Like most consumers, you have probably paid interest on a loan, whether it was a credit card, student loan, auto loan, or home mortgage. As an investor, it might be advantageous to be on the other side of the lending equation by purchasing bonds.
When you invest in a bond, you are loaning money to the bond issuer in exchange for the issuer's promise to repay the principal on the specified maturity date, plus the interest, which is usually paid every six months. Bond maturities typically range from 30 days to 30 years. Bonds with longer maturities generally pay higher interest rates than do similar bonds with shorter maturities.
Types of bonds
Bond issuers typically fall into three categories: U.S. Treasury bonds, municipal bonds, and corporate bonds.
U.S. Treasury bonds are generally considered to be among the safest investments because they are guaranteed by the federal government as to the timely payment of principal and interest. Even though the recent government shutdown and debt-ceiling crisis led to volatility in the Treasury market, the effect was relatively mild and the market settled once the crisis was averted.
Municipal bonds are issued by state and local governments. The return on municipal bonds may be higher than Treasury bonds but lower than corporate bonds with comparable maturities. However, the interest on bonds issued by your own state or local government is typically free of federal income tax. Because municipal bonds tend to have lower yields than other bonds, tax benefits tend to accrue to investors in the highest tax brackets.
Corporate bonds may offer higher interest rates than Treasuries and municipal bonds with comparable maturities, but they are associated with a higher degree of risk, which varies based on the creditworthiness of the companies that offer them.
All bond holders will receive the bond's interest and principal, unless the bond issuer defaults.
Discounts and premiums
Individual bonds are typically sold with a face value of $1,000 and a minimum purchase of $5,000. If a bond is held to maturity, interest-rate volatility should not affect the bond's principal value or yield. However, bonds bought or sold on the secondary market can be highly sensitive to changing interest rates; the principal value and yield may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost.
As interest rates rise, bond prices typically fall, because prospective buyers can theoretically obtain a new bond at a higher rate. To attract buyers in this situation, a seller may need to offer an existing bond at a discount. The reverse also holds true. As interest rates fall, bond prices typically rise, and a seller may be able to obtain a premium for an existing bond with a higher rate than is currently available.
Investors who buy a municipal bond issued by another state usually have to pay income taxes. Although some municipal bonds may not be subject to ordinary income taxes, they may be subject to federal or state alternative minimum taxes. If a tax-exempt bond is sold for a profit, investors could incur capital gains taxes.
(Charles Sims Jr. is president/ CEO of The Sims Financial Group. Contact him at 901-682-2410 or visit www.SimsFinancialGroup.com.)