Bond Buying Simplified

So, here are the options for bond buyers: You could buy bonds with high yields with various maturities. Or, you could buy deeply discounted bonds — the so-called zero coupon bonds — to avoid reinvestment risk. Or, you could buy floaters, which are the bonds that vary in price as interest rates increase or decline.

But that's far from a list of all of the available options. There are bonds that do not pay coupons during the life of a bond, but rather accumulate and accrue, and are paid all at once along with the principal. By investing in such a bond, an investor does not have to shop around looking for opportunities to reinvest.

There are also bonds that pay interest, but interest that is adjusted according to some benchmark, most often the consumer price index. By investing in such bonds, an investor effectively keeps up with inflation, thus alleviating some of the risks brought on by rising price levels.

All that is well and good, but how is an ordinary investor to go about picking the right bond? The answer to that question would have to be based on the investor's strategic goals or, in other words, what the investor wants to accomplish with his money. However, there is one important thing to remember: investing in bonds is very different from investing in stocks.

Investors should know that bonds are infinitely more precise investment tools than stocks. Unlike stocks, bonds are not impacted by the volatility of earnings, at least not directly and not even remotely to the same extent as equities.

Specific investment strategies are what lie at the heart of buying bonds. If an investor's investment objective is to maximize income, he should be buying a bond offering the highest coupon for the current price and hold it to maturity. If you are such an investor, call your broker and ask for high coupon bonds. Your broker will have substantial inventories to choose from. Just don't forget to ask your broker also why you might be paying a premium price for the high yield bond and how your real is return calculated.

On the other hand, if an investor wants to profit from the power of compounding interest, he should ask his broker about bonds with the best yield to maturity. That particular yield would include the current yield plus capital gains. However, there is something to be on the lookout for — and that is if a bond is callable. When the bond has that option embedded in its covenant, it means that the issuer can buy it back if interest rates fall enough to justify debt reduction even if it means paying premium prices.

Some investors are sick and tired of price volatilities. Well, there are bonds out there offering protection against price fluctuations as well. High coupon bonds usually offer fair protection because, the higher the coupon, the faster the bond repays the cost of purchase and the smaller the window of opportunity for fluctuating interest rates to adversely impact the bond's cash flows. The only problem with this strategy is that high-yield bonds usually come at steep prices. But if you want volatility protection, you'll have to pay for it.

Finally, for investors looking for performance bonds, they should be looking in to bonds that are sold at deep discounts from their redemption value and relative to term and credit rating. In the case of performance bonds, what investors are focusing on are capital gains, rather than income. Admittedly, in the current low interest-rate environment, finding performance bonds can be difficult. This would also be a reason to call your broker and go through his firm's inventory of bonds; something is bound to catch your eye.