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YOUR GUIDE TO THE 7 DIFFERENT TYPES OF BONDS

YOUR GUIDE TO THE 7 DIFFERENT TYPES OF BONDS

Any bond’s instrumental characteristic – which authenticates it and distinguishes it from any other – is the entity that has issued it, since as an investor you’re counting on that issuer to have your hard-earned money returned to you.

The following are the most commonly-used types of bonds:

– Investment-grade corporate bonds (high quality)

– Higher yielding corporate bonds (poor), referred to as “junk bonds”

– Bonds that are backed by a mortgage

– Foreign bonds

– Municipal bonds

– Treasury bonds

– Other U.S. government bonds

Investment-grade corporate bonds

Carrying ratings that are at least triple-B from Moody’s Investors Service, Standard & Poor’s – or both (For the ignorant: ratings go with triple-A being the highest, followed by Double-A, Single-A, Triple-B and so forth), investment-grade corporate bonds are issued by financing institutions or companies which have stronger balance sheets.

Although the risk of such bonds defaulting is considered very remote, their yields still score much higher than both agency and Treasury bonds, despite the fact that they are fully taxable – like most other agencies. These bonds, however, tend to underperform Treasuries and agencies during times of economic downturns.

High-yield bonds

Generally carrying ratings below triple-B, high-yield bonds are issued by financing institutions or companies which have weaker balance sheets. The prices of these bonds are directly related to the health of corporate balance sheets. These bonds tend to track stock prices more closely than their investment-grade counterparts. According to Steve Ward, Chief Investment Officer of Charles Schwab Corporation, high-yield bonds do not provide the kind of asset-allocation benefits that come with mixing high-grade stocks and bonds.

Mortgage-backed bonds

These bonds have a higher face value as opposed to other bonds ($25,000 for such as opposed to $1,000-$5,000 for others). They do, however, suffer from what is called “prepayment risk.” The value of such bonds drop as mortgage prepayments rise to a higher rate – which is why they do not reap rewards from declining interest the way other bonds do.

Foreign bonds

A rather complicated kind of bond, foreign bonds are of different types. While there are some which are dollar-denominated, most foreign bond funds have approximately 1/3rd of their assets in foreign-currency-denominated debt (Source: Lipper).
For foreign bonds that are denominated by foreign currency, the issuing party makes a promise to pay in fixed interest — and thereafter return the principal amount in a different currency. The size of said payments once they get converted into dollars depends on the prevalent rates of exchange. For instance, if the dollar proves to be stronger than the foreign currency, foreign interest payments get converted into smaller dollar amounts (and vice versa).

The performance of a foreign bond fund depends more on exchange rates than on interest rates.

Municipal bonds

Popularly known as “munis,” municipal bonds are issued by U.S. states and local governments and their sub-agencies. They are available in investment-grade as well as in high-yield varieties. Although interest for such bonds is indeed tax-free, it does not automatically translate to be being beneficial for everyone. This is due to the fact that taxable yields end up being higher as compared to muni yields in order to compensate investors for the taxes.

Treasury bonds

Backed fully by taxing authorities, treasury bonds are issued by the federal government in order to finance the budget deficits. Due to having Uncle Sam’s full and official approval, such bonds are regarded as credit-risk free. They do have a critical downside, however, which is the fact that their yields tend to be the second lowest – just above tax-free munis.

However, they tend to outperform higher-yielding bonds during economic downturns, not to mention the fact that the interest on them is exempt from certain state income taxes.

Other U.S. government bonds

Alternatively known as agency bonds, these are normally supplied by federal agencies such as mainly Ginnie Mae (the Government National Mortgage Association) and Fannie Mae (FNM) (the Federal National Mortgage Association). Differing significantly from the mortgage-backed securities that are issued by the same agencies, as well as by Freddie Mac (FRE) (the Federal Home Loan Mortgage Corp.), the yield coming from such bonds are significantly higher than their Treasury counterparts. While they don’t have the full approval of the U.S. government at large, the credit risk for these bonds is considered minimal-to-none. Interest on such bonds is taxable at state as well as federal levels.

When is the best time to cash-in those old savings bonds?

Are you one of the many people who are still holding on to their old Savings Notes (Freedom Shares), H or HH bonds, or E bonds? Maybe now is the time when you can actually do something with those. After all, those bonds no longer earn interest and perhaps are (or are on their way to) causing you tax problems. In fact, you’d be surprised to know that the United States Treasury Dept. says that there are current outstanding U.S. savings bonds that don’t earn interest are collectively worth over $12 billion!

Which brings us to the most important question – how can one know if their bonds belong to this category – and if it does, then what can be done about it?

The best way to find out is to check your old bonds. Originally known as E Bonds, these were issued by the federal government began since the mid-1930s. Issued in a variety of denominations, they were mostly bought by citizens at a 75 percent of face value discount. In simpler terms, an individual paid $75 to buy a $100 bond.

The federal government ceased issuance of E Bonds from June 1980 and replaced them with EE bonds. These bonds calculate the earned interest a bit differently from E bonds, with investors buying then at half of their face value and receiving interest from them bonds once they redeem the bonds.

The bonds keep earning interest till their ‘original maturity’ (i.e. the point when the original price paid for a particular bond and the accumulated interest equal the bond’s face value. Interest payments, however, can – and are extended automatically beyond that point (generally for a ten-year-period), till the time the bond reaches its ultimate maturity, after which it is unable to earn any interest.

This is often where things get difficult. Since actual final maturity dates often vary from bond-to-bond, so it can be confusing. Take as an example, the E bonds which were issued from May 1941. Originally matured as of November 1965, these bonds had 40 years till they reached final maturity. Today, almost all of them are no longer earning interest. Contrastingly, E bonds which were issued from December 1965 and reached original maturity by June 1980, have just 30 years till they reach final maturity. As of today, all E bonds that were issued until April 1975 no longer earn interest. As for EE Bonds – they too reach final maturity in 30 years from their original maturity. Given that none of them are older than July 1980, it is only a matter of a couple of years before they cease earning interest.

Savings Notes, also known as Freedom Shares, were all issued between May 1967 and October 1970, when the Vietnam War was at its height. Much like their Like E/EE counterparts, they were sold at a discount and the interest was deferred until redemption. They too had 30 years to reach final maturity do not earn interest any more.

H and HH bonds, however, are a bit different from the aforementioned. Bought by investors at face value, these bonds pay out interest semiannually and in cash. H Bonds were first issued by the government from June 1952 through January 1957. These reached final maturity in 29 years and 8 months. H bonds issued from January 1957 till the introduction of HH bonds in January reach final maturity in 30 years. As of today, H bonds issued till April 1975 no longer earn interest. That said, HH bonds, which were stopped by the government since August 2004, reach final maturity in just 20 years. Additionally, all HH bonds which are more than 20 years old must be cashed in order to retrieve the face value i.e. the original investment.

TAX IMPLICATIONS ON VARIOUS BONDS:

While there are no state and local taxes levied on savings bonds, one does have to pay federal taxes at the rate of ordinary income taxes.

H or HH bondholders, on the other hand, have to pay taxes on the interest that they receive annually; buyers need not pay when they redeem the last payment (which is actually a return of the principal amount).

With E and EE bonds and Savings Notes, however, bondholders will have to pay taxes on the accumulated interest either when they redeem them, or when the bonds reach final maturity (and have not been redeemed). Said interest income is taxable for the year of final maturity or redemption – whichever is applicable.

In case the bondholder ends up missing this particular time period, and have only recently realized that the E Bonds that they have at home matured years back, they will need to file an amended tax return and might also be subject paying interest and a late penalty. It is always advisable for people in this situation to speak to their financial or tax advisor first.

The Investor’s Guide for Bond Investment

Any bond investor must have any and all of their investments well-suited to the objectives of the investment, degree of risk tolerance, as well as other personal circumstances. By referring to the following guide and keeping all factors in check, investors can determine the role their bonds have in their portfolio:

#1: Overall objectives of investment

Investors who value growth and have little to no concern for income are looking for better appreciation of capital. Bonds which fulfill such criteria won’t have a major role in their portfolios.

Total return investors, on the other hand need both capital appreciation and income generation in well-balanced proportions. Bonds, therefore, will have a more important place in their portfolios.

Income investors, who prioritize dividend or interest income over capital appreciation, will have bonds playing a very important role in their portfolios.

#2: Time Frame of Investment

The time period in which an investor needs the principal should be instrumental in the process of selecting bonds. Usually the yield increases with the lengthening of the maturity date. In fact, it is this reason why investors tend to purchase bonds that have long maturity dates – so that they can get higher yields.

The investor, however, must be very careful when using that strategy. In the event that they do purchase a long-term bond – and thereafter sell it before it matures, the market value of the bond can get severely affected by changes in interest rate. While it is impossible to control changes interest rate changes, it is certainly possible for investors to curb the effects of said changes by choosing bonds whose maturity dates lie closest to when the principal is required.

#3: Risk tolerance

Usually, the risk is greater when the return on the bond is high. This is exactly the reason why U.S. Treasury securities (considered to be some of the most stable and risk-proof bonds) carry lower rates of interest than their corporate or municipal counterparts. Before purchasing a bond, investors must be absolutely sure to have completely understood all risks involved.

#4: Desire to minimize income taxes

While income generated from U.S. Treasury securities is exempt from local and state income taxes, it is still subject to federal income taxes. Income generated from municipal bonds is totally exempt from federal income taxes and exempt from state and local income taxes – if the investor is a resident of the issuing state. Income from corporate bonds, however, is subject to both state and federal income taxes.

Investors who invest in bigger bonds generally tend to find ways to have their interest tax-exempted. Investors should, however, know that income tax exemption is exclusively applicable to interest income; any capital gained by selling a bond will still be subjected to income taxes.

#5: Personal Factors

The following personal variables should be taken into consideration when purchasing a bond. Any investor must make sure that the bond they are investing in fulfills these basic criteria by adeqautely answering the following questions:

  • What is the price of the bond?
  • Is the bond insured?
  • What is the credit rating of the bond?
  • What is the yield-to-maturity?
  • What is the maturity of the bond?
  • Does the bond have call provisions?
  • What is the coupon rate?
  • How is the bond’s interest income taxed?

The role that the bond will play in an investor’s portfolio will be totally dependent on the answers to the above questions.

4 GREAT WAYS TO GENERATE INCOME AFTER RETIREMENT

Putting a plan in place that can generate enough money to support you after retirement can be tricky at best. Not following the right plan…or rushing into something may just sound the death knell for all of your hard-earned savings.

Here are five great ways in which you can generate good income during your retirement. They’re no “get-rich-quick” schemes, and will need quite a bit of involvement; however, the rewards will be worth it in the end.

TOTAL RETURN PORTFOLIO

Constructing a portfolio of bond and stock index funds (or working with a financial advisor who does this work) is a fantastic way to create a stable source of income post-retirement. The portfolio, which is created to help you achieve a respectable long-term rate of return, allows you to additionally follow a specific set of withdrawal rate rules which will typically permit you to draw 4-7 percent a year. It will also allow you to increase your withdrawal in relation to inflation.

The logic that underlies “total return” is that you, the investor, are able to target a 10-20-year average annual return which exceeds – or at least equals your rate of withdrawal. While you may be targeting a long-term average, your returns can – and does deviate from said average every year. Therefore, in order to follow the investment approach successfully, you should maintain a diversified allocation that is independent of the yearly portfolio fluctuations.

This approach is best-suited to experienced investors, who are well-versed with the art and science of managing money and making timed, disciplined and logical decisions. It can also be taken by people who can – and are willing to invest by hiring an advisor who is experienced in using the approach.

RETIREMENT INCOME FUNDS

This is a special type of mutual fund, which automatically distributes your hard-earned money across a diverse portfolio of bonds and stocks by owning an assortment of other mutual funds. Specially constructed to provide a single package that can accomplish all needs and fulfill all objectives, these funds are managed with the sole aim of producing a stable monthly income, which is then distributed to you, the investor.

Funds vary in type on the basis of their objective – while some produce high monthly income use principal to fulfill their payout targets, others produce a low monthly income amount but have a more balanced approach as regards preserving principal.

The greatest advantage of a retirement income fund is for you to have the ability to control your principal amount and be able to access your money anytime you want. However, you must know that this comes with a catch – withdrawing amount from your principal will lead to a proportionate decrease in your future monthly income.

RENTAL REAL ESTATE

Quite unsurprisingly, rental property can – and does act as a stable source of income. Make no mistake, though – it is neither a get-rich-quick scheme nor a passive involvement where you can sit and earn while doing nothing. Owning and managing real estate is a proper business in itself, and will never generate proper income if it is not treated as such.

Rental real estate will include several different kinds of requirements – both intended and unintended – in terms of money, time and most importantly, involvement on your part. Therefore, you must factor-in any and all expenses and other things that may be required to maintain the rental property. You should also consider a definite time-frame for which you will own and maintain the property, and consider the vacancy rates (given that no property can remain occupied 100% of the time).

Unsure where to start? Try reading books on investing in real estate, talk to retirees who work as experienced investors, or join a club that specializes in real estate investing.

BONDS

Simply put, a bond is made when you loan your hard-earned money to a municipality, corporation or government. The bond, which is set to mature at a specific date, will earn the lender a specific amount of money (paid by the borrower) for a specific period of time until the bond matures, which is when the principal is returned to the lender. For many retirees, this interest income (called “yield”) which received from a bond (or a bond fund) can act as a stable source of income.

Bonds are of several types, each of which indicates the time-period before maturity and the level of financial strength of the bond’s issuer. Besides short-term, mid-term, and long-term bonds, there are floating rate bonds (which have adjustable interest rates), and high-yield bonds (which have low ratings but pay high coupon rates). Bonds are also available individually and in packages.

A bond’s principal value fluctuates with change in the rate of interest. For instance, a rising interest rate environment leads to decrease of existing bond values. While this principal fluctuation won’t matter if you plan on holding the bond to maturity, it will if you own a bond mutual fund and wish to sell it and use the funds for living expenses.

You should definitely buy bonds if you’re looking for small but stable income – and a guaranteed principal after a certain amount of time (i.e. once they mature). But if you’re trying to get high returns, or making gain on capital appreciation, you should consider other options.