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In the United States you will often hear of corporate bonds and government bonds being touted by many, but exactly what are corporate and government bonds and how can you use them to build wealth?
In this discussion TheWealthIncreaser.com will focus on government and corporate bonds and discuss ways that you can possibly use them to build wealth more efficiently.
Municipal, Mortgage-backed, Agency and Corporate bonds will all be discussed to further enhance your understanding of the bond market. You can also purchase bonds as part of a Mutual Fund, ETF, Target Date Fund, 401k’s, IRA’s or other retirement plans by utilizing brokers or doing the selections yourself on your brokerage account.
Treasuries (Bills. Bonds, Notes) and CDs (Certificates of Deposit) are often considered the safest of investments on the market because they are government backed, and they too will be covered in this discussion.
Other bond investments, like municipal or corporate bonds, have credit ratings from rating agencies like Moody’s Investors Services and Standard & Poor’s. The higher the credit rating, the more likely an issuer is to make timely interest and principal payments.
Conversely, the lower the credit rating, the greater the risk that the issuer can’t make timely interest or principal payments. Prices for bonds with longer maturities tend to be more sensitive to changes in interest rates compared to shorter-term bonds. Be particularly cautious of junk bonds as they are riskier, and the inability of the issuer to make payments should be of higher concern to you. On the flip side you can potentially receive higher returns, but with more risk.
Municipal, are bonds issued by states, cities, counties, and other local governments, as well as enterprises that serve a public purpose, such as universities, hospitals, and utilities. Those who issue municipal bonds generally pay “interest income” that is “exempt” from federal and potentially state income taxes.
Corporate are bonds issued when companies issue corporate bonds to raise capital for activities such as expanding operations, purchasing new equipment, or building new facilities. The issuing company is responsible for making interest payments and repaying the principal at maturity.
Mortgage-backed securities are created by pooling mortgages purchased from the original lenders. As an investor you would receive monthly interest and principal payments from the underlying mortgages. These securities differ from traditional bonds in that there isn’t necessarily a predetermined amount that gets redeemed at a scheduled maturity date.
Agency bonds are issued by either a government-sponsored enterprise (GSE) or a government-owned corporation (GOC) and are debt obligations solely of the issuing agency (fannie-mae and freddie-mac come to mind as well as the Tennessee Valley Authority and the Hoover Dam).
There are generally two types of government bonds that you can buy directly at TreasuryDirect.gov, and they are marketable and non-marketable.
Marketable:
Marketable bonds include TIPs, (Treasury Inflation Protected securities), Treasuries (Bills, Bonds, Notes), FRNs (Floating Rate Notes), and STRIPs (Separate Trading of Registered Interest and Principal securities).
Non-marketable:
Non-marketable bonds include series EE and series I-Bonds (series is based on issue date), and they can be purchased in electronic form on treasurydirect.gov or purchased with your tax refund at set purchase amount intervals–you will receive a paper bond(s).
TheWealthIncreaser.com will start by discussing bond basics and because marketable bonds cause more confusion for many and are generally a more complex transaction than purchasing non-marketable bonds, government marketable bonds will be discussed first among bonds, followed by corporate marketable bonds and then non-marketable bonds.
Bond Basics
When you buy a bond, you are a company’s (or government entity) lender and the bond is like an IOU-a promise to pay back the money you’ve loaned to the company or agency, with interest back to you.
The amount of income a bond pays is largely determined by the prevailing interest rate at the time of issuance and other factors specific to that bond.
In simplified form, face value multiplied by interest rate equals interest payment to you.
$1,000 * 5% = $50
You might receive 2 coupon payments a year for $50 each and get payment of face value in 5 or 10 years, depending on term of the bond.
Bonds are often used to generate income, protect earnings, diversify portfolios and a strong point for many with government bonds are that they are often backed by the full faith and credit of the U.S. government.
What determines a bond’s yield?
Two key factors that determine a bond’s yield are credit risk and the time to maturity.
Credit risk: A bond’s yield generally reflects the risk that the issuer will not make full and timely interest or principal payments.
Rating agencies provide opinions on this risk in the form of a credit rating. Bonds with lower credit ratings generally pay higher yields because investors expect extra compensation for greater risk.
Maturity: Generally, the longer the maturity, the higher the yield. Investors expect to earn more on long-term investments because their money is committed for a longer period of time, and they lack access to it.
Who Issues?
Bonds are issued by both public and private entities.
Many cities, states, the federal government, government agencies, and corporations issue bonds to raise capital for a variety of purposes, such as building roads, improving schools, opening new factories, and buying the latest technology—along with other stated purposes.
How Bond Yields Work?
The yield you’re quoted when you buy a bond is often different from the interest it pays.
I’m sure you want to know why that is the case!
Because in addition to the annual interest rate, the bond’s return reflects any difference between its purchase price and its face value—the amount you’re expected to receive when the bond matures.
If you buy the bond at a price higher than the face value (at a premium), you’ll receive less than you paid when the bond matures. Let’s say face value is $1,000 and you pay $1,100, when the bond matures you will only get $1,000.
If you buy the bond at a price lower than the face value (at a discount), you’ll receive more than you paid when the bond matures. Let’s say face value is $1,000 and you pay $900, when the bond matures you will get $1,000.
If you sell the bond before it matures, you get its current price, which may be higher or lower than the amount you originally paid and you are in essence forfeiting your future coupon (interest) payments.
Frequently Asked Questions about Bonds…
TIPS (Treasury Inflation-Protected Securities) Basics
- Treasury Inflation-Protected Securities (TIPS) are a type of Treasury bond that is indexed to an inflationary gauge to protect investors from a decline in the purchasing power of their money.
- TIPs with a fixed principal can be stripped (more on stripping later in this discussion).
- TIPS are issued with maturities of five, 10, and 30 years and are considered a low-risk investment because the U.S. government backs them.
- Auctions are held several times a year.
- TIPs pay interest every six months based on a fixed rate determined at the bond’s auction.
- The principal value of TIPS rises as inflation rises.
- The principal amount is protected since investors will never receive less than the originally invested principal.
- The principal value of TIPS rises as inflation rises, while the interest payment varies with the adjusted principal value of the bond.
- TIPS can be purchased directly from the government through the TreasuryDirect system, in $100 increments with a minimum investment of $100.
- Some investors prefer to get TIPS through a TIPS mutual fund or exchange-traded fund (ETF). However, purchasing TIPS directly allows investors to avoid the management fees associated with mutual funds.
Suppose you as a bond investor owns $1,000 in TIPS at the end of the year, with a coupon rate of 2%. If there is no inflation as measured by the CPI, then you will receive $20 in coupon payments for that year. If inflation rises by 4%, however, then the $1,000 principal will be adjusted upward by 4% to $1,040. The coupon rate will remain the same at 2%, but it will be multiplied by the adjusted principal amount of $1,040 to arrive at an interest payment of $10.40 for the year.
Conversely, if inflation were negative—known as deflation—with prices falling 5%, then the principal would be adjusted downward to $950. The resulting interest payment to you would be $9.50 over the year. However, at maturity, you would receive no less than the principal amount invested of $1,000 or an adjusted higher principal, if applicable. Learn more about TIPs by visiting “Treasury Inflation Protected Securities (TIPS),” at TreasuryDirect.gov.
Treasuries
You can buy most at auction or in the open market. If bought at auction you can re-invest your earnings automatically. If you have an investment account with a brokerage, many brokerages allow you to purchase treasuries on their platform and re-invest as well.
Treasuries (Bills, Bonds, Notes)
NOTE: Treasuries have a competitive and non-competitive bidding process, and you want to be aware of that proactively, as opposed to after the fact.
Treasury Bill Basics
Note about Cash Management Bills: Cash Management Bills (CMBs) are also available at various times and for variable terms. Cash Management Bills are only available through a bank, broker, or dealer and cannot be purchased at TreasuryDirect.gov.
Treasury issues short-term cash management bills periodically to manage short-term financing needs.
*Bills are issued in electronic form only for periods of 4, 8,13, 17, 26 and 52 weeks.
- Interest is “fixed rate” and is set at auction.
- Interest is the difference between what you paid and the face value you get
- when bill matures interest is paid
- minimum purchase is $100 and sold in increments of $100
- Taxes at federal level are due on interest earned yearly (no state or local taxes)
- Not eligible for STRIPs
Treasury Bond Basics
*Issued in electronic form only.
- Term is either 20 or 30 years.
- Bonds pay a fixed rate of interest every six months until they mature and that rate is determined at auction.
- You can hold a bond until it matures or sell it before it matures.
- Interest rate is never lower than .125%.
- Minimum purchase is $100 and interest is paid every 6 months until maturity.
- Sold at auction several times a year.
- Taxes at federal level are due on interest earned annually (no state or local taxes).
- Are eligible for STRIPs.
NOTE: Treasury Bonds are not the same as U.S. Savings Bonds
EE Bonds, I Bonds, and HH Bonds are U.S. savings bonds and are “non-marketable,” meaning they can’t be sold in the secondary market, see U.S. Savings Bonds.
Treasury Note Basics
*Issued in electronic form only
*Term is of 2, 3, 5, 7, or 10 years.
*Notes pay a fixed rate of interest every six months until they mature. The rate is fixed at auction.
*You can hold a note until it matures or sell it before it matures.
- Interest rate is never lower than .125%
- Minimum purchase $100 and interest is paid every 6 months until maturity
- Sold at auction several times a year
- Taxes at federal level are due on interest earned each year (no state or local taxes)
- Are eligible for STRIPs
- Whether you purchase at auction or on the secondary market the bonds can be readily bought and sold.
FRNs (Floating Rate Notes)
*are relatively short-term investments that are issued in electronic form only.
- Mature in two years.
- Pay interest four times each year.
- have an interest rate that may change or “float” over time.
- You can hold a FRN until it matures or sell it before it matures.
- Minimum purchase $100, sold in increments and Interest paid every 3 months.
- Sold at auction.
- Federal tax due each year on interest earned. No state or local taxes
- Are not eligible for STRIPs.
STRIPs
You can buy, hold, sell, and redeem STRIPS only through a financial institution, a broker, or dealer who handles government securities.
Treasury securities with a fixed-principal, such as notes, bonds, and TIPS are eligible and may be stripped!
Treasury Bills and FRNs can’t be stripped!
The idea behind STRIPS is that the principal and each interest payment become “separate securities” that are treated individually.
Each separated piece is a zero-coupon security that matures separately and, has only one payment.
You can learn more about stripping by going to TreasuryDirect.gov!
Corporate Bonds
Corporate bonds are often used by investors in their portfolio to help reduce the risk of returns from other investments. Many investors use a laddered approach (purchase bonds or bond funds of varying maturities to reduce risk) and many laddered corporate bonds pay 5% or better if properly structured.
Investors usually select Junk or High Yield Corporate bonds so that they can obtain a higher rate of return and possibly an increase in the bond price down the road.
The segment that is considered high-yield would be rated B to BB+ by S & P or B to Ba1 by Moody’s.
They can be a good choice during economic expansion and quite risky during an economic decline.
High-yield bonds are also less sensitive to interest rate movement than the other categories mentioned in this discussion. You can buy junk-bonds through a broker or invest through a fund.
Investment grade bonds are purchased by many mutual fund companies and more conservative investors as they are not as risky as junk bonds but provide a stable return in many instances.
Although many domestic bond funds invest a small percentage in markets overseas you may be able to diversify your fixed income investments and receive a more attractive yield (bond yields and inflation on international bonds tend to have a low correlation to the U. S. Bond Market).
Some corporate bonds pay interest monthly, but quarterly or semi-annually are more common!
Be sure you are properly positioned to invest as there will be more risk. In addition to interest rate risk which is always a constant when investing in bonds—you will also have currency risk.
Depending on your “life stage” you could use international bonds to increase your nest egg–or utilize them during retirement if you are properly “positioned” to do so!
To help reduce currency risk, some International Bond Funds enter into “currency forward contracts” that lock in an exchange rate to buy or sell a currency on a future date and locks in the foreign currency fluctuations versus the United States Dollar. In addition, other methods are used to reduce currency risk depending on the company that you choose. As with any fund it is important that you are aware of the expense ratio—and particularly with International Bond Funds as there are usually other fees added that you won’t see on the expense ratio but will be charged to your account nevertheless.
Even though you can get hefty returns during good times, market risk can be substantial when bond funds in international markets plummet during volatile times, therefore it can never be stressed enough that you must be in the “right financial position” and at the “right stage in your life” to utilize International Bonds & Bond Funds in your portfolio for maximum results.
Non-marketable Bonds
Series EE and Series I Bonds
These are also government issued bonds that are sold at a “discount of face value” and mature over 20 to 30 years.
Series I bonds are also adjusted for inflation twice a year!
Non-marketable bonds include series EE and series I-Bonds (series is based on issue date), and they can be purchased in electronic form on TreasuryDirect.gov or purchased with your tax refund at set dollar amounts with your tax refund–you will receive a paper bond(s).
The interest would accumulate in your account and once you cashed in you would receive the interest and principal. If you cash in early there could be a penalty! In order to get the full face value on the bond, you would have to keep the bond for the full term. You could also be taxed on the interest unless an exception such as proceeds were used for educational purposes–were to apply.
CD’s (Certificate of Deposit) & Money Market Accounts
A CD with a fixed term and guaranteed rate can be a good place for money you plan to spend down the line, such as a wedding, or the purchase of a house or boat. Due to early withdrawal penalties, however, the money is not as easily accessible as funds in a savings account. This makes a liquid savings account a better option for money you may need for emergencies.
You want to ensure that you properly establish an emergency funds at the earliest time possible to help with unplanned events that will occur in the short and long-term. A CD could work for you as part of your emergency fund if you found low penalty CD’s that otherwise met your goals and you used a laddered approach in establishing the fund.
Unlike bonds, a CD’s fixed term is guaranteed to pay a specific yield on a set date in the future! If you like the safety of bonds and CDs, you may want to set up a bond or CD ladder so that you can have better access to your funds, particularly if you will be using part or all for your emergency fund utilization!
You can use a CD calculator to determine exactly how much interest the CD that you are considering can earn when the CD matures so you will know your “numbers” in advance. And you can go to bankrate.com to learn more about CDs and how the one you are considering ranks as far as safety and penalties are concerned.
Since CDs usually pay fixed yields, a CD may be a smart option in a falling interest rate environment. When rates are decreasing, you may be able to lock in a higher yield than what will be offered in coming months or years.
Although they are not in the bond family, CD’s and money market accounts are worth considering depending on your goals as there are a large number of consumers who possess these accounts and like their safety ($250,000 protection through FDIC).
With interest rates fluctuations Certificates of Deposits and Money Market Accounts will vary on what they pay in returns, and returns that you expect may depend on FED policy of keeping short term rates close to zero or utilizing FED policy to raise interest rates!
Conclusion
You can use bonds to fund your IRA if you have a brokerage account. You can possibly save on management fees by purchasing Treasury bonds directly at TreasuryDirect.gov.
Bonds can play an important role as you approach retirement and even during your retirement years. Used as part of an overall or comprehensive wealth building approach they can play a role in helping you live out your retirement years with dignity. If you are uncomfortable selecting bonds you can use bond mutual funds or let mutual fund managers select bonds that are part of the mutual fund that they manage. Target Date and Educational accounts may automatically include bonds in your account if you are currently using that type of financial product.
All bond types have their pros and cons so you may want to do additional research or consult with your financial advisor if you are still uncomfortable with bonds.
Bonds can also be used to fund your, your children’s, or grandchildren’s education, and the interest earned could be tax free if you meet the educational guidelines outline in the IRS tax code.
Treasury marketable securities are sold through auctions. In 2023, Treasury Direct held 428 public auctions and issued about $22 trillion in Treasury marketable securities–no small change!
Treasury marketable securities include Bills, Bonds, Notes, Treasury Inflation-Protected Securities (TIPS), and Floating Rate Notes (FRNs). What makes them “marketable” is that you can sell or transfer them before they mature and there are always ready buyers. Agency, mortgage-backed, municipal and other bonds are available at the federal, state and local level and are offered by various entities.
You can strip some marketable bonds and basically break them down into individual payments!
Corporate bonds include investment grade, junk, international, bond funds and other classifications and they can be found in abundance in the financial markets. You can set up an account with all bond types in 15 minutes or so at many brokerages as the process is fairly straightforward.
Many mutual funds that you may already have, or are considering, may already have a percentage invested in bonds that you may not be aware of. If you have a target date fund or a 529 savings plan a portion of your investment is more than likely already invested in the bond market.
Non-Marketable bonds include series EE and I bonds and they can be purchased by you, but can’t be sold in the financial markets.
Bonds can be an important part of your wealth building future if you utilize them in the appropriate manner and you have addressed your finances in a comprehensive manner as a major part of your approach to your future, whether it be for retirement or any other purpose.
All the best to your bond management success…
Set up a non-competitive bidding account at TreasuryDirect.gov…
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