Who do you think has a better deal going: an entrepreneur or a banker? Investing in stocks and bonds offers a pretty similar risk-reward trade-off.
When you buy a stock, you're becoming a partial owner of a company. If the enterprise thrives, you get a cut of the profits, either through a rise in its stock price reflecting growing earnings power, or via regular payments known as shareholder dividends. If the company becomes sickly, you're likely to suffer too, as the price of your stock sinks and the dividend payments are cut or suspended.
Bondholders, on the other hand, are like mini-bankers. When you buy a bond, you are lending money to a company or government entity. In exchange, the borrower agrees to pay you a fixed rate of interest, known as a bond dividend. Unlike the dividends on stocks, these are legal obligations and can only be suspended by the issuer in the most dire of circ*mstances. Because the payments are supposed to be set at a predetermined rate, bonds are known as fixed-income investments.
When you lend out your money by buying bonds, the party that issues them is legally bound not only to pay you regular dividends but to return the money you lent it, known as principal, at the end of a set term. Such terms can range from one day to 30 years. If the borrower runs into financial trouble in the meantime and becomes unable to repay all its obligations, or if it declares bankruptcy outright, the law states that bondholders get back their principal before stockholders receive a dime. That safety is appealing in volatile markets.
"In an environment where stock dividends are being ratcheted down or extinguished, you can count on the coupons from your bonds," says Marilyn Cohen, Forbes' fixed-income columnist.
How are bond dividend rates set? Based on the level of risk bondholders incur. Safety comes in two basic forms: The stability of the issuer and the length of time its bonds will be in circulation.
At the safest end of the issuing spectrum are short-term U.S. government bonds, which currently pay around 0.5% a year in dividends (long-term ones are paying around 2.5%). Among the riskiest are corporate bond issuers. Dividends on bonds maturing within a few years can run in excess of 20% annually.
Bankruptcy by an issuer is by no means the only risk bondholders incur. As the maturity of a bonds lengthens, the risk also rises that inflation will kick up and erode the value of bondholders' fixed-income payments. That's another reason the longer the maturity of bonds from a given issuer, the higher its regular dividend payments tend to be.
Even if an issuer continues to cover its bond payments, higher inflation will erode the value of a bond, and its price will fall in the same way a stock's price does (the price matters most you intend to sell a bond before it matures; if you hold it until maturity, you'll still be entitled to receive back the full par value). Deciding which bonds or bond mutual funds are right for you means figuring out where on the risk-reward spectrum you're comfortable.
To get comfortable, it helps to know a bit of bond-market lingo. The government or company selling the bond is the issuer (bonds themselves are sometime referred to as issues). The amount of money lent, the principal, is also known as the par, or face, value, because it represents how much the bond is worth at the time it's issued.
The length of time the bond is outstanding before the principal is repaid is called the maturity period. The interest you're paid over the life of the bond is called the coupon rate. While most bonds pay dividends semi-annually, the periods can range from monthly to a single payment upon bond maturity.
Perhaps your Grandma showed up at your 11th birthday party with a Treasury bill instead of the Nintendo game you really wanted. Treasuries are debt securities sold directly by the U.S. government and are the world's most widely circulated bonds.
Treasuries come in three forms: Treasury bills have a maturity period of one year or less; Treasury notes, between two and 10 years; and Treasury bonds, which mature between 20 years and 30 after issuance.
The Department of the Treasury issues bonds for the federal government, but it is by no means the only issuer in the government sector. Federal agencies, ranging from the Small Business Administration to the U.S. Postal Service, sell bonds, as do state, local and county governments.
State and local government bonds are often categorized as municipal bonds, known as munis. They also include debt instruments issued by local agencies, like school and sewer districts. A big part of the attraction of munis is that their dividend payments are exempt from some or all federal, state and local taxes. This makes munis solid candidates to hold outside a retirement account, like a 401(k) or IRA, which are already sheltered from dividend taxes. Because your tax obligation is lower or non-existent on munis, their dividends tend to be somewhat lower than those paid on similarly risky taxable bonds.
The other main category of bonds are corporate issues, or corporates. Since private enterprises, unlike governments, can't levy taxes to meet their bond obligations, corporate bonds are only as safe as the companies that issue them.
Bonds from the most solid companies are referred to as investment-grade. The safest don't pay much more in dividends than the U.S. government, because they're considered nearly as unlikely as Uncle Sam to go bankrupt and default on their bonds.
As the stability of bond issuers declines, the amount they must pay investors in regular dividends to convince them to own their bonds increases. At the high end of the risk spectrum is the high-yield debt, also known as junk bonds. The dividends on many are currently in the high teens.
How do you buy a bond? If you're looking for safety and willing to live with low yields, you can buy U.S. Treasuries via TreasuryDirect.gov. There are no commissions or transaction costs in buying bonds this way, and it's remarkably user-friendly for a government Web site.
Corporate bonds tend to carry a $1,000 par value. You can buy them through a broker, but you'll pay a commission and spread between the bid and ask prices. Unless you've got a lot to invest, you'll also end up with most or all of your eggs in one basket.
A better idea for most small investors is a bond mutual fund. Pick one with an ultra-low expense ratio and no up-front sales charge, or load. That way, you--not the fund firm--will reap the rewards.
