The following post was originally published on Wealthminder
This is the second segment in our three part series on bonds. If you missed the first segment, you may want to read “How do bonds work?” first. There are many ways one could break down the bond market, but fortunately there is a relatively small set of categories most investors need to be aware of and understand.
US Corporate Bonds
Corporate bonds are bonds issued by companies to help fund their businesses. They pay interest, typically semi-annually, until their maturity (or earlier if they are callable and the corporation decides to call them) and then the principal is returned to you as the owner of the bond. The interest you are paid is treated like regular income on your tax return.
Corporate bonds are usually broken into 2 sub-groups: investment grade and high yield (or junk bonds). The difference between the 2 is determined by the underlying credit rating of the bond. What does that mean? It means there are 3rd parties companies that evaluate how likely they think it is that the corporation will actually pay you all of the interest and that they have promised. If their rating falls below a certain level, then the bond is called a high-yield bond. As the name implies, bonds that are labelled high-yield pay a higher rate of interest than investment grade issues in order to compensate the investor for the increased risk.
A simple analogy for most consumers is the mortgage market. If you have a high credit score, you are able to obtain a mortgage at a lower interest rate than if you have a low credit score. The same logic applies to companies when they want to borrow money.
US Government Bonds
US Government Bonds are those issued by our government in order to pay for various government functions. While there are many agencies that issue bonds, we’ll focus on the 2 types of government bonds most individual investors will encounter, Treasuries and TIPs. Like other bonds, both of these bonds pay interest semi-annually until their maturity date and then the original principal amount is returned to the owner. Unlike corporate bonds, government bonds are not callable. One additional benefit of government bonds is the interest is tax deductible on your state and local tax returns.
The difference between Treasuries and TIPs is pretty simple. Treasuries pay a fixed rate of interest over the life of the bond. TIPs on the other hand adjust the amount you receive with inflation. So, if you want a quick proxy for what the market thinks inflation will be, just look at the difference between the rate of a Treasury and a TIP of the same maturity. For example, the recent rate on a 10 year TIP is about 0.5% while the 10 year Treasury is about 2.75%. This means that the market expects inflation to be about 2.25% over the next 10 years. If inflation ends up being less than that, you would be better off buying Treasuries, and if it’s more, you would be better off with TIPs.
There is one additional quirk about TIPs you should understand. The way the inflation adjustment works is not by increasing the interest rate, but by adding to the principal amount you receive when the bond matures. For example, if you bought a $1,000 TIP and the interest rate was 0.5%, you would receive $5 in interest the first year. Let’s say inflation was 3% in year 1. For year 2, your principal would be adjusted to $1,030 and you would receive $1,030 x 0.5% = $5.15 in interest. The kicker is that you have to pay taxes on both the interest and the increase in principal even though you won’t receive the increased principal until the bond matures.
Municipal bonds are issued by state and local governments here in the US. They are typically used to fund public projects like schools, infrastructure, gov’t buildings, etc., but they can be issued for things such as hospitals or stadiums that involve private parties. Like the other types of bonds we’ve discussed, interest is typically paid semi-annually until the bond matures and then the original principal is returned. As with corporate bonds, muni bonds are often callable. One of the biggest benefits of munis is that the interest in usually deductible on your federal return, and if the bond is issued by your state, it can be deducted from your state return too.
To compare a tax-free bond’s yield to a taxable one, you calculate something called the tax-equivalent yield. Sounds complicated, but it really isn’t. Simply divide the yield on the muni bond by 1 – your tax rate. For example, if live in Virginia, buy a Virginia bond paying 4% and are in the 28% federal tax bracket (5% state), your tax-equivalent yield is 4/(1-.28-.05) = 5.97%.
International bonds are a relatively new asset class from a US investor perspective, although foreign countries and companies have clearly issued bonds for a very long time. In fact, the value of foreign bonds in the market now exceeds the value of bonds issued in the US. Foreign bonds can be issued either in dollars or in the local currency, and in general, they work very similarly to US bonds. The main reason for US investors to consider international bonds is the same reason to consider international stocks, diversification.
The 3 primary subsets investors should consider are developed market corporate bonds, developed market government bonds (often called sovereign bonds) and emerging market bonds. Like with their equity and fixed income counterparts, these bonds come with varying levels of risk/reward. On the one end are emerging market bonds, which carry the greatest level of risk and typically pay the highest interest rates, and on the other end is foreign developed sovereign debt, which carries a lower rate of interest and is backed by the full faith of a government, like Germany, England or Japan.
Now that you understand the different types of bonds and how bonds work, keep an eye out for the final article in our series. It will help you understand the role bonds play in a portfolio.