This month, we take our final look at bonds and the bond market. We'll tackle two subjects: rating systems and some of the key risks to investing in bonds. We'll also offer up an Internet site or two with more good information on bonds, so that you can get as much information as you'd like before you start investing.

Rating Systems

As you'll remember from our last installment, there are all sorts of bonds. Some are issued by governments, some by corporations. Some are asset backed, others are backed by a general security against the assets of the company. Others aren't backed at all. ...

So how do you find out whether the bond is a good investment?

Well, the first way is to do a lot of research. Find out who is offering the bond. Research the company, and the bond issue, to determine whether you'll be able to get your money back if things go wrong. At the same time, you can try to determine for yourself whether anything is likely to go wrong with the company.

Or, you can leave it to the experts. Two companies that are the "experts" on rating bonds are Moody's and Standard & Poor's (S&P). Both Moody's and S&P are hired to determine the bond rating for a bond issue. They look at the various risks the government (or company) is going through, including currency risk, country risk, and the like, and they look at how the bond is backed. Then they make a determination on whether the bond is high risk or low risk. The higher the risk of the bond, the less chance you'll get your money back, and (of course) the higher the yield will have to be for the company to sell the bond.

What makes it a bit confusing is that Moody's and S&P have different ways of rating bonds. A bond with an "A" rating or higher should be able to "make it" regardless of the economic situation. A bond below BBB or Baa is considered a "junk bond"--a bond that comes with a high risk. The following table summarizes bond ratings from these two agencies.

Moody's

Standard & Poor's

Meaning

Aaa

AAA

Extremely high quality bond

Aa

AA

Very high quality bond.

A

A

"Fair" quality bond.

Baa

BBB

Medium quality bond

Ba

BB

"Junk" bond--below investment grade.

B

B

"Junk" bond--below investment grade.

Caa or lower

CCC or lower

Highly speculative or in default.

Risks of Investing in Bonds

Even though most bonds are a lot safer investments than stock, there are still significant risks to investing in the bond market. Here are some of those risks:

Risk of Default

The biggest risk in investing in a bond is the risk that the corporation or government that you've lent your money to defaults on their bond. Usually, a company will only default if the company has no cash, or is near bankruptcy. A government will typically only default if it has no cash or if there is an abrupt change in government (such as a takeover by force) where the new government will not honor the old government's debts.

The best way of assessing default risk is by looking at the S&P or Moody's ratings for the bond. These ratings (discussed above) assess the likelihood of default.

Currency Risk

If you're buying a bond that pays in euros, the rising or falling of the euro as compared to the U.S. (or Canadian) dollar will have a big effect on how much money you'll get back. Remember: The bond you buy is payable in the currency that is written on it, and if you buy a bond in some other currency, it's just like holding that currency. If, for example, you bought a bond in Mexican pesos, and the peso is devalued, you're going to be left holding very little.

Interest Rate Risk

If interest rates rise, the value of your bond will go down. People buy bonds on a "calculated yield"--so a $100 bond that's paying 5% interest will be worth a whole lot less to an investor if the general interest rate rises to 7% than if it stays at 4%. The farther away your bond is from maturity, the harder it will be hit if interest rates go up.

High Commission Fees

Although bonds are typically a relatively safe investment, you may lose out when you sell them, due to the high commissions charged by bond traders. The problem is, most bond investors are huge, multinational investment houses, which buy and sell $100,000 worth of bonds at a time. If you've got a small number of bonds to sell, you may not get market price. The best way to avoid these costs is to hold your bonds until they mature, and then cash out. A bond fund may also be a way of avoiding these commissions, but we'll be talking about those when we talk about mutual funds and other "pooled" investments.

Early Redemption

When investing in bonds (especially in a volatile interest rate economic climate) beware of bonds with "call options." A call option allows the company or government that sold you the bond to redeem it, at face value (or some other price known as the "call price"), at any time. The problem with a call option is that if interest rates go down a lot, a $100 bond paying a high rate of interest will typically sell for more than $100 in the open market (to make up for the high interest paid on the bond as compared to the current interest rate). But a call option means the company can redeem the bond at any time for $100 (or whatever the call price is), regardless of market value.

Other Sources of Information on Bonds

Quicken.ca has a lot of information on bond trading for beginners. The link above will take you to a great article on bond trading techniques, and a look down the right hand side of the page will give you a half dozen more articles on bond trading, including a very handy bond glossary.

The Solomon Smith Barney Web site has a great education center that talks all about municipal bonds. Find out whether investing in municipal bonds is right for you ... and which bonds to invest in.

I've never heard of these guys, but Equity Analytics appears to have a good 20-part series on bonds. It's geared to more experienced investors, so if you're into understanding market minutiae, then you might want to check it out.