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A primer on bonds for the baffled investor

Because bonds deliver a consistent stream of income,

Because bonds deliver a consistent stream of income, many investors view them as the perfect retirement vehicle. But, bond prices can fluctuate. Credit: iStock

Now that the kids are back in school, it's time to hit the books for you and your money. For the next few weeks, I am going to cover basic financial and investment concepts that seem to flummox people.

When I wrote about bonds a couple of years ago, I received a lot of positive feedback, so I am repeating much of that column today.

Companies have two basic ways to finance their operations: through stock and through bonds. When you purchase stock ("shares" or "equity"), it represents ownership of a publicly traded company. As a common stock holder, you get a piece of what the company owns (assets) and what it owes (liabilities). You also are entitled to voting rights and dividends, which are the portion of a company's profits it distributes to shareholders.

Stock prices move based on supply and demand: If more people think the company will deliver future financial results, they will buy the stock and its price will rise.

When you buy a bond, you are actually lending money to an entity — the United States government, a state, a municipality or a company — for a set period of time — from 30 days to 30 years — at a fixed rate of interest. (The term "fixed income" is often used to describe the asset class of bonds.) At the end of the term, the borrower repays the obligation in full.

Bond prices fluctuate based on the general direction of interest rates. Here's how it works: If you own a 10-year U.S. government bond that is paying 5 percent, it will be worth more now, when new bonds issued by Uncle Sam are paying only 1.6 percent. Conversely, if your bond is paying 2.5 percent and your friend can buy a new bond paying 5 percent, nobody will be interested in your bond, and the price will fall.

That's why bond prices move in the opposite direction of prevailing rates, regardless of the bond type. So, if you hear that interest rates are on the rise, you can count on your individual bond or bond mutual fund dropping in value.

Although bonds often are hailed as safe, bond investors face a number of risks, in addition to the interest rate risk described above. One is credit risk, which is the risk of default, or that the entity does not pay you back. That is a pretty low risk if the entity is the U.S. government, but can be high if it's a company or town that is in trouble.

Another risk is inflation. Even if the bonds are paid in full, the promised rate of interest can turn out to be worth less over time due to inflation, which eats into the fixed stream of payments.

Because bonds deliver a consistent stream of income, many investors view them as the perfect retirement vehicle. But, as mentioned above, bond prices can fluctuate.

The worst calendar year for the broad bond market was 1994, when returns were minus 2.9 percent due to an unexpected upward shift in interest rates. (Prices dropped more, but the interest from bonds helped defray some of those losses.)

So, you can lose money in the bond market, though the magnitude of the fluctuations tends to be smaller than those in stocks and other riskier asset classes.

When I wrote about bonds in 2012, many readers said I was crazy to advocate them because interest rates were going to explode higher. Two years later, bond prices have not moved much higher, but chances are that interest rates will rise in the coming months and years.

That does not mean you should avoid bonds, but you need to be careful about the types you put in your portfolio.

If you stick to shorter-duration and higher-quality bonds, they can still have a stabilizing effect on a diversified portfolio over time.

Jill Schlesinger, a certified financial planner, is a CBS News business analyst.

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