Identifying potential bond investments

Here’s a look at some items you need to evaluate before
investing in a fund:

 Issuer stability: This is also known as credit quality,
which assesses an issuer’s ability to pay back its debts,
including the interest and principal it owes its bond
holders, in full and on time. Although many
corporations, the United States government, and a multitude
of municipalities have never defaulted on a bond,
you can expect that some issuers can and will be unable
to repay.

Maturity: A bond’s maturity refers to the specific future
date when you can expect your principal to be repaid.
Bond maturities can range from as short as one day all
the up to 30 years. Make sure that the bond you select
has a maturity date that works with your needs. T-Bills
and zero coupon bonds pay interest at maturity. All other
bonds pay interest every six months. Most investors buy
bonds in order to have a steady flow of income (from
interest).

The longer the maturity in a bond, the more risk associated
with it — that is, the greater the fluctuation in
bond value based upon changes in interest rates.

 Interest rate: Bonds pay interest that can be fixed-rate,
floating, or payable at maturity. Most bond rates are fixed
until maturity, and the amount is based on a percentage
of the face or principal amount.

 Face value: This is the stated value of a bond. The bond
is selling at a premium when the price is above its face
value; pricing below its face value means that it’s selling
at a discount.

 Price: The price you pay for a bond is based on an array
of different factors, including current interest rates, supply
and demand, and maturity.

 Current yield: This is the annual percentage rate of
return earned on a
bond. You can find a bond’s current
yield by dividing the bond’s interest payment by its purchase
price. For example, if you bought a bond at $900
and its interest rate is 8% (0.08), the current yield is
8.89% — 8% or 0.08 ÷ $900 = 8.89.


 Yield to maturity (YTM): This tells you the total return
you can expect to receive if you hold a
bond until it
matures. Its calculation takes into account the bond’s face
value, its current price, and the years left until the bond
matures. The calculation is an elaborate one, but the broker
you’re buying a bond from should be able to give you
its YTM. The YTM also enables you to compare bonds
with different maturities and yields.

Don’t buy a bond on current yield alone. Ask the bank
or brokerage firm from whom you’re buying the bond to
provide a YTM figure so that you can have a clear idea
about the bond’s real value to your portfolio.

 Tax status: The interest you earn on U.S. Treasury bills,
notes, and bonds is exempt from local and state tax.
Interest paid on municipal bonds is usually exempt from
local (if you live in the municipality issuing the bond),
state (if the municipality issuing the bond is in your state
of residence), and federal tax, although you pay capital
gains tax on any increase in the price of the bond. On
corporate bonds, you pay both state and federal taxes,
where applicable, for interest paid and capital gains taxes
on any increase in price.

If you sell a
corporate, treasury, or municipal bond for more
than you paid for it, you’ll pay capital gains tax on the difference.