When a governmental body or agency or a corporation wants to raise money, one way they can do it is to float a bond issue. When you buy a bond, you are essentially loaning money to the issuer. You expect to earn interest and to be repaid your principle on the maturation date (the date when the bond must be repaid).
Bonds are not without risk. Bond prices go down when interest rates go up. If you have to sell your bond before maturity and interest rates have gone up, the bond will be worth less than its face value. You’ll lose money with the sale.
In addition, you face the risk that the borrower may default on repayment of your capital. To help bond investors determine this kind of risk, both Standard & Poors and Moody’s have developed ratings for bonds. S & P rates bonds AAA to D, with AAA being the safest. Moody’s ratings range from Aaa to C, with Aaa being the safest. To protect your investment, you should buy only AAA, AA or Aaa rated bonds.
Bond Mutual Funds
One of the ways of protecting yourself against risk when investing in bonds is to use bond mutual funds. Like stock mutual funds, bond mutual funds offer the advantages of diversification, professional management and convenience. They also allow you to enter the bond market with a small amount of capital.
Your After-Tax Return
For the past decade the stock market has been extremely strong that many investors have ignored the weaker bond market. The bond market does offer one advantage that the stock market does not. Many governmental issues are tax-exempt. That means not only do you earn interest, but you do not pay taxes on the interest you earn. That can amount to an extra 15% to 31% in your pocket, depending on your tax bracket.