When people talk about investing, the term âstocks and bondsâ comes up a lot. But why exactly should you invest in either of these options? Understanding the basics of investing in bonds is an important part of getting started as an investor and choosing the best investments for yourself.
Here’s a guide to help you determine why you might want to invest in bonds, the types of bonds available, and what else you need to know about this crucial part of an investment portfolio.
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What are investment bonds?
When you buy a bond, you are essentially lending money to a business or government. Companies and governments issue bonds to raise funds for business operations, extensions or large infrastructure projects.
During the term of the bond, you receive interest on the amount of the bond at an agreed rate. This agreed upon interest rate is the reason why bonds are also generally referred to as âfixed incomeâ investments because you get a fixed amount back. On the maturity date of most bonds, you get back the face or face value of the bond.
When a bond is first issued, the price you pay for the bond is usually its face value. For example, you can buy a bond with a face value of $ 1,000 at an interest rate of 4% (also called a coupon rate).
After issuing a bond, investors can also sell it before its maturity date. At this point, the bond may sell for a âpremiumâ or a âhaircutâ. When an existing bond offers a higher coupon rate than the rate currently offered on new bonds, it typically trades above (premium) its face value in the secondary market and becomes a premium bond.
When a bond offers a lower coupon rate than the rate currently offered on new bonds, it trades below (discount) its face value and becomes a discount bond.
Why invest in bonds?
Investing in bonds offers several advantages over other investments. First, they are a relatively safe investment compared to stocks, as their value usually does not fluctuate as much as stock prices. That is why they are a popular option for diversifying your investment portfolio. While bonds generally don’t generate the high returns that an investment in stocks can generate, they can provide stability to your investment portfolio. Having a mix of stocks and bonds can reduce your financial risk when the stock market fluctuates.
Another advantage of investing in bonds is their predictable income stream. Since bonds pay a fixed amount of interest (usually paid twice a year), you can usually count on this income. Depending on the type of bond you invest in, this income may even be tax exempt.
Of course, like other types of investments, there is a certain element of risk when investing in bonds. Although this is rare, the bond issuer can default on its bond obligations. When this happens, you may lose interest payments, not get your original investment back, or both.
Types of investment bonds
Bonds come in various forms. Here are some of the more common categories.
- Corporate bonds. Companies, including well-known names like Apple, Walmart, ExxonMobil, and Pfizer, issue corporate bonds. Corporate bonds tend to offer higher interest rates than other types of bonds, but the risk of default is higher. To reduce the risk of losing money in the event of default, check the credit ratings of corporate bonds issued by agencies like Standard & Poor’s and Moody’s. Corporate bonds with a lower credit rating are called high yield bonds or junk bonds. Because the risk of issuer default is higher, the interest rate (or return) is also higher.
- Municipal bonds. Municipal bonds, also known as âmunicipal bonds,â are bonds issued by states, counties, cities, and other state and local government agencies. Municipal bonds are typically issued to pay for large, expensive investment projects, such as building hospitals, schools, airports, bridges, highways, water treatment facilities, or power plants. .
- U. treasury bonds. The US government issues these bonds, which are generally considered the safest investments. Because the risk of default is lower than that of corporate bonds, they usually pay a lower interest rate. US Treasury bonds are divided into three categories, based on their maturity. Treasury bills have maturities of four weeks, eight weeks, 13 weeks, 26 weeks and 52 weeks. T-Notes have maturities of two, three, five, seven or 10 years. T bonds mature in 30 years.
To invest in corporate and municipal bonds, you usually need to hire a broker. You can buy Treasury bills directly from the US government through TreasuryDirect without going through a broker.
For some investors, the selection of individual investment bonds can be intimidating. This is why many people choose to invest in bond mutual funds rather than individual bonds. Bond mutual funds hold a large number of bonds with a variety of maturity dates, interest rates, and credit ratings. This can make it much easier to diversify your bond portfolio because the fund invests in bonds and you have an interest in a small amount of each bond within the fund rather than investing a large amount in a single bond. .
How are the obligations imposed?
Bonds are generally taxed in two ways: when you earn interest on the bond and any capital gain on the sale.
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When you earn interest, the IRS expects you to report that income on your tax return. Whether or not this income is taxable depends on the type of bond you invest in.
- The interest you earn corporate bonds is generally always taxable.
- Most interest income earned on municipal bonds is exempt from federal income tax. When you buy municipal bonds issued by the state where you file state taxes, the interest you earn is also exempt from state income tax. If you buy municipal bonds issued by another state, you’ll still avoid federal taxes, but you’ll likely be subject to state (and possibly local) income taxes.
- S. Treasures are exempt from state and local income taxes, but are taxable at the federal level.
After the end of the tax year, your financial institution or the bond issuer should send you a Form 1099-INT report all taxable and tax-exempt interest you received during the year. Typically, corporate bond interest will be in box 1, interest on U.S. Treasury bills will be in box 3, and tax-exempt interest on municipal bonds will be in box 8.
Even if you don’t have to pay income tax on the interest, you still have to include it on your tax return. This is because even though some bond interest is tax exempt, the IRS still includes it in some calculations. Perhaps most notably, if you collect income from Social Security, interest on tax-exempt municipal bonds may affect how your Social Security benefits are taxed.
The IRS includes interest on municipal bonds in your adjusted gross income. If half of your Social Security benefits plus other income, including interest on municipal bonds, is between $ 32,000 and $ 44,000 for a joint tax return ($ 25,000 to $ 34,000 for tax filers payments), up to 50% of your social security benefits may be taxable. Beyond these thresholds, up to 85% of your benefits could be taxable.
Capital gains tax
If you buy a bond when it’s issued and hold it until maturity, you generally won’t have a capital gain or loss. However, if you sell the bond before its maturity date for more than you paid, you will usually realize a capital gain. If you sell it for less than you paid for it, you will usually suffer a capital loss.
After the end of the tax year, your financial institution will send you a Form 1099-B showing all bond sales that occurred during the year.
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