SIGMA Σ CAPITAL GROUP
Integrity - Performance - Financial Intelligence
Global Wealth Management & Financial Intelligence Education
>> Home |  Education |  Services |  Schedule |  Learning-101 |  Contact |  Sigma-Group
 
Sigma Capital - Financial Intelligence 101
Bonds Learning 101
 
 

    Bond Introduction
  • What is a Bond
  • Price Down Vs Yiled Up & Price Up Vs Yield Down
  • Risk Vs Reward: How Bonds Behave

    Types of Bonds
  • Types of Bonds 101
  • How U.S. Treasury Bonds Work 101
  • Agency Bonds 101
  • Municipal Bonds 101: A Primer
  • Corporate Bonds 101
  • Keep Pace with Inflation Indexed Funds 101
  • Junk Bonds 101: High Yield, High Risk
  • Going Global: Brady Bonds 101
  • Savings Bonds 101: The Old Reliables

    Bond Investing Strategies
  • Different Bonds Investing to Diversify the Risk
  • Bond Laddering 101
  • Bonds vs. Bond Funds
 
    Bonds Introduction
    What is a Bond ?

    Technically, a bond is a Loan and YOU are the lender. Who's the borrower? Usually, it's either the government, a
    state, a local municipality or a big company like General Electric. All of these entities need money to operate -- to fund
    the federal deficit, for instance, or to build roads and finance factories -- so they borrow capital from the public by
    issuing bonds.

    Practically, When a bond is issued, the price you pay is known as its "face value." Once you buy it, the
    issuer promises to pay you back on a particular day -- the "maturity date" -- at a predetermined rate of interest --
    the "coupon." Say, for instance, you buy a bond with a $1,000 face value, a 5% coupon and a 10-year
    maturity. You would collect interest payments totaling $50 in each of those 10 years. When the decade was up, you'd
    get back your $1,000 in full.

    A key difference between stocks and bonds is that stocks make no promises about dividends or returns.
    General Electric's dividend may be regular, but the company is under no obligation to pay it. And while GE stock
    spends most of its time moving upward, it has been known to spend months -- even years -- going the other way.

    When GE issues a bond, however, the company guarantees to pay back your principal (the face value) plus
    interest. If you buy the bond and hold it to maturity, you know exactly how much you're going to get back (in most
    cases, anyway. We'll discuss some exceptions later). That's why bonds are also known as "fixed-income"
    investments -- they assure you a steady payout or yearly income. And although they can carry plenty of risk
    (we'll discuss why in our How Bonds Behave lecture), this regular income is what makes them inherently less volatile than
    stocks.
 
    Price Down Vs Yield Up & Price Up Vs Yield Down

    Since the first bond hit Wall Street, it's the thing that has most confused beginning investors. You've probably heard the
    mantra at least once before: When yield goes up, price goes down, and vice versa. But if you're like most people, you
    haven't the faintest clue why.

    How they happen

    So far, we've discussed bonds as if investors always buy and hold them until they mature. A lot of people do just that,
    but many others -- including the pros -- buy and sell them on the open market before they reach maturity.
    Consequently, the price of a given bond can fluctuate -- sometimes wildly. That means it's unlikely you'll ever be able to
    sell a bond for "par," or 100% of its face value.

    Now, consider what happens when the price goes up or down. As you already know, a bond's periodic coupon and its
    ultimate payout never change once the bond is issued. Consider a 30-year bond with a face value of $1,000 and a 6%
    ($60) coupon. If the price falls to $800, you'll still get $60 each year in interest and $1,000 when the bond matures. The
    same holds true if the bond's market price jumps to $1,200. Obviously, then, the $800 bond is a much better deal --
    you're getting the same payout for $400 less.

    What Does 'Yield' Mean?

    Yield is a figure that captures this change in value. It's the percentage return your bond investment promises at any
    given price.

    In its most simple incarnation -- known as "current yield" -- it can be expressed with this formula: Yield = Coupon/Price.
    When you buy a bond for face value, the yield is simply the coupon, or interest rate. But when the price fluctuates, the
    yield grows or shrinks to compensate in either direction.

    Let's look at that 6% bond again. If you were to buy it for $1,000, the current yield would simply be 6% ($60/$1,000).
    But if the price drops to $800, the yield rises to 7.5%. Why? Because the guaranteed coupon -- $60 -- is now 7.5% of
    the $800 you paid for the bond ($60/$800). If the price rises to $1,200, the percentage shifts Yield to Maturity

    But, it gets even more complicated. In the real world, when people talk about yield, they're really talking about another
    figure, called "yield to maturity." This represents the total return you can expect if you buy a bond at a given
    price and hold it until it matures.

    Yield to maturity includes the fact that the bond you bought for $800 will pay you $1,000 when it's due. It also assumes
    you reinvest the coupons at the same rate and figures in the compounding effect. If, in the above example, you
    add that $200 difference and the effects of reinvested coupons, the yield to maturity calculates out to 7.73% -- a
    significantly better deal than the original coupon of 6%.

    Once you've grasped the inverse relationship between price and yield, you're ready to take on the bond market's next
    puzzler: If yields and prices move in opposite directions, how come both high yields and high prices are considered good
    things?

    The answer depends on your perspective. If you're a bond buyer, high yields are what you're after, because you want
    to pay $800 for that $1,000 bond. Once you own the bond, however, you're rooting for price. You've already locked in
    your yield, and if the price rises, it can only be a good thing -- especially if you need cash someday and want to sell the
    bond to get at it.

 
    Risk vs. Reward: How Bonds Behave

    Just because Bonds have a reputation as conservative investments doesn't mean they're always safe.
    Any time you lend money, after all, you run the risk it won't be paid back. Companies, cities and counties occasionally In
    fact, economists label the yield of the shortest-term U.S. bonds "the risk-free rate of return." (See Types of Bonds.)

    Paradoxically, another source of risk for certain bonds is that your loan may be paid back early, or "called." This is known
    as prepayment risk. While it's certainly better than not being paid back at all, it forces you to find another, possibly less
    lucrative, place to put your money. When you buy a bond, the prospectus will indicate whether a bond is callable and
    give you a "yield-to-call" figure. If you have a choice, buy a bond without the call option.

    Inflation

    By far, the greatest danger for a buy-and-hold bond investor is a rising inflation rate. Nothing spooks bond traders more
    than cheerful headlines about full employment or strong economic growth. When the economic news is good, the bond
    markets often take it as a bad sign -- a harbinger of an impending period of slowly rising consumer prices. The hotter the
    economy, the worse the threat. And the more downward pressure on bond prices.

    Why is inflation such a problem for bondholders? Think about it this way: Rising prices make today's dollars worth less in
    the future than they're worth today. Since a bond can lock up your money for as long as 30 years, a rising rate of
    inflation can have a particularly corrosive effect.

    All this explains why bond traders live in a hall of mirrors. What you or I might consider good news, they often consider
    bad. The bond market itself is a minute-by-minute referendum on the threat of inflation. If the threat is high, prices fall
    and yields -- or interest rates -- rise. This is often an excellent time to buy bonds. But if you own them already, you're
    stuck.

    Yield vs. Risk

    Inflation risk, credit risk and prepayment risk are all figured into the pricing of bonds. The more risk, the higher the yield.
    It's also true that investors demand higher yields for longer maturities. The reason for that is obvious -- given enough
    time, a once-healthy corporation can go bankrupt and suddenly lose the ability to pay its obligations. Inflation could run
    rampant, seriously eroding the purchasing power of that $1,000 you're supposed to get back in 30 years. These things
    are unlikely or you'd never invest in the first place. But the longer you tie your money up in a bond, the more at-risk it is
    statistically.

    The credit quality of companies and governments is closely monitored by the two major debt-rating agencies; Standard &
    Poor's and Moody's. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those
    ratings -- expressed as letters (Aaa, Aa, A, etc.) -- help determine the interest rate that a company or government has
    to pay when it issues bonds. The market determines the price -- and thus the yield -- after that.
 
    Bonds Types
    Types of Bonds 101

    Most bonds have been issued by one of three groups: the government (U.S. government), state and local governments
    or corporations. But to confuse things, these entities issue many different types of bonds that run the gamut in terms of
    risk and reward. Here's a quick introduction to the ones you'll encounter most often.

    U.S. Government Bonds (Government)

    The bonds issued by United States are called Treasurys. They're grouped in three categories.

  • U.S. Treasury bills - maturities from 90 days to one year
  • U.S. Treasury notes - maturities from two to 10 years
  • U.S. Treasury bonds - maturities from 10 to 30 years

    Treasurys are widely regarded as the safest bond investments, because they are backed by "the full faith
    and credit" of the U.S. government. In other words, unless something apocalyptic occurs, you'll most certainly get paid
    back. Since bonds of longer maturity tend to have higher interest rates (coupons) because you're assuming more risk, a
    30-year Treasury has more upside than a 90-day T-bill or a five-year note. But it also carries the potential for
    considerably more downside in terms of inflation and credit risk (see previous writing).

    Compared to other types of bonds, however, even that 30-year Treasury is considered safe. And there's another
    benefit to Treasurys: The income you earn is exempt from state and local taxes.

    Municipal Bonds

    Municipal bonds are a step up on the risk scale from Treasurys, but they make up for it in tax trickery. Thanks to
    the U.S. Constitution, the federal government can't tax interest on state or local bonds (and vice versa).
    Better yet, a local government will often exempt its own citizens from taxes on its bonds, so that many munis are safe
    from city, state and federal taxes. (This happy state of affairs is known as being triple tax-free.)

    These breaks, of course, come at a cost: Because tax-free income is so enticing to high-income investors, triple tax-free
    munis generally offer a lower coupon rate than equivalent taxable bonds. But depending on your tax rate, your net
    return may be higher than it would be on a regular bond.

    Corporate Bonds

    Corporate bonds are generally the riskiest fixed-income securities of all because companies -- even large,
    stable ones -- are much more susceptible than governments to economic problems, mismanagement and competition.
    Cities do go bankrupt, but it's infrequent. Not so rare is the once-proud company brought low by foreign rivals or
    management missteps. Lehman Brothers, General Motors, LTV Steel and the Chrysler bankruptcies come to mind.

    That said, corporate bonds can also be the most lucrative fixed-income investment, since you are generally rewarded for
    the extra risk you're taking. The lower the company's credit quality, the higher the interest you're paid. Corporates come
    in several maturities:

  • Short term: one to five years
  • Intermediate term: five to 15 years
  • Long term: longer than 15 years

    The credit quality of companies and governments is closely monitored by two major debt-rating agencies: Standard
    & Poor's and Moody's. They assign credit ratings based on the entity's perceived ability to pay its debts over time.
    Those ratings -- expressed as letters (Aaa, Aa, A, etc.) -- help determine the interest rate that company or government
    has to pay.

    Corporations, of course, do everything they can to keep their credit ratings high -- the difference between an A rating
    and a Baa rating can mean millions of dollars in extra interest paid. But even companies with less-than-investment-grade
    (Ba and below) ratings issue bonds. These securities, known as high-yield, or "junk," bonds, are generally too
    speculative for the average investor, but they can provide spectacular returns.

    Zero-Coupon Bonds

    Zero-coupon bonds are fixed-income securities that don't make interest payments each year like regular bonds. Instead,
    the bond is sold at a deep discount to its face value and at maturity, the bondholder collects all of the compounded
    interest, plus the principal.

    Why would you want to do that? Zeros are usually priced aggressively and are useful for investors who are looking for a
    set payout on a given date, instead of a stream of payments that they have to figure out where to invest elsewhere.
    People saving for college tuition and retirement are the prime targets. College portfolios make use of zero-coupon
    Treasurys -- known as Treasury strips -- for two reasons. First, you can buy them in a maturity that matches the date
    your child will enter college. And, they generally have a slightly higher yield than a regular bond.

    Zeros do have a tax drawback, however, unless you hold them in a tax-deferred retirement account or an education
    IRA. Since interest is technically earned and compounded semiannually, holders of zeros are obliged to pay taxes each
    year on the interest as it accrues. That means you have to pay the tax before you get the money, which might be a
    struggle for some investors.
 
    How U.S. Treasury Bonds Work 101

    For the ultimate safety with your bond investments, you can turn to the U.S. government, the most reliable borrower in
    the world. The U.S. government has never defaulted on a loan, and it would take a mighty big catastrophe before the U.
    S. Treasury could collapse. To put it simply, you'll never have to worry about the U.S. not paying you back if you buy
    some of its bonds.

    Since U.S. government bonds are among the safest in world, they almost always have lower yields than other bonds of
    the same maturity. That is the price you pay for quality. And they do have some risks. For instance, you can not predict
    what price you will be able to get for your bonds if you need to sell at some point before maturity.

    Another advantage of Treasuries is that interest payments are exempt from local and state taxes (however, not from
    Federal income taxes).

    Treasury securities cannot be redeemed before maturity and do not have call provisions. Some Treasury bonds issued
    before 1985 did have call provisions, however, so you need to watch out if you buy these bonds in the secondary
    market. As soon as the bonds are called, interest payments cease.

    You can buy Treasuries through a broker, or you can buy them directly from the federal government, which holds regular
    auctions that individual investors can participate in. However, if you buy directly from the government, you can't redeem
    the security prior to maturity. You'd have to use the services of a broker to sell your bond in the secondary markets.

    Treasury Bonds, Bills and Notes

    The United States government issues several different kinds of bonds through the Bureau of the Public Debt, an agency
    U.S. Department of the Treasury. Treasury debt securities are classified according to their maturities:

  • Treasury Bills have maturities of one year or less.
  • Treasury Notes have maturities of two to ten years.
  • Treasury Bonds have maturities greater than ten years.

    Treasury Bonds, Bills, and Notes are all issued in face values of $1,000, though there are different purchase minimums
    for each type of security.

    Investors often shorten the word Treasury to just the letter "T" when referring to these bonds. Thus, Treasury Bonds
    are known as T-Bonds, Treasury Notes are called T-Notes, and Treasury Bills are T-Bills.

    Treasury Bills are issued in three maturities. Bills with 91-day and 182-day maturities are auctioned by the Treasury
    each Monday. 364-day Bills are auctioned every four weeks on Thursday, 13 times a year. The interest rate of
    T-Bills is determined at each auction, depending on what bidders are willing to pay. T-Bills do not make interest
    payments, however. Instead, they are purchased at a discount to face value. They are the only Treasury securities that
    sell at a discount.

    U.S. Treasury Notes are issued in two-, three-, five-, and ten-year maturities. The two year and five year Notes are
    auctioned each month, while the three year Notes are issued quarterly, and ten year Notes are auctioned six times a
    year. All Notes pay interest twice a year, and expire at par value.

    Treasury Bonds are usually issued in thirty-year maturities, and pay interest twice a year.

    No matter what you're buying, you can often get a better deal when you buy direct. And the U.S. Treasury has a special
    program for individual investors to help cut out the middleman (in this case, your broker) and help you to
    purchase T-Bonds, Bills, and Notes.

    The program is called Treasury Direct, and it allows you to set up an account to make purchases of Treasury securities
    at auction, along with all the big guns. The main attraction of Treasury Direct is that there are no brokerage fees or
    other transaction charges when you buy through the program. (There is a $25 per account annual maintenance fee, but
    only if your account is greater than $100,000.)

    To set up a Treasury Direct account, you'll need to fill out an application form that you can download from the program's
    web site. The minimum investments in Treasury Direct are $10,000 for bills; $5,000 for notes maturing in less than five
    years; and $1,000 for securities that mature in five or more years. Interest is then paid into your Treasury Direct
    account, as is a security's par value when it matures.

    Another advantage of Treasury Direct is that you can access your account on the Web to check account balances or
    reinvest a security when it matures.
 
    Agency Bonds 101


    In addition to the U.S. Treasury and local municipalities, other government agencies (usually at the federal level) issue
    bonds to finance their activities. These agency bonds help support projects relevant to public policy, such as farming,
    small business, or loans to first-time home buyers. Agency bonds are no small matter, however -- according to the Bond
    Market Association, agency bonds worth $845 billion are now outstanding in the market. These bonds do not carry the
    full-faith-and-credit guarantee of government-issued bonds (for example U.S. Treasuries), but investors are likely to
    hold them in high regard because they have been issued by a government agency. That translates into more favorable
    interest rates for the agency, and the opportunity to support sectors of the economy that might not otherwise be able
    to find affordable sources of funding.

    Among the federal agencies that issue bonds are:

  • Federal National Mortgage Association (Fannie Mae)
  • Federal Home Loan Mortgage Corporation (Freddie Mac)
  • Farm Credit System Financial Assistance Corporation
  • Federal Agricultural Mortgage Corporation (Farmer Mac)
  • Federal Home Loan Banks
  • Student Loan Marketing Association (Sallie Mae)
  • College Construction Loan Insurance Association (Connie Lee)
  • Small Business Administration (SBA)
  • Tennessee Valley Authority (TVA)

    While most investors in federal agency securities are institutional, individuals can also invest in this segment of the debt
    securities market.
 
    Municipal Bonds 101 : A Primer

    Municipal bonds ("munis") are what help local or state governments to pay for public projects, such as the
    construction or improvement of schools, schools, streets, highways, hospitals, bridges, low-income
    housing, water and sewer systems, ports, airports and other public works.

    There are many different types of municipal bonds, including general obligation bonds, limited and special tax
    bonds, industrial revenue bonds, revenue bonds, housing bonds, moral obligation bonds, double
    barreled bonds, tax anticipation notes, bond anticipation notes, and revenue anticipation notes.

    The differences between all these kinds of munis comes down to how the issuer expects to eventually repay the bonds
    and make the interest payments. For instance, in the case of general obligation notes, the bond is simply backed by the
    "the full faith and credit" of the issuer. That means the local or state government that has issued the bond can use just
    about any means available to guarantee payments, including raising taxes.

    Other bonds are issued with specific provisions to raise taxes or create a new tax. These are known as limited or special
    tax bonds. Will the project being undertaken generate revenue from tolls, sewage fees, water bills, or other services?
    These are revenue or industrial revenue bonds.

    The key point is how the issuer of a municipal bond expects to be able to repay the bond.

    Municipal bonds are usually high quality issues, since the governments that stand behind the bonds are generally not in
    danger of going bankrupt. At least, that's the conventional wisdom -- but there are plenty of examples that show
    otherwise. Just look at New York City's fiscal problems of the 1970s or, more recently, Orange County,
    California's brush with bankruptcy.

    Some municipal bond issuers purchase insurance to guarantee that their bonds will be repaid. But who do you think
    actually pays for that insurance? The bondholders, in the form of a lower return. Better stick with highly-rated bonds if
    you're looking for protection, rather than this type of insurance.

    In order to encourage taxpayers to invest in these bonds, thereby allowing cities and states to make necessary
    improvements, the federal government has made interest payments from muni bonds exempt from federal income taxes.
    Muni bonds are known as tax-free for this reason.

    If reducing taxes is your goal, it gets even better. If you buy a municipal bond issued in your state, then you don't have
    to pay state income taxes on the interest you are paid on the bond. These bonds are double tax-free munis.

    And if you buy a muni issued by the city or locality where you live, you won't have to pay local income taxes. The term to
    describe these is -- you guessed it -- triple tax-free. If you live someplace where the local taxes are high, like New York
    City, these bonds can be attractive.

    The trade-off you make when you buy a municipal bond is that you receive a lower coupon rate or current yield than
    you'd get with a comparably-rated, similar maturity corporate bond. The tax savings are supposed to make up the
    difference so that in the end you could come out ahead by buying the bond with the lower yield.

    Generally, muni bonds make more sense for investors in high tax brackets. Remember, however, that the
    payoff of saving on your tax bill might not be worth giving up the additional returns you might be able to receive from
    another asset class or type of bond.
 
    Corporate Bonds 101 Explained

    It is a fact of operating a business, you often need money in order to grow your business, expand to new locations,
    upgrade equipment, or any of a thousands other uses of capital. Generally speaking, companies have three choices
    when they want to raise cash. They can issue shares of stock, they can borrow from the bank, or they can borrow from
    investors by issuing bonds.

    Corporate bonds come in dozens of varieties. Many corporate bonds feature a call provision that allows the issuing
    company to pay back the principal to bond holders before maturity.

    Other corporate bonds are known as convertibles because they carry a provision that the bond can be converted into
    shares of common stock under certain circumstances. Convertible bonds can be more attractive that bonds with no
    conversion provision, depending on the price of the underlying stock.

    Most corporate bonds are fixed-rate bonds. The interest rate the corporation pays is fixed until maturity and will
    never change.

    Some corporate bonds use floating rates to determine the exact interest rate paid to bond holders. The interest rate
    paid on these bonds actually changes, depending on some index, such as short-term Treasury bills or money markets.
    These bonds do offer protection against increases in interest rates, but the trade-off is that their yields are typically
    lower than those of fixed-rate securities with the same maturity.

    Other corporate bonds, called zero-coupons, make no regular interest payments at all. No payments at all? Yes, but it's
    not a trick. These bonds sell at a deep discount to face value, and then are redeemed at the full face value at maturity.
    The bond holder earns interest on these bonds along the way -- it's just that it's all paid back with the principal when the
    bond ends.

    No matter how interest payments are structured, the interest that the company will pay comes down to one factor: at
    what rate will investors believe the bonds are a good investment. When you buy a corporate bond, you must have faith
    that the company will eventually repay you, as well as make regular interest payments to you.

    Rather than take the company's word for it, there are companies that specialize in evaluating corporations and other
    bond issuers to determine their fiscal strength. Moody's Investors Services, Fitch IBCA, and Standard & Poor's Rating
    Services all specialize in assigning ratings to bonds that determine the ability of their issuers to repay those bonds.

    While all three of these services are available mainly to subscribers, their Web sites can help you to understand how
    their ratings work, and provide industry analyses and other reports.

    The following are summaries of the definitions of Moody's ratings for long-term bonds.

  • Aaa - Best quality, with smallest degree of investment risk.
  • Aa - High quality by all standards; together with the Aaa group they comprise what are generally known as high-
    grade bonds.
  • A - Possess many favorable investment attributes. Considered as upper-medium-grade obligations.
  • Baa - Medium-grade obligations (neither highly protected nor poorly secured). Bonds rated Baa and above are
    considered investment grade.
  • Ba - Have speculative elements; futures are not as well-assured. Bonds rated Ba and below are generally
    considered speculative.
  • B - Generally lack characteristics of a desirable investment.
  • Caa - Bonds of poor standing.
  • C - Lowest rated class of bonds, with extremely poor prospects of ever attaining any real investment standing.

    Corporate bonds usually offer higher yields than munis for two reasons. First, there is generally more risk involved
    with corporate bonds since companies are more likely to run into financial problems than local governments. Second,
    your earnings from a corporate bond are taxable (compared to the tax-free status of muni bonds).
 
    Keep Pace with Inflation-Indexed Bonds 101

    Inflation-indexed bonds give both individual and institutional investors a chance to buy a security that keeps pace
    with inflation.

    When you buy Inflation-Indexed securities, the U.S. Treasury pays you interest on the inflation-adjusted principal
    amount. Competitive bidding before the security's issue determines the fixed interest or coupon rate. At maturity, the
    Treasury redeems your securities at their inflation-adjusted principal or par amount, whichever is greater. It issues
    Inflation-Indexed securities through Public Debt's TreasuryDirect system and through TRADES -- the commercial book-
    entry system where financial institutions or government securities brokers/dealers hold the securities on your behalf.

    The securities values are periodically adjusted for inflation, and the principal you receive when they mature won't drop
    below the par amount at which they were originally issued. Like other Treasury securities, they're safe -- backed by the
    full faith and credit of the U.S. government. And, you get a tax break. Inflation-Indexed securities are exempt from
    state and local taxes, although federal income taxes apply.
 
    Junk Bonds 101 : High Yields, High Risk

    Mention junk bonds to many investors and they will flinch at the thought of high-flying financiers of the 1980s such as
    Ivan Boesky and Michael Milken. There is a reason that junk bonds are so named, of course. These are the bonds that
    pay high yields to bondholders because they do not have any choice -- their credit ratings are less than pristine, making
    it difficult for them to acquire capital at an inexpensive cost. The end result for investors is that junk bonds pay high
    yields, but they also carry higher than average risks that the company might default on the bond.
 
    Going Global: Brady Bonds 101

    In the 1970s, in the peak of that decade's oil rush, many of the world's commercial banks were flush with deposits from
    newly-wealthy petroleum magnates. With cash to spare, banks indulged in heavy lending to the governments of many of
    the world's less-developed countries (LDCs).

    However, prices of oil and other commodities plunged in the early 1980s, and the LDCs found themselves strapped for
    cash and began to borrow even more. As the spiral continued, many countries found it difficult or impossible to service
    their debts, and the banks refused to make additional loans. In desperation, Mexico and other countries soon declared
    that they would no longer make any interest payments to the banks. A full-blown international debt crisis erupted.

    With so many banks left holding a portfolio of defaulted loans, institutions created several ingenious ways of making the
    most of a bad situation. These included implementing such strategies as debt buybacks, swapping loans into "exit
    bonds," converting loans into local currency for investments in local businesses, and exchanging the defaulted
    commercial bank loans for a new type of bond known as Brady Bonds.

    Brady Bonds are named after former U.S. Treasury Secretary Nicholas Brady, who, along with the International
    Monetary Fund and the World Bank, led the debt-reduction plan for LDCs. Their idea was to restructure the debts of an
    LDC, allowing that country to achieve economic growth and make interest payments, by converting the defaulted loans
    into a bond collateralized by U.S. zero coupon bonds to ensure payment of the principal.

    Most Brady Bonds are denominated in US dollars, but there are also bonds denominated in the currencies of several
    other countries. They are coupon-bearing bonds with fixed, step or floating rate (or some combination of each), having
    maturities of 10 to 30 years. Brady Bonds are issued as either par or discount bonds, and have a multitude of other
    options attached (such as warrants connected to raw products in the native country).
 
    Savings Bonds 101: The Old Reliables

    For millions of Americans, U.S. Savings Bonds have been the vehicle of choice to reach their savings goals.
    They have lots of advantages that have helped to make them so popular.

    U.S. Savings Bonds are managed by the Bureau of the Public Debt, just like other Treasury securities. Savings bonds are
    known by their Series name. Currently, Series EE and Series HH bonds are available to the public.

    You can buy a savings bond at just about any bank, with as little as $25. Fill out the application, make your payment,
    and your bonds will be delivered to you by mail within 15 business days. Many companies offer a payroll savings plan to
    allow their employees to automatically withhold money from each paycheck that goes to purchase savings bonds. The
    purchase price is always half of the face value. That means that a $50 bond costs $25; a $10,000 bond costs $5,000.
    Besides $50 and $10,000, there are six other denominations of bonds available: $75, $100, $200, $500, $1,000, and
    $5,000.

    They are liquid investments, which means it is easy to cash in your savings bonds if you need the money. There is no
    penalty if you cash in your savings bonds anytime after the first six months that you have owned them, and you can
    cash them in at any bank.

    The principal and interest of savings bonds are guaranteed by the full faith and credit of the United States. If you ever
    lose a savings bond, it can be replaced. Interest on savings bonds is exempt from state and local income taxes. Federal
    income taxes are postponed until you cash your bond, or until it stops earning interest (30 years down the road).

    When a savings bond reaches maturity, it does not stop accumulating interest like most other bonds. It is automatically
    extended for ten years, and can be extended for additional periods following that. Interest continues to accrue on the
    bonds during these extensions.

    Another benefit of U.S. Savings Bonds is that the interest can be exempt from taxes if the bonds are used for college
    expenses for the bond owner, the owner's spouse, or a dependent. The bonds have to be purchased after December
    31, 1989 in order to qualify, and registered in the name of a person who is 24 years of age or older on the first day of
    the month in which the bonds are issued, not -- and this is very important -- in the name of the future student.
 
    Bond Strategies
    Different Bonds Investing to Diversify the Risk

    Whether you as an investor are just starting your investing career or have already amassed a tidy nest egg, your
    portfolio needs some steady and reliable income. For younger people, that income will balance out the periodic dips in a
    stock-dominated asset mix; for those in retirement, it will provide money to live on.

    We are discussing here about a long-term investment -- a core commitment to the fixed-income arena that is unaffected
    by your view of the current state of the bond market or inflation. The strategy is to buy and hold your bonds until
    maturity, so the foundation should be safe, liquid government bonds -- in particular, intermediate-term Treasurys (those
    that mature in two to 10 years).

    Why not long-term bonds? Because as it turns out, long bonds actually underperform intermediates on a buy-and-
    hold basis. Using data spanning the past 30 years from investment-research firm Ibbotson Associates, SmartMoney
    calculated that over a 10-year holding period, a portfolio of Treasury notes with a constant average maturity of five
    years outperformed a portfolio of 20-year bonds (the standard benchmark back in the 1960s). The five-year notes
    returned 8.5% averaged annually, while the 20-year bonds returned 8%. In addition, intermediate notes are roughly
    half as volatile as long bonds. And in terms of balancing your overall portfolio, intermediates are less closely correlated to
    the ups and downs of the stock market.

    Treasury Direct

    If you are just starting out, you can simply buy five-year Treasurys, or - if you have a lot of assets allocated for bonds
    -- you can put together a so-called ladder of Treasurys. Either way, your best bet for buying bonds is the
    government's commission-free Treasury Direct program, which allows you to bypass brokers and their fees. An
    application to open an account may be obtained online by linking to the New York Federal Reserve's Web site or by
    contacting your nearest Federal Reserve Bank. You can also call the U.S. Bureau of Public Debt at 202-874-4000.

    Two- and three-year notes are available for a $5,000 minimum investment, while five- and 10-year notes have $1,000
    minimums. You can set up an account online. If for some reason you need to sell the Treasurys in this account before
    they mature, you will have to have them transferred to a broker, who will charge at least $50 per transaction. In
    addition, Treasury Direct accounts of $100,000 or more face an annual $25 maintenance fee.

    Agency Bonds

    Also extremely safe and liquid, but offering a slightly higher yield, are government-agency bonds issued by the likes of
    the Tennessee Valley Authority, Farm Credit Financial Assistance Corp., the Federal National Mortgage Association and
    the Government National Mortgage Association. (These debentures should not be confused with the mortgage-backed
    bonds that are also issued by FNMA and GNMA; mortgage-backed securities are extremely sensitive to fluctuations in
    interest rates and should be avoided.)

    It's hard, however, to gain any edge with these bonds over Treasurys. That's because they're generally available only
    through brokers and thus incur commission costs that cut into their yield. How much? The standard retail brokerage fee
    comes out to 0.5%, or, in the lingo of the bond world, 50 basis points. Even if you have $100,000 to invest and
    negotiate a lower commission, perhaps 20 basis points, the advantage over Treasurys will probably come to only around
    $50 a year.

    The exception is if you have a very large portfolio and can sink perhaps $1 million into agency bonds; you might then be
    able to get the institutional-commission rate of just 10 basis points. Or, at a more modest level, you might be able to
    hook up with a financial adviser who specializes in making bulk government-agency-bond purchases directly from banks,
    lumping clients' investments together in order to build million-dollar packages of agency debentures.

    Muni Bonds

    Investors with substantial income should also consider combining tax-free municipal bonds with their Treasurys. While the
    stated yields of munis are lower than those of Treasurys, the effective return for investors in high tax brackets is almost
    always better. As with treasurys, individual muni bonds can also be laddered to limit your interest-rate exposure. But
    because they tend to trade in fairly large lots (usually $25,000) and because, as a precaution against default risk,
    investors should spread their money among a variety of different locales, building a muni portfolio requires a commitment
    of $100,000 at a bare minimum.

    If you do not have enough now to build a muni ladder, the next best option is to look to a series of municipal-
    bond mutual funds. The best are Vanguard's Municipal Limited-Term and Intermediate-Term funds (which both have a
    minimum initial investment of $3,000). They maintain a low 0.22% expense ratio and are run with minimal maturity
    fluctuation and risk-taking.

    What About Corporates?

    While investors have traditionally been steered to these vehicles because they offer higher interest income than
    government bonds, we are dubious about endorsing them. In part, it is a question of costs eating into those higher
    yields. First there are the taxes: Income from corporates is fully taxed at all levels. If your state and local rates (which
    are not applicable to government bonds) are a mere 6%, that would cut the effective return of an 8% yield to 7.5%.
    Next come the transaction costs: both brokerage commissions and the cut taken by the bond dealers (known as the
    spread). All told, they can easily eat up 1% or more of your investment.

    Perhaps most important, though, is that the best bonds are usually callable by the issuer, meaning the corporation can,
    at its discretion, pay off its obligation at a stated price and stop paying interest. That becomes a heads-you-win, tails-I-
    lose proposition for investors. If interest rates decline and the value of the bonds goes up, the corporation may call
    them, disrupting your expected income stream and cutting off a potential capital gain. Meanwhile, if interest rates rise,
    you are stuck holding a less valuable security that is yielding below-market rates.
 
    Bond Laddering 101

    One popular way that investors can help to balance risk and return in a bond portfolio is to use a technique called
    laddering.

    Building a laddered portfolio means that you buy a collection of bonds with different maturities spread out over your
    investment time frame. For instance, in a ten-year laddered portfolio, you might purchase bonds that mature in 1, 2, 3,
    4, 5, 6, 7, 8, 9, and 10 years. When the first bond matures in a year, you'd reinvest in a bond that matures in ten
    years, thereby preserving the ladder (and so on for each year).

    The rationale behind laddering is not complicated. When you buy bonds with short-term maturities, you have a high
    degree of stability -- but because these bonds are not very sensitive to changing interest rates, you have to accept a
    lower yield.

    When you buy bonds with long-term maturities, you can receive a higher yield, but you must also accept the risk that the
    prices of the bonds might change. With a laddered portfolio, you would realize greater returns than from holding only
    short-term bonds, but with lower risk than holding only long-term bonds. By spreading out the maturities of your
    portfolio, you get protection from interest rate changes. If rates fell by the time you need to reinvest, you would have
    to buy a bond with a lower return, but the rest of your portfolio would be generating above-market returns. If rates
    increased, you might receive a below-market return on your portfolio, but you could start to take care of that the next
    time one of your laddered bonds matures.
 
    Bonds vs. Bond Funds

    Bonds are Complex financial instruments - especially if you are a novice investor with little experience in the markets.
    That is why a lot of people choose bond funds when they seek to diversify their investments with some
    fixed-income exposure. Our view is that if you are willing to put in the effort, you are better off buying individual
    bonds instead of bond funds. But in the real world, a fund is sometimes worth the convenience.

    Points to consider

    Like an equity mutual fund, a bond fund is managed by a professional investor who buys a portfolio of securities and
    makes all the decisions. Most funds buy bonds of a specific type, maturity and risk profile -- 15 year corporates, for
    instance, or tax-free municipals -- and pay out a coupon to investors -- often monthly, rather than annually or
    semiannually like a regular bond.

    The chief advantage of a bond fund is that it is convenient. It is also true that when it comes to buying
    corporate and municipal bonds, a professional manager backed by a strong research organization can make better
    decisions than the average individual investor. Consequently, if you want to dabble in junk bonds or shelter your income
    with triple-tax-free New York City 30-year bonds, you may be better off going the easy route and picking a good fund.

    The disadvantage of a bond fund is that it is not a bond. It has neither a fixed yield nor a contractual obligation
    to give investors back their principal at some later maturity date -- the two key characteristics of individual bonds. Then
    there are the fees and expenses that can cut into returns. Finally, because fund managers constantly trade
    their positions, the risk-return profile of a bond-fund investment is continually changing: Unlike an actual
    bond, whose risk level declines the longer it is held by an investor, a fund can increase or decrease its risk exposure at
    the whim of the manager.

    The other thing about building your own portfolio of bonds is that you can tailor it to meet your circumstances, meaning
    the bonds will mature precisely when you need them. A bond fund cannot deliver that sort of precision.

    The advice is this: If you lack the time or interest to manage a bond portfolio on your own -- or if you want a mixed
    portfolio of corporates or municipals -- buy a bond fund. But if you want a tailored portfolio of Treasurys
    to mature when your kid goes to college -- and you want to avoid the fees and added risk associated
    with bond funds -- buy ordinary Bonds.