Dear Carrie: I'm 37 and have been building up my IRA. So far, I've been focused on stocks, but I've read I should have some bonds, too. However, bonds seem really confusing and I've heard they can be risky. Can you help me get started? --A Reader
Dear Reader: You're right that bonds can be both confusing and risky -- and especially so in today's economic environment. That's because bond performance is directly related to interest rates, and today's rates are about as low as they go. But there's a lot more to understand about bonds, so let's take a look at some of the basics. Then we can get into whether or not you want to consider buying them.
(SET BOLD) What is a bond? (END BOLD)
A bond is like an IOU. You lend a borrower money and, in return, the borrower promises to pay you interest, as well as return your money (principal) at a set date (maturity).
As an example, let's say that you purchase a bond with a face (or par) value of $1,000, interest of 5 percent, and a maturity of 10 years. Because most bonds pay interest on a semiannual basis, you can expect to receive two payments of $25 a year. Then in 10 years, when the bond matures, you will get your $1,000 back, assuming the borrower (bond issuer) can make good on its promise.
There are many different bonds, but in the United States, you can divide them into three primary types. Think of each type of bond as a different type of borrower.
-Corporate bonds are issued by corporations seeking to raise capital.
-Municipal bonds, also called "munis," are issued by state or local governments and government agencies. Oftentimes, the interest is exempt from federal and state taxes.
-U.S. Government bonds are issued by the U.S. Treasury. These are broken down into Treasury bonds (10- to 30-year maturity), Treasury notes (2- to 10-year maturity), and Treasury bills (90-day to 12-month maturity). In addition, TIPS, or Treasury Inflation-Protected Securities, offer a rate of return that is linked to inflation
Although bonds are generally less volatile than stocks, bonds carry their own set of risks. Bonds with longer maturities tend to pay higher rates -- as do bonds that are higher in risk. If you're thinking about buying bonds, two of the most important risks to understand are credit (or default) risk and interest-rate risk.
Credit risk is the likelihood that the borrower will be able to pay you back. It just makes sense that if a borrower is less likely to repay you, you'll require a higher rate of return to compensate.