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A Beginners Guide To Bond Investing

Aug 17, 2007
Unlike the volatile stock market, bonds are quite stable over long periods (most of the time). They have more predictable characteristics owing to their fixed interest rates. This guide will make some sense of bonds for those looking to get into investing.

1. Bonds Are Expensive

Unlike stocks, bonds are traditionally much more expensive, and are given out in $1000 increments and a minimum investment of $5000. Of course, the benefit of dishing out this kind of money is that with other investors bond funds can be pooled and diversified, maximizing return while minimizing risk.

2. Have An Expert Do It For You

Since the fund is managed by investment professionals, so the theory goes, it has a better chance of achieving its goals than the sucess you might have trying to invest on your own. You have limited time and training needed to make those kinds of decisions. For that service, of course, the investor pays a fee.

3. Bonds Are Very Safe

OK, thats somewhat of a lie. Bonds arent entirely safe, but highly rated corporates (AA or above) or U.S. Treasuries are as good as it gets. Unlike the stock market, bonds are very low-risk investments. As such, they also have a very low return on your investment.

4. Buyer Beware

When choosing a representative for your bond, be sure they are reputable. Some traders charge trading fees, as much as $10 per trade, and this can add up to a huge trading fee by the end of the year. One scam some traders do is invest your money in lower amounts, in some cases charging the $10 for a trade that wouldn't make $10.01 in profit.

5. Tax Issues

Adding to the complexity are the differing tax rules affecting your return on bonds.

Municipal, State and Federal municipal governments issue bonds to borrow money beyond what taxes bring in. Unlike companies, they can make those lower yielding bonds more attractive by coupling them with tax incentives. An example, state and local bonds, are generally free of U.S. Federal taxes and are often offered tax-free by those states or municipalities.

A higher yield bond could return less after-tax income depending on the investor's tax rate, and on whether the bond is subject to Federal or state taxes.

An example, assume $10,000 is invested in two different bonds: The first being a Municipal tax-free yielding 4%, and the second being a taxable bond with a yield of 5.5%. So in the case of the first $10,000 x .04 = $400 and in the case of the second $10,000 x .055 = $550. The second appears to be a better return. But now assume a 28% tax rate. $550 x .28 = $154 lost to taxes, leaving only $396 ($550 - $154). Notice how the higher stated yield returns less actual yield. A higher tax rate will make the situation even worse. An example, at 33% only $368 of interest is retained after tax.

So the lesson is to remember to factor in all taxes, since a bond can be free of say Federal tax but subject to state tax or vice-versa.
About the Author
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