When you invest in a bond, you are essentially entering into a financial relationship with an institution that is loaning it money in exchange for locking in an interest rate. The borrower is either a business that is issuing the bond in order to acquire capital to build up their business, or its a governmental agency that is doing so in order to fund a public project.
Bonds are more predictable than stocks but it depends on the different types of bonds as to how risky they may be. Consumers can determine the amount of risk by looking closely at the interest rate. If it appears certain that you will be able to get back the bond’s principal by the date it matures, then you can consider it low-risk bond. These types of bonds include Treasury bonds and corporate bonds that are issued by large, public companies. Bonds that are higher risk include mortgage-backed securities and junk-bonds Junk bonds are bond s that are rated below investment grade at the time of purchase. These can be enticing because of their higher yields. But they carry a much higher risk of default and therefore are not considered a good deal for anyone looking for a safe investment.
If you are looking to invest in a bond, it is best you know all of your options. Here is a brief overview of the kinds of bonds that are available:
I bonds are savings bonds which are backed by the US government. The difference between I Bonds and the regular treasury bond is in the interest gained. The rate earned on I Bonds is a combination of two rates: the fixed interest rate set when the investor bought the bond and a semi-annual variable rate tied to the current inflation rate. The maximum you can purchase for an I bond is $5,000 per calendar year. The interest will stop accruing 30 years after it is issued. If this bond is cashed and used to pay education expenses, it is completely tax-exempt. Earnings from I-Bonds are exempt from state and local taxes. Federal taxes can be deferred until the bond is redeemed or reaches the date of maturity. If you redeem a bond within the first five years of purchase, there will be penalties. If the bond is cashed after the first five years, there are no penalties, .
TIPS (Treasury Inflation-Protected Securities)
To protect investments against inflation you can purchase 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. The term on TIPS is from five to 30 years. Interest is paid out every six months until maturity. During the time you have the bond, the principal amount increases if inflation occurs. However, the interest rate on these bonds is set when purchased and will never change.
Government Backed Securities
Government-backed securities are available in the form of Treasury bills, also known as T-Bills, notes and bonds. T-bills are short-term US government securities with maturity of a year or less and can be purchased through a broker, a bank, or directly from the government. At the date of maturity, the buyer of the T-bill receives the entire amount stated on the bond certificate. The amount difference between the face amount and the amount the bondholder paid for the certificate is considered the interest gained, which is also known as the ‘discount yield’. This interest is exempt from your state and local income taxes, but not exempt from federal income taxes. Treasury notes have longer terms than T-bills and a fixed interest rate. Notes are issued for 2, 3, 5, or 10-year periods. Owners of Notes and bonds receive interest payments every six months and must be reported as interest income on federal tax returns.
Series EE savings bonds are issued at a deep discount from face value . They pay no annual interest since the interest accumulates within the bond itself. When the bond matures, interest is paid out and it is exempt from state and local taxes but federally taxed . The Series EE is exempt from federal income tax if cashed and used for college tuition.
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. The terms on these bonds range from 10, 15, 20 years and longer and pay the highest interest rate of all the bonds, due to increased risk of default. If a company ends up in financial trouble, the corporate bondholders are paid first with short-term creditor’s payments to follow if available. .
Municipal bonds called munis are issued by local governments. These bonds are long-term. and are tax free and tax-exempt . They are used by local governments to fund public projects. Their interest income is not subject to federal income taxes and 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.