When it comes to investing in bonds, I like teaching kids by going straight to municipal bonds. It’s like the way elementary school teachers teach kids social studies: They start in Kindergarten with the immediate community—here’s the school, the fire department, the grocery store, the police station, the post office. Then they expand out to differentiating between rural versus urban, then states, then countries. They do this for a reason, which is that kids retain information that they can relate to. Your teen or college student is the developmental equivalent of an elementary financial student.

As a college professor, when I want to explain how the economy works, I make my students write an article about the financial health of the university. Because it’s a state school, it’s a microcosm, and they learn so much faster than if I try to explain concepts in a large sense.

Bonds are very similar. Once they grasp the definition, they’ll like the local advantages of a municipal bond, plus they may even learn a thing or two about why the local government needs to borrow money, and what it’s being used for. They’ll love the fact that they are the creditor in the situation.

Learning about municipal bonds is a good follow up investment lesson to the stock primer, because like stocks, municipal bonds are also securities.

Here’s the step by step primer on bonds for teens:

1. Give them a gerneral definition that spells out the difference between a stock and a bond: Any bond is essentially an I.O.U. It’s a formal contract between the issuer/borrower (for municipal bonds the city or state government is the borrower) and the bond holder (you, the bond purchaser/lender), to repay the borrowed money with interest at fixed intervals.

While both stocks and bonds are equities, the main difference is a stockholder has a stake in a company (one of the owners), whereas a bondholder is a creditor who has lent a government money and expects to be paid back with interest. The interest is called a coupon—which comes from the old days, when actual paper was issued for a bond, and coupons were attached. On coupon dates, the bond holder would bring the coupon to the bank and trade it in for the interest payment.

Bonds have a long maturity cycle, up to 30 years, another difference from stocks. (Really short-term bonds, usually a year, are called Treasury Bills, or T Bills for short, and mid-range bonds are called Notes. I’ll do a separate blog on those.) Learning a long term investment vehicle, right after learning about stocks, which can be bought and sold every nanosecond, can help teens understand the spectrum of choices, and why you want both in a portfolio.

Municipal bond interest is exempt from Federal taxes, and in some cases from state taxes. You need to live in the state where the bond issuer is in order to get a state level tax break.

2. Have them choose four municipal bonds to compare for performance, each from a different state. Make at least one of them local. But also make at least one of them from another state. Have them make a chart. They can go to muncipalbonds.com, where there’s a state by state search to choose bonds.

3. Point out the tax benefits of the local municipal bond fund.

4. Have them research what each municipal issuer is using the bond money for. See if they can even find out! They’ll get nice and worked up about it if they can’t. It’s essential that they understand governments issue bonds in order to raise money for projects that should benefit the community. Buying your own state’s municipal bonds is the act locally part of the groovy world view. You’re investing in the upkeep of where you live.

By comparing different municipalities and their performance, kids will understand that not all local governments are run equally, and they vary greatly in wealth.

5. Tell them how municipal bonds are bought—either through an onsite investment advisor at your bank or credit union, or through a brokerage house. If possible, bring your teen to visit the investment advisor at your local financial institution, and have them analyze the four municipal bonds your kid has chosen to compare.

Make sure your kid asks the investment advisor what the dangers of bonds are. It’s always interesting to hear the answer. Essentially, bonds are safe, but nowadays people worry about municipalities in certain states going bankrupt. Still, they are safe, which is why there’s an inverse relationship between bonds and the stock market: When the stock market goes down, the average price for a bond rises, indicating greater demand for them.

6. Bonds can be an expensive buy in, but if you have a 529 college fund set up for your teen, you can make an investment in a municipal bond within that account. It will make your kid much more interested in that account, and what it means.

Please share your thoughts about buying bonds, and which bonds are your favorites.

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