You may know that bonds are one way to get income from your investments. You may also know they can help you diversify your portfolio since they often move in the opposite direction of stocks. Yet some people might stay away from bonds because they don't understand how these investments work, or the pricing structure has turned them off to the idea. Here we go over retail notes, which often work as a good alternative to more confusing bond funds.

Bonds Can Be Confusing
With accrued interest, markups, commissions and changing prices, bond investing is not always easy. In 2003, the National Association of Security Dealers (NASD) issued the results of a 55-question investor-literacy survey. The results of survey showed that just 71% of the participants understood the concept of a bond and only 39% knew the inverse relationship between bond prices and interest rates. These numbers may explain why some people avoid bonds.

Diversifying Is Not Always Easy
If you don't understand bond pricing, using bonds to diversify may be difficult to achieve. The typical face value of a corporate bond is $1,000, but if you buy one on the secondary market, you may pay more or less than that amount. The price depends on several factors including prevailing interest rates and credit ratings. Grasping these complex factors can present a roadblock in the attempt to use bonds strategically. (If, however, you would like to start learning, check out Bond Basics and Advanced Bond Concepts.)

As such, to gain some diversification using bonds, many investors invest in bond mutual funds. You can start with a small amount and receive diversification; however, the trouble is that you don't know exactly what income you'll receive while you own the fund (because you own units of a basket of bonds rather than the actual bonds, which you would own if you bought the bonds yourself). There are also ongoing fees that you pay to the fund company to manage your investment.

When interest rates are falling, it's easy to ignore these fees because the value of the fund's shares goes up (remember bond prices and interest rates have an inverse relationship). But when interest rates rise, expenses could consume a larger portion of your returns. Plus, a bond fund has no maturity date, so there is no point in time when you are assured of getting back your original investment (as you are when you own a bond directly).

Finally, bond funds also present a potential tax problem. Many owners of taxable bond funds aren't very happy when they get their Form 1099 from their funds. These shareholders often realize that they do not have complete control over when they must take capital gains (short or long term) and how they can get hit with taxes even if they haven't sold any of their shares.

For instance, when interest rates start to rise, the bond fund's share value can drop. This might cause other fund holders to panic and sell. Fund managers then need the cash to meet the redemptions, so they have to sell bonds that may have appreciated, and must pass that growth to each shareholder, even if the money is reinvested in additional fund shares. Thus, shareholders who stayed in the fund end up with a distribution that they didn't even want, but they still have to pay the associated tax on that distribution. And to make bad matters worse, they might have to pay tax while their fund's value is falling.

Retail Notes Offer Another Option
There is another choice for income-seeking investors that is easy to understand and inexpensive to buy. Retail notes are fixed-income securities that you can purchase directly from the issuer at par in $1,000 increments with no accrued interest or added markups. They are fixed-rate subordinated, unsecured obligations of the issuing company. The notes and accompanying interest payments are backed by the full faith and credit of the issuer and are either callable or non-callable. The callable notes usually provide higher yields and include call protection for a set time (for further reading on callable securities, see Call Features: Don't Get Caught Off Guard.). Once you buy the notes, you will receive regular fixed-interest payments (monthly, quarterly or semi-annually) until maturity.

The notes are offered weekly by a limited number of issuers, many of which are top-rated, well-known international corporations. The offers are valid for one week and include a series of coupon rates, maturities, interest-payment frequencies, call dates and credit ratings. Issuers, however, have the right to change or cancel an offering without notice. You can invest in these securities through a broker who can provide you with the weekly postings.

These notes are suitable for fully taxable accounts, or you can put them in your IRA, where the interest income accumulates tax deferred. And investors who want to create an income (bond) ladder can purchase retail notes with different maturity dates and interest-payment schedules.

Even though there might be a secondary market for retail notes, they are meant to be held until maturity. Therefore, they are not suitable if you are looking to trade them for the capital gains (but this is the kind of fixed-income strategy that presents the complexities we discussed above). But like other fixed-income investments, the market value of retail notes can fluctuate until maturity.

Finally, most retail notes have a unique survivor's option. This feature gives your estate the ability to return the notes back to the issuer at par value. Therefore, just in case the note is worth less than par value when you die, your heirs can still return the notes for par value.

The Bottom Line
If you are looking to include or increase the amount of fixed assets in your portfolio, retail notes can make your investing easier. They are simple to understand, can be purchased for a moderate amount, and provide a stable income. Plus, they're often a whole lot simpler than bond funds, which is something that any time-strapped investor is likely to appreciate.

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