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Many investors have become interested in bonds in the last 18 years due to the two bear markets in stocks that investors suffered through.  You may recall the Dot Com melt down in the 2001- 2002 time period when the NASDAQ index went from 5000 to 1100.  Then, we all painfully recall the 2008 financial meltdown where the Dow Jones Industrial average plunged from 14000 to 6500 in about a 18 month time frame.

Given these painful experiences, many investors simply fled the stock market and were happy to invest in bonds.

Why bonds? Bonds pay interest, and at least some income is better than capital losses that investors suffered in the stock market.  Additionally, although bond prices do fluctuate daily, generally, the volatility of bond prices is lower than the volatility of stock prices.

Most bond investors are making the investment with the goal of receiving income from the interest payments.  Some bond investors do trade bonds and hope to realize capital gains.

Some bonds are more risky than other bonds and therefore an investor would expect a higher rate of return from the more risky bonds.  So even within an asset class such as bonds, there varying risk and return levels that the investor can implement.

For the purposes of this posting, we will keep it simple and look at three types of bonds:

Treasury Bonds

  • are direct obligations of the US Treasury, backed by the full faith and credit of the US Government..
  • very small chance that the US Government would default on these debt obligations; remember if the US Government needs cash they simply print it, or raise taxes!
  • US Government issues T-bills, T-Notes, Treasury bonds.  The difference is the maturity date of the bond.  Typically T-Bills mature in less than 2 years, T-Notes between 2 and 9 years, while  Treasury  bonds  have 10, 20, 30 year maturities.
  • are generally considered to be very safe, thereby generating lower rates of return
  •  Interest income from these bonds is subject to Federal Income taxes but is free from state income taxes
  •  biggest risk is probably inflation, particularly with the long term bonds.

Municipal Bonds

  • are issued by city, county, state local governments.
  • are more risky then the US Treasury issued noted above.
  • like the US Treasury debt obligations can be issued for short, intermediate or long term periods.
  • are backed by the revenue collecting capabilities of the issuing municipality.
  • interest rates paid by municipal bond issuers is generally higher then the interest paid by the US Government on the Treasury debts.
  • interest income is free from Federal taxes and for state residents who purchase municipal bonds from municipalities in their state of residence will also be free from State income taxes.
  • biggest risk is again inflation for longer term bonds AND the financial strength of the issuing municipality.  Occassionally, although very infrequently, municipalities suffer financial distress and may not be capable of meeting their obligations as debtors.

Corporate Bonds

  • are issued by Corporations
  • are generally considered to be more risky than municipals and Treasury issues.
  • are backed by the Corporation’s ability to run a profitable business in order to make the interest payments and remain in business to return the principal when the bond matures.
  • interest rates are higher than the interest rates paid by municipalities and Federal Government.
  • interest income from Corporate bonds are subject to to Federal and state income taxes.
  • interest rates paid are strongly influenced by the credit worthiness of the Corporation issuing the bond and the term of the bond.
  • Corporations with poor credit ratings will issue bonds, which are known as “junk bonds”.  Not all junk bonds will default.  Please note that many “High Yield” Bond funds are high yield for a reason: the managers are focused on providing higher returns by acquiring bonds with lower ratings.
  • risks for Corporate bonds include business risk, financial risk, inflation risk.

Obviously there is are many more details to be aware of when investing in bonds, than can be addressed in a quick posting like this.

Do bonds belong in your investment portfolio? For most investors the answer will be yes.  All investors need to thoroughly investigate and understand the actual assets held within their investment portfolio and how those investments will help them achieve their goals in light of time period for the goal and the level of risk the investor is willing to face.