WASHINGTON, June 5, 2016 – I suspect most readers of this series are primarily interested in investing in stocks, not bonds. During my career as a broker, I was pretty much the same. Stocks are generally more exciting and more interesting investments, involving strategies, stories, corporate intrigue, battles with the government and, of course profitability for investors. If they find the right stocks at the right time, that is.
Bonds—aka “fixed income” or “debt” instruments—have, historically, been considerably less interesting, particularly for younger investors who are looking for higher profits and, yes, more excitement in their portfolios. This is largely because bonds are, historically, an infinitely more boring kind of investment, a variation, really, on that old passbook savings account of yore, except that you generally get more interest on a bond than on those pretty much obsolete savings accounts we used to open at your friendly neighborhood bank.
But, for a variety of reasons, you need to know how bonds work. So if you’ll follow along here, we’ll explain the wonderful world of bonds in this article and the next.
Spoiler alert: Terminology gets a little thick, and we’ll also have to do a bit of oversimplified math, so hang in there. You’ll eventually be glad you did.
The difference between stocks and bonds
As we noted in earlier installments, common stocks (or just “stocks”) are equity investments. That means each share of Company X you own actually represents your part-ownership in Company X. Depending on that company’s fortunes, your share of stock may grow or shrink in value, depending on whether its business is good, bad or even indifferent. Further, shares that pay dividends may raise—or lower—those dividends, depending on the company’s fortunes as well.
Bonds are pretty much the opposite of stocks but similar to the preferred stocks we discussed in our previous article. If you purchase a bond or “corporate bond” offered by Company X, you’re purchasing the debt of that company.
For a new bond buyer, that’s something of an unusual situation. Most of us are used to paying down debt (loans) we’ve incurred, notably our home mortgages or our credit cards. When we pay down that debt, each payment we make involves paying back principal—a portion of the total amount owed—and interest—the fee the lending institution or credit card charges us for using, or effectively renting, their money in order to use it for our purposes.
But purchasing (investing in) a corporate bond reverses that situation. That’s because a bond is a debt instrument. We are actually lending Company X our money. In effect, it’s as if Company X is financing its new factory or the development of their new product by borrowing our money. We are the lending institution, and Company X is paying principal and interest back to us. Now there’s a switch.
The (taxing) difference between corporate and municipal bonds
Although, like common and preferred stocks, there are numerous flavors of bonds, bonds are essentially split into two different types, at least in the U.S. These are corporate bonds and municipal bonds.
The distinction is quite simple. Corporate bonds are bonds issued (sold) by a corporation. Municipal bonds are bonds that are issued by the federal government, by individual states and by municipalities.
Why the distinction? It’s all based on the tax treatment of bonds. The interest that’s paid out on a corporate bond is, like most interest under our current tax code, taxable interest, both federally and (usually) locally. The interest that’s paid out on a municipal bond is currently free of all federal tax* and usually free from state tax as well—assuming that bond has been issued by the state where you live or one of its municipalities.
You can buy a bond from any other state or municipality, of course, and it’s still federal tax-free. But more than likely, if it’s an out-of-state issue, your own state will tax the interest at your current tax rate.
There are currently a couple of exceptions to this general rule. Municipal bonds issued by Washington, D.C., Puerto Rico, the U.S. Virgin Islands and a couple more U.S. territories or possessions are not only free of federal tax, by statute, they are also state tax-free, no matter where you live.
Having said that, though, you still have to be a bit careful here these days. If you’ve been watching any news lately, you’ll be aware that Puerto Rico’s bonds are in serious trouble, which means holders of their bonds are in serious trouble as well. (We’ll talk about this and other risks in a later installment.)
Corporate bonds nearly always pay a higher interest rate than municipal bonds. Again, there’s a simple reason for this: Interest on corporate bonds is taxable, while interest on municipal bonds is not federally taxable, and—if you watch what you’re doing—it’s not state taxable either.
That distinction between corporate and municipal bonds is important when it comes to determining which bonds you may wish to add to your portfolio. Here’s the general rule of thumb when determining what kind of bond purchase might be appropriate for you.
If you’re in a lower tax bracket, or if you’re placing certain investments in a tax-advantaged account such as a self-directed IRA, the amount of tax you’ll pay on that higher interest either won’t be very high (in a regular account held by a lower-tax rate investor); or, in the case of the IRA, the interest effectively won’t be taxed at all, since it’s accruing in a tax-sheltered account.
If you’re purchasing bonds in a non-tax sheltered account and you’re in a higher tax bracket, however, you may be better off investing in municipal bonds, even though they pay a lower rate of interest. But that’s because that interest is tax-free. Which means that if you’re in a higher tax bracket, you’ll keep all that interest, whereas, if you invest in a higher-paying corporate bond, you’ll have to send a portion of your interest to Uncle Sam and your state, giving you an effective lower rate of return.
I’m not a math whiz, so I’ll cop out at this point and suggest you work with your tax adviser to determine your current tax bracket and then use that to figure out whether the corporate or municipal bond works out better or more to your advantage, in terms of how much interest you’ll actually get to keep—i.e., your effective rate of return. If you already know you’re in one of the higher tax brackets, however, it’s pretty much a rule of thumb you’ll be better off investing in municipal bonds.
But, as always, your mileage may vary due to other factors. Today’s bond market has been at times surreal and can go against common wisdom. I’ll get to this kind of anomaly in a future column, once we get the basics down.
Next: How do bonds actually work in the marketplace, and who wants to buy them?
*Note: During the depths of the Great Recession, certain municipal bonds (Buy America Bonds) were sold that did not give holders that longstanding tax break. There aren’t too many of these out there. But if you’re looking for a tax advantage, you’ll want to avoid buying any of these or any funds or ETFs that are involved in them.