Bonds |
| Overview | If you're looking for an investment that is less risky than stocks, but still has earning potential, bonds can be a useful way to help round-out your portfolio. As fixed-income investment, bonds differ from stocks in that they offer a definite return on your investment.
For this reason, bonds are a good option for people who want to increase their wealth without risking capital, such as retirees who want a guaranteed income for their investment or a family preparing to send their teenagers to college. The annual interest income a bond generates usually averages between 4 and 9 percent. |
What Are Bonds? |
A bond is essentially a loan. When you buy a bond, you are lending someone your money. In most cases that someone is the U.S. government or a large company. The principal you "lent" -- or the purchase amount of the bond -- is its face value. In exchange, you receive regular interest payments, called coupons. The length of the loan is the bond's maturity. Bonds expire or come due on their maturity date, at which time the entire value of the bond is repaid.
Bonds can be bought and sold like any other investment. While their rate of return is not as high as stocks, they also don't have the same level of risk. One of the reasons for this is that a bondholder gets paid first before stockholders, if a company goes bankrupt. Risk becomes even less a factor when you buy bonds through mutual funds. As long as you hold a bond to maturity (the full term of the bond, which can be as little as one-year or as long as 30 years), your principal will be paid in full. |
What You Should Know |
Many experts recommend bond mutual funds due to the less liquid nature of bonds over stocks. Bonds range from the super-safe U.S. government bonds (called Treasuries) to risky corporate issues called "junk bonds." In most cases, the higher the expected return on the bond, the higher the risk of losing principal. Generally, though, the longer the maturity of the bond, the more volatile the price. Short-term bonds are considered the safest option. But, bond investment isn't always safe. Companies, cities and counties occasionally do go bankrupt and those loans may not be paid back. Another risk associated with bonds is that your loan may be paid back early, forcing you to find another place for your money. A rising inflation rate can also be detrimental, in which case the fixed amount of money you receive will be worth less and less as prices rise. |
Tax Breaks |
All government bonds include a tax break. In addition, income from local government bonds (municipals) are immune federal taxes, just as income from U.S. Treasury bonds are immune from local taxes. Oftentimes, local governments will exempt its own citizens from taxes on its bonds, making municipals exempt from city, state and Federal taxes (triple tax-free). However, these tax-free municipals usually offer a lower coupon rate than equivalent taxable bonds. Any capital gain from selling a bond for more than its purchase price is taxable and holders of corporate bonds will have their earnings taxed by the city, state and federal government. |
