Close-Up: Bonds

Ed Rabinowitz

Physician's Money Digest, October31 2003, Volume 10, Issue 20

Presented by McNeil Makers of Tylenol

n.

Bonds: Certificates of ownership of a specified portion of a debt due to be paid by a government or corporationto an individual holder and usually bearing a fixed rate of interest.

When we hear the word "bond," it'sinevitable that we think of JamesBond, otherwise known as secret serviceagent 007. The other type of bondyou should be aware of, particularly from a financialperspective, is the type you purchase and add to yourinvestment portfolio. And just as secret agent 007can be counted on to save the day, the return on abond is all but guaranteed.

The Die Broke Complete Book of Money

The reason bonds are so secure is that when youpurchase a bond, points out Stephen Pollan, author of (HarperCollins; 2001), you're not buying ownership in acompany and sinking or soaring with the company'sperformance. When you buy a bond, you're lendingthe issuer—the federal government, cities, counties,states, and corporations—your money in return for aguaranteed rate of return over a predetermined periodof time.

Of course, not all bonds are equally secure, butthe ones issued by the federal government—and thereare several types—are about as secure as they come.

Types of Bonds

When you purchase a US government bond, youcan take comfort in the knowledge that the governmenthas never defaulted on a loan. It is, in effect, themost reliable borrower in the world. The US governmentissues several different kinds of bonds throughthe Bureau of the Public Debt, an agency of the USDepartment of the Treasury. These bonds are classified according to their maturity. Treasury bills havematurities of 1 year or less; Treasury notes mature in2 to 10 years; and Treasury bonds have maturitiesgreater than 10 years.

Treasury bills are issued in 3 maturities: 91-day,182-day, and 364-day. The Treasury auctions the 91-day and 182-day bills every Monday. The 364-daybills are auctioned every 4 weeks on a Thursday, 13times per year. Treasury bills do not make interestpayments. Instead, they are sold at a discounted rateand then pay their face value at maturity. They alsorequire a minimum investment of $10,000, with additionalpurchase increments of $1000.

In contrast, US Treasury notes are issued in 2-, 3-,5-, and 10-year maturities. The 2-year and 5-yearnotes are auctioned monthly, the 3-year notes quarterly,and the 10-year notes 6 times a year. All maturitytypes pay interest twice a year and expire at facevalue. Treasury bonds also pay interest twice a year,with the 30-year bond considered the benchmarkagainst which all other bonds are measured.

Buying Bonds

In his book, Pollan points out that the great featureabout bonds is that the purchaser knows exactlyhow much money they are going to earn and whenthose earnings are realized. As such, they're the perfectinvestment vehicle if you're going to need a certainamount of money at a fixed point in the future,such as during your retirement years or when yourchild enters college.

You can purchase bonds through a broker, but if youbuy direct you can usually get a better deal. The USTreasury has a program targeted to helping individualinvestors called Treasury Direct. Individuals can set upan account to make purchases of Treasury securities atauction. There are no brokerage fees or other transactioncharges when you buy through this program. Thereis, however, a $25 annual maintenance fee per account,but only for accounts in excess of $100,000.

To set up an account, all you need to do is completean application that you can download from theprogram's Web site, www.publicdebt.treas.gov/sec/sectrdir.htm. Minimum investments in the programare $10,000 for bills, $5000 for notes maturing inless than 5 years, and $1000 for securities thatmature in 5 or more years. Interest accumulated ispaid directly into your account, as is the bond's valuewhen it matures. And for convenience, you canaccess your account online to check balances or reinvesta security when it matures.

Bond Buying Strategies

Buying bonds is not as complicated as buying equities,author Stephen Pollan explains, but thereare still some good strategies to follow:

  • Buy only highly rated bonds. This type of bondpurchase virtually eliminates the possibility of default.
  • Invest in bonds for the long term, with theexpectation you'll keep them until they mature andfor the regular income they provide.
  • If you buy bonds that are callable, make surethat their timing will not have an adverse impact onyour investment goals.
  • Buy the bonds of large corporations and municipalities.That's because there is usually a good secondarymarket for these bonds. If you do have to sellearly, you can get a good price.
  • Buy intermediate-term bonds of 1- to 10-yearmaturities because they yield more than short-termbonds and are less volatile than long-term bonds.
  • Create a diverse portfolio with different issuesand different maturity dates.

CME Quiz

1) Bonds can be purchased from

  1. The federal government
  2. Municipalities
  3. Corporations
  4. All of the above

2) Treasury bills require a minimum investment of

  1. $5000
  2. $10,000
  3. $15,000
  4. $20,000

3) US Treasury notes are issued in 2-, 3-, 5-, and

  1. 8-year maturities
  2. 10-year maturities
  3. 12-year maturities
  4. 15-year maturities

4) The US Treasury's program that helps individualspurchase bonds is called

  1. Treasury Direct
  2. Treasury Guarantee
  3. Treasury Match
  4. Treasury Investment

5) As a good rule of thumb, invest in bonds for

  1. The short term
  2. The mid-term
  3. The long term
  4. All of the above

Answers: 1) d; 2) b; 3) b; 4) a; 5) c.