Investing 101

Even though past performance is no guarantee of future results, historically, investing in common stocks has proved to be the best way to build and protect wealth over the long term. But many Americans, afraid of losing their principal, invest heavily in lower risk debt securities.

Bonds are debt securities issued by organizations to finance various projects. All bonds have certain features in common, including coupon, maturity, face or par value, and credit quality rating. When you buy a bond, the issuer promises to pay a certain rate of interest (called the coupon) for a certain period of time (until the bond matures). Interest is often paid semiannually. The principal is also called the par or face value.

Two major rating services, Moody's and Standard & Poor's, assign letter ratings to bonds to give investors an idea of a bond issue's quality and the issuer's ability to make timely payments of interest and principal. The highest rating is AAA, then AA, A and so on down the line to D, the lowest rating.

If you're considering an investment in bonds, don't look exclusively at the interest rate paid. Think of bonds as you would a loan. Your brother-in-law may not be very good at paying back loans (if he were a bond, he'd get a lower quality rating), so if you were going to lend him $10,000 for five years, you'd ask him to pay more interest than if he had a great repayment history. And you probably wouldn't want to lend him money for 30 years. Bonds are the same: The longer the maturity or the lower the rating, the more interest you should receive.

There are several categories of bonds: those issued by corporations, the federal government and its agencies, state and local governments, and foreign governments.

1. Corporate bonds. There are several types of corporate bonds; they're classified based on the collateral that backs the payment of interest and repayment of principal. Corporate bonds can be secured by real estate (mortgage bonds), equipment (equipment obligations), stocks and bonds (collateral trust obligations), or the general credit of the issuing company (debentures).

Corporations can retire debt prior to maturity in several ways, including calling in their bonds and converting them into other securities. If your bonds are called or converted, you'll receive your principal back and interest payments will cease or change.

Corporations with lower quality ratings need to offer greater incentives to investors in the form of high yields. These higher-yield, lower-rated bonds are often called "junk bonds" because there is a greater likelihood investors' interest and principal will be at risk.

2. Federal government bonds. The federal government, like corporations and state and local governments, borrows funds (through the sale of Treasury securities) to conduct its business. Since Treasury securities are backed by the U.S. government, they have the highest safety rating. There are three kinds of Treasury securities: bills, notes and bonds.

Treasury bills are short-term securities with maturities of one year or less. They are issued at a discount from face value, and they are issued in minimum denominations of $10,000, with $5,000 increments available above $10,000.

Treasury notes are intermediate-term securities, with maturities ranging from one to 10 years. Denominations range from $1,000 to $1 million or more.

Treasury bonds are long-term investments, with maturities of 10 years or longer, issued in minimums of $1,000.

You can buy Treasury securities directly from the U.S. Treasury or from banks or brokerage firms.

Agencies of the U.S. government also issue securities; while these are not obligations of the Treasury, they have an inherent backing by the federal government and are considered to be of the highest credit quality. You may have heard of the "Mac" family-Ginnie, Fannie and Freddie Mac, otherwise known as the Government National Mortgage Association, Federal National Mortgage Association and Federal Home Loan Mortgage Association. These securities are based on pools of mortgages and are called "pass-through securities" because the interest and principal paid monthly by homeowners is passed through to investors.

3. State and local government bonds. Home is where the heart is, and it's also where investors can find interest-bearing investments free of state and federal income taxes. If you purchase municipal bonds in your state, the interest paid on these bonds is tax-free. Interest paid on bonds issued by the Commonwealth of Puerto Rico is tax-free in all 50 states. (For some investors, this income may be subject to the federal alternative minimum tax, a flat tax applied to wealthy taxpayers to ensure they pay at least some tax.)

4. Foreign government bonds. Foreign governments issue bonds to finance their projects, too; sometimes interest rates are higher than those of U.S. government bonds. But before you invest, be sure you understand the inherent risks in foreign securities, including currency fluctuations and political and social instability.

This article was originally published in the January 1996 print edition of Entrepreneur with the headline: Investing 101.