Bonds are great option over stocks during economic slowdowns

By Chris Goodmacher
Daily Bruin Contributor With the current economic downturn, "money
is fleeing stocks and going toward stable, fixed-income
investments," according to Frank Foellmer, director of research for
Quincy Cass Associates, a consulting firm. Fixed-income investments
are those that provide a set, consistent payout, such as bonds.
It1s often the case that when stocks go down, bonds go up, making
them a tool for diversifying your portfolio. In the third quarter
of 1998, the Standard & Poor’s 500 index dropped by 11 percent
due to fear of a global economic slowdown. But faced with the same
news, the bond market produced a 6 percent gain, according to
finance.yahoo.com. Investors will often turn to bonds during
unstable times for their added stability. "They’re a conservative
long-term vehicle," said Henry Chang, internal vice president of
the Undergraduate Investment Society. "They1re consistent. You know
when it comes, how much it’s going to pay," he continued.

How bonds work Bonds are loans given to the federal or state
government, a municipality or a corporation that are paid back with
interest. All of these entities need money to operate so they
borrow capital from the public by issuing bonds, according to
finance.yahoo.com. A key difference between stocks and bonds is
that with bonds the principal and the interest are guaranteed by
the issuer. When you buy a bond, you pay 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," according to SmartMoney.com, an online magazine run by
The Wall Street Journal. For example, if you buy a bond with a
$1,000 face value, a 5 percent coupon and a 15-year maturity, you
would collect interest payments totaling $50 in each of those 15
years. When the 15 years were up, you would get your $1,000 back.
With zero-coupon bonds, however, interest is not received
periodically, but both the interest and the principal are paid
together at maturity, according to Eric Sussman, professor at the
Anderson School at UCLA. Zero-coupon bonds can be found in most of
the major bond categories, according to Sussman. Well known
examples of these are U.S. Savings Bonds "You walk into a bank and
pay $50 for a $100 bond due in 10 years," Sussman said. "No
(interest) payments until the 10 years are up, and you get $100 at
the end."

Bond ratings and types Bonds are not without risk and are, in
fact, categorized along a spectrum of risk, according to Sussman.
Agencies such as S&P’s and Moody’s grade bonds from Aaa down to
Ddd, which would indicate bankruptcy. Ccc ratings usually indicate
junk bonds. These agencies rate bonds based on their ability to pay
back the principal and the interest, according to Foellmer. "Junk
bonds doesn’t mean they’re junk, they’re just a lot higher risk,"
Sussman said. Certain types of bonds usually have general risk
levels associated with them. Government bonds include U.S. Treasury
bonds and bonds issued by the federal government, according to
Foellmer. "The least risky are the U.S. Treasury bonds,"Sussman
said. There are three different types of bonds issued by the U.S.
Treasury: bills, notes and bonds. Treasury bills, also known as
T-Bills, have maturities of one year or less. Treasury notes have
maturities of two to 10 years. Treasury bonds have maturities
greater than 10 years, according to finance.yahoo.com. Agency bonds
also fall under the general category of government bonds and are
usually issued at the federal level. These are bonds issued by
government agencies, such as the Federal National Mortgage
Association (Fannie Mae) and the Student Loan Marketing Association
(Sallie Mae). They generally have "a higher risk than government
bonds," Sussman said. State and local governments usually issue
municipal bonds or "munis." Private munis also exist, such as those
issued by private hospitals, according to Sussman. A feature of
municipal bonds is that they are "income tax free, generally,"
Sussman said. Municipal bonds are usually high quality issues,
since the governments that stand behind the bonds are generally not
in danger of going bankrupt, according to finance.yahoo.com.
Corporate bonds are those issued by major corporations. "(Corporate
bonds) usually mature in an average of 10 years," Sussman said. The
risk level of corporate bonds varies in according to the stability
of the company issuing the bond.

Caveats According to Sussman, bonds with long-term maturities
are generally regarded as riskier. "It’s one thing to say lend me
some money and I’ll pay you back tomorrow versus lend me some money
and I’ll pay you back in 30 years," Sussman said. To compensate for
this, most long-term maturity bonds offer competitive interest
rates. Also, "bonds don’t lend themselves well to small
investments," Foellmer said. They usually involve a $1,000 minimum
bond purchase, according to Sussman. Many government and corporate
bonds deal in amounts from $10,000-$25,000, according to Foellmer.
By far, the greatest danger for a buy-and-hold bond investor is a
rising inflation rate, according to finance.yahoo.com. Inflation
makes today’s dollars worth less in the future than they’re worth
today, and thus even though the dollar amount may be higher when a
bond matures, less can be bought with the money. "The interest rate
is fixed on the bond. If the interest rates change, the bond
changes in value," Foellmer said. When you’re money is tied up in a
30 year bond with 7 percent interest, and interest rates rise to 8
percent, you would be stuck getting a lot less money than the next
guy with a bond of the same maturity and higher interest rate.

Strategies A way out of such a problem would be to sell the bond
before maturity. There are two markets when it comes to bonds, the
primary and the secondary market, according to Chang. "Buying from
the primary market means buying directly from the source, the
government or a corporation," Chang said. "The secondary market is
where you get rid of bonds before maturity," he continued. What you
receive for your bond depends on the interest rate and maturity of
the bond, in relation to the market. For example, if you want to
sell a 10-year bond with an interest rate of 7 percent, and the
bond market is full of 10-year bonds with interest rates at 8
percent, it’s not likely you will get a buyer. Another strategy
used in bond investing is called laddering which involves buying a
collection of bonds with different maturities spread out over your
investment time frame, according to finance.yahoo.com. For example,
a 10-year laddered portfolio might include bonds that mature in 2,
4, 6, 8 and 10 years. 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, according to
finance.yahoo.com.

Invest wisely Inside the category of bonds are highly
specialized areas to suit the needs of specific investors. Becoming
a successful investor involves knowing the playing field and
finding your niche. This complexity applies to the vast majority of
investment tools, all of which have complex ups and downs. Because
the field of investing is so diverse and complex, experts say one
of the best things to do is to be informed. Resources to look into
include books, reputable Web sites, investment clubs, classes and
college seminars. Due to this complexity, any advice you get from
investors is usually hedged by the disclaimer: do your own
research.