People tell me that they are intimidated by bonds because they don't really understand the way that they act in the investment markets. They tell me that they tend to mix them up with stocks, most commonly forgetting that just because they are considered a security, does not mean that they will appreciate in value in the same way or in unlimited time frames.

Bonds have been in the news lately because of the equity-like returns being generated. According to Mark Gilbert, Bloomberg columnist, European corporate bonds have returned 15 percent, while Euro junk bonds have been four times that much even though these returns may not be sustainable. Investors may see equity-like losses rather than the security of regular interest payments.

The easiest way to think about a bond is this: it is a formalised version of an informal loan. I loan money to you, and if you aren't a shifty relative, you will pay it back to me at some agreed upon time, while providing me with some interest to keep me happy with the whole deal. Of course, that is a simplistic view, but add in a few terms, conditions, lawyers to draft the bond offering and a bunch of investment bankers to sell it, and you have a group of bonds available for sale on the open market - in the millions, sometimes billions of units at any one time.

Bond offerings which are securities actually start with say, a company needing capital to fund a new processing plant, and not interested in selling more stock diluting current share ownership; or, a municipality needs a new airport but does not want to raise taxes; or a government wants to control the money supply by issuing bonds, or buying them back.

Companies who issue bonds are generally publicly traded giants. Municipalities are established to operate for the public good, sometimes in partnership with commercial enterprises, but they don't issue stock for purchase, nor do governments of countries. It can certainly be argued that as taxpaying residents of a country, we already own all the country stock, implicitly. Governments cannot operate without the (reluctant in many cases) participation of their resident citizens. A prize to the reader who remembers where the phrase "no taxation without representation" came from.

In some respects, bonds are more complex than common stocks because they can be structured in so many ways. A stock or a share of a company is just that - a percentage of ownership; it may be an extremely tiny piece of the action, but it is equity. A company can issue more than one class of shares with various conditions attached ; preferred shares are an example that resemble bonds in character. Generally, though, shares are thought of as an investment that has the ability to grow exponentially, provided that the company that issued the shares continues to survive and thrive.

Kinds of bonds - not all bonds are created equal, some have far more respectability than others; maturity dates and interest rates may differ; some pay interest out every six months, others are sold at discount rates where the interest accrues over time and is received at maturity. Bonds are subject to credit ratings that will have a direct effect on price and interest rates offered.

Bonds are issued (in the initial offering) on the premise that if I loan (buy from) the lender (the corporation, municipality or government) a sum of money, say $1,000 for five years paying four percent per annum (the coupon rate), I will receive a bond certificate (now usually just a notation in my brokerage account) for the same amount. Every six months on the date inscribed on the certificate and six months out, I will receive half of that interest. At the end of five years, I get my principal back. What is so complicated about that? Ah, but here is where it gets interesting. I don't want to keep this bond, because bank and market interest rates are rising and I've seen some others that pay a higher rate of 5.2 percent. So, I decide to sell my bond on the secondary bond market. Easy, in a flash - except for one thing, no one wants to pay me $1,000 for this bond because of the lower interest rate, so I let it go for $950 a discount of $50. The new owner holds it until the bond matures when he receives not $950, but $1,000 - a profit of $50. Sometimes, a bond pay such a good rate of interest that the purchaser will pay more than the $1,000 (par value).

And so it goes on the secondary market, even though the coupon rate on each bond remains the same, bonds principal values rise and fall, depending upon the pressure from outside market interest rates. Active bond traders work these fluctuating rates, trading bond positions to make a profit during changes in principal values. It becomes confusing for the individual bond holder, though, because headlines will routinely trumpet the fact that "now is a bad time to own bonds" when interest rates rise. It is only a disadvantage if you have to sell bonds at a discount. If your plan with your portfolio manager is to buy and hold the bonds to maturity while receiving a constant interest rate flow, you are indifferent to the volatility of the bond market. You do not have to redeem.

Maturity. Why don't bonds appreciate in value similarly to stocks? Bonds almost always have an endpoint of maturity where the contract is over. The principal is paid back - most of the time. They may fluctuate during their issuance period, and in the secondary markets, rising above or below par value influenced by interest rate movements, but ultimately as they approach their maturity date the value drops/rises to the 100% principal value that will be returned to the bond holder. They mature to the original issuance value, in Wall Street vernacular, unlike stocks that conceptually can grow forever such as Berkshire Hathaway which has grown 362,000 percent since 1964.

One of the biggest criteria for bonds, critical for selling at competitive rates, and even more so, to realise your return of capital, is the credit rating of the company, municipality or country issuing the bonds. A perception of instability or financial weakness can wreak havoc on bondholder portfolios. Bonds also have pecking orders in repayment under duress. Senior secured bonds are paid before unsecured, or that was the way it used to work until financial institutions faced the sub-prime meltdown. Stay tuned for a dissertation on credit and rating agencies and the testing of the individual investor.

Martha Harris Myron, CPA, CFP(US) TEP(UK) JP - Bermuda is an international Certified Financial Planner™ practitioner. She specialises in independent fee-only cross-border tax, estate, investment, and strategic retirement planning services for Bermuda residents with cross-border and multi-national connections, internationally mobile people and US citizens living abroad. For more information, contact martha.myron@gmail.com">martha.myron@gmail.com or 735-4720.