As you now know, bonds are about safety and interest. They're a place to keep our money safe, and/or a place to keep money when we need interest checks in the mail. If you're working and your income is adequate, you may not need that extra income just yet. So for now you'll be buying bonds primarily for their safety. But when you retire and your salary is history, you'll be buying bonds not just for safety, but also to supplement your Social Security or other retirement income you'll (hopefully) be getting. So when will an investor look for bonds or other loaner investments? When they don't want to expose their money to the risk of ownership investments, when they need regular interest checks to pay the bills, or both.

Now let's put bonds in categories by seeing who's trying to sell you bonds, then looking at the safety, interest and tax advantages of different types.

People who borrow money by selling bonds are called bond issuers, and they fall into three rough categories. Private companies, local government and the federal government. If you lend to a company, you're about to invest in corporate bonds. Lend to a state or local government and you're investing in municipal bonds. Lend to Uncle Sam and you're buying treasury bonds.

When you consider safety, you can't beat Uncle Sam. That's because the federal government can print money whenever they feel the urge, so they'll always be able to pay their debts no matter how many $600 toilet seats they buy. If you're buying a corporate bond, on the other hand, the financial smarts of the company is the main thing, because if the company doesn't manage its finances well, it won't have the money to repay you. Local government bonds, like those issued by a state, county or city, fall somewhere in between corporate and federal government bonds on the safety scale. Sometimes these bonds are backed by the taxing authority of the local government that issues them, making them very safe. Other times the repayment of these bonds could depend on the money brought in from some specific project, like a toll road or a stadium, making them a bit iffier.

So if safety were our only concern, the choice would be easy. We'd want to go where the money's minted: Treasury bonds. Next we'd choose local government, since in many cases they can repay debts by raising taxes. And bringing up the rear would be corporate bonds. Since every company manages its money differently, to determine the safety of a corporate bond we'd have to scrutinize the company's books. An onerous task, especially since their financial condition can change at the drop of a hat. Fortunately, however, we're spared this burden because there are people who are happy to do the detail work for us. They work at places called rating services. Two of the best known are Standard & Poor's and Moody's. Their job is to pore over the books of basically every company and municipality that issues bonds and render a final verdict on each one in the form of a grade. So bonds end up stamped with grades, kind of like eggs. AAA is best, then AA, A, BBB, BB, etc. on down to C. Any bond that earns one of the highest four categories of rating, i.e., AAA down to BBB, is called "investment grade." Bonds with ratings below investment grade are often called "junk bonds." (So what would you call a company's bonds if they were AAA rated, but the company's business was junk yards? I guess investment grade junk bonds.) In any case, pretty much all bonds are rated by one or more ratings services except federal government (Treasury) bonds. As I've explained, since Uncle Sam prints money, his bonds are automatically risk-free: no rating needed.

As you might imagine, the more risk you're willing to take, the more reward you're going to make. So generally speaking, you're going to be getting less interest on treasury bonds than you are on local government bonds, which in turn will pay less than corporate bonds. And AAA corporate bonds will pay a lot less than "junk" grade corporate bonds. So as with many things in life, you get what you pay for. In this case, you gain safety by giving up income.

But here's something else we need to look at...the taxes we'll have to pay on the interest we'll be getting.

Did you know that you've got people eying your wallet every time you make money? Not just your spouse and kids. I'm talking about Uncle Sam and his local cronies. Every time you get a check, the federal government wants a cut. Depending on how much money you make, the feds will expect to get from 10 to 38 cents of every dollar; that includes interest earnings from bonds. In addition, depending on where you live, your state, city and/or county government may also demand a piece of the action. So don't turn around too fast; there are a bunch of people back there reaching for your wallet.

Want to send some of these tax collectors packing? It's possible, because a long time ago these government guys got together and made a deal regarding taxes. Simply put, if you invest in bonds issued by the federal government, you don't have to pay state or local taxes on the interest. If you buy a bond issued by any state or local government, you generally don't have to pay federal taxes on the interest. And if that bond is issued by your resident state, you may not have to pay state or local taxes either. All this tax forgiveness flying back and forth between federal and state tax collectors is what's known as reciprocity: you don't tax investors who buy our bonds, and we'll reciprocate by not taxing investors who buy yours. If, however, you buy a bond that's issued by a corporation, no reciprocity: you have to pay everybody. This absence of tax forgiveness is what's known as a bummer.

Now we're going to bring all this tax stuff home with an example, which is going to require a little math. So take a deep breath and focus: don't worry, it's just a paragraph or two.

Say you live in Cincinnati, Ohio, file a joint return and your taxable income is around 50 grand. A quick glimpse at various tax tables (as if there were such a thing) reveals that you're in the 27% federal tax bracket, five percent state tax bracket and two percent local tax bracket. This tells us that when you earn a dollar of interest, you're going to pay a total of 35 cents to tax collectors: 27 cents goes to Washington, five cents goes to Columbus, and two cents goes to Cincinnati. Now let's assume we're out scouting for bonds and find three likely candidates. One is a corporate bond, issued by Procter and Gamble. One is a Treasury bond, issued by Uncle Sam; one is a City of Cincinnati municipal bond, issued to pay for a new stadium. The Treasury bond is, of course, risk-free, and the other two bonds are AAA-rated. All three pay 10% interest. Which would you buy? To find out, we have to figure out the after-tax return of each.

Before we start, remember the rules:

- Corporate bonds are taxed by both state and federal governments.

- Federal bonds are free from state tax.

- State and local bonds are free from federal tax.

- State and local bonds purchased by local residents are normally totally tax-free.

Now let's see what's happening with our three bonds.

If we earn a dollar of interest from the Procter and Gamble bond, everybody has their mitts out: we pay a total of 35 cents to federal, state and local tax collectors, leaving us with 65 cents. So our bond that paid 10% before taxes only pays 6.5% after taxes. Now look at the Treasury bond. We have to pay federal taxes of 27%, so when we earn a dollar, we only keep 73 cents. But at least we don't have to pay state or local taxes. So on this bond, our after-tax interest is 7.3%. Now let's look at the City of Cincinnati stadium bond. We get to keep the whole 10% because here we pay no taxes: federal, state or local.

On the surface, these bonds seem very similar since they're all safe and all pay 10% interest. But hold them up to the tax tables and we see that they're not alike at all. The City of Cincinnati municipal bond puts more money in our pocket by far.

If you're not catatonic from all that computing, maybe you'd like to learn the formula so you can amaze your friends and family by magically computing the after-tax return on any interest-bearing investment. Here's all you do: subtract your tax bracket from 100 and multiply the result by the interest rate you're looking at. Like so...

Total federal, state and local tax bracket: 35%

100% minus 35% = 65%

65% times interest rate = after-tax interest rate

Got it? If that sunk in, you now know more than the vast majority of investors. Sad, but true.

Perhaps you're thinking at this point, "Why bother figuring out this tax stuff at all? Since I know that practically any municipal bond is federally tax exempt, and municipal bonds issued within my home state are state and locally tax-free to boot, I'll just buy those. Problem solved." Ah, if only life were so easy. The problem is that you're not the only one who knows these tax facts. Your city, county and state have accountants that know this stuff, too. So what do they do? They lower the interest accordingly to negate the advantage you'd otherwise have. Likewise, the feds know that you won't be paying state or local taxes on their interest payments, so they lower the interest they pay. Remember our conversation about the safety of bonds? The higher the safety, the lower the interest? Same principle here. The more tax advantages you receive, the less interest you receive. (That, by the way, is the entire reason that reciprocity exists in the first place. So the various issuers of government debt can pay less interest. Which in turn, allows them to borrow more money.)

Now you pretty much know the ropes when it comes to bondage. But there's still another loose end or two to tie up. For example, the longer you lend your money, the higher the rate you'll lock in. To illustrate, say you're going to lend me a box of fifties. (I'll give you may address later.) I'll agree to pay you interest. (How does half a percent sound?) But we've still got to decide on one other thing: when I'm going to pay you back. (How about January, 2080?) Same with bonds. A bond comes with all this stuff spelled out. The amount, (most bonds are sold in $1,000 increments) the interest rate (sometimes called the coupon) and when the bond comes due (known as the maturity date). If you're going to lend me money (not the smartest move you've ever made) you'd want a higher interest rate if you were going to lend it to me for a longer period of time. Why? Because when you give me your money, you no longer have the use of it. Which means you can't take advantage of a better offer should one come along. So the longer you agree to part with your money the higher the interest rate you'd demand.

We can see this concept in action whenever we lend money. When you put your money into a savings account, you can leave it there for 10 minutes if you want. And what do savings accounts pay? Squat. If you put your money into a six-month certificate of deposit, the money is tied up for six months, but you get a higher rate. Choose a five-year certificate of deposit, and the rate will be higher still. Bottom line? The longer you'll agree to leave your money with someone, the more interest you'll get. This isn't always the case, but it's a decent rule of thumb.

A couple more fine points and we'll stop with the theory and rejoin real life. As I've explained, the longer you're willing to tie your money up, the better rate you'll often get. But what happens if you agree to tie your money up for years, but then decide you need it in months? If you've invested in a certificate of deposit from a bank, getting your money back entails a penalty. The fee for breaking the deal is typically six months worth of the interest you've earned. In the case of a bond, there's no interest penalty. You can merely sell your bond on the open market. Depending on the bond in question, there is an active market for used bonds. The market with the most volume is the U.S. Treasury market, but there is some action to be had with municipal and corporate bonds as well. So converting your long-term bond back into short-term cash isn't that difficult. Converting into the same amount of money as you invested, however, might be.

Since bonds come with a fixed rate of interest, determining their market value isn't rocket science. All you need to know is what interest rates are on similar bonds at the time you want to sell. Let's use an example. Say that a couple of years ago, we put a thousand dollars into a 10-year Treasury bond with a five percent interest rate. When we bought it, we obviously thought that we'd be able to leave that money alone for 10 years, but since then we've discovered that we like Harleys more than we like bonds and would rather have one of those instead. So it's time to sell our bond. How much will we get? Well, our bond now has eight years until its maturity date, so we check the newspaper and see what treasuries with eight years left until maturity are currently paying. Turns out that interest rates have gone up since we bought our bond. Eight-year treasuries are now paying 10%. Hmm...why would anyone buy our five percent bond when they can buy one elsewhere that pays 10%? They wouldn't, unless we lower the price. Remember that we put $1,000 into our bond, and it pays 5%, which means it pays $50 a year. The $50 a year can't change...that's etched in concrete...well, in ink at least. But what can change is the price we're willing to take for our bond. For example, suppose we sell our bond for $500. Since it pays $50 a year, that would give it a return of 10%. (50 divided by 500 = 10%) So if we really want to cash out, we'd have to consider taking $500. Actually less, since the broker who's going to find the buyer for us also wants to get paid too. This is not a pleasant prospect...getting only $500 for a $1,000 investment. But that's life. When you want to sell, you take what you can get. Our only consolation is that buying Harley accessories will soon make losing $500 in the bond market seem like chickenfeed.

In our example we took a huge hit when we sold our bond, but we could just as easily have made a profit by cashing out early. If we'd locked in a 10% interest rate and rates had fallen to 5% instead of the other way around, we'd have been able to sell our bond for twice what we paid for it.

So here we learn two additional nuances about bonds. First, they can be sold on the open market prior to the date they come due. Second, bond prices in the open market will move in the opposite direction that interest rates do. Imagine a seesaw. On one seat are bond prices; on the other are interest rates. If rates are going up, bond prices are going down. If rates are going down, bond prices are rising. So as it turns out, despite the fact that bonds are normally bought for safety and income, our boring farmer could have a little Mae West in him after all. Because it's possible to gamble with bonds. If interest rates are high and you think they could be falling soon, you could benefit by buying bonds now and selling them at a profit later. Just as with stocks, blackjack or craps all you have to do to win is be either right or lucky.

Whew...now we know a lot about bonds. But are we any closer to feeling comfortable with them? If anything, bonds may seem more confusing than ever about now. True, we've learned that bonds are basically nothing more than an IOU, complete with an interest rate and due date. But we've also learned that quality is important; there are lots of issuers to consider; income taxes play a huge role in determining what kind of bond to buy; market interest rates can have an impact on what are bonds are worth if we decide to sell early. This is where Wall Street would like us to stand aside, write them a check and let them take care of all this complex stuff for us. No thank you.

Just as with stocks, there are mutual funds that will do all the work for us. They pick the bonds, they do the paperwork, they send us our interest if we need it or reinvest it if we don't. For example, the Vanguard Intermediate Term Bond Index Fund.

As I write this, this fund has three billion dollars in it, and that three billion dollars is about half invested in U.S. Treasury-related bonds and the other half in corporate bonds. The average quality of the bonds is AA, so this is pretty safe stuff. In terms of interest, the fund is earning a little less than five percent (4.88% to be exact.) The vast majority of the bonds in the portfolio (more than 95%) will mature between five and 10 years from now. That doesn't mean that our money has to be invested for that long...as you know you can sell bonds any time you want, and that includes selling shares of your bond mutual fund. But as you also know, bonds can fluctuate in value, which means if interest rates go up, this fund can go down in value and we can lose money. Today the price of the fund is $10.45/share, and over the last year that price has been as high as $10.70 and as low as $10.05. Not huge price swings, but price swings nonetheless. So this isn't a place that we'd put money that we needed day after tomorrow. It's a place we'd put long-term money when we've had our fill of stocks but still want to earn as much as safely possible.

As with all mutual funds, this particular one charges money for the services it provides. The expense ratio is .21%, and if we don't keep at least $2,500 in the fund, we'll also have to pay a $10 annual maintenance fee. But we don't pay a commission when we buy or sell and we don't pay a 12b1 fee either. So we're giving up .21% of interest in exchange for diversification, professional management and record-keeping.

Now maybe you're asking, "Hey, what about those tax-free bonds you talked about?" Good question. After all, when it comes to taxes, less is always more. But as I explained when I talked about tax-free bonds, the advantage is offset by lower interest rates. For example, Vanguard has an intermediate term tax-free municipal bond fund as well. But its tax-free interest rate is only 3.37%. Remember the formula we used before to convert taxable return to after-tax return? Let's use it here:

Return on taxable fund: 4.88%

Federal Tax Bracket: 30%

100% - 30% = 70%

70% x 4.88 = 3.47%

After tax return of Intermediate Term Bond Index Fund: 3.47%

After tax return of Intermediate Term Tax Exempt Fund: 3.37%

See how that works? Because the tax-free fund pays less, it doesn't do us any real good to choose it. In fact, we're earning a little less by trying. So let Uncle Sam have his pound of flesh...we'll keep our lives simple and just stick with the taxable version.

Before we leave this section, I'm going to suggest an alternative to a bond mutual fund: U.S. Savings Bonds. It's my second choice, but the simplicity, tax advantages and low cost make these something worth considering.