- Three factorsaffect the price and interest paid by bonds. Time to maturity: Bonds can be maturing in 30 days or 30 years. Normally, longer term bonds will pay higher rates than shorter term ones, other factors being equal. This is called a normal yield curve. If short term rates are higher than longer term ones, the yield curve is said to be inverted.
The credit quality of the issuer affects the interest earned from a bond. The U.S. Government is considered the safest debtor and will pay the lowest rates. Bond issuers are given credit ratings ranging from AAA down to D for default. Bonds with ratings below BBB are considered to be "junk" bonds and will pay a higher rate of interest.
The coupon rate is the amount of interest the bond pays based on the face amount. A $10,000 bond with a 10 percent coupon will pay $500 in interest twice a year ($1,000 total per year). The market will adjust the market price of the bond to make the return to the bond buyer in line with current interest rates. If current rates are 6 percent, a bond buyer will pay more than $10,000 to get that 10 percent coupon bond. - Be careful in the quest for more yield. Use the current U.S. Government Treasury rates as a guideline for safe interest rates. More yield can be achieved by buying bonds of lower credit quality or extending the term. Lower credit quality is accompanied by some level of default possibility, the higher the yield the greater the chance of default. Extending the maturity leaves you stuck with a low yielding bond if interest rates increase.
Construct a bond ladder with your bond investments. Your bond holdings should have a range of maturities, so some bonds are paid off each year and are invested at a longer term for a higher yield. A bond ladder protects the principal and earns maximum interest in rising and falling interest rate environments.
If you are in a high tax bracket, buy municipal bonds. Muni bonds pay interest that is exempt from federal income tax, and bonds from your own state are state income taxe exempt also. The rules about to maturity and credit quality also apply to municipal bonds. - Mutual and exchange traded funds that invest in bonds provide diversification, professional management and monthly dividend payments. Funds are available that own government bonds, high and low quality corporate bonds and municipals. For high-quality corporate bonds paying better yields than government bonds, "Money" magazine suggests the Vanguard Intermediate Term Investment Grade mutual fund or the iShares iBoxx $ Investment Grade Corporate Bond ETF, symbol LQD. Remember, the share prices of bond funds will decrease in a rising interest rate environment.
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