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Bonds should be an important part of
any investor's portfolio. Particularly when there is relative volatility and risk in the
stock market, as there is in today's market, you want to protect yourself, at least
somewhat, from that risk. You should hold common stocks, as well as bonds, as a part of
your portfolio. How large that part should be depends on many factors such as your age,
life stage and more. The same is true for bonds. Usually, portfolios are light with regard
to bonds for younger investors as they have the time to take the risks inherent in common
stocks and recover from them. As you age, you should gradually move money from common
stocks into bonds. As you near retirement, bonds should definitely be a larger part of
your portfolio than stocks -- though you can certainly win with equities even into
retirement.
You should only consider an investment in bonds, however, after you establish a liquid
emergency savings account for yourself -- either through a bank or a money market mutual
fund. But, that is a topic for another day and another column!
Bonds are simply debt. Corporations and governments that need to raise money to finance
their operations issue them. Upon issue, bonds are offered for sale to the public. If you
buy a bond, you own part of the debt of the company or governmental agency that issued the
bond. In return for buying the bond, you will receive periodic interest payments and the
return on your principal upon maturity. Since the coupon rate on your bonds does not
change over their life, it is a fixed stream of income that is a valuable addition to any
investor's portfolio.
You have several options regarding the types of bonds in which to invest. First, there are
U.S. Treasury bonds with maturities of 10 - 30 years and may be bought in denominations of
$1000 or more. They have little risk of default as they are backed by the full faith and
credit of the U.S. government. As a result of their low risk, return is also low - but
safe. You pay federal taxes on your bond income but Treasury bonds are exempt from state
and local taxes. Beginning in 1997, the U.S. Treasury has offered 10-year notes called
Treasury Inflation Protection Securities or TIPS. The investor in a TIP still receives the
annual interest paid semiannually - your fixed stream of income. Then, you also receive an
automatic increase in the initial value of the principal to account for inflation. TIPS
are particularly valuable investments in inflation is high but not the preferred
investment for a low inflation environment.
Your next option is corporate bonds, which make up more than half of the bond market. They
are debt obligations of corporations that need to raise money for their operations. They
have a higher return than Treasury securities but also higher risk. Compared with common
stocks, however, corporate bonds are quite safe and their return is considerably lower
than your potential return on common stock. Two ratings services, Moody's and Standard and
Poor's, provide credit ratings for corporate bonds. Investment grade bonds are the safest
but pay the lowest return.
One type of corporate bond that has been popular in the past is the junk bond. A junk bond
is a lower quality bond that is not rated investment grade. Junk bonds are riskier than
investment grade bonds but may have a place in your portfolio as they can give you a
higher yield.
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