Smart Bond Investing—Bond Basics

The Power of Compounding

 

Regardless of the type of investment you select, saving regularly and reinvesting your interest income can turn even modest amounts of money into sizable investments through the remarkable power of compounding. If you save $200 a month and receive a 5 percent annual rate of return, you will have more than $82,000 in 20 years' time.

 

 

The Power of Compounding

 

 

Accrued Interest

 

Accrued interest is the interest that adds up (accrues) each day between coupon payments. If you sell a bond before it matures or buy a bond in the secondary market, you most likely will catch the bond between coupon payment dates. If you're selling, you're entitled to the price of the bond, plus the accrued interest that the bond has earned up to the sale date. The buyer compensates you for this portion of the coupon interest, which is generally handled by adding the amount to the contract price of the bond.

 

Use our Accrued Interest Calculator to figure out a bond's accrued interest.

 

Zero-Coupon Bonds

 

Bonds that don't make regular interest payments are called zero-coupon bonds—zeros for short. As the name suggests, these are bonds that pay no coupon or interest payment. Instead of getting an interest payment, you buy the bond at a discount from the face value of the bond, and you are paid the face amount when the bond matures. For example, you might pay $3,500 to purchase a 20-year zero-coupon bond with a face value of $10,000.

 

Federal agencies, municipalities, financial institutions and corporations issue zeros. One of the most popular zeros goes by the name of STRIPS (Separate Trading of Registered Interest and Principal Securities). A financial institution, government securities broker or government securities dealer can convert an eligible Treasury security into a STRIP bond. As the name implies, the interest is stripped from the bond. A nice feature of STRIPS is that they are non-callable, meaning they can't be called to be redeemed should interest rates fall. This feature offers protection from the risk that you will have to settle for a lower rate of return if your bond is called, you receive cash, and you need to reinvest it, also known as reinvestment risk. For more information, see the STRIPS section.

 

Caution—Interest Is NOT Invisible to the IRS The difference between the discounted amount you pay for a zero-coupon bond and the face amount you later receive is the imputed interest. This is interest that the IRS considers to have been paid, even if you haven't actually received it. While interest on zeros is paid out all at once, the IRS demands that you pay tax on this "phantom" income each year, just as you would pay tax on interest you received from a coupon bond. Some investors avoid paying the imputed tax by buying municipal zero-coupon bonds (if they live in the state where the bond was issued) or purchasing the few corporate zero-coupon bonds that have tax-exempt status.

 

Floating-Rate Bonds

 

While the majority of bonds are fixed-rate bonds, a category of bonds called floating-rate bonds (floaters) have a coupon rate that is adjusted periodically, or "floats," using an external value or measure, such as a bond index or foreign exchange rate.

 

Floaters offer protection against interest rate risk, because the fluctuating interest coupon tends to help the bond maintain its current market value as interest rates change. However, their coupon rate is usually lower than that of fixed-rate bonds. Because a floating bond's rate increases as interest rates go up, they tend to find favor with investors during periods when economic forces are causing interest rates to rise. Most floater coupon rates are generally reset more than once a year at predetermined intervals (for example, quarterly or semiannually). Floaters are slightly different from so-called variable rate or adjustable rate bonds, which tend to reset their coupon rate less frequently. (Note: Floating and adjustable-rate bonds may have restrictions on the maximum and minimum coupon reset rates.)