While bonds can play an integral role in a well-diversified portfolio, investors should fully understand their characteristics before investing. While they are all considered debt instruments, bonds are created by different entities for very different purposes and carry varying risks and tax-related liabilities. Simply put, bonds are issued by companies and government are bonds a safe investment to fund their day-to-day operations or to finance specific projects. A bond’s face value, or the price at issue, is known as its “par value,” and the interest payment is known as its “coupon.
The price of bonds will fluctuate, similar to stocks, throughout the trading day. If an investor purchases a bond in the secondary market at the face value, the bond is considered to be sold at “par. In general, there are three main categories that bonds will fall under: Government, Municipal, and Corporate. The current yield rate indicates the current rate of return an investor will receive on each dollar invested, without any adjustments for differences between the purchase price and the maturity value. The yield to call rate indicates the overall rate an investor will earn, including adjustments for any differences between the purchase price and the call price, in the event the bonds are called by the issuer.
It is important that investors make note of the yield to maturity and yield to call on any bonds they are considering purchasing. A popular way for investors to help balance risk and return in a bond portfolio is to utilize a technique called laddering. To build a laddered portfolio, investors purchase a collection of bonds with different maturities spread out over their investment time frame. By staggering maturities, investors may be able to reduce the impact that changes in interest rates can have on their portfolio. For example, an individual who wishes to create a laddered portfolio could purchase bonds that mature each year during a span of ten years. By using a rollover strategy as well, when the first bond matures, the investor could reinvest those funds in a bond that matures in ten years. As each bond matures, the investor would continue this process.
After ten years, the investor would own all ten-year bonds, with one maturing every year. However, it is important for investors to compare the tax-advantaged bonds to taxable investments in order to determine the best investment for their situation. In order to compare rates of return on investments, it is helpful to adjust the tax-free rates to their “taxable equivalent” rates. This is the taxable rate that would have to be earned in order to net the same tax-free rate, after paying federal income taxes. To calculate the taxable equivalent rate, simply divide the tax-free rate by one minus your federal tax bracket rate. Based on this calculation, the investor would have to earn 5.