Understand bonds before dismissing them
Over the long run, stocks tend to perform much better than bonds. Still, understand how bonds work before you dismiss them. Bonds are essentially long-term loans. If a company issues bonds, it’s borrowing cash and promising to pay it back at a certain rate of interest.
Bonds sold by the U.S. government’s Treasury Department are called “Treasurys.” State and local governments issue “municipal bonds,” while businesses issue “corporate bonds” (sometimes called “corporate paper”). Companies on less-than-solid ground offer high-interest-rate “junk” bonds to attract buyers. The rates are high because there’s a higher risk that someday the firms won’t have the cash to cover interest payments and the bonds will default.
Bond investors receive regular interest payments from the issuer at what is called the “coupon rate.” For example, if you buy a $1,000 bond with a coupon rate of 10 percent, you’ll receive payments of $100 per year. When the bond matures — after perhaps five, 10 or 30 years — you’ll get back your initial loan, called “par value.” Most corporate bonds have a par value of $1,000, while government bonds can run much higher.
Sometimes a company will “call” its bond, paying back the principal early. All bonds specify whether and how soon they can be called. Federal government bonds are never called.
Bond investors don’t necessarily buy a bond at issue and hang on through maturity. Many bonds are traded between investors, with their prices rising and falling in reaction to changing interest rates. For example, when rates fall, people bid up bond prices. If banks are offering 4 percent, a 6 percent bond starts looking good.
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Ask the Fool
Q: I have some Winn-Dixie stock from my mom that has done nothing but sink in value over the past five years. Do you think it will go up? — A.S., Hendersonville, N.C.
A: What we think shouldn’t matter as much as what you think. Whenever you own stock in a company, you should have a good grip on how it makes its money, what its growth prospects are, how financially healthy it is (in terms of cash, debt, etc.), and how well it can compete, among other things.
No one can know exactly how the firm will ultimately fare, but the grocery business is a tough one these days. Supermarkets, which have long had thin profit margins, are now competing with the likes of Wal-Mart, which doesn’t like to lose.
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My dumbest investment
In the 1960s, studying the stock market, I noticed that Transitron Electronics was priced low in the fall and higher in the spring. I made $14 per week then, mowing lawns. In the fall, I bought 10 shares at $6.50 each. Later, I learned that the company paid no dividends! In the spring, I sold my shares at $5.50 each. In the fall, I bought again, at $4.50. The stock’s performance was dismal. Several years later, it was at $12 and was dropping again. I sold my $45 investment for $103 and was glad to be out. — Rich E., Topeka, Kan.
The Fool Responds: First off, know that it’s OK for a firm to not pay dividends. Many smaller, faster-growing firms don’t, preferring to reinvest excess cash back into the business. Next, it’s dangerous to try to time the market by jumping in and out of stocks. That can rack up a lot of commission fees and boost your tax bill.