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..., although there will be some movement in prices of these funds (remember, lower interest rates mean higher prices and vice versa). If you include these funds in your portfolio, the income produced by them is free of federal taxes. Understanding Bond Types Agency Bonds Agency bonds refer to a group of bonds issued by organizations related to the U.S. government. These agencies typically do not have the explicit backing of the U.S. government behind their bonds, although some do. Most fall into a category of collateral-backed mortgages or loans, meaning there is some asset, usually real estate tied to the loan. These bonds pay higher rates than strict U.S. Treasury issues for the somewhat, although not much, higher risk. These bonds are typically sold in large denominations to institutional investors. Here are Municipal Bonds Local governmental entities like states, counties, townships, cities, utility districts and so on also issue bonds to finance their work. These municipal bonds, often called munis, fund new roads, schools, sewers and other projects. In some cases, fees collected from the project go to retire the bonds, in other cases tax money is used or a combination of both. Although not as safe as the U.S. Treasury issues, munis have a good record of security. One of the key features of these bonds is that the income is free from federal income tax. This tax-free feature, combined with the relative security makes municipal bonds attractive to conservative investors. As an add bonus, in some circumstances, the bonds may be free of state and local tax also. You buy munis from a broker either at new issue or existing bonds. Zero Coupon Bond Another type of bond is the zero coupon bond. The other bond types above differed by issuer. This bond type is issued by many entities, but because it is so different from traditional bonds, I have set it apart. Zero coupon bond, as the name suggests, pay no regular interest. Instead, you buy the bond at a deep discount and redeem it at full face value. For example, you might buy a $1,000 par value zero with 10 years to maturity for $700. In ten years, you would redeem the bond for $1,000. The Corporation Bond A corporate bond represents a promise of the borrower (e.g., a corporation) to make interest and principal payments to the lender (the creditor or bondholder) according to a specified timetable. A bond is a long-term contract in which the bondholders lend money to a company. In return the company (usually) promises to pay the bond owners a series of interest, known as the coupon payments, until the bond matures. At maturity the bondholder receives a specified principal sum called the par, face or nominal value of the bond. The time to maturity is generally between 7 and 30 years The bond indenture spells out the specifics of the bond contract: 1. Face value, maturity date, coupon rate of interest, and payment dates Note: The bond's Yield to maturity (YTM) is not set in the indenture--it is determined by the going market rate of interest 2. Any security to be used as collateral in case of default 3. Early payment procedures: Bonds with staggered maturities are sold in packages with part of the total issue being paid off as it matures. A bond issue with a sinking fund is paid off in portions as contributions to the fund are made each year. A call provision gives the option to the corporation to retire the bonds before maturity (to "call" the bonds) at a pre-stated call price. A decrease in interest rates provides the incentive for firms to exercise the call option (known as a refunding operation) The decision whether to refund or not is a capital budgeting decision. There are cash outflows involved in the form of the call premium that are usually required when bonds are called, flotation costs incurred when new bonds are sold, and tax deductions lost when lower-interest-rate bonds replace higher-interest-rate bonds. The inflows come mainly from the interest savings (lower payouts of interest represent cash inflows) that come when high-interest-rate debt is retired and replaced with lower-interest-rate debt. UNDERSTANDING RISKS Investments, including those made in fixed income vehicles, involve trade-offs. Shorter maturities provide more liquidity but usually have lower rates of return. Longer maturities generally offer higher yields but are subject to wider swings in price. High quality bonds offer safety at the cost of lower yields while higher yielding bonds have a higher degree of risk associated with them. A financial Consultant helps clients sort through the myriad of variables relating to a particular investment and works with clients to develop a risk profile that will determine which investments are most suitable for that client. The greater the risk assumed by the investor, the greater the potential for reward. There are several risks to consider in determining the suitability of various types of investments when building a portfolio of bonds or other securities. Inflationary Risk Inflationary risk measures the effects of continually rising prices on investments. If the yield on an investment is lower than the rate of inflation the investor's money will have less purchasing power as time passes. Selection Risk When all other factors have been considered there is still the possibility that the investor will make a poor choice in selecting an investment vehicle. One particular type of issue may fall from favor with the market and underperform the rest of the market. Timing Risk Timing is the essence of success. An investment in the highest quality security might perform poorly simply because the investment was timed wrong. Reinvestment Risk Because bond investors usually seek a steady stream of income, they risk not being able to reinvest their interest income or principal at the same rate as the yield on the bond. This 'reinvestment risk' is especially evident during periods of falling interest rates. Market Risk The risk that investors may lose some or all of their principal due to price volatility in the market is called market risk. Prices of bonds can fluctuate with changing interest rates. There is an inverse relationship between bond prices and bond yields: as bond yields go up, prices fall and vice versa. Discount bonds are more responsive to changes in market rates than those selling at a premium, or above par. As interest rates fall, however, discount bond prices tend to rise faster than premium bond prices. Longer term maturities are generally more sensitive to changes in interest rates while shorter term maturities do not fluctuate as widely in price. Credit Risk Credit risk involves the danger of losing all or part of an investment's value due to the failure of the issuer. The creditworthiness of the issuer and the rating assigned to the issuer by a major rating agency such as Moody's Investor Service, Standard & Poor's or Fitch should be considered when evaluating the ability of an issuer to meet its obligation. Investors should keep in mind that higher relative yields on an investment are a reward for assuming more credit risk. Liquidity Risk Being able to dispose of or liquidate an investment when the need arises is as critical to an investor as whether the investment has appreciated in value or made interest payments on a timely basis. If no buyers can be found when the investment is offered for sale it might as well be worthless. The marketability of a security is an important consideration when determining if an investment is suitable for an investor's needs. Legislative Risk Congress has the power to change existing laws affecting securities. By changing the tax consequences of owning private activity bonds or making additional types of bonds subject to the alternative minimum tax, the market value of certain bonds may fall substantially. Changes in the capital gains tax law could affect timing strategies already in place concerning planned liquidations of securities for retirement, educational expenses or other purposes. Call Risk Related to reinvestment risk, call risk is the risk that a bond might be called prior to maturity and the investor would not be able to reinvest call proceeds at a rate of interest as high as was being received on the called bond. Planned income flows could be changed or interrupted. See the section on Understanding Call Provisions elsewhere on this site for a discussion of the types of call provisions and how an understanding of calls can minimize your call risk. Types of secured and unsecured bonds: Mortgage bonds are secured by real physical assets. Bonds backed only by the good name of the firm are unsecured bonds known as debentures Senior debentur...