the future

So, if stocks are shares in companies, what are bonds?

Bonds are a type of loan, a contract to borrow money and repay it.

But, for once, the investor is making the loan!

And the recipient of the loan, the borrower, will repay the principal (the face amount) on a fixed date (the maturity date) and pay interest (at the coupon rate). Most bonds have pre-set coupons and pay a regular stream of fixed income to the investor. This cash can be spent or can be reinvested. Each bond (issue) has its own coupon and maturity date, and usually has a $1,000 face value.

Who are these borrowers? Well, for starters:

the United States Treasury and its government agencies, many large and small corporations, as well as states and municipalities. These issuers raise capital by selling bonds to investors.

Why would one want to invest in bonds? What are the advantages?

· Safety—bonds are among the least risky investments, and all investors should have a balance of “risk and reward” that suits their comfort level or risk tolerance.

· Diversity—to avoid the pitfall of “all your eggs in one basket”

· Income—to provide reliable current or retirement cash needs, or to match future obligations

· Growth—if income payments are reinvested, assets can double in about 10 years!