While it’s common to invest in bonds, it’s fairly uncommon to understand the ins and outs of this essential asset class.
And, while you don’t need to be a bond expert to understand their benefits, it does help to have a high-level understanding of what they are and how they function when considering the role they could play in your retirement income strategy.
In this guide, we will explore the basics of bonds, review different types, explain how they function, how they are taxed, and the impact of current interest rates on their value. By understanding these core aspects, you will be better equipped to make informed decisions about how they fit into your overall financial plan.
First, What Are Bonds?
Bonds are a loan from you (the buyer) to a company or government (the issuer).
Bonds are an investment and are often called “fixed-income.” They are considered one of the three major asset classes—alongside stocks and cash.
When you buy a bond, you become a lender to either the company that issued it or the government that issued it. You agree to loan them money for a specific period at an agreed-upon interest rate, and they agree to pay you back your principal plus interest at the end of the period.
And bonds are essential—a critical part of a diversified investment portfolio that counterbalances more volatile assets like stocks, which can help reduce your overall risk. In other words, bonds are more price-stable than stocks, which can help smooth out the ride on your investing journey. They are like the slow and steady tortoise in your portfolio, whereas stocks would be the fast but less steady hare.
Different Types of Bonds
Next, there are different types of bonds that cater to different investment needs and risk profiles.
Here are a few examples:
- Government Bonds: These are issued by the national government and come with a guarantee from the government. They are considered the safest type of bond but offer lower returns. As of August of 2023, these pay roughly 5.4% interest per year.
- Municipal Bonds: Also known as “munis,” these bonds are issued by states, cities, or other local governmental entities to fund public projects like schools or highways. They are generally exempt from federal taxes and from some state and local taxes, making them particularly attractive to investors in high tax brackets.
- Corporate Bonds: These are bonds issued by corporations to fund their capital needs. They typically offer higher yields than government and municipal bonds to compensate for the increased risk. As of August of 2023, these pay roughly 5.5% interest per year.
- Foreign Bonds: These bonds are issued by a foreign government or corporation. While they can offer higher returns, they also carry additional risks, including exchange rate and political risks.
- High-Yield Bonds: Also known as “junk bonds,” these bonds offer higher yields because they are issued by entities with lower credit ratings. While they can provide greater returns, they also carry a higher risk of default. Investors should use strong caution when considering any investment in junk bonds.
Each type caters to different investment needs and risk profiles and offers varying returns, providing investors many ways to diversify their portfolios.
Understanding The Basics of How Bonds Work
Bond Issuers and Bond Pricing
Bonds are issued by various entities, including governments, municipalities, and corporations.
The agreement is simple: the issuer promises to pay back the bond’s face value at a specific date, known as the bond’s maturity date, and a set interest rate, known as the coupon rate.
Next, the price of a bond and the coupon rate is determined by various factors:
- Interest Rates: Bonds offer a fixed rate of interest, known as the coupon rate. When prevailing market rates rise, bond prices usually fall; when they drop, bond prices usually rise.
- Creditworthiness: The creditworthiness of the issuer is an important factor in determining the bond’s coupon rate. For example, bonds issued by governments are generally considered to be safer than those issued by corporations, resulting in a lower coupon rate.
- Maturity: The date the bond matures and the investor receives their principal back.
- Duration: A measure of sensitivity to interest-rate movements. For every 1 point of duration, a bond price is expected to move by the percentage in opposite fashion to a change in broad interest rates. For example, if a bond has a duration of 2, and interest rates go down 1%, that bond will likely go up in price by 2%. If a bond has a duration of 10 and interest rates go up 1%, the price of that bond is likely to fall by 10%. Duration factors in both the maturity timeline and amount of cash flows (interest payments) between now and maturity. The longer the maturity and lower the interest payments, the higher the duration. The shorter the maturity and higher the interest payments, the lower the duration.
Ultimately, bonds enable issuers to raise funds from investors and investors to earn a return on their investment. By providing a predictable income stream, bonds can be an attractive investment option for those seeking steady income and lower volatility.
Yield to Maturity (YTM)
Next, Yield to Maturity (YTM) is a critical concept that every bond investor should understand. Let’s break it down.
What is Yield to Maturity (YTM)?
YTM is the annualized total return you would expect to receive if you held a bond until its maturity date. For example, a one year bond with a 5% YTM will pay you a 5% total return. A three month bond that pays 5% YTM will earn a return on your money that is equivalent to 5% for the whole year. YTM takes into account both the interest payments you receive annually and any capital gain or loss you would incur if you bought the bond at its current market price and held it until maturity. It also factors in any discount or premium you pay for the bond.
Why is YTM Important?
YTM serves as a single, comprehensive figure that you can use to compare prospective returns across different bonds. This is particularly useful when comparing bonds with different maturities and coupon rates.
Difference Between Current Yield and YTM:
The current yield of a bond only considers the annual interest payments relative to the bond’s price. It’s calculated by dividing the annual interest payment by the bond’s current market price. However, it doesn’t take into account any capital gain or loss if the bond is held until maturity.
Investors should weigh YTM over current yield because YTM includes both the interest payments and any capital gain or loss. This makes YTM a better measure of expected return.
In summary, understanding YTM is crucial for making informed decisions about which bonds to invest in. It provides a complete picture of what you can expect to earn from a bond if you hold it until maturity, making it a valuable tool for comparing different investment options.
Taxation of Bonds
The tax treatment of bond income depends on the type of bond.
U.S. Treasury Bonds
Interest earned from U.S. Treasury bonds is subject to federal income tax but is exempt from state and local taxes. This makes them attractive to investors in high-tax states like California, New York, and Hawaii. This can also make US Treasury bills more attractive than Bank CD’s.
Municipal bonds, or “munis,” are issued by states, cities, and other local entities. The interest from most municipal bonds is federally tax-exempt. Additionally, if the bond is issued within the investor’s state of residence, the interest could also be exempt from state and local taxes. The tax-exempt status of municipal bonds can be especially beneficial for high-earners in high tax brackets.
Corporate bonds issued by businesses do not enjoy any tax exemptions. The interest earned on these bonds is subject to both federal and state income taxes. This is important to consider when comparing the yield of a corporate bond to that of a Treasury or municipal bond.
It’s important to note that while some bonds offer tax advantages, investors should always consider their overall investment objectives and the risk/return characteristics of bonds. For example, although corporate bonds are fully taxable, they typically offer higher yields to compensate for the greater risk than government and municipal bonds. So, always consider your personal tax situation and goals when deciding how to invest in bonds. This will ensure that you’re on track for a healthy and diversified portfolio of investments.
Lastly, since bonds are often considered a tax-inefficient investment due to their interest income, it may be wise to consider holding some or all of your bonds in a tax-advantaged retirement account. By doing so, you can defer taxes on the interest income while the funds are in the account. This is just one example of a tax planning strategy you can use to lower your tax liability while maintaining your desired investment portfolio.
The Impact of Current Interest Rates on Bonds
One of the most interesting and unique aspects of bonds is how they are affected by interest rates, and at the time of writing, interest rates are at a 22-year high.
Interest rates and bond prices have an inverse relationship, meaning when interest rates go up, bond prices typically go down—and vice versa. This occurs because prevailing interest rates are the benchmark against which all bonds, new and old, are measured. When interest rates go up, new bonds come to market with those higher rates, making older, lower-yielding bonds less attractive to investors. As a result, the prices of those existing bonds tend to decline.
Alternatively, when interest rates go down, existing bonds with higher yields become more attractive to investors than new bonds, leading to an increase in the prices of the existing bonds.
This relationship between interest rates and bond prices is critical to understanding the bond market.
In the end, investing in bonds is a great way to diversify your investment portfolio, but the amount and types to hold will vary significantly based on your age, risk tolerance, tax situation, and timeline until retirement.