As for his investment philosophy, he pushes the envelope every week -- every day, in fact. He made a lot of money day-trading in last year's Nasdaq comet, only to ride it back to Earth this year.
When I mention the idea of bonds, his eyes glaze over. Back in his youthfully raucous days, that term raised goose bumps: His conception of bonds being related to incarceration -- as in bail bonds to get the heck out of jail.
But, do as I suggest and not as my friend does: Bonds may or may not be right for you now, but someday they may help round out your portfolio.
Unlike stocks, which actually convey to you a percentage of ownership in a company, bonds can best be understood as loans -- an IOU, as it were. A company or government entity needs money for a particular purpose; they issue bonds to raise that money -- promising in return to pay back your initial investment plus an ongoing premium. You're familiar with certificates of deposit (CD's) that can be bought at any bank. Like CD's, bonds promise to pay you an amount based a fixed interest rate over the life of the notes. At the end of the term, the bonds "mature," and your initial investment is returned to you.
Bonds can be classified based on the time they mature. Generally speaking, "short-term bonds" mature within a few years; "intermediate-term bonds" mature within three to 10 years; and "long-term bonds" mature in more than 10 years. The longer the maturity of the bonds, the higher the interest rate that's paid. For example, a 2-year bond may pay 5.4 percent while a 5-year bond would pay a bit more -- perhaps 5.6 percent.
Bonds are not -- I repeat, not -- risk-free. Various services -- Standard and Poor's, Moody's and Duff & Phelps -- "rate" bonds for their creditworthiness. In other words, how capable is the company or government unit of paying the interest rate and repaying the principal?
These ratings generally range from AAA to D, with a number of incantations in between such as BBB, BB, B, CCC, etc. The higher the rating, the more confidence you can have in the bond.
You've probably heard the term "junk bonds". What are they? These are bonds at the lower end of the rating scale. To attract investors, companies or governments pay a higher interest of higher-risk bonds. My advice: Buy only highly rated bonds and stay away from junk bonds unless you are like my friend and want to live on "the wild side."
Keep in mind: Bonds sometimes do "default," meaning you lose any interest promised -- plus your principal. So, though generally safe, there is risk associated with bond investing.
Here are some of the different types of bonds you may consider buying:
- Treasury bonds. Issued by the U.S. government, they come at different timelines of maturity -- ranging from a year to more than 10 years. Their main advantage is that the interest is paid tax-free at the federal level. But, if your state imposes an income tax, you'll have to pay taxes on interest to your state government.
- Municipal bonds, known as "munis," are issued by state and local government units. The biggest advantage in munis is that they are tax free at the federal level and within the state in which they are issued. Because of this double-whammy tax advantage, they generally pay a lower interest than T-bonds.
- Corporate bonds are backed by the company that issues them, so like buying a stock, you'll need to have a comfort level with the company. For example, IBM has for years issued bonds to finance some of its initiatives, and most investors feel comfortable that Big Blue will pay up.
Now, let's consider the different purposes bonds can play in your portfolio:
Because bonds generally do not move to the same beat as other investments, they can play a role in diversifying your portfolio. Bad economic times can cause interest rates to rise and investors to become nervous. In such times, stocks generally decline in price. But those rising interest rates actually result in higher bond payouts. Thus, bonds often can counter a down stock market within your portfolio.
Perhaps you're interested in making a major purchase within five years or so -- say a new home. With bonds, you know going in what your payout will be within that time period. Voila: The down payment on your new home built with relative ease and light risk. Once you have retired and you have a nice nest egg, you might want to consider "parking" some of your retirement money into bonds. This is a relatively safe vehicle with a fixed income and a fixed timeline -- very attractive for investors who have a comfortable cushion but don't need the money right away. Bonds are not for all investors. Researching and buying into them can be time-consuming and clearly not as sexy as choosing stocks. But there is one final idea you might want to consider -- bond mutual funds.
Like stock mutual funds, bond mutual funds are comprised of a portfolio of certificates that spreads your risk. For example, a single bond portfolio might consist of 80 to 100 or more different bonds. For a single purchase, you get a piece of each of those bonds.
This greatly simplifies the task you face in researching your purchase. More importantly, it substantially cuts your risk. If one of those 80-100 bonds happens to go into default, you're not going to feel much pain.