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How bonds work
The ins and outs of taxable and tax-free debt
Companies and governments issue bonds to fund their day-to-day operations or to finance specific projects. When you buy a bond, you are loaning your money for a certain period of time to the issuer, be it General Electric or Uncle Sam. In exchange, the borrower promises to pay you interest every year and to return your principal at "maturity," when the loan comes due, or at "call" if the bond is of the type that can be called earlier than its maturity (more on this later). The length of time to maturity is called the "term."
Because a bond's life span and schedule of interest payments are fixed, bonds are known as "fixed-income" investments. And because a bond represents an IOU, rather than an ownership interest like a stock, bondholders go to the front of the creditors' line if the issuer goes bankrupt. Stockholders stand at the rear.
A bond's face value, or price at issue, is known as its "par value." Its interest payment is known as its "coupon." A $1,000 bond paying 7% a year has a $70 coupon (actually, the money would usually arrive in two $35 payments spaced six months apart). Expressed another way, its "coupon rate" is 7%. If you buy the bond for $1,000 and hold it to maturity, the "yield," or actual earnings on your investment, is also 7% (coupon rate divided by price = yield). If you buy the bond for $1,100 in the secondary market, though, the coupon will still be $70, but the yield will fall to 6.4% because you paid a "premium" for the bond. For an analogous reason, if you buy it for $900, its yield will rise to 7.8% because you bought the bond at a "discount." If its current price equals its face value, the bond is said to be selling at "par."
The bottom line: There are many ways of expressing a bond's return, but "total return" is the only one that really matters. This includes *all* the money you earn off the bond: the annual interest and the gain or loss in market value, if any. If you sell that $1,000 bond with the $70 coupon for $1,050 after one year, your total return is $120, or 12% -- $70 in interest and $50 in capital gains. (Prices are usually expressed based on a par value of 100, by the way, so when you sell that bond for $1,050 the price would be quoted as 105.)
Types of bonds
"U.S. Treasuries" are the safest bonds of all because the interest and principal payments are guaranteed by the "full faith and credit" -- that is, the taxing power -- of the U.S. government. Interest is exempt from state and local taxes, but not from federal tax. Because of their almost total lack of default risk, Treasuries carry some the lowest yields around. Nevertheless, because their safety is so alluring, Treasuries are among the most liquid of debt instruments.
Treasuries come in several flavors:
"Corporate bonds" pay taxable interest. Most are issued in denominations of $1,000 and have terms of one to 20 years, though maturities can range from a few weeks to 100 years. Because their value depends on the creditworthiness of the company offering them, corporates carry higher risks and, therefore, higher yields than super-safe Treasuries. Top-quality corporates are known as "investment-grade" bonds. Corporates with lower credit qualify are called "high-yield," or "junk," bonds. Junk bonds typically pay higher yields than other corporates.
"Municipal bonds," or "munis," are America's favorite tax shelter. They are issued by state and local governments and agencies, usually in denominations of $5,000 and up, and mature in one to 30 or 40 years. Interest is exempt from federal taxes and, if you live in the state issuing the bond, state and possibly local taxes as well. Note, though, that Illinois, Kansas, Iowa, Oklahoma and Wisconsin tax interest on their *own* muni bonds. And the capital gain you may make if you sell a bond for more than it cost you to buy it is just as taxable as any other gain; the tax-exemption applies only to your bond's interest.
Munis generally offer lower yields than taxable bonds of similar duration and quality. Because of their tax advantages, though, they often return more -- after taxes -- than equivalent taxable bonds for people in the 28% federal tax bracket or above. (More on this shortly.) They come in several flavors:
Incidentally, just as the federal government does not tax income on most bonds issued by states and municipalities, many of the states and cities do not impose income tax on earnings from bonds issued by the feds. Put another way, Treasuries are usually exempt from state and local tax. Nobody makes a big deal about this, though, since state and local income tax rates are generally so low that the actual benefit is minimal.
To compare taxable and tax-free yields, use our tax-equivalent yield converter -- which is the next step in this lesson.