One of the most important reasons why investors choose to invest in bonds is for their steady and predictable stream of income through interest payments. Though they 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.
Bonds, sometimes called debt instruments or fixed-income securities, are essentially loans. 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.
Corporate bonds are issued by corporations to help pay for expansion, equipment or operating expenses. Corporate bonds typically pay a fixed interest rate, and payments are usually made every six months. The interest on corporate bonds is taxable at ordinary income rates by federal and state governments.
Municipal bonds can be classified as a general obligation bond (G.O.) or a revenue bond. General obligation bonds are backed by the credit and taxing power of the issuing jurisdiction, whereas interest paid to revenue bond holders comes from the cash generated from revenues of the particular project they are funding. For this reason general obligation bonds are generally considered less risky than revenue bonds. Most states do not tax municipal bond interest from that state, though regulations vary from state to state. Also, interest from municipal bonds is generally federally tax-exempt.
Private activity bonds are municipal securities in which the proceeds are used by one or more private entities. Private activity bonds can be issued to fund, among other things, stadiums, hospitals and housing projects. Investing in municipal bonds that are considered private activity bonds can subject you to the alternative minimum tax (AMT). If you are already subject to AMT, you would not want to own a bond that is considered a private activity bond.
The federal government borrows money in the same way corporations do. However, Treasury securities are very different from corporate bonds. Sold by the U.S. Department of the Treasury, they are backed by the full faith and credit of the U.S.government. For that reason, they’re considered relatively safe, since the government can always raise taxes to pay its debt. 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 on your federal return
U.S. Savings Bonds
Like the above Treasury securities, savings bonds are issued by the U.S. Treasury. U.S. savings bonds are generally classified as E/EE, H/HH or I Savings Bonds. However, they are not traded on the open market, and are not considered Treasury securities. Unlike most bonds, which are coupon bonds, savings bonds are registered bonds. The owner’s name is printed on them, and they must be redeemed by the registered owner or beneficiary. Tax on savings bonds is generally deferred until maturity. For more information on savings bonds, you can visit http://www.savingsbonds.gov/.
One way of comparing bonds is to look at their yields. When you are comparing different bond types, you should look at 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.
To determine a taxable equivalent yield that is specific to you, check out Vanguard’s taxable equivalent yield calculator.
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.