Understanding bonds.

Making M-O-N-E-Y from corporate and government I-O-Us

While Wall Street was recently slammed, the wake-up call provided investors with a chance to seek out a balanced diet of investment vehicles. One of the best ways to diversify one's portfolio is by adding bonds to your asset mix. "Traditionally, investors have viewed bonds as boring investments that do not give good returns and that burden portfolios," says Dale Bryant, a portfolio manager with the Bryant Group in New York. "They couldn't be more misled. Sometimes bonds can do better than equities. Adding bonds can reduce portfolio volatility."

Of course, there are many types of bonds to choose from, including: U.S. government, municipal, corporate, mortgage, asset-backed securities, federal agency securities, and foreign government securities. Bryant advises the average investor to "keep about 30% of his or her portfolio in fixed-incomelike securities and cash" As retirement nears, however, bonds could comprise as much as 70%.

When you buy a bond, you are loaning money to the company, government, or local municipality or agency. In exchange for the cash loan, the bond issuer agrees to repay you--with interest--within a certain period of time. That time period is called maturity. Bond maturities can range from one day to 30 years. Maturity terms are often categorized as follows:

* Treasury bills (short-term): maturities up to two years

* Treasury notes (intermediate-term): maturities of three to 10 years

* Treasury bonds (long-term): maturities of 10 or more years

Interest may be fixed, floating/variable, or payable at maturity. Most debt securities carry a fixed interest rate. Typically, investors receive interest payments semiannually. For example, a $1,000 bond with an 8% coupon rate will pay investors $80 a year, in payments of $40 every six months. At the time of this article, the current rate on treasury bills was 3.65%, on treasury notes it was 4.73%, and on treasury bonds it was 5.19%. Interest rates can be researched daily in local newspapers or go to www.bankrate .com for rates and updates.

Also, some treasury bonds have no periodic interest payments. Instead, the investor receives one payment at maturity that is equal to the purchase price plus the total interest earned, compounded semiannually at the interest rate when the bond was purchased. Known as "zero-coupon bonds," they can be sold at a substantial discount from their face value. The further away the maturity date, the more substantial the discount. For example, a bond with a face value of $20,000 maturing in 20 years might be purchased for about $6,600. At the end of 20 years, the investor will receive $20,000, if the coupon rate averaged 5.8% and compounded automatically until the bond matured. Bryant cautions the investor to be aware that although the buyer of the zero coupon bond does not receive interest payments yearly--as they would with a regular bond (coupon)--the buyer is responsible for paying taxes on the accumulation of interest on the bond, an amount known as the accreted value of the bond.

An important factor for bond investors to figure into their purchase plans is "credit quality." Bond choices range from the highest credit quality U.S. Treasury securities, which are backed by the full faith and credit of the U.S. government, to bonds that are below investment grade. Credit quality must be considered because it determines the probability of you getting paid back or not. Securities firms and banks maintain research staffs to monitor the ability and willingness of the issuer to make their interest and principal payments when due. Such ratings services include Moody's Investors Service, the Standard and Poor's Corp., and Fitch. The highest ratings are AAA (S&P and Fitch) and Aaa (Moody's). Bonds rated in the BBB category or higher are considered investment grade. Securities rated BB and below are considered "high-yield" and therefore riskier, but can offer nearly stock-market-like returns.

To find out more about bonds, read Savings Bonds: When to Hold, When to Fold, and Everything in Between by Daniel J. Pederson (The Savings Bond Informer, $19.95). Also, visit the Website www.pub licdebt.treas.gov/sav/savfaq.htm and print out the brochure Buying/Owning Savings Bonds to get answers to bond basics. Or you can purchase Money Matters for $1.50 by calling 888-878-3256. Another informative site, www.savings bonds.com, offers easy-to-use calculators and a lost-bond search service. The service helps you dig up any bonds you may have acquired as a child but no longer have hard copies of in hand. It's also great for anyone who lost the precious documents during a flood or fire.