If you happened to pick up a January 2020 edition of Healthy Cells, you’ll remember that I started a series on the basics of finance by addressing all you ever wanted to know about stocks. Again, if you have a business degree, this article is not for you. But if you want to learn the elementary “ins and outs” of investing, please join me as we dissect bonds this month.
A bond is nothing more than a fancy I.O.U. In the world of investing, lots of parties can issue bonds: companies like Apple, Inc. or Procter & Gamble, countries like U.S. Treasury bonds or German bonds, or municipalities like the State of Iowa or the Village of Coal Valley or the Rock Island/Milan School District. Whenever most people hear in conversation or on the radio or TV that “the market is up,” they automatically think of the stock market. Would it surprise you to know that the markets that trade bonds are bigger than any stock market?
An issuer, say ABC Co., might make a decision to issue bonds to finance the building of a new plant to make combines. When the company does so, they are selling an instrument that makes two promises to a potential investor: (1) that at the end of a given time period, provided up-front, the company will pay the amount of the bond back to the investor and (2) that in the meantime, the company will pay the investor a sum of money (interest) usually twice a year at a rate that is also provided to the investor up-front. The two payouts together will equal the face amount of the bond multiplied by the interest rate.
Let’s look at an example: Susan has $5,000.00 in her savings account making less than 1.00% interest. She doesn’t need the money for expenses anytime in the foreseeable future and wants the money to grow at a higher rate. She talks to her financial advisor, Mary, and they decide together to use Susan’s $5,000.00 to buy five brand-new 7 year $1,000.00 bonds issued by XYZ Co. that carry an interest rate of 3.00%. By buying the bonds, Susan is receiving a promise from XYZ Co. that they will pay her $5,000.00 in 7 years and that every 6 months, she will receive $ 75.00 in interest ($ 5,000.00 X .03 / 2 times per year). For the next 7 years, Susan will receive a 1099 tax form from her financial advisor’s brokerage company that she has earned $ 150.00 in taxable interest. Interest earned from a bond issued by a company is taxed at your ordinary tax rate, which may be higher than the rate you might pay if you received dividend income from a stock.
Most people think bonds are “safe,” and stocks are “risky.” It’s not unusual for new investors to think they can’t lose any money if they invest in bonds. Not so! When you decide to invest in a bond, you take on two kinds of risk: “credit risk” and “interest rate risk.” Anytime you invest in any type of bond, that bond’s degree of safety is measured as “credit risk” by big credit-rating agencies like Standard & Poor’s or Moody’s.
The business of these agencies is to carefully analyze and study every bond out there and publish a “rating” to alert investors as to the likelihood of the issuer paying the bond back when it matures as they promised to do. If you buy a bond, the relationship between “risk” (will they pay me back?) and “reward” (can I get a higher interest rate?) is inverse. That means that “riskier” bonds or those with lower credit ratings will always pay a higher interest rate to compensate the investor for the higher risk of not being paid back. Bonds issued by the U.S. government are backed by the full faith and credit of our country and are considered the safest bonds in the world. They have no credit risk but also have very low-interest rates. Bonds issued by a third-world country or a company that has fallen on hard times or a city on the verge of bankruptcy will carry a much higher degree of risk and will offer a much higher interest rate to induce investors to buy its bonds. These kinds of bonds with low credit ratings go by two names: “high-yield bonds” or “junk bonds.” For some people, a small investment in “high-yield bonds” is appropriate, but please, please know what you’re getting into. The innocent but attractive “high-yield” label may sound great, but you need to know that you’re taking on the risk of perhaps losing money. “Interest rate risk” is present in every bond investment, even U.S. government bonds. It is reflective of how interest rates move. Let’s look at an example: If Mike buys a $1,000.00 10-year U.S. government bond at 3.00% and the U.S. is impacted by global economic changes that cause interest rates to be 5.00% five years into his investment when he wants to sell the bond, his bond will have decreased in value, and he will receive less than the $ 1,000.00 he invested if he sells early. His bond is only offering buying investors 3.00%. A buyer of bonds won’t want Mike’s bond. He or she will want a new bond paying 5.00%, so will only buy Mike’s bond if they can do so at a “bargain” by paying less than the full amount he would receive if he held the bond for the full ten years.
Let’s stop for a moment and talk about taxes on bonds issued by countries. U.S. government bond interest is tax-free at the state and local level but fully taxable at your ordinary tax rate for federal taxes to the IRS. Bonds issued by non-U.S. countries are fully taxable at your ordinary tax rate at the state, local and federal levels.
Lastly, I’m going to spend a minute on municipal or “muni” bonds. Municipal bonds that are issued to raise money to benefit the public good are generally exempt from federal taxes. They may be exempt from state or local taxes if the bond investor lives in the state or municipality (city, village, school district, etc.) that issued the bond. Since there is a value to investors of tax-free income, the interest rates of municipal bonds are lower than taxable bonds issued by corporations. Nobody likes paying taxes, so many people think they want municipal bonds. The cold, hard facts are that the difference in interest rate is to such a degree that municipal bonds really make the most sense for investors in high tax brackets. Check with your financial advisor.
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563-949-4705. Have a great February!