Bonds represent a "loan" of money from the bond holder to the bond issuer. Just like a loan, the issuer "borrows" money from the investor and promises to pay "interest" (dividends) on a regular basis, over a fixed period of time, to the investor. The issuer also promises to repay the principal amount of the bond to the investor at maturity or at the end of the fixed time period.
The rate of dividends paid is fixed at the time of issue and does not change. However, the principal value of the bond will fluctuate on a daily basis depending upon many factors, including interest rate changes, supply and demand, tax law changes, and the credit-worthiness of the issuer.
Bonds are usually "rated" by nationally recognized ratings services (i.e., Moody's, Standard & Poor's, etc.) using many factors, including past history, credit-worthiness, future earning prospects, cash-flows, other debt, and many more. The rating of a bond is a guide to help determine the relative "safety" of the investment.
The four highest ratings (AAA - AA - A - BBB) are considered "investment grade." Below this is considered noninvestment grade, with the lower ratings (i.e., CCC - CC - C) considered speculative or "junk" bonds. The lower rated bonds are generally considered to have a higher risk factor and therefore generally pay a higher dividend rate to the investor as compensation for the higher risk.
Note: An important factor to keep in mind: the current market value of a bond will rise and fall inversely to the rise and fall of market interest rates. As interest rates go up, the current value of the bond goes down, and vice versa: bonds held to maturity are redeemed at full or par value; bonds sold before maturity may be worth more or less than their original cost.
Perhaps the most common bond is the "Government Bond" which includes U.S. Treasury Bills, Notes, and Bonds, which are issued by and guaranteed by the U.S. Government as to the timely payment of dividends when due, and principal at maturity. These are considered "safe" because the U.S. Government has never failed to pay dividends and principal and is regarded as having no credit risk. Also bonds may be issued by or guaranteed by agencies of the U.S. Government such as FNMA, GNMA, FHA, SLMA, etc. While these are not direct obligations of the U.S. Government, it is implied that the U.S. Government will back the issuing agencies. This also conveys a very high (usually AAA) credit rating to this type of security.
These are issued by corporations, are usually rated, and may or may not be backed by specific assets or revenues of the corporation. Corporate bonds are considered riskier than Government bonds because the bonds are only as "safe" as the corporation. As we have seen in the past, many corporations, or industries in general, that were once thought of as completely safe, have encountered difficult times and now are not considered as good an investment risk.
Municipal bonds are generally issued by state and local governments; i.e., cities, boroughs, townships, counties, etc., and their political subdivisions, agencies, and instrumentalities. This includes industrial development authorities, public water and/or sewer projects, health and education facilities, and many more.
The most obvious advantage to investing in municipal bonds is that the income generated to the investor is generally exempt from Federal taxes. Issues from within the investor's state of residence are also generally free of state and local income taxes.
There are also nonincome-producing bonds, often referred to as "Zero Coupon" bonds. These bonds are essentially "stripped" of their dividends and are offered at a deep discount to par. The investor receives the full par value of the bond at maturity. The difference between the purchase price and the redemption value represents the investor's return. The investor would purchase a Zero Coupon bond when current income is not needed, but a fixed maturity value at a future time is desirable. This may include retirement, college, etc. Zeros may be issued by the U.S. Government agencies, municipalities, and corporations.
As with other bonds, municipal or "tax-exempt" bonds are rated for credit-worthiness in much the same manner - revenues, debt load, future projections, etc.
Many investors use mutual funds to participate in the income stream derived from bonds. Mutual funds provide diversification, professional management, liquidity, and the option of receiving a monthly income or automatic reinvestment. There are many bond funds, each dedicated to a certain objective. Some invest primarily in Government Securities, some in Corporate Bonds, and some may have both, in addition to income-producing stocks. Generally, a tax-exempt fund will only invest in Municipal Securities, either nationally or within an individual state.
Current income should be the primary objective of investing in a bond or income fund. Many investors will invest for reasons other than income; i.e., tax reduction, safety, future income needs, preservation of capital, etc. Income funds normally do not have capital appreciation as a primary objective, but some funds offer growth as a secondary objective. The level of income and/or growth potential depends upon the strategy, objectives, and philosophy of the particular fund.
The basic decision with respect to investing in a bond fund is whether a taxable or tax-exempt fund is more appropriate. The key factor is the individual tax bracket.
The yield spread between taxable and tax-exempt bonds is such that persons in high brackets should consider tax-exempt funds.
The interest yield on long-term bonds is generally higher than what is available in the short-term market. There have been times when unusually high demand for short-term capital has driven short rates higher. However, be aware that long-term bonds are generally more volatile regarding the principal value, thus resulting in a less stable net asset value.
Common stock represents ownership in a corporation. Successful operation of the corporation means more funds available for reinvestment in the corporation and for distribution to the stockholders. Such payments to stockholders are called dividends.
The proportion of earnings which is paid to stockholders compared with the amount retained for reinvestment depends upon the individual company's objectives. Companies which retain a high percentage of earnings are generally considered to be growth-oriented stocks. Those that pay out a large percentage of their earnings in the form of dividends are usually more attractive to investors who are willing to sacrifice some degree of growth for current income.
The value of a common stock is determined by the forces of supply and demand in the marketplace. Theoretically, stock of a successful company or one with bright prospects should rise in value due to rising demand for its ownership. However, this is not always true because of the wide variety of factors affecting stock prices. For example, the price of a stock may reach an unreasonably high level due to excessive enthusiasm on the part of investors and then may drop as a corrective function, irrespective of the company's continuing success. On the other hand, a company with poor operating results and marginal prospects may drop to a level that is absurdly low in relation to the value of the underlying assets, only to be bid up in price by investors seeking undervalued issues.
The general movement of the stock market can affect the price of an individual issue. The stock market as a whole rises and falls as a result of almost limitless factors, constantly reacting to current events and anticipating future trends. Sometimes these factors have little effect on the operations of a single company, but a particular company's stock price may be affected by the general movement of prices.
Millions of shares of stock change hands daily. These transactions usually take place in centralized continuous auction markets called exchanges, or in the over-the-counter market where the price is negotiated between dealers. Shares of most large companies trade on exchanges.
Institutional investors such as banks, insurance companies, and pension funds generally buy and sell large blocks of stock and, therefore, have a significant effect on the stock market.
There is a wide range of types of common stock. Every company has its own record of earnings, its own style management, and its own objective for long-term growth. Some companies are high-risk investments while others are generally considered to be relatively stable and predictable with respect to their sales and earnings.
Many investors use mutual funds as a means of participating in the equity markets. Mutual funds provide the advantages of diversification of assets, dividend reinvestment, liquidity, and, importantly, professional management. There are a large number of mutual funds, each dedicated to a certain objective. Some strive for maximum capital appreciation, while others have investment characteristics that are more income-oriented, similar to those of a bond fund. An investor should consider very carefully the objective of the fund and the fund's track record. In many cases, a combination of two or more funds is appropriate.
Growth of capital should be considered the primary benefit to be derived from an investment in a stock-based mutual fund. In general, as greater risk is assumed, benefit potential is increased commensurately. Greater upside potential, however, is often accompanied by a higher degree of volatility and downside risk.
It should be mentioned that while the primary benefit with respect to most stock funds is capital appreciation, there are varying degrees of commitment to this objective. Finally, many funds aggressively seek capital appreciation; others strive for a combination of capital appreciation and income. Finally, other stock mutual funds may invest in income-producing stocks with low growth potential. The level of growth potential depends upon the philosophy and strategy of the particular fund.
The money market refers to short-term debt instruments issued by the Federal Government, commercial banks, and corporations with high credit ratings. Money market instruments provide safety of principal and a rate of interest income, which is a reflection of current short-term borrowing rates. For example, a three-month certificate of deposit issued by a bank might provide the investor with a 3% annualized return over the period. In essence, the bank is borrowing from the investor at a rate, which is competitive with other short-term investment alternatives available to the investor.
Money market investments are usually taxable at the State and Federal level.
There is a wide variety of short-term money market investments. Among the best known are:
Certificates of Deposit
A CD is an interest-bearing time deposit in a bank, usually maturing anywhere from one month to one year from the date of issuance and usually negotiable.
U.S. Treasury Bill
A type of U.S. Government obligation which is bought at a discount and matures at par value, in most cases within 13 weeks, 26 weeks, or one year. The difference between the purchase price and the redemption value represents the investor's return.
Notes sold by large business firms and some finance companies through commercial paper dealers. Maturities range from 30 days to six months.
There is an extremely low degree of risk associated with an investment in a money market instrument. While it may not be said that all money market instruments are guaranteed, the risk of default on interest or principal payments from the U.S. Government, a major bank, or a major corporation issuing highly rated commercial paper is remote.
Money market funds are portfolios consisting of a number of money market instruments. Large funds may hold hundreds of different issues simultaneously. Investor capital is pooled and each investor owns shares representing fractional interest in the portfolio. The value of the shares should not change. This arrangement permits the investor to participate in the money market without having to come up with a large cash outlay. Other advantages are automatic reinvestment of dividends, a high degree of liquidity, professional management, and diversification of assets. These characteristics are common to most mutual funds, and market funds are essentially a type of mutual fund. The yield, or interest return, on a money market fund will change because as issues in the portfolio "mature," the proceeds are "rolled," or reinvested, into other issues. The result is that the yield is being adjusted regularly, usually on a daily basis.
The primary benefit of a money market fund is a safety of principal. While many investors have concentrated on the interest yield for the last several years, this has been largely due to the unusually high level of short-term interest rates. Money market funds are designed to provide safety of principal while providing a level of income as is compatible with the objective of current income.
Money market rates run very near to the rate of inflation, so the investor is earning a pre-tax return which is roughly comparable to the rate of inflation. Since interest on a money market fund is usually taxable, the after-tax rate of return will probably be such that the investor has not kept pace with inflation. There are several money market funds in which the objective is to provide current income that is exempt from Federal income taxes, through a portfolio of short-term municipal securities. Persons in high tax brackets should give this serious consideration.