Dear Generation Y,
Let’s learn some basic stuff about bonds. We’ll keep it simple and see how they fit into our future. First, what is a bond? We are familiar with the word, but beyond that, what is it? Why buy a bond? Who sells bonds? What is the money used for? How do I get my money back? All good questions my young friend.
Bond issuers come in all shapes and sizes: governments (national, local, international) and corporations are big issuers. And a bond is simply a contract between two entities. So, if a corporation needs money for some reason (expansion perhaps), they can get money a few different ways and one way is to issue bonds. So they say: hey investor, lend me your money and I will make you two promises. The first promise is that I will give you your money back at the end of a predetermined number of years. And the second promise is that along the way I will pay you every six months an amount that is equal to the interest rate as “written” in the contract. So, If you buy a bond, you’ll get a bit of money every six months, and then after a number of years you’ll get the entire loan amount returned to you.
Okay, all that makes sense. But here’s what you’re thinking: how long will my money be tied up? What if I only want to lend the money for a short period of time? If my money is tied up for a long time, I need more incentive to make the loan. These are all brilliant thoughts and you are wise to ask questions and make demands.
Bond maturities vary, so you can choose the maturity that’s right for you. And of course you’ll need extra incentive to lend your money for longer periods of time. Companies know this and therefore promise to pay you a higher interest rate every six months on the money you lend them. Very nice. But keep in mind that bonds change hands during the life of the contract, so you can always sell your bonds to someone else if you need your money sooner than planned.
Your next questions are these: 1. Given that some companies are in better shape financially than others, why would I buy a bond from one that is not highly rated? And 2. What if I lend money to a company that goes under between now and the maturity date? Again excellent questions. The lower rated/higher risk companies know that they have to sweeten the pot to get investors to buy their bonds, so they offer even higher interest rates. And these bonds are called High Yield Bonds (very clever).
High quality companies get to pay lower interest rates because there is a high certainty that you will get your money back at the end of the term. Lower quality rated companies have to pay you a higher rate to help offset the risk that you may not get your money back at the end of the term. And of course, there is a spectrum.
Those are the basics and now we have to think about how to fit bonds into your lives. Here’s what makes sense: 1. Put lower rated high yield bonds in your IRA. The reason is that the higher interest payments you get from these bonds will be in your non-taxable account and you won’t have to deal with paying taxes on all that income for a good number of years. 2. Following the same logic, put the higher quality bonds in your regular savings account. The lower interest payments won’t generate a large tax bill.
So in your regular/taxable savings account you will have growth stocks and high quality bonds. In your retirement account you can put dividend paying stocks and high yield bonds. This is great! No dividends and low bond income means lower tax bill. And all that dividend income plus interest monies from high yield bonds in the no taxes til I’m old account! And you have a nice buffet of risk levels in your total investment portfolio.
Well done Jane. Follow me on Twitter @cmchristian17.
Next up – Let’s look for low cost mutual funds. We love shopping for deals!!
ttyl,
Connie
Invest Gen Y 