Investing

Types of Investments: Bonds

when you invest in a bond you are lending money to the US government, a corporation or a municipality.

Description

When you invest in a bond you are lending money to the US government, a corporation (like IBM or Amazon), or a municipality (like the city of Chicago or Denver). In other words, these entities are borrowing money from you to help them pay for programs, new projects, and ongoing business operations.

Bonds are generally used to meet intermediate to long-term needs. The US government issues bonds with terms ranging from less than one year to as long as 30 years.

Similar to a loan, when you invest in a bond you receive interest from the bond issuer. Interest is stated as an annual interest rate or yield and is paid each year until the bond’s maturity date. The maturity date is the date the bond issuer is scheduled to repay the principal amount you invested in the bond. Let’s use an example of investing in a US government bond to bring this concept to life. The US government issues bonds with terms ranging from less than one year to as long as 30 years. When you invest in an individual US government bond, the US government guarantees repayment of your principal if you hold the bond until it matures. The interest you are paid on the US government bond is based on current interest rates at the time of purchase and the term of the bond. Review the example below illustrating how a bond investment works for an investor.

Primary purpose

Government bondFor illustrative purposes only. The illustrative example shown above does not reflect the investment or performance of an actual bond. Source: Financial Fitness Group.

Bonds are generally used to meet intermediate to long-term needs. Because bonds pay periodic interest, they are commonly used by investors who need income, like retired individuals. Additionally, long-term investors often allocate a percentage of their investment dollars to bonds to maintain a more moderate risk profile. In general, high-quality bonds are considered safer investments than stocks.

Risk-return profile

Interest rate risk. When you purchase a bond you take on interest rate risk. When interest rates rise, bond prices and the values of fixed-income securities generally fall. For example, let’s say you invest in a bond paying a fixed interest rate of 4% over the next five years. What happens if interest rates change? If after one year interest rates have risen to 5%, you own a bond that is only paying 4%. Clearly, 4% is not as good as 5%, but you are stuck with this rate for four more years while others can invest in the new bond at 5%. On a $10,000 bond, you are only earning $400 per year in interest while others are earning $500.

In short, when you buy a bond you are accepting the risk that interest rates could change and you could lose out on the opportunity to earn a higher rate over the term you own the bond. In our example above, if for some reason you needed to sell your bond, no new investor would be willing to buy your lower interest-rate bond when they could simply go buy the higher interest rate bond. In order to convince someone to buy your bond they would demand a discount on the price of your bond because they would be giving up $100 per year in interest for four years. They would only be willing to pay you $9,600 for your bond that will be worth $10,000 when it matures. This is how they make up for the $400 less in interest.

Credit risk. Investors take on credit risk when they purchase a bond that is not issued by the US government. Corporate and most municipal bonds do not guarantee repayment of your principal. In the US, credit risk is associated primarily with corporate and municipal bond issuers. It is important to evaluate the corporation’s or municipality’s ability to pay its debt—that is, to make all interest and principal payments on time and in full.

Most corporate and municipal bonds carry a credit rating provided by a rating agency such as Standard & Poor’s or Moody’s. Bonds are rated on a scale starting at AAA, AA, A, BBB, BB and so on. Bonds rated BBB or higher are considered investment grade and are generally prudent investments because the corporation or municipality has a strong likelihood of paying the interest and principal to investors on time and in full. Bonds with lower ratings increase the risk of the issuer defaulting and not being able to pay their investors their principal and interest.

Municipal bonds have a unique quality compared to government and corporate bonds. The interest they pay to investors is exempt from federal income taxes. This is attractive for individuals in higher income tax brackets and can often provide them with a higher after-tax interest amount when compared to government and corporate bonds.

Income generated from an investment in a municipal bond is generally exempt from federal income taxes. Some income may be subject to state and local taxes and to the federal alternative minimum tax. Capital gains, if any, are subject to tax.

Bonds have had an average return of 6.5% over the last 30 years ending December 31, 2017 (source: Chart Source). Inflation has averaged 2.6% over the same period (source: Calculator.net).

Note: As of 2018, bonds are experiencing much lower returns than this 30-year average due to very low interest rates. Inflation is also much lower than the historical norm.

Taxes

The interest you earn on a bond is taxed differently based on the type of bond. Here are some general guidelines.

Tax guidelinesSource: Financial Fitness Group.

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Disclosures