Investing in bonds, like the name implies, is all about establishing a relationship. So as with any relationship, you should make sure you understand the potential implications before you commit. In this case, you are entering into a financial relationship with an institution, loaning it money in exchange for locking in an interest rate. The borrower is either a company that issuing a bond in order to acquire capital to expand their business, or a government agency that is doing so in order to fund a public project such as the building of a school.
Bonds are more predictable than stocks. But the different types still vary in terms of how risky they are. You can determine the degree of risk by taking a close look at the interest rate. If it seems certain that you will be able to earn back the bond’s principal by the date it matures, then consider it low-risk. Typical low-risk bonds include Treasury bonds and corporate bonds issued by large public companies. Higher-risk bonds include mortgage-backed securities and the infamous and so-called junk-bonds, a bond that is rated below investment grade at the time of purchase. These can be seductive due to their higher yields but carry a much higher risk of default and are not considered a good bet for the investor who is looking at bonds as a relatively safe investment.
When looking around for which bonds to invest in, it’s best to research all your options. Here is a quick look at what is available.
Government Backed Securities
Government-backed securities come in the form of Treasury bills (T-Bills) notes and bonds. T-bills are short-term US government securities with maturity of a year or less. They can be bought through a broker, a bank or directly from the government. At maturity, the buyer of the T-bill receives the full amount stated on the bond certificate. The difference between the face amount and the amount the bondholder paid for the certificate is considered the interest gained, also called the discount yield. This interest is exempt from state and local income taxes, but not from federal income taxes.
Treasury notes have longer terms than T-bills and their interest rate is fixed. Notes are issued for two, three, five, or 10-year periods. Note and bond owners receive interest payments every six months. This interest must be reported as interest income on federal tax returns.
I bonds are savings bonds backed by the US government. The difference between these bonds and the regular treasury bonds is in the interest gained. The rate earned on these bonds is actually a combination of two rates: a fixed interest rate set when the investor buys the bond and a semiannual variable rate tied to the current inflation rate. The maximum purchase for an I bond is $5,000 per calendar year, and the interest stops accruing 30 years after it is issued. Earnings from these bonds are exempt from state and local taxes, and federal taxes can be deferred until the bond is either redeemed or reaches the maturity date. If this bond is cashed to pay education expenses, it is completely tax-exempt. However, if the bond is redeemed within the first five years, the holder will be penalized the previous three months’ interest rate, there is no penalty fee if cashed after five years.
TIPS (Treasury Inflation-Protected Securities)
In addition to I Bonds, another way to protect your investments against inflation is by purchasing inflation indexed $1,000 bonds known as TIPS. Tips are guaranteed to beat inflation because the principal is adjusted every six months according to the consumer price index. During the time you have the bond, the principal amount increases if inflation occurs, however, the interest rate on these bonds never changes and is set when the security is purchased. The term on TIPS is from five to 30 years and interest is paid out to investors every six months until maturity.
Series EE savings bonds are issued at a deep discount from face value and pay no annual interest since the interest accumulates within the bond itself. Interest is paid out when the bond matures and it is federally taxed but exempt from state and local taxes. This bond is similar to the tax benefit an I bond provides in that the Series EE bond’s interest is exempt from federal income tax if used for funding a college education. When searching for current rates on bonds, look at TreasuryDirect.
Corporate bonds are long-term interest bearing debt issued by a corporation. Corporations issue bonds as a way to increase company funds to finance major projects, expansion, acquisitions or refinancing. These are long-term taxable bonds (10, 15, 20 years or longer) that pay the highest interest rate of all the bonds, due to increased risk of default. If a company is facing financial trouble, corporate bondholders are paid first before short-term creditors. Moody’s Bond Survey and Standard and Poor’s are rating services that grade bonds based on the credit risk of the corporation or municipality issuing the bond. The quality and creditworthiness of the issuing company is displayed through these bond ratings. A high quality bond rating of AAA from Standard and Poor’s, means the bond is of the highest investment quality, suggesting the company will have the ability to pay both principal and interest at maturity. A rating of DDD means the corporation is in default and the bond (also referred to as a junk bond) is extremely risky and more than likely, the company won’t be able to pay back the principal and interest.
Local governments issue long-term bonds in the form of municipal bonds called “munis”. These are tax free and tax-exempt bonds that are used by the local governments to finance public improvement projects such as roads, bridges and parks. Their interest income is not subject to federal income taxes. If you live in the municipal bonds’ issuing state, its interest income is exempt from state and local taxes. Capital gains on these bonds are taxable. These bonds offer a lower interest rate than corporate bonds, because of their tax-exempt advantages. Municipal bonds could bring in an after-tax return higher than a corporate bond. There are also a variation of these bonds, so when researching look through sites like Morningstar.com or Bloomberg.com to see which type of bond best fits into your future financial picture.