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Bond Basics: Understanding the Ins and Outs of the Bond Market, Part 2

Investors in the stock market often use the bond market to complement their equity investments with income, reduced volatility, and a diversification of their overall investment portfolio.

Bonds are often thought of as less risky, but they too have inherent risks that investors need to be aware of.

In last month’s post, (Bond Basics, Part 1), we outlined Bond Terminology, and what terms like Coupon rate, Current Yield, Yield to Maturity, Yield to Call and Duration mean to a bond’s performance. This month we will discuss the different types of bonds, and next month (in Bond Basics, Part 3), we’ll cover the risks associated with bonds and mitigation strategies.

By understanding different types of bonds and their risks, an investor can make a more educated decision on how to best structure their portfolio to meet their needs.

U.S. Government Bonds: safe, secure, and steady!

Government Bonds (federal) come in many shapes and sizes. They have a wide range of maturities, and some have unique protections against inflation (e.g., TIPS, I-Bonds). The advantages of Government bonds include security of principal, certainty of income, and the full guarantee of the United States government behind them. This makes Government bonds a universally accepted form of collateral, and they are readily traded on open markets. Earnings from Government bonds is also exempt from state and local taxes. A disadvantage of government bonds is that they generally pay a lower rate than comparable corporate bonds, due to the low risk associated with them. Here are the different kinds of U.S Government bonds:

    • Treasury Bills or T-Bills

      • Treasury Bills or T-Bills are short-term bonds with maturities between 4 and 52 weeks. They are issued at a discount, redeemed at face value, and do not pay a coupon. The minimum denomination is $100.
    • Treasury Notes

      • Treasury Notes have maturities of 2 to 10 years, pay a coupon semi-annually, and the minimum denomination is $100.
    • Treasury Bonds

      • Treasury Bonds are long-term investments with a maturity of 30 years. They pay coupons semi-annually and have minimum denominations of $100. These bonds are sold at treasury auctions and can be sold at a discount or premium.
    • Treasury Inflation-Protected Securities or TIPS

      • Treasury Inflation-Protected Securities or TIPS adjust the principal of the bond every six months according to the Consumer Price Index (CPI), which the coupon payment is based on. TIPS have maturities of 5, 10 and 30 years, and are sold at treasury auctions; thus they can also be sold at a discount or premium. A disadvantage to be aware of is that the coupon payment is typically lower than an equivalent-maturity government bond due to the expected inflation protection.
    • Savings bonds include I-Bonds and EE Bonds

      • Savings bonds include I-Bonds and EE Bonds. The minimum denominations are $25, and the price is flexible over that amount. I-Bonds are like TIPS in that they pay a base rate, but I-Bonds also pay a rate adjusted semi-annually based on the CPI. I-Bonds are sold at maturities of 30 years, and there are interest penalties if redeemed within 5 years of purchase. They are limited to $10,000 amounts that can be purchased per person per year. EE bonds are guaranteed to double in value in 20 years, pay a fixed rate, and are sold with 30-year maturities. Both of these Savings bonds can have tax-advantages if used for higher-education expenses (that are subject to income limits). There is also flexibility on when to pay taxes on the interest earned on these bonds: they can be paid annually as interest is earned, or they can be paid at maturity.

Municipal Bonds: When you really want to avoid the taxman!

Municipal Bonds or Munis are bond funds that are issued by state and local municipalities to fund various non-federal government projects. There are unique advantages and disadvantages.

  • Advantages include:
    • Earnings that are free from federal taxes. Munis purchased from the state of residency can also be free of state income taxes. These are obvious advantages and are primary examples of why they are purchased, especially by people in high-income tax brackets.
    • General Obligation bonds that are secured by Tax revenue are generally considered safe investments.
  • Disadvantages include:
    • The interest earned is added to other income to compute how much Social Security income is taxed.
    • Business-centered Munis called revenue bonds (like the kind used to build a Stadium or TolRoad) can have the income added to the Alternative Minimum Tax computation, but this is a rare occurrence for most taxpayers.
      • These revenue bonds are also not secured by taxes, and interest is paid from the revenue generated by the venture.
      • Revenue bonds may pay a higher rate of interest, but there is increased risk of default.
    •  The interest paid by a Municipal Bond is lower in general than an equivalent corporate bond because they don’t have to because of the tax savings.
    • Capital gains on the sale of Municipal bonds are fully taxable.

Corporate Bonds: Maximizing your income while tempering the risk of equity investments!

A corporate bond, in its essence, is a loan to a corporation. The bond is redeemed at the maturity date and pays a fixed coupon rate, typically semi-annually. The interest rate is fixed and cannot be changed.

  • Advantages include:
    • Interest or coupon payments that are usually higher than equivalent maturity government and municipal bonds.
    • Corporate bonds provide dependable income payments compared to a dividend-paying stock, which can fluctuate with company earnings.
    • The bond holders are “in front of the line” for company payments in a bankruptcy proceeding.
    • Companies that have consistent performance earn bond ratings between AAA and BBB indicating low default risk, while companies that have lower ratings will pay a higher coupon to compensate for their lower rating.
  • Disadvantages include:
    • There is a higher risk of default than government and municipal bonds, especially for the bonds rated lower than BBB, which are also called “junk bonds.” Because these jun- bond companies have marginal performance, they are especially vulnerable to market changes and have a higher correlation to equities.
    • Corporate bond income is fully taxable, as are any capital gains if any are realized with the sale of the bond.
    • Corporate bonds can sometimes be “called,” that is redeemed early by the company in a falling-interest-rate environment, which we will discuss next month.

The number of bond choices can be daunting, and there are unique risks to bonds which we will discuss next month. Your financial advisor can help you tailor the bond choices in your portfolio to your specific investment needs. For more information on how we can help please visit us at our website, or schedule a free consultation.

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F5 Financial

F5 Financial

F5 Financial is a fee-only financial advisory firm that takes a holistic approach to financial planning, personal goals, and behavioral change.