Investment-grade bonds offer investors a reasonable certainty of regularly receiving the periodic income (interest) and retrieving the amount originally invested (principal). Bonds are usually issued at a par value (also known as face value) of $1000. An investor typically earns a low to moderate return on bond investments, an appropriate yield when compared with the higher total returns earned on riskier stocks and stock mutual funds. Fewer than 800 of the 23,000 largest U.S. companies that issue bonds meet the highest investment-grade rating standards. Owning some bonds (or bond mutual funds) along with stocks and cash diversifies an investment portfolio. The Bond Market Association (http://www.investinginbonds.com/) sponsors a bond website
Speculative-grade bonds pay a high interest rate. These are often called junk bonds, and they are long-term, high-risk, high-interest-rate corporate (or municipal) IOUs issued by companies (or municipalities) with poor or no credit ratings. The interest rates paid investors on junk bonds are 3.5 to 8 percent higher than those of Treasury bonds. Also called high-yield bonds, they carry investment ratings that are below traditional investment grade and carry a higher default risk. The default rate on high-quality bonds is less than 1 percent. The default rate on junk bonds over time has ranged from a low of 2 percent to a whopping 31 percent. For more information, see Bond Pickers (www.bondpickers.com) or www.defaultrisk.com or search Google using “high-yield bond offerings.” Individual investors often avoid buying individual junk bonds because of the substantial financial risk involved with owning too few investments. Instead, they reduce risk by diversifying their investments through a “high-yield income” bond mutual fund that has junk bonds in its portfolio.
Corporate, U.S. Government, and Municipal Bonds
Three types of bonds are available: corporate bonds, U.S. government securities, and municipal government bonds. Corporate Bonds Corporate bonds are interest-bearing certificates of longterm debt issued by a corporation. They represent a needed source of funds for corporations. The dollar value of newly issued bonds is three times the dollar value of newly issued stocks. Because of tax regulations, corporations often finance major projects by issuing long-term bonds instead of selling stocks. One reason they do so is that payments of dividends to common and preferred stockholders are not tax deductible for corporations, unlike interest paid to bondholders. State laws require corporations to make bond interest payments on time. Therefore, companies in financial difficulty are required to pay bondholders before paying any short-term creditors.
Compared with other bonds, corporate bonds pay the highest interest rates. The default risk varies with the issuer. To help you in appraising the risks and potential rewards of bond investments, independent advisory services, such as Moody’s Investors Service and Standard & Poor’s, grade bonds for credit risk. These firms publish unbiased ratings of the financial conditions of corporations and municipalities that issue bonds. A bond rating represents the opinion of an outsider on the quality or creditworthiness of the issuing organization. It reflects the likelihood that the issuing organization will be able to repay its debt. Ratings for each bond issue are continually reevaluated, and they often change after the original security has been sold to the public. Investors have access to measures of the default risk (or credit risk), which is the uncertainty associated with not receiving the promised periodic interest payments and the principal amount when it becomes due at maturity. Bond rating directories are available in large libraries and online. Table 14.3 shows the bond ratings used by Moody’s and Standard & Poor’s. The higher the rating, the greater the probable safety of the bond and the lower the default risk. The lower the rating of the bond, the higher the stated interest rate or the effec tive interest rate. When bonds are reduced in price from their face amount, more risk is involved. Higher ratings denote confidence that the issuer will not default and, if necessary, that the bond can readily be sold before its maturity date. Investment-grade corporate bonds may provide returns as much as 1.5 percentage points higher than the returns available on comparable U.S. Treasury securities.
U.S. Government Bills, Notes, and Bonds U.S. Treasury securities are the world’s safest investment because the government has never defaulted on its debt. U.S. Treasury securities are backed by the “full faith, credit, and taxing power of the U.S. government,” and this all but guarantees the timely payment of principal and interest. U.S. government securities are classified into two groups: (1) Treasury bills, notes, and bonds and (2) federal agency issue notes, bonds, and certificates. Treasury bills, notes, and bonds are collectively known as Treasury securities, or Treasuries. The federal government uses these debt instruments to finance the public national debt. Treasury securities have excellent liquidity and are simple to acquire and sell. Previously issued marketable Treasury securities are bought and sold in securities markets through brokers. New issues can be purchased online using the Treasury Direct Plan (www.savingsbonds.gov). The interest rates on federal government securities are lower than those on corporate bonds because they are virtually risk free. The possibility of default is near zero. Individuals with a conservative investment philosophy are often attracted to the certainty offered by U.S. government securities. Investors can purchase Treasury securities through their bank or broker or directly from the Treasury. Investors often buy Treasury issues to protect a portion of their assets and to diversify their portfolios. Although interest income is subject to federal income taxes, interest earned on Treasury securities is exempt from state and local income taxes.
Speculative-grade bonds pay a high interest rate. These are often called junk bonds, and they are long-term, high-risk, high-interest-rate corporate (or municipal) IOUs issued by companies (or municipalities) with poor or no credit ratings. The interest rates paid investors on junk bonds are 3.5 to 8 percent higher than those of Treasury bonds. Also called high-yield bonds, they carry investment ratings that are below traditional investment grade and carry a higher default risk. The default rate on high-quality bonds is less than 1 percent. The default rate on junk bonds over time has ranged from a low of 2 percent to a whopping 31 percent. For more information, see Bond Pickers (www.bondpickers.com) or www.defaultrisk.com or search Google using “high-yield bond offerings.” Individual investors often avoid buying individual junk bonds because of the substantial financial risk involved with owning too few investments. Instead, they reduce risk by diversifying their investments through a “high-yield income” bond mutual fund that has junk bonds in its portfolio.
Corporate, U.S. Government, and Municipal Bonds
Three types of bonds are available: corporate bonds, U.S. government securities, and municipal government bonds. Corporate Bonds Corporate bonds are interest-bearing certificates of longterm debt issued by a corporation. They represent a needed source of funds for corporations. The dollar value of newly issued bonds is three times the dollar value of newly issued stocks. Because of tax regulations, corporations often finance major projects by issuing long-term bonds instead of selling stocks. One reason they do so is that payments of dividends to common and preferred stockholders are not tax deductible for corporations, unlike interest paid to bondholders. State laws require corporations to make bond interest payments on time. Therefore, companies in financial difficulty are required to pay bondholders before paying any short-term creditors.
Compared with other bonds, corporate bonds pay the highest interest rates. The default risk varies with the issuer. To help you in appraising the risks and potential rewards of bond investments, independent advisory services, such as Moody’s Investors Service and Standard & Poor’s, grade bonds for credit risk. These firms publish unbiased ratings of the financial conditions of corporations and municipalities that issue bonds. A bond rating represents the opinion of an outsider on the quality or creditworthiness of the issuing organization. It reflects the likelihood that the issuing organization will be able to repay its debt. Ratings for each bond issue are continually reevaluated, and they often change after the original security has been sold to the public. Investors have access to measures of the default risk (or credit risk), which is the uncertainty associated with not receiving the promised periodic interest payments and the principal amount when it becomes due at maturity. Bond rating directories are available in large libraries and online. Table 14.3 shows the bond ratings used by Moody’s and Standard & Poor’s. The higher the rating, the greater the probable safety of the bond and the lower the default risk. The lower the rating of the bond, the higher the stated interest rate or the effec tive interest rate. When bonds are reduced in price from their face amount, more risk is involved. Higher ratings denote confidence that the issuer will not default and, if necessary, that the bond can readily be sold before its maturity date. Investment-grade corporate bonds may provide returns as much as 1.5 percentage points higher than the returns available on comparable U.S. Treasury securities.
U.S. Government Bills, Notes, and Bonds U.S. Treasury securities are the world’s safest investment because the government has never defaulted on its debt. U.S. Treasury securities are backed by the “full faith, credit, and taxing power of the U.S. government,” and this all but guarantees the timely payment of principal and interest. U.S. government securities are classified into two groups: (1) Treasury bills, notes, and bonds and (2) federal agency issue notes, bonds, and certificates. Treasury bills, notes, and bonds are collectively known as Treasury securities, or Treasuries. The federal government uses these debt instruments to finance the public national debt. Treasury securities have excellent liquidity and are simple to acquire and sell. Previously issued marketable Treasury securities are bought and sold in securities markets through brokers. New issues can be purchased online using the Treasury Direct Plan (www.savingsbonds.gov). The interest rates on federal government securities are lower than those on corporate bonds because they are virtually risk free. The possibility of default is near zero. Individuals with a conservative investment philosophy are often attracted to the certainty offered by U.S. government securities. Investors can purchase Treasury securities through their bank or broker or directly from the Treasury. Investors often buy Treasury issues to protect a portion of their assets and to diversify their portfolios. Although interest income is subject to federal income taxes, interest earned on Treasury securities is exempt from state and local income taxes.
Treasury Bills, Notes, and Bonds Treasury bills, or T-bills, are short-term U.S. government securities issued with maturities of a year or less. They are sold at a discount from their face value (par). The difference between the original purchase price and what the Treasury pays you at maturity, the gain or “par,” is interest. This interest is exempt from state and local income taxes but is reported as interest income on your federal tax return in the year the Treasury bill matures. Stated as an interest rate, the return on such investments is called a discount yield. For example, if you buy a $10,000 26-week Treasury bill for $9750 and hold it until maturity, your interest will be $250. An investor can hold a bill until maturity or sell it before it is due.
When a bill matures, the proceeds can be reinvested into another bill or redeemed and the principal will be deposited into the investor’s checking or savings account. A Treasury note or bond is a fixed-principal, fixed-interestrate government security issued for an intermediate term or long term. Notes are issued for two, three, five, or ten years and bonds have a maturity of more than ten years. Notes and bonds exist only as electronic entries in accounts. The interest rate is higher than the rates for T-bills because the lending period is longer. Owners of Treasury notes and bonds receive interest payments every six months, which is reported as interest income on their federal tax return in the year received. When the security matures, the investor is repaid the principal. Investors can hold a note or bond until maturity or sell it.
I bonds are nonmarketable savings bonds backed by the U.S. government that pay an earnings rate that is a combination of two rates: a fixed interest rate that is set when the investor buys the bond and a semiannual variable interest rate tied to inflation that protects the investor’s purchasing power. They are sold at face value, such as $50 for a $50 bond. Interest stops accruing 30 years after issue, and I bonds pay off only when redeemed. If you redeem an I bond within the first five years, you will forfeit the three most recent months’ interest; after five years, you will not be penalized. The maximum purchase allowed in one calendar year is $30,000. All earnings on savings bonds are exempt from both state and local income taxes, while federal taxes can be deferred until the bonds are either redeemed or reach final maturity. I bonds cashed in to pay education expenses are tax exempt.
TIPS, also known as Treasury Inflation-Protected Securities, are marketable Treasury bonds whose principal increases with inflation and decreases with deflation. These inflation-indexed $1000 bonds are the only investment that guarantees that the investor’s return will outpace inflation. TIPS bonds are sold in terms from 5 to 30 years, and interest is paid to TIPS owners every six months until they mature. The interest rate is set when the security is purchased, and the rate never changes. The principal is adjusted every six months according to the rise and fall of the consumer price index (CPI); if inflation occurs and the CPI rises, the principal increases. The government sends the interest payment on the new principal to the investor’s account.
The fixed interest rate on TIPS is applied to the inflation-adjusted principal; so if inflation occurs throughout the life of a TIPS security, every interest payment will be greater than the one before it. The amount of each interest payment is determined by multiplying the inflation-adjusted principal by one-half the interest rate. The inflation-adjusted amount added to the principal on a TIPS bond every six months is taxable, even though the investor does not receive the money until the bond matures. Thus, TIPS bonds pay “phantom taxable interest income,” like zero-coupon bonds , so the investor pays federal income taxes on the interest earned each year. The investor uses other funds to pay the taxes on that income. When TIPS mature, the federal government pays the inflation-adjusted principal (or the original principal if it is greater). Investors can hold a TIPS bond until it matures or sell it before it matures. The interest on TIPS bonds can be excluded from federal income tax when the bond owner pays tuition and fees for higher education in the year the bonds are redeemed.
U.S. government savings bonds are nonmarketable, interest-bearing bonds. Series EE savings bonds are issued at a sharp discount from face value and pay no annual interest, and they may be redeemed at full value upon maturity. For example, a $100 savings bond might be purchased for half of its face amount, $50. The interest, compounded semiannually, accumulates within the bond itself, and the return to the investor comes from redeeming the bond at its stated face value at the maturity date. Interest on Series EE bonds is exempt from state and local taxes. There is no federal income tax liability on the interest at redemption if the proceeds are used to fund the child’s college education. (Series HH savings bonds [no longer sold] were issued at par and acquired only by exchanging Series EE bonds. Interest on Series HH bonds is exempt from state and local taxes.)
Municipal Government Bonds municipal government bonds (also called munis) are long-term debts issued by local governments (cities, states, and various districts and political subdivisions) and their agencies. Their proceeds are used to finance public improvement projects, such as roads, bridges, and parks, or to pay ongoing expenses. Moody’s Bond Record rates some 20,000 munis, and twice as many unrated securities exist. Bonds range in quality from AAA-rated state highway bonds to unrated securities issued by local governmental parking authorities. The investor’s interest income on municipal bonds is not subject to federal income taxes. This is because the U.S. Constitution requires that municipal bond interest be exempt from federal income tax. Because the interest income is tax free, municipal bonds are also known as tax-free bonds or tax-exempt bonds. Interest income on munis also is exempt from state and local income taxes when the investor lives in the state that issued the bond. Municipal bonds offer a lower stated return than other bonds. However, if your marginal tax rate is higher than 25 percent, it generally makes economic sense to invest in municipal bonds because the after-tax return on a muni might be higher than that of a corporate bond.
When a bill matures, the proceeds can be reinvested into another bill or redeemed and the principal will be deposited into the investor’s checking or savings account. A Treasury note or bond is a fixed-principal, fixed-interestrate government security issued for an intermediate term or long term. Notes are issued for two, three, five, or ten years and bonds have a maturity of more than ten years. Notes and bonds exist only as electronic entries in accounts. The interest rate is higher than the rates for T-bills because the lending period is longer. Owners of Treasury notes and bonds receive interest payments every six months, which is reported as interest income on their federal tax return in the year received. When the security matures, the investor is repaid the principal. Investors can hold a note or bond until maturity or sell it.
I bonds are nonmarketable savings bonds backed by the U.S. government that pay an earnings rate that is a combination of two rates: a fixed interest rate that is set when the investor buys the bond and a semiannual variable interest rate tied to inflation that protects the investor’s purchasing power. They are sold at face value, such as $50 for a $50 bond. Interest stops accruing 30 years after issue, and I bonds pay off only when redeemed. If you redeem an I bond within the first five years, you will forfeit the three most recent months’ interest; after five years, you will not be penalized. The maximum purchase allowed in one calendar year is $30,000. All earnings on savings bonds are exempt from both state and local income taxes, while federal taxes can be deferred until the bonds are either redeemed or reach final maturity. I bonds cashed in to pay education expenses are tax exempt.
TIPS, also known as Treasury Inflation-Protected Securities, are marketable Treasury bonds whose principal increases with inflation and decreases with deflation. These inflation-indexed $1000 bonds are the only investment that guarantees that the investor’s return will outpace inflation. TIPS bonds are sold in terms from 5 to 30 years, and interest is paid to TIPS owners every six months until they mature. The interest rate is set when the security is purchased, and the rate never changes. The principal is adjusted every six months according to the rise and fall of the consumer price index (CPI); if inflation occurs and the CPI rises, the principal increases. The government sends the interest payment on the new principal to the investor’s account.
The fixed interest rate on TIPS is applied to the inflation-adjusted principal; so if inflation occurs throughout the life of a TIPS security, every interest payment will be greater than the one before it. The amount of each interest payment is determined by multiplying the inflation-adjusted principal by one-half the interest rate. The inflation-adjusted amount added to the principal on a TIPS bond every six months is taxable, even though the investor does not receive the money until the bond matures. Thus, TIPS bonds pay “phantom taxable interest income,” like zero-coupon bonds , so the investor pays federal income taxes on the interest earned each year. The investor uses other funds to pay the taxes on that income. When TIPS mature, the federal government pays the inflation-adjusted principal (or the original principal if it is greater). Investors can hold a TIPS bond until it matures or sell it before it matures. The interest on TIPS bonds can be excluded from federal income tax when the bond owner pays tuition and fees for higher education in the year the bonds are redeemed.
U.S. government savings bonds are nonmarketable, interest-bearing bonds. Series EE savings bonds are issued at a sharp discount from face value and pay no annual interest, and they may be redeemed at full value upon maturity. For example, a $100 savings bond might be purchased for half of its face amount, $50. The interest, compounded semiannually, accumulates within the bond itself, and the return to the investor comes from redeeming the bond at its stated face value at the maturity date. Interest on Series EE bonds is exempt from state and local taxes. There is no federal income tax liability on the interest at redemption if the proceeds are used to fund the child’s college education. (Series HH savings bonds [no longer sold] were issued at par and acquired only by exchanging Series EE bonds. Interest on Series HH bonds is exempt from state and local taxes.)
Municipal Government Bonds municipal government bonds (also called munis) are long-term debts issued by local governments (cities, states, and various districts and political subdivisions) and their agencies. Their proceeds are used to finance public improvement projects, such as roads, bridges, and parks, or to pay ongoing expenses. Moody’s Bond Record rates some 20,000 munis, and twice as many unrated securities exist. Bonds range in quality from AAA-rated state highway bonds to unrated securities issued by local governmental parking authorities. The investor’s interest income on municipal bonds is not subject to federal income taxes. This is because the U.S. Constitution requires that municipal bond interest be exempt from federal income tax. Because the interest income is tax free, municipal bonds are also known as tax-free bonds or tax-exempt bonds. Interest income on munis also is exempt from state and local income taxes when the investor lives in the state that issued the bond. Municipal bonds offer a lower stated return than other bonds. However, if your marginal tax rate is higher than 25 percent, it generally makes economic sense to invest in municipal bonds because the after-tax return on a muni might be higher than that of a corporate bond.
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Clearly, new investors will not pay $1000 for a bond with a performance of 5% when they can buy new bonds with an updated coupon rate of 6% for each $1000. What will happen to your specific bond (with a 5% coupon rate)?guarantor loans
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