The Motley Fool: Understanding bonds and their role

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 that may be perceived as low quality are forced to offer high-interest-rate “junk” bonds to attract buyers. The rates are high because there’s a higher risk that someday the companies 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. Once issued, bonds can be traded among 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 5 percent, an 8 percent bond starts looking good.

Over the long run, though, bonds rarely trump stocks. According to Jeremy Siegel’s “Stocks for the Long Run” (McGraw-Hill, $30), from 1926 through 2001 (notice that includes the Great Depression years), long-term government bonds returned a nominal average of 5.3 percent per year, compared with 10.2 percent for the stock market. If you had invested $5,000 in bonds for 50 years, it would have grown to $66,000. In stocks, it would have become $643,000 – quite a difference.

Ask the Fool

Q: Does a lower stock price signify a smaller company? – Q.T., Decatur, Ill.

A: Not at all. You must factor in the number of existing shares to get an idea of a company’s size. If Drive-Thru Dentistry Inc. (ticker: DRILZ) has a stock price of $10, for example, and 1 billion shares outstanding, its market price (“market capitalization,” or “market cap,” to use Wall Street lingo) is $10 billion. If it has just 200 million shares outstanding, its market cap is $2 billion.

For some real-life examples, look at JPMorgan Chase, Best Buy and Hershey. All were recently trading for around $50 per share, but their market caps were, respectively, $175 billion, $25 billion and $12 billion.

My dumbest investment

In 2001, I had just started investing and had been hurt, but not hammered, by the tech bubble collapse. In the wake of 9/11, I realized that companies were being hammered by the market irrationally, and I saw a buying opportunity. My first pick was Boeing, at $33. It was obvious to me that no matter what happened in commercial aviation, Boeing would be well-positioned to benefit from military responses to terrorist attacks. Then I bought United Airlines and soon watched it self-destruct. As of today I am still ahead, thanks to Boeing (recently at $90). And since this was in my early investing days, the dollar amounts involved were small. I learned several valuable lessons: Don’t invest if you don’t understand the company and its financials. Don’t be afraid to get out when you realize your own stupidity. A good idea does not make a good investment. – Nathan, via e-mail

The Fool Responds: Even in good times, airline stocks have been troublesome, as they typically struggle with fare wars, volatile fuel costs, bad weather, aging fleets, costly empty seats and more.