What is a bond? A bond is a security instrument which acknowledges that the issuer has borrowed money and must repay it to the bondholder at a specified rate of interest over a predetermined period of time. These securities are referred to as debt obligations which represent ownership in a corporation. In short, bonds are debt and are issued for a period of more than a year. So, when you (investor) are buying a bond, you are actually lending money. The seller (company) of the bond agrees to repay the principal amount of the loan at a specified time. So when you buy a bond you loan your money to a company, a city, the government – and they promise to pay you back in full, with regular interest payments.
When an industrial expansion will create jobs, revenues, and development, many communities will offer incentives to attract the location. Bonds are an important incentive, authorized by state law to provide advantageous financing for certain businesses.
So how is your money utilized? A city may sell bonds to raise money to build a bridge, while a federal government issues bonds to finance its spiraling debts.
It is said that the bonds and stocks move in the opposite directions. In other words, when stocks go up in value, bonds go down and vice-versa. This is because stocks generally do well when the economy is booming – consumers are buying, companies are making more earnings, and investors have more to invest.
On the other hand, when the economy starts to decline, companies’ earnings will drop, and stock prices are temperamental – this is when investors want the safe interest payments guaranteed by bonds.
However, sometimes both stocks and bonds go up in value at the same time. This is usually because there is too much liquidity chasing too few investments, as is the case at the top of a market.
There are several different kinds of bonds. Depending on your goals, your tax situation, you can choose from municipal, government, corporate, mortgage – backed or asset – backed securities or international bonds.
Taxable bonds & tax-exempt bonds
Tax-exempt bonds are debt securities issued by a state or local government development agency on behalf of a private business. Once issued, tax-exempt bonds are sold in the open market or purchased by investors or financial institutions.
Tax-exempt bonds are similar to conventional loans. Bonds are not grants. Borrower’s have to pay back the bond’s principal plus interest to the bond.
In short, the bonds issued by a municipal, county or state government, whose interest payments are not subject to federal income tax, and sometimes also state or local income tax.
- Municipal bond: Municipal bonds are generally suitable for high-income investors who are seeking to reduce their taxable investment incomes. These bonds are issued by state and local governments, often to finance specific projects such as highways, schools, recreational facilities, and the like. They are generally exempt from federal tax, and are generally state tax-free for residents of the state in which they are issued. Even though the interest is tax-exempt, any capital gains are taxed at the appropriate levels.
- Government Bonds: The interest from treasury bills, notes and bonds as well as U.S. government agency securities is taxable at the federal level only.Treasury bills (T-bills), notes and bonds are marketable securities the U.S. government sells in order to pay off maturing debt and to raise the cash needed to run the federal government. When you are buying one of these securities, you are lending your money to the government of the United States.T-bills are short-term obligations issued with a term of one year or less, and because they are sold at a discount from face value (maturity), they do not pay interest before maturity.Treasury notes and bonds, on the other hand, are securities that have a stated interest rate that is paid semi-annually until maturity. Notes are issued in two-, three-, five-, and 10-year terms. On the contrary, bonds are long-term investments with terms of more than 10 years.
- Convertible Bonds: A convertible bond is the one that can be converted in to equity capital of a firm at the discretion of the bondholder after a specific time period.
- Zero Coupon Bonds: They are also known as “strips” or “zeroes”, and are the treasury based securities that are sold by brokers at a deep discount and redeemed at full face value when they mature in 6-30 years.
- Foreign Currency Bonds: It is defined as a bond that is issued in any currency other than the domestic currency of the organization. These bonds are issued with the intention of benefiting from interest rate differences and exchange gains.
- Extensible or Retractable Bonds: Bonds which has more than one maturity date in the bond can be redeemed.
What are the taxable bonds? In most jurisdictions, public bodies issue “Taxable Bonds” bonds that do not qualify for federal income tax exemption. Despite their name, Taxable bonds may bear interest that is exempt from state or local income tax and intangibles tax in the state in which they are issued, and other incentives might be utilized in connection with the bond financing.
How will you differentiate between the taxable and tax-exempt bonds? The interest on corporate bonds is taxable by local, state, and federal governments. However, interest on bonds issued by state and local governments – generically called municipal bonds, or munis – generally is exempt from federal income tax.
In order to attract investors, taxable bonds typically pay a higher interest rate than tax – exempt bonds.
So, how will you equip yourself with the appropriate information on the taxable and tax-exempt bonds?
In contrast to government bonds and equities, the municipal bond market is well suited to evaluate how individual tax rates affect asset prices. Not surprisingly, individual holdings of municipal bonds dominate the holdings of other corporate entities. Municipal bonds bearing income tax liabilities are termed market discount bonds. When a municipal bond is issued, the coupon payments and original issue discount (OID) are exempt from federal tax.
So, before you invest into any bond, analyze the market and the different bonds and invest only when you think you can go ahead with it.