Building you own Portfolio
The most popular types of bonds have been issued by one of three groups: the United States Government, City, State, and Local Governments, and Corporations. Each bond category has different tax consequences, and varying degrees of risk. As to what types of bonds to own, you will want to own taxable bonds in tax deferred accounts like IRA痴 and tax free bonds in taxable accounts. With taxable accounts, you will have to take into consideration your tax bracket, and compare the tax free yields on municipal bonds to the after tax yields of taxable bonds.
I recommend that investors own individual bonds instead of bond mutual funds. With individual bonds, you know what you paid, what you池e going to get back at maturity, and what interest payments to expect. In bond funds, you cannot see the changes the fund manager is making in the portfolio, and the interest you receive may drop, as well as your original principal.
When building a bond portfolio outside of a retirement plan, you need to understand that the interest you receive on certificates of deposit, savings accounts, taxable money market accounts, government bonds and corporate bonds are taxed as ordinary income. Sometimes, if you池e not careful, the additional income you receive from these taxable investments can cast you into a higher tax bracket. Here痴 what to do:
1) Know your tax bracket.
2) Compare the after tax yield on a taxable bond to the tax free yield with the same maturity date.
TAX BRACKETS
Federal Tax Rate 2004-2005
Federal
Ordinary
Income
Tax
Rates Applicable Income Ranges (Based on Filing Status)
Single Married/Joint Head of Household15%: $6,001- $12,001- $10,001-
$27,950 $46,700 $37,45027%: $27,951- $46,701- $37,451-
$67,700 $112,850 $96,70030%: $67,701- $112,851- $96,701-
$141,250 $171,950 $156,60035%: $141,251- $171,951- $156,601-
$307,050 $307,050 $307,05038%: $307,051+ $307,051+ $307,051+
1 Consult your tax advisor to determine your federal income tax filing status.
2 Taxable income of Surviving Spouses (qualifying widow(er) s) may be subject to tax rates normally applicable to taxable income of married taxpayers filing joint returns.
TAXABLE OR TAX FREE
In this next example, I wanted to show you a comparison of a $50,000 investment in bonds at 5% tax free and 6.5% taxable. I also chose a tax bracket of 30%, which isn稚 the high or the low, but right in the middle. Here are the results:
$ 50,000 yielding 5% tax free = $2,500 per year
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Minus 0% taxes = $2,500 net
$50,000 yielding 6.5% taxable = $3,250 per year
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Minus 30% taxes = $2,275 net
The bottom line obviously, is you keep more money by investing in a tax free bond at 5% verses a taxable bond at 6.5% in the 30% tax bracket. Another big factor we need to consider is the safety of the bond. Rarely, will you find a taxable corporate bond that is insured and guaranteed. The above comparison was made using today痴 actual yields from (Feb 2005) long term tax free and corporate bonds. Since most tax free municipal bonds carry some kind of guarantee or insurance to secure the principal and timely payments of interest, tax free bonds look much more appealing.
SAFETY RATINGS OF BONDS
Standard & Poor痴 and Moody's are the best-known and most influential credit rating agencies. Their role as raters is to assess the risk of certain bonds through the study of all information provided to the public, and to assign to the issue and issuing company grades that accurately reflect the company's ability to meet the promised principal and interest payments.
When S&P and Moody痴 issues a credit rating on a bond, it is not a recommendation to purchase, sell or hold a particular security. But the initial ratings, and revised downgrades and upgrades, greatly affect the attractiveness of the bond in the eyes of both issuers and holders. Bonds with higher ratings offer lower yields, while a lower rating usually results in a lower price on the bond -- a less expensive purchase for the investor, but a riskier investment.
Since any bond rating of triple B (BBB) or higher is considered 澱ank quality�, I would recommend that you keep all your purchases at this level or higher. The only exception is with tax free municipal bonds where most tax free bonds are insured and guaranteed. I would take advantage of this high level of safety and concentrate my purchases in insured bonds with triple A (AAA) ratings.
Bond Rating Codes
Rating S&P Moody's
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Highest quality AAA Aaa
High quality AA Aa
Upper medium quality A A
Medium grade BBB Baa
Somewhat speculative BB Ba
Low grade, speculative B B
Low grade, default possible CCC Caa
TYPES OF BONDS
Bonds sell in increments of $1,000, and this is known as 菟ar value�. Tax free municipal bonds must be bought in $5,000 increments, but par value is still $1,000. Bonds are normally issued at $1,000, and mature at $1,000. An investor that buys a bond for less than $1,000 is buying the bond at a discount, if they pay more than $1,000, they are buying the bond at a premium.
1) Government Bonds: The bonds issued by the United States Government are known as Treasury痴, and are widely regarded as the safest bond investment since they are backed by the full faith and credit of the U.S. government. These bonds are grouped in three categories.
a) U.S. Treasury Bills- maturity dates range from 90 days to 1 year.
b) U.S. Treasury Notes- maturity dates range from more than a year to 10 years.
c) U.S. Treasury Bonds- maturity dates of 10 years or more.
2) Municipal Bonds: Municipal bonds are issued by city, state and local governments for the public good, and are tax free. From time to time you will see taxable municipal bonds, but the main attractiveness of municipal bonds is their tax free status.
Often, tax free bonds carry some sort of guarantee or backing, which can be in the form of insurance, escrow, or the taxing power of the municipality. Municipal bonds are only a small step up on the risk scale from U.S. Treasury痴, but are often a more attractive investment due to their avoidance of state and federal taxes.
3) Corporate Bonds: Corporate bonds are generally the riskiest bonds in the market place because corporations are susceptible to changes in the economy, competition, and yes, even corporate corruption. Despite some of these risks, there are some big blue chip companies that issue bonds that investors should consider. Corporate bonds are taxable, and investors who do not wish to venture into corporate bonds should consider taxable (insured) municipal bonds instead.
4) Zero- Coupon Bonds: Zero- coupon bonds are bonds that do not make interest payments every year, but instead sell at deep discounts to their maturity values. For example, you can buy a zero- coupon bond at 50 cents on a dollar and when they mature, they mature at a dollar. At maturity, the investor collects all of the compounded interest plus the principal.
Zero- coupon bonds can be issued by the government, a municipality, or a corporation. A taxable zero like a government or corporate bond has some drawbacks since investors must pay taxes each year as the interest on the bond accrues. This can be frustrating since the investor has not actually received any income. Taxable zeros are normally more attractive in tax deferred accounts.
LADDERING YOUR BOND PORTFOLIO
Bond prices are impacted primarily by the rise and fall of interest rates. Quite simply, bond prices move inversely with interest rates. As interest rates increase, bond values go down. Likewise, if interest rates decline, bond values tend to increase.
To manage risk and to minimize the impact of interest rate changes, investors need to diversify their bond portfolios based on varying maturities. This diversification is known as Laddering Maturities. Laddering involves building a portfolio of bonds with staggered maturities so that a portion of the portfolio will mature each year, or some other specified time period. By spreading out the maturities, you are investing at different interest rates, with the shorter-term bonds paying a lower rate, and longer-term bonds paying a higher rate. In the mean time, you are spreading out the risk of principal fluctuation.
I recommend that investors own bonds with maturity dates ranging from 1-5 years on the short end, with bonds maturing in each of the 5 years. After the fifth year, buy bonds that mature in 5 years increments until your final maturity dates are 25 to 30 years out. You will want to invest even amounts of money at each maturity with the exception of the longest maturities. For example, if you are investing $10,000 in each maturity, you may want to only invest $5,000 in years 25 and 30.
WHERE TO BUY YOUR BONDS
Most discount brokers like Fidelity or Schwab carry a broad inventory of bonds or have links on their websites where you can purchase bonds through one of their vendors. If you need assistance, one of their service representatives can help you find what you池e looking for.
