Last time, on Long Term Returns...
If Cash is like the relationship one has with their spouse; dependable, safe, there for you during times of crisis, then Bonds are like the relationship one has with their long-term mistress or mister: A thing on the side that is less certain, more complicated, and certainly more sexually exciting.
What is a Bond?
A bond is a loan contract, but more promiscuous: Some bonds get passed around ten times a day or more. But it's otherwise similar to a loan: You ‘buy’ the bond, or lend out your money, and will receive interest payments until the maturity date. When the bond matures you will receive your principal back.
When an entity goes bankrupt and tries to pay its debts, bondholders get paid before stockholders see a single cent- one reason why bonds are safer than stocks.
What Types of Bonds are there?
Government Bonds- Most governments by collecting taxes and fines or by borrowing via bonds. The chances of a government defaulting on a bond is extremely low, unless it's Illinois, Greece or worse. The main reason government bonds are riskier than cash for long-term investors is because of the interest rate volatility, not the default risk. Government bonds can be divided further into two categories-
Federal Bonds- These ultra safe include Series I & EE Savings Bonds and Treasury Bills, Notes, Bonds, and Securities. They can only be bought direct from the Treasury.*
Municipal Bonds- Bonds issued by smaller governments. Still super safe unless the municipality is Illinois, Michigan, or California.
Corporate Bonds- Bonds issued by corporations. These cover a large range of risk, but they are all much riskier than Government bonds.
Which Bonds Are Best For Me?
I can't decide that for you, but I can help you avoid getting gutted by the IRS. Your picks will be heavily influenced by your tax burden. For example, a guy making $35,000 in a tax-free state like Texas shouldn't be touching municipal bonds.
Corporate Bonds are taxed at ordinary income rates. This is ‘tax-inefficient’. This article details some more shortcomings of corporate bonds.
The following are exempt from state & local taxes:
Treasury Bills, Notes, Bonds, and Securities (TIPS): Taxed at ordinary income rates.
I bonds and EE bonds: Federal tax deferred. You don't pay taxes until you redeem the bond anytime between 1-30 years from the purchase date. Taxes are waived completely if you use the proceeds to pay for education expenses.
Municipal bonds: 100% tax-free
Let's see how tax considerations impact a bond portfolio.
After a college career of responsible drinking and safe sex, Becky Bondage graduates cum laude and gets a job in Austin that pays $36,000, putting her near the top of the 15% tax bracket. She buys shares of a bond fund that includes corporations she supports (Whole Foods, Costco, etc.)
Next year, her job relocates her from tax-free Texas to Brooklyn which means she has to pay state and city tax. She receives a salary increase to $38,000 year, just edging her into the 25% tax bracket. This year taxes on her corporate bonds will be around double what they were last year. No longer satisfied with risk to reward ratio of her corporate bonds, she sells them and purchases government bonds. She finds that after taxes, her gains are similar, but less volatile, and less paperwork for her during tax season.
Savings Bonds are Awesome
I will talk about these Federal bonds in depth later. Hint: They're awesome.
Bonds are an essential part of any long-term investor's portfolio. We will discuss them in more detail later, but next we will look at stocks.