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URL:  http://boards.fool.com/bond-and-f-i-faqs-part-1-a-25173292.aspx

Subject:  Bond and F-I FAQs: Part 1 A Date:  2/14/2007  2:08 PM
Author:  Lokicious Number:  19761 of 35644

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Bonds and “Fixed” Income Investing: Introduction
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What are Bonds?

• Bonds are “debt securities” (IOUs) issued by governments, agencies, or corporations to institutional or individual investors from whom they borrow money.

• They pay periodic dividends (usually semi-annually) until they mature or are “called.”

• They may be held until their maturity-date (unless they get “called” or liquidated during bankruptcy), at which point they pay back the “face-value” of the bond.

• They may also be traded on the bond market, i.e., sold prior to maturity, typically for more or less than face value.

• A good source for terminology and “bond basics” is bondsonline:
http://www.bondsonline.com/Educated_Investor_Center/Bond_Basics.php
http://www.bondsonline.com/Educated_Investor_Center/Types_of_Bonds.php
http://www.bondsonline.com/Educated_Investor_Center/Buying_Selling_and_Trading.php

• The “learn more” section from investinginbonds.com has similar information
http://www.investinginbonds.com/

• NASD on buying bonds:
http://apps.nasd.com/investor_Information/smart/bonds/000100.asp

• Also, see Vanguard's glossary
http://flagship5.vanguard.com/VGApp/hnw/content/Glossary/IndexPages/GlossaryIndexPageNumContent.jsp

• For comments and recommendations about books on investing in bonds, see this thread
http://boards.fool.com/Message.asp?mid=23489486&sort=whole


What is “Fixed Income Investing”?

• “Fixed-Income” investing is a misnomer. It is actually a financial strategy in which you put money into investment or savings instruments with the intent of having at least as much buying power (after inflation) when you need to use the money as it had when you put it away, while minimizing the risk of losing the principal. “Principal preserving” is a better term. Income (interest, dividends) is often not, in fact, at a fixed rate.

• Except for money you need to have available for very short-term purposes, you should be able to find “principal preserving” financial instruments that will at least keep pace with inflation, with 2-3% above inflation (pre-tax) as a reasonable goal. (Historically, average “real returns,” over time, from a combination of CDs, Intermediate and Long Term Treasuries, and Investment Grade Corporate Bonds, have been in the 2.75%-3.75% above inflation range, but inflation adjusted returns have been lower during the 2001-2006 period.)

• This link has data on annual “real returns” (above inflation) for 5 and 10-year Treasury Bonds, with a 2.8% average (both median and mean). Other options, with little risk to principal, typically provide slightly more income. http://boards.fool.com/Message.asp?mid=23212071

• US Savings Bonds, Money Market accounts, CDs (Certificates of Deposit), and traditional Savings accounts, are cashed in, not traded, thus avoiding the risk of selling at a loss, although Savings Bonds and CDs may be subject to a penalty if cashed in early.

• Tradable bonds may serve as simple principal preserving vehicles, if held until maturity, not sold on the open market prior to the maturity date. (This includes buying on the open market, then holding to maturity.)

• A starting point for a principal preserving strategy is to find the option with a true fixed rate (a CD, a US Treasury Bond or Note) that is currently paying the highest interest for the length of time in which you are interested. Then, use this as the basis against which to compare options with variable rates or options that depend on total returns (income plus or minus principal), even though the comparisons will inevitably involve estimates and guesses.

How About Bond Funds?

• Bond funds are mutual funds that invest in bonds.

• Individuals buy shares in these funds then receive dividends, based on the dividends paid by the bonds held by the fund. Sometimes funds also distribute “realized capital gains” from bonds they sell for more than they cost.

• When individuals sell their bond fund shares, they will get back more, less, or the same as they paid for the shares, depending on the prices (“Net Asset Value,” a.k.a. “NAV”) at which the shares were bought and sold.

• Bond fund share prices (NAVs) should be expected consistently to fluctuate up and down, depending on prevailing interest rates, which affect the tradable value of the bonds held by a fund. This is different from the expectation for stock mutual funds, which, except during bear markets, over time have seen NAVs steadily increase (along with realized capital gains),

• Many people assume investing in bond funds is a “buy and hold,” principal preserving strategy, but it is not, since your principal, in the form of NAV (plus realized capital gains), is subject to fluctuation.

• However, your total return on a fund (dividends and realized capital gains plus or minus the value of fund shares) may make bond funds a good alternative to “buy and hold” principal preserving choices. You just need to understand there is no guarantee you will be able to sell your shar