Investors seeking to diversify their portfolios would be wise to consider bonds. Bonds are debt instruments that differ fundamentally from investments in stocks.
While stocks confer a portion of ownership in the issuing company, bonds do not. When an investor purchases a bond, that investor is loaning money to the issuer. With most bonds, the issuer is committing to pay the investor interest on a set schedule until the bond matures. At maturity, the issuer has to repay the principal. A notable exception to this rule is a zero coupon bond, which is sold below face value and doesn’t pay interest until maturity.
Bonds offer the advantages of regular income from the interest payments and are less risky than stocks. However, bonds have the risk of default, which happens when the issuer is not able to fulfill its payment obligations to the investor. Secured bonds are secured by a form of collateral, which could be an asset such as a building or company equipment. Therefore, secured bonds are less risky than unsecured bonds, or debentures, which are only backed by the issuer’s creditworthiness.
Common Types of Bonds
Corporate bonds are issued by corporations. They tend to pay higher interest rates than non-corporate bonds. The interest on corporate bonds is taxable.
Municipal Bonds, or muni bonds, are issued by a state, city, or other local government entities. General obligation bonds are backed by the municipality’s creditworthiness. Municipal revenue bonds are repaid from a specific source of revenue such as toll road proceeds. They’re riskier than general obligation bonds because the revenue source could fail to produce the expected income. Usually, the interest on muni bonds is exempt from federal taxes. Investors who purchase these bonds from their state of residence are exempt from state and local tax on the interest.
Treasury bonds are issued by the United States government. They’re considered a very safe investment. Interest on treasury bonds is subject to federal taxes yet exempt from state and local taxes.