Bond Basics

Understanding how bonds work, and how to make them work for you

Stock prices soared in the late 1990s, while bond prices mostly stayed flat. Then came the turnaround, with stocks slumping in 2000 and 2001 while bond prices rallied. So if you had investments only in stocks in 2000, you most likely lost money. The fact is that one of the best ways to increase the potential for profitable investing may be to put money in both stocks and bonds. Here is a primer on bonds that can help you better understand these valuable assets.

Types of bonds

Bond mutual funds generally invest in one of two types of bonds Government bonds are issued by the federal government to finance its operations and the national debt, as well as by government agencies to finance home buying, loans to small businesses and other activities. Corporate bonds are issued by businesses to finance growth and new investment. Ottawa guarantees government bonds, meaning it warrants the timely payment of principal and interest on them. Corporate bonds don't have this guarantee and are subject to higher risks, but they usually pay a higher rate of interest than government bonds do.

Short-term vs. long-term bonds

Bonds are also defined by the length of time for which they are issued. Short-term bonds mature in three years or less; intermediate-term bonds mature in three to 10 years; and long-term bonds mature in 10 or more years. The longer a bond's term is, the more volatile it is - there is more time for it to be buffeted by economic, financial and political forces. That's why long-term bonds typically pay the highest interest rates. Short-term bonds are the least volatile because they have less time to be affected by those same forces. They usually pay the lowest interest rates. Intermediate bonds split the difference.

Asset Allocation

You never know whether stocks or bonds will be the better performers in a given year, so you must prepare for either situation. Consider splitting your asset allocation between stocks and bonds according to your age, years left to retirement, tolerance for risk and investment objectives. Review that allocation annually and make adjustments as circumstances in your life change.

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