Best Bond Rates
Earnings on bonds are related in terms of yield. The yield reflects the correlation between the price that was paid for the bond and the interest rate the issuer is paying. If a bond with a face value of $5,000 is purchased for $5,000, it has been purchased at par. If it is purchased for $4,500, it is purchased for less than par. Bonds can sell below, or above par, for any number of reasons, including credit risk or interest rate risk. If the bond issuer pays 5% interest on $5,000, the yield is 5%. But the yield on the $4,500 bond that pays 5% and was purchased for $500 below par is 5.5%, a full half of a percentage point higher. If the purchaser holds the investment to maturity, he or she is receiving a higher yield and will also benefit from the additional $500 earned when the issuer returns the face value of the bond.
Yield allows investors to compare one investment to another accurately. For example, in general, a bond that has a 5.5% yield may be a better investment choice than a stock with the same dividend yield, or a certificate of deposit with a lower yield. While this example doesn't take the risk of each investment into account, all things being equal, yield provides a way to compare "apples to apples".
Rates on Government Issued Bonds
U.S. government issued notes, bills, and bonds are the safest financial investments that can be purchased. While U.S. Treasuries are not at all appropriate for younger investors who need to accumulate assets between the ages of 25 and 45, they are appropriate for older investors who need to focus on capital preservation and income. However, because Treasuries present virtually no risk of default, they don't really increase in price and have low yields compared to other investments.
U.S. Treasuries provide a lower yield when they sell above par, which is known as "selling at a premium to par." When you buy any Treasury instrument above par value, you're paying the government to borrow your money, rather than the government paying you. However, the return of your principal is all but guaranteed.
When Treasuries sell above par, investors have a decision to make. Do they choose the safety of the investment or do they choose an investment that will return a higher yield but won't be as safe? It's helpful to know that Treasuries really only sell above par in extreme situations. For example, wars or natural disasters that affect the global economy can trigger financial anxiety, which pushes individuals, corporations, and countries toward the safest investment possible.
Long-term Treasury Bonds have maturity dates of 30 years. These will typically pay the highest rate of interest and have the highest yield. The downside, of course, is that your money will be tied up for 30 years if you hold the bond until maturity. The length of the term subjects you to interest rate risk if interest rates rise. If rates rise, you could earn a higher yield on a different investment. But Treasury Bonds trade in a highly liquid secondary market, which means that they can be bought and sold after the initial purchase. Investors who are willing to buy and sell bonds will often get a better return than those who hold them.
Rates on Municipal Bonds
Like all investments, bond prices are affected by supply and demand. The initial price is determined by a combination of interest rates, the financial condition of the issuer, and the interest buyers have in the issue. But bond prices can change after issue. Municipal bonds present a greater risk of default than U.S. Treasuries, but usually not by much. A state government will often back a city and the federal government will back a state. However, cities have declared bankruptcy and defaulted on bonds in the past. Even though municipalities and states can raise taxes, assess tolls, or otherwise raise money in order to continue paying interest and principal, they still run the risk of overextending.
Municipal bond rates are almost always lower than U.S. Treasuries or corporate bonds because they are free from federal income tax, and in many cases, state and local taxes as well.
One caveat to the federal tax exemption of municipal bonds is the alternative minimum tax (AMT). If the bonds are issued to fund private activity projects, the interest earned may be subject to the AMT. Private activity projects are those that are not used strictly for governmental purposes. While airports, housing projects, and non-profit facilities are generally built for the public, they are often used and/or maintained by private entities. Bonds issued for these purposes typically pay a higher yield than other municipal bonds because the earnings are not tax-exempt.
Finally, if you're considering municipal bonds for the tax-exempt advantages, your tax bracket will determine whether or not they are an appropriate investment for you. For example, if you're in the 15% bracket, it is not likely that municipal bonds present a good investment. If, however, you're in the 25% or 28% bracket, you are likely to gain an advantage. If you're in the 33% or 35%, you should strongly consider investing in municipal bonds.
Best Bond Rates on Corporate Bonds
Corporate bonds present the best chance of earning high yields. While earnings are taxable at both the state and federal levels, the rewards can be significantly higher.
For those who can tolerate the risk on a financial and emotional level, one strategy with corporate bonds is to invest in high-yield bonds for a short period of time. Rather than investing in these issues for the long haul, which presents risks of time and interest rates, short-term ownership can increase the return. While it's important to consider trading costs and tax implications in a standard brokerage account, playing with high-yield bonds within a tax-qualified account has significant value.
If this strategy appeals to you, consider investing in ETFs rather than in bonds directly. ETFs offer diversification, liquidity, and the ability to get in and out of trades quickly. They're also less expensive than mutual funds.
Before choosing a bond or bond fund make sure it fits into the overall financial plan you've established for yourself and your family. While some bonds present a safe investment from the standpoint of capital preservation, they can present interest rate and earnings risk by not paying as much as other investments. Always be sure to read and understand all of the features associated with the bond or fund before making the purchase.
While we've covered the basics of bond investing here, there is much more to maximizing the success of your bond investing strategy. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
More Bond Guidance
- Bond Investment Guide — The complete guide to bond investing.
- US Treasuries — Details about how to invest in US treasuires.
- Municipal Bonds — Details about how to invest in municipal bonds.
- Corporate Bonds — Details about how to invest in corporate bonds.
- Bond FAQ — Frequently asked questions about bond investing.