American-dollarsThe fixed income market is gigantic and as a result not all bonds are the same! Here is a rundown of the most common bond types:

 

Municipal Bonds: Are bonds issued by states, municipalities, cities, and other local governments.  Their ability to pay is based on either the taxing ability of the entity or revenue from a public works project (i.e. ticket sales from a public stadium).  Why own them?  They are free from federal income tax regardless of where you live and if the bond is issued in the state in which you live, they are also free of state-income tax.  These are widely favored by high-income earners as a way to avoid paying additional taxes.  However, because of their tax-free nature the yields available are often lower than other bond types.

 

Treasury Bonds: Widely regarded as a “risk-free” asset as these represent the debt issued by the United States Government.  They are funded by the Federal Government’s ability to collect taxes.  Because of their risk-free nature during times of crisis people flock to these bonds because they believe the U.S. Government is the best bet to not go bankrupt.  This security results in lower yields than other types of bonds.  Income is taxable.

 

Treasury Inflation Protected Securities: Are just like normal Treasury Bonds except that they provide protection for inflation.  One of the major risks with traditional bonds is that they pay you a fixed amount and over time despite the fact that inflation erodes the value of the dollar.  $100 today won’t buy you the same amount in 10 years.  These bonds build in this inflation protection by adjusting how much you receive by the rate of inflation.

 

Corporate Bonds: Represent bonds that are issued by public and private companies.  Typically companies issue bonds when there is need for capital to expand their operations.  Riskier than Treasury bonds and with no tax-free benefit they historically provide a higher yield than other fixed income types.  However, the companies’ ability to repay is based on their ability to earn a profit.  Income is taxable.

 

Floating Rate Bonds: Up until now we have assumed that all bonds pay a fixed amount (i.e. $100 a month).  The amount these bonds pay varies with prevailing interest rates.   Typically, the yield is tied to a well known benchmark such as the Fed Funds Rate or the London Interbank Offered Rate (LIBOR) with an additional percentage added to that stated rate.  For example a floating rate bond could pay you LIBOR plus 1%.  The payment amount is readjusted at every coupon date.  It is most common for these bonds to be issued by corporations but they can be issued by municipalities as well.  Income is taxable.

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