The market offers an array of investment possibilities, from bank accounts to hedge funds. All of these investments have one thing in common – they aim to deliver a return that is in excess of the rate of inflation, and that covers the tax paid on earnings. Any investment that passes these hurdles delivers future purchasing power, and the ability to secure that power is what savvy investing is all about. Bonds are just one of the options that you can consider.

Think of a bond as a savings account where the issuer of the bond pays you the investor a regular income, this annual income is the coupon or yield. This savings account is basically an IOU from the issuer, whether that is the US government, or a company like Microsoft. Depending on how risky the IOU is, the higher the coupon is likely to be. The big difference between a bond and a savings account is that you can sell the bond at any time, whereas a savings account, and its right to interest payments, cannot be sold.

Looking at historical returns gives an indication of the characteristics of the available universe of investments. The total arithmetic returns in U.S. stocks, bonds, bills and inflation 1926 – 2004 were:

• Stocks -12.39%
• Long Term Government Bonds - 5.82%
• T-Bills - 3.76%
• Inflation - 3.12%

(Source: Source: Stocks, Bonds, Bills and Inflation, 2005 Yearbook, Ibbotson Associates, Chicago.)

So when we look at this why would any one bother with bonds? Stocks have consistently demonstrated that they outperform bonds over time. The reason to consider bonds is that they are a fundamentally different type of investment where the bondholder is a creditor of the company and the bonds are IOUs, whereas a stockholder is a part-owner of the company, and subject to greater risk.

Some of the reasons why investors consider bonds:

• Dividends are not guaranteed with stocks, but they are with bonds. There is something reassuring about the regular income that bonds deliver
• Bonds can provide a tax shield – investing in municipal and government bonds can reduce federal, state and local taxes
• Stocks are far more volatile than bonds, and thus the shorter your investment horizon the riskier they are. A study by Ibbotson Associates showed that stocks were three times more volatile than bonds between 1926 and 1990. The stock market has fallen by more than 40% in a single year, whereas the highest grade of bonds have never fallen by more than 6%
• Of all these factors the most important is that bonds can provide current income with reduced volatility. And remember even with a 10 year investment term you might not come ahead if you have a 100% allocation to stocks.

If you understand these benefits you are already moving beyond bond investing basics.

Bonds are known as fixed-income securities, and they are traded in both the Money Markets and the Capital Markets.

The Money Markets are made up of financial instruments which mature in under a year. In addition to bonds this includes:

• Federal funds
• Bank certificates of deposit
• US Treasury bills
• Call Loans
• Banker’s acceptances
• Commercial paper
• Repurchase agreements
• Municipal notes

The Capital Markets consist of financial instruments with in excess of one year to maturity, and these include:

• Domestic and foreign stocks
• Domestic and foreign corporate bonds
• Domestic and foreign government bonds
• Municipal notes (local and state)
• Municipal bonds (local and state)

In addition to the market in individual bonds there are bond mutual funds which invest in a pool of bonds. Some funds target short term bonds, whilst others go after long term returns. Since buying individual bonds tends to be less simple than investing in stocks, mutual funds are a popular way to access the bond markets.

Finance often seems more complex that it really is because of all the specialized language that it uses. A lot of the time the language is just unnecessary and is there to make the salesmen of Wall Street seem smart. Bonds have their own specialized language too, but it’s not too hard to master it and move beyond bond investing basics.

The par value of a bond is the amount that will be returned to the investor when it matures. This is also sometimes called face value. Most bonds are sold for $1,000 and that is the amount returned to the investor at the end of the term. When we talk about the maturity of a bond we are referring to the amount of time until the par value is returned to the investor. However, when bonds are bought and sold prior to maturity it is usually at a discount to the par value, but they could also trade above $1,000 – a premium to par value. The coupon is the interest rate that is paid annually or semi-annually, it is a percentage of the par value.