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Bonds are designed to provide the bond issuer with funds for investments or expenditure. Depending on who issues the bond, there are three major types: corporate, government and municipal.
Companies may resort to traditional loans or bonds to get funds for investments or to cover day-to-day operations. Because bonds often come with lower interest rates and more favorable terms than traditional loans — companies may prefer to choose the bonds route.
But since companies may go bankrupt or fail to pay off their debt, corporate bonds can have a higher risk than US government bonds.
Tax implications: Corporate bonds are subject to both federal and state income tax.
As the name suggests, government bonds are issued by the government. In the US, that’s the Treasury Department.
Because of that, they are often referred to as “Treasuries” or sovereign debt. And since this type of bond is backed by the US government, they are considered one of the safest investments.
Depending on the length of the bond’s maturity, government bonds have different names. For example:
Tax implications: Government bonds are subject to federal taxes but are often exempt from state and local taxes.
Municipal bonds, also known as “munis,” are issued by states, cities and counties, as well as government agencies. These are often used to fund local projects, such as schools, sewers and highways.
Tax implications: Interest income from municipal bonds is usually exempt from federal tax and may be exempt from state tax as well. However, capital gains are often taxed.
When a company or government entity needs money either for investments or day-to-day obligations, it can issue bonds. The bond issuer sets the terms, i.e. the bond’s face value, maturity date and interest rate.
The maturity date is the day when the bond issuer has to pay the principal back to the bondholder. The interest rate is the amount, say 5% annually, paid to the bondholder.
The face value is what the bond issuer will pay for each bond on the maturity date. It’s also the value on which the interest rate is calculated.
Here’s how that would work:
For comparison, the same $9,000 investment in the S&P 500 index with an average annual return of 10% would earn $10,192 or 114% return on investment.
Bonds may not be the first choice for growth investors because they often come with lower returns. But other investors may find the bond’s advantages appealing.
Despite its advantages, there are some risks to consider.
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