Considerations When Investing in Bonds

Bonds are fixed income securities which pay investors a set interest rate for a pre-determined period of time and then return the original principal at their maturity. There are many different types of bonds. Corporations often raise money by issuing bonds in addition to selling stock. Governments often use bonds to pay for their ongoing operations or specific projects, such as highways or new construction.

Though bonds are not risk-free (e.g., a bond issuer could default on a payment or even fail to repay the principal), bonds as a whole are considered somewhat less risky than stocks. Here is a brief description of a few types of bonds and distinguishing attributes of each.

Corporate Bonds are issued by corporations and typically pay a fixed interest rate usually every six months. The interest on corporate bonds is taxable at ordinary income rates by federal and state governments.

Mortgage Backed Securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans. Mortgage backed securities pay investors interest, but as mortgages within the pool of loans are refinanced, investors can also receive return of principal payments.

Municipal Bonds are issued by state and local governments. Interest from municipal bonds are generally federally tax-exempt and can also be state tax-exempt for residents of the issuing municipality.

Treasury Securities are issued by the U.S. Department of the Treasury and are backed by the full faith and credit of the U.S. government. For that reason, they are considered relatively safe. There are many different types of Treasury Securities, including, treasury bills, treasury bonds, and treasury notes. Investors do not owe state income taxes on Treasury securities; however, the interest is taxable as ordinary income at the federal level.

US Savings Bonds are issued by the U.S. Treasury. However, they are not traded on the open market, and are not considered Treasury securities. Savings bonds are registered bonds because the owner’s name is printed on them, and they must be redeemed by the registered owner or a beneficiary of the registered owner. Tax on savings bonds is generally deferred until maturity.

One way of comparing bonds is to look at their yields. When comparing various types of bonds, it is important to consider the taxable equivalent yield. The taxable equivalent yield will allow you to compare bonds that are taxed differently along a level playing field. Each person’s taxable equivalent yield will vary depending on their personal federal and state income tax rates. For example, the following chart illustrates the effective interest rate (the taxable equivalent yield) that you would earn when investing in different types of bonds, given a federal tax rate of 33% and a state income tax rate of 8%.

*Please note that this chart only considers the coupon or yield of an investment and not the yield to maturity of an investment. The yield to maturity incorporates both the coupon and the price appreciation (or depreciation) of a bond.

Making maximum benefit of the bond allocation in your portfolio can be a tricky component of managing an investment portfolio. For more information, or to discuss your personal investment strategy, please contact our office.