Monday, May 9, 2011

What Bond Types Should You Buy for Income?

Investment income generally comes from debt (or loan) instruments - like bonds. Before deciding on what type of debt instrument you'll use to generate your invested retirement income, you should know their characteristics. Here's a quick overview.

U.S. Treasuries are the safest bonds since the government guarantees their interest and principal. Their safety, though, produces the lowest yields, since higher returns only come with higher risk. The interest income you earn from Treasuries is exempt from state and local taxes, but not from federal tax.

Treasury bills, have the shortest maturities - 13 weeks, 26 weeks, and one year. You buy them at a discount to their $10,000 face value and receive the full $10,000 at maturity. The difference reflects the interest you earn from them. So the greater the discount, the higher is the interest rate they pay.

Treasury notes mature in two to 10 years with interest paid semi-annually at a fixed rate. The minimum investment is $1,000 or $5,000 depending on maturity.

Treasury bonds have the longest maturities at 10 years. They also pay interest semi-annually and are sold in units of $1,000.

Zero-coupon bonds are Treasury-based securities that are sold at a deep discount and redeemed at full face value when they mature in six months to 30 years. That difference reflects your earned interest. Although you're not paid an interest annually, you're still taxed on the implied "phantom interest" that you earn each year! So, you need some cash to pay the yearly tax on the attributed phantom interest. Hold them in a tax-deferred account to avoid having to pay the annual tax.

Inflation-indexed Treasuries pay a real rate of interest on their principal. But that principal amount rises or falls with the consumer price index. You don't collect the inflation adjustment principal, though, until the bond matures or you sell it. But you still owe federal income tax on that phantom amount each year - in addition to tax on the interest you currently receive. It's best to hold them in tax-deferred accounts too.

Mortgage-backed bonds represent ownership in a package of mortgage loans issued or guaranteed by government agencies. They generally yield up to 1 percent more than Treasuries of comparable maturities since they carry more risk.

Corporate bonds pay taxable interest. The creditworthiness of the company determines the bond's risk. They carry higher risk and, therefore, higher yield than Treasuries. Top-quality corporates are known as "investment-grade" bonds. Corporates with lower credit quality are called "high-yield," or "junk," bonds. Junk bonds typically pay higher yields than other corporates.

Municipal bonds are issued by state and local governments and agencies. Their interest is exempt from federal taxes and if you live in the state issuing the bond, that state's state and local taxes are exempt as well. Their yields are typically lower than taxable bonds of similar duration and quality because of their tax exemptions. However, for people in the 28 percent federal tax bracket or above, they may give a higher net return then taxable bonds.

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