I’m totally new to this whole thing, could you possibly give an example of how bonds work?

When you buy a bond, you are actually loaning your money to the organization that issued the bond. That is why bonds are often called debt instruments. The principal (the face value of the bond) is repaid on the maturity date. In the meantime, you are paid a set amount of interest, usually every six months. This interest is called the coupon or coupon rate. It’s called that because bonds used to come with little coupons attached that you would cut off and send in twice a year to receive the interest payment. How quaint. Nowadays, the coupon rate is nothing more than the annual interest rate.

When bonds are originally issued they are issued in even denominations, usually $1,000 and occasionally $5,000, with some government bonds at $10,000.

Let’s look at how bonds are described. For example, you could buy a New York State G.O. (Government obligation) with a maturity of 5-1-06 and a coupon of 5.25% priced at $96.425. Now, before we get confused, let’s look at each of those components.

Maturity = the day that you get all of your original investment back. In this case, you would get back $1,000 per bond on May 1, 2006.

Coupon of 5.25% = This is the annual interest rate. Every six months you will receive an interest payment on your initial investment. This payment will be equal to the coupon rate (divided by 2 since each payment is for only half a year) times the denomination of the bond. So in this case you will receive $26.25 ($1,000 x .0525/2) every six months. In the case of tax-free bonds, the interest is tax-free.

Priced at $96.425 = All bonds are priced in units of $100 even though you can’t buy them for that. Our example is the most common kind of bond — a $1,000 denomination. This bond is selling at a discount to its original price. If a $1,000 bond is priced at 96.425, then your price per bond will be $964.25, not $1,000.00. The original price was $100.00 (meaning that it actually sold for $1,000), but once a bond enters the secondary market (you can buy and sell them at any time), the price fluctuates based on how the bond compares to the terms that new bonds are being offered under. This bond’s coupon rate is lower than the current interest rate for a comparable newly issued bond, so it is selling for less than its original value.

Bond pricing gets complicated so hold on.

Say you have an old 20-year bond that expires in 5 years and has a coupon interest rate of 10%. Wow. New 5-year bonds are only paying 5%, so obviously your bond is worth more — the question is, what price would someone pay for your bond with its premium interest rate? Well, the market tells us that people are willing to pay $1,000 for a 5-year bond that pays them $50 a year in interest, but your bond pays $100 a year in interest, so you might think that someone would be willing to pay a lot more for it, based on the interest it pays. That’s true, but there are other factors — both bonds pay $1,000 in cash at the end of 5 years — so maybe the price should be the same. Then you have to look at the entities that issued the bonds — are they equally likely to still be in business and be able to repay the bond’s principal?

There is a complicated formula that takes into account the length of time to maturity, the coupon rate vs. the current equivalent interest rate, the relative possibility of default between the two issuing companies, and comes up with a price for your bond that is supposed to make it the equivalent of a newly issued, comparable bond. Oh, if you have something called a ‘bearer bond’, which means that the issuer of the bond doesn’t have your name on the certificate, make sure that you register them in order to get your interest and to be notified of any changes.

Wow, there’s a lot to bonds. Are there any books I can read about them to learn more?

Here are two books you may want to look at. The first is The Bond Book by Annette Thau (Probus Publishing, 1992). It was written for the individual investor and covers all areas of the bond market, including governments, municipals, and corporates.

On a more professional level is Frank J. Fabozzi, editor, The Handbook of Fixed Income Securities (4th edition, 1994, Irwin). This is loaded with more information than most people want or need to know. However, it is a great resource.

So what are tax-free bonds? Those sound good!

Tax-free municipal bonds (often called munis) are debt securities issued by various cities throughout the United States. As such, they are given special tax-free status. If you live in, say, Indiana, and buy an Indianapolis muni, you will pay no federal, state, and, in many cases, local taxes on the interest you receive. But before you start dreaming of an IRS-free life, let’s take a closer look. First, tax-free bonds usually come with a lower interest rate — after all, you get to keep all of it, right? But how do you know that you won’t come out ahead buying a higher interest rate bond and paying the taxes?

So how do I decide between a tax-free or a regular bond?

It’s not that hard a decision. You simply convert the regular bond’s interest rate to its equivalent after-tax rate and compare that with the tax-free bond’s interest rate. Whichever is larger wins.

To find the after-tax rate, first you add up the your marginal income tax rates. If you are in the 15% bracket for federal income taxes and pay 4% in state taxes, your marginal tax rate is 19%. If you are in the 28% federal bracket and your state taxes are 7%, your marginal tax rate is 35%. Now you have to find the reciprocal of your marginal tax rate. Just subtract from 1. The reciprocal of 19% (0.19) would be 0.81, the reciprocal of 35% (0.35) would be 0.65. Now you can convert any interest rate to its after-tax equivalent.

Say you were considering buying a new issue corporate (taxable) bond with a coupon rate of 8%. The after-tax equivalent for someone in the 19% bracket is 6.48% (8% x 0.81), but for someone in the 35% tax bracket, the after-tax equivalent rate is 5.2% (8% x 0.65).

So for someone in the lower tax bracket, the tax-free bond would have to beat 6.48% to be a good deal, but for someone in the higher bracket, the tax-free bond would only have to beat 5.2%.

It works in reverse, too. To see how a tax-free bond compares to a taxable bond, divide the tax-free interest rate by your tax rate. A tax-free bond paying 5% would be equivalent to a taxable interest rate of 7.69% for someone with a marginal tax rate of 35% (5/.65= 7.69), but only equivalent to 6.17% for someone with a marginal rate of 19% (5/.81=6.17).

In general, tax-free bonds are usually only attractive to persons in the upper income brackets.

What percentage of bonds should I have in my portfolio?

Hold on there. You are assuming you should have bonds in your portfolio? There is a whole industry out there dedicated to convincing you of that, and people who make a living issuing pronouncements such as Due to market machinations attributable to phase inducted waves in the upper troposphere we are instructing our clients to move from a 35% position in bonds to a 40% position until the deep geothermal wave pattern returns to an asynchronous mode. Right.

The whole portfolio allocation rap is just another facet of market timing. One can construct wonderful scenarios showing how much money one would have made by switching from stocks to bonds at strategic points in the past, but we have yet to find someone who can accurately and consistently call the shots for the future. Until we locate such a prognosticator, we suggest staying fully invested in stocks with all money that you won’t need for the next 5 years. Gonna buy a house in three years? Put the down payment in some nice bonds, CDs, or even a money market account. But planning for retirement in 20 years? History has spoken pretty firmly on that one — stocks have always done better over the long run.

Here at the Motley Fool we don’t spend a lot of time on bonds because we are focused on your long-term investments and we don’t think bonds are good for that — but, hey, we also don’t tell you what to do with your money, so if if it makes you feel better to have a few bonds in your long-term portfolio, be our guest. Just don’t expect a lot from them. )

For more on this topic see our Tax Q&A area.