Bonds are an excellent investment option for the person interested in less risky investments. Bonds provide governments with operating funds or funds for specific projects. The tax advantage of owning bonds is that they decrease taxable income. Bond purchases are deducted from your taxable income, which translates into less tax due!
Bonds are fixed-income securities. The amount the will be earned is known at the time of purchase, (i.e. fixed).
Most people are familiar with Treasury issued bonds. The EE, I and Treasury Bills. EE bonds and I bonds are what is called savings bonds.’ These bonds are issued at maturity value. With an EE bond, the purchaser will pay half the face value of the bond; i.e. one would pay $25 for a $50 bond. EE bonds have flexible interest rates and will mature when the interest earned is enough to bring he bond up to the face value, currently 13 to 30 years.
I bonds are fixed interest bonds. Like EE bonds, I bonds are issued at maturity (face) value. Because I bonds have a fixed interest rate, the exact date of maturity can be calculated. The interest on I bonds is computed monthly and compounded twice per year.
Treasury Bills, also called T-Bills, are short term investment tools. T-Bills are not technically bonds because they mature in less than a year! Treasury Bills are purchased through a broker during the weekly auction. Terms are 4, 13, or 26 weeks. T-Bills are rarely held until maturity, but are usually called within a few days.
(A Call is when the issuer of the bond asks holders redeem the bonds. The issuer will usually offer compensation for the early call.) Interest earned on Treasury Bills is treated as “interest income” for the purpose of tax reporting.
Municipal Bonds are bonds issued by a municipality or other entity. Municipal bonds cover improvements or special projects such as new roads, bridges, stadiums, schools, etc.
Municipal bonds, called muni’s, are of two types: General Obligation and Revenue. General Obligation bonds are based on the taxing authority of the issuing agency. The issuer can assess taxes to ensure that the bond is repaid. General Obligation (GO) bonds are the more secure of the two types and thus carry a lower interest rate.
Revenue Bonds pay higher interest rates because they are riskier. Funds to repay revenue bonds come directly from the project being financed. For example, a new mega parking locale for the court house. The revenue collected from the use of the parking lot will pay for it’s cost.
If the muni is insured, the insurance company will pay if the issuer defaults. Not all munis are insured and not all muni bonds are backed by the government. Only bonds backed by the federal government will have the federal tax exemption. So, be sure to check this item when considering muni’s.
An example of a munis not be backed by the federal government would be a Casino complex or a stadium.
Muni’s can be tax deductible at the state/local level if the holder resides in that state/city. Interest earned on municipals is treated as capital gains for tax reporting purposes when the bond is redeemed.
Corporate bonds are issued by corporations. Corporate bonds are fixed interest instruments. They are industry based, such as, restaurant, retail etc. Corporate bonds are short term, intermediate, and long term bonds. Short term is less than 5 years, intermediate are less than 12 years, and long term are over 12 years.
Corporate bonds are either cyclical or non-Cyclical. Cyclicals are your high investment grade bonds. Stable companies with solid finances and very good prospects of continued growth issue these Bonds. Economics and commodity prices have little impact on cyclicals. Cyclicals have the lower interest rate because they have little risk.
Non-cyclicals are “below investment grade”. Generally known as junk bonds. These are high risk, highly speculative bonds. Because they are so risky, the interest is about 4-6 % higher than Treasury rates. Revenues and earnings are heavily tied to the economy and commodity prices.
Non-cyclicals have higher debt and wildly fluctuating revenue and incomes. This bonds are called speculative because no on knows how they will perform.
International Bonds are bonds that can be traded in the American market and the foreign market.
Agency Bonds. Agency Bond issuers are not government agencies. These are private companies that have a charter from the government to conduct business on their behalf, (The Small Business Administration, The Federal Home Loan Banks, The Federal Student Loan Program, etc.). It is implicitly understood that bonds issued by these agencies are backed by the government.
A good example of how this implicit agreement works is the current situation with the housing market. The market is in dire condition. The Treasury by lowering interest rates enables homeowners to make payments, which in turn, allows lenders to meet their obligations to investors.
While the government did not issue the bonds, the Agencies were acting in the government’s interest. So the government will “bail them out”, because such agencies are vital to the function of the government.