Bonds

When you buy a bond, you're making a loan to a corporation, the federal government, or state or local governments, for such things as factories, highways and schools. In exchange for the use of your money, you earn interest and the promise of repayment of your principal on a set date. Bonds are rated according to their credit quality, a standard measure of the financial strength and credit-worthiness of the bond issuer. As a general rule, higher-quality bonds pay lower interest rates, while lower-quality bonds pay higher rates to attract investors.

A bond's value is closely tied to movements in interest rates, so if you sell a bond before it's due date, you'll receive its current value, which could be more or less than you paid for it. Bond prices increase when interest rates fall, and decrease when interest rates rise. That's because if an older bond's interest rate is higher than the rate being paid on newly issued bonds, buyers are willing to pay more for it to get the higher interest. If an older bond's interest rate is lower than the rate paid by newly issued bonds, its price will fall to attract buyers. How a bonds value reacts to interest rate changes depends in part on its maturity. In general, bonds with longer maturities are more sensitive to changes in interest rates, so their market prices can fluctuate significantly. To compensate investors for this added risk, longer-term bonds generally pay higher yields.

Treasury securities, issued by the federal government, earn interest that is subject to federal taxes, but exempt from state and local income taxes. Treasury securities are considered safe from credit risk because the payment of principal and interest is backed by the full faith and credit of the U.S. government. However, just like other bonds, Treasuries are subject to interest rate risk, so if you sell a Treasury security before it matures, it may be worth more or less than you paid for it.

There are three types of Treasury securities: Treasury bills, which require minimum investments of $10,000, have a maturity of one year or less, and are issued at a discount from their face value. Treasury notes, sold in minimums of $1,000 or $5,000, mature in one to ten years. Treasury bonds issued in minimum denominations of $1,000 mature in ten years or longer. You can buy individual Treasury securities through commercial banks, brokerage firms, or commission-free through Federal Reserve banks and branches or the Bureau of the Public Debt. You can also invest in Treasuries through a mutual fund if you have a limited amount of money to invest, or if you want to invest small amounts regularly.

Municipal bonds are issued by state and local government agencies. The interest they pay is generally exempt from federal income taxes, and in many cases, from state and local taxes as well. However, any investment gains made from the sale of municipal bonds are taxable. Because of their tax-exempt status, municipal bonds pay lower interest rates than taxable bonds. Whether you'll benefit from a municipal bonds tax advantage depends on your tax bracket. The key is to look at its taxable equivalent yield-what you would have to earn in a taxable investment of similar quality for an equal return.

Like other types of bonds, municipal bonds are subject to interest rate risk and credit risk. General Obligation bonds, sold to finance roads, schools, and government buildings, typically have high safety ratings because they're backed by the full faith, credit, and taxing power of the issuer. Revenue bonds, issued to raise money for specific projects, such as airports, toll roads, and toll bridges, are usually backed only by the funds raised by that particular project.

Since the interest paid on municipal bonds is generally tax free, munis are not appropriate investment for IRAs and other tax-favored retirement accounts. That's because money withdrawn from these accounts is subject to income tax, regardless of what it was invested in. Depending on how much you have to invest, you can buy municipal bonds individually, or through mutual funds. You can also buy munis through unit investment trusts, which are investment companies that invest in a fixed portfolio of securities.

Treasury strips, commonly called Treasury zero coupons, are Treasury securities that have been stripped into their separate interest payments and principal components. After a security has been stripped, each of the separate components can be sold or traded individually, to investors. The components of a stripped security are sold in a wide variety of maturities. The minimum par value of a component is $1,000, with multiples of $1,000.

You can buy Treasury strips through financial institutions and brokerage firms. Zeros pay no interest until they mature. Instead, you buy a Zero at a deep discount then the interest accumulates within the security until you redeem it at maturity for its face value. If you hold the component until it matures, your return is the difference between the purchase price and the maturity value.

Treasury zeros are useful investments when you want to be sure of receiving a certain amount of money at a specific date, such as for your child's education. Another plus: Because zeros don't pay interest until they mature, you won't have to worry about how to reinvest periodic dividends, as you would with regular bonds, and what rated you'll earn on those reinvestments. It's like the interest payments are automatically reinvested at a set rate, thereby guaranteeing that rate.

Treasury zeros are direct obligations of the Treasury. Therefore, their value at maturity is backed by the full faith and credit of the United States. And Treasury zeros aren't callable, so you don't have to worry about finding a new investment before you're ready.

If you bury a Treasury zero, plan on holding it until it matures. That's because like other bonds, if you need to sell a Zero before maturity, you may get more or less than you paid for it because a bond's market price fluctuates with changing interest rates. Furthermore, Zeros are even more volatile than standard types of bonds, because they pay no interest until the bond matures. So if interest rates rise, Zeros fall further in value than ordinary Treasuries.

Treasury zeros are free from state and local taxes. However, you have to pay federal taxes on the earned interest each year, even though you don't receive it until the security matures. Reporting and paying federal tax on this so-called phantom income is one reason that taxable zeros are often put in tax-favored accounts such as IRAs, or held in custodial accounts for children in lower tax brackets.

U.S. SERIES EE SAVINGS BONDS, sold at 50% of their face value and available in $50 to $10,000 denominations, are backed by the full faith and credit of the U.S. government. You can purchase them through some credit unions, other financial institutions, and payroll savings plans. The terms for Series EE bonds have changed over the years, but these changes aren't retroactive, so a bond earns interest under the terms that were in effect when it was purchased.

Because EE bonds earn market-based rates, you can't be certain when a bond will reach face value. For example, a bond that earns an average of 5% will reach face value in 141/2 years, while a bond that earns an average of 6% will reach face value in 12 years.

New bonds earn interest, based on market yields for five-year Treasury securities, through periodic increases in value for up to 30 years. These new bonds don't have a guaranteed interest rate. However, if a bond doesn't reach its face value in 17 years, the Treasury will make a one-time adjustment to increase the bond's redemption value to face value - this translates to a guaranteed minimum yield of 4.1%.

You can redeem EE bonds anytime after six months, but they're designed to be held for the long term. With new bonds, for example, if you cash in before you've held it for five years, you'll incur a three-month interest penalty. The interest earned on EE bonds is subject to federal income tax, but not to state or local income taxes. You can elect to pay the federal tax annually as it accrues, or defer payment until you cash in the bond, or until it reaches final maturity. Interest earned on bonds purchased on or after January 1,1990, may be partially or fully exempt from federal income tax if you use them for certain college education expenses, and if you meet designated income limits and other conditions.

Stocks

When you buy shares of common stock, you become part-owner of a corporation along with many other people and institutions, commonly numbering in the thousands. As a stockholder, you can make money in two ways: First, the company may pay dividends, which are your share of the company's profits. Second, if the price of the stock goes up, you can sell your shares for more than you paid. Conversely, if the stock's price declines, you risk losing money. With thousands of companies to invest in, each with different levels of risk, stock selection takes some study. You should have the time and commitment to do ongoing investment research and analysis, and enough money to diversify your holdings.

Over the long haul, the stock market, as measured by the Standard & Poor's 500 Index, has significantly outperformed other types of investments, as well as inflation. While stocks deliver a bumpy ride along with their higher average returns, historically, good periods have offset bad ones and lowered the risk of loss. In fact, over the past 71 years, through periods of market crashes, wars, high inflation, and economic booms, large-company stocks have returned a pretax average annual gain of 11%. The key is to be prepared to weather short-term downward cycles and to focus on long-term performance, not day-to-day or year-to-year fluctuations.

STOCK AND BOND MUTUAL FUNDS, most of which are open-end mutual funds, offer instant diversification and professional money management. (Closed-end funds issue a fixed number of shares and are traded like regular stocks on one of the major stock exchanges or in the over-the-counter market.) When you invest in a mutual fund, your money is pooled with the money of thousands of other people and invested in a portfolio of stocks, bonds, cash, or other securities depending on the fund's objectives. As a shareholder, you share in a fund's gains, as well as its losses. You can sell your shares on any business day, however, the amount you'll get back depends on how the fund's investments are valued at the time, and any applicable fees. Mutual funds are not insured or guaranteed by any government agency, nor are they guaranteed by any financial institution, no matter how or where their shares are sold.

There are thousands of mutual funds, each with different fees, goals, risks, and returns, so you need to do your homework. Before you invest, read the prospectus to make sure the fund is an appropriate investment for you. Key things to look for: investment objectives and policies, the tenure of the fund manager, fees and operating expenses, past performance, and details of how to buy and sell shares. Also compare a fund's investment returns, as well as its expense ratio, to the averages for the fund's peer group and the appropriate market indexes over different time periods.