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An Inverse Relationship: Interest Rate Risk
Another risk common to all bonds is interest-rate risk. In normal circumstances, when market interest rate levels rise, existing bonds' market values usually drop (and vice versa), although past performance does not assure future results. However, interest rate risk's effect on market value may be a relatively minor factor for income-oriented, buy-and-hold investment strategies. That's because bondholders are generally entitled to receive the full principal value of their bonds at maturity, regardless of any short-term changes in market value that might have been caused by fluctuations in market interest rates.
Most Bonds Fall Into One of Four General Categories
- Government Agency
Types of Bonds
Bonds come in a variety of forms, each bringing different benefits, risks, and tax considerations to an investor's portfolio. Most bonds fall into four general categories: corporate, government, government agency, and municipal.
- Corporate Bonds
Issued by corporations, these bonds may provide an investor with a steady stream of income.
- Risk Considerations: The primary risks associated with corporate bonds are credit risk, interest rate risk, and market risk. In addition, some corporate bonds can be called for redemption by the issuer and have their principal repaid prior to the maturity date. When bonds are called in a declining interest environment, investors may not be able to obtain new bonds that offer the same yield.
- Tax Considerations: Interest earned on a corporate bond is generally taxed as ordinary income at your applicable federal and state income tax rates. If you sell or redeem a bond for more than you paid, the difference would be taxed as a capital gain.
- Government Bonds
Government bonds are issued by the U.S. Treasury and backed by the full faith and credit of the U.S. government. They include intermediate- and long-term Treasury bonds. Intermediate-term bonds mature in three to 10 years, whereas long-term bonds generally mature in 10 to 30 years.
- Risk Considerations: Among the lowest risk of all bond investments, these bonds have low credit risk because they are backed by the full faith and credit of the U.S. government. A government bond does present market risk if sold prior to maturity, and also carries some inflation risk -- the risk that its comparatively lower return will not keep pace with inflation.
- Tax Considerations: Treasury bond interest is fully taxable at the federal level but it is exempt from state and local taxes. Gains on sale or redemption are also taxable.
- Government Agency Bonds
These bonds are indirect debt obligations of the U.S. government issued by federal agencies and government-sponsored entities. Examples of such organizations are the Federal National Mortgage Association (FNMA or "Fannie Mae") and the Government National Mortgage Association (GNMA or "Ginnie Mae").
- Risk Considerations: Agency and entity bonds are widely seen as having low credit risk due to their association with government chartered entities. But because these bonds are not directly issued by the U.S. government, they are not necessarily backed by its full faith and credit. In addition to the risks inherent in government bonds, agency bonds run the risk of going into default, although such an occurrence is generally considered unlikely. Because of this added risk, however, these bonds generally offer higher yields than government bonds.
- Tax Considerations: These bonds are fully taxable at the federal level and, in some cases, at the state and local levels as well. Gains on sale or redemption are also taxable.
- Municipal Bonds
Municipal bonds, or "munis," are issued by a U.S. state, county, city, town, village, or local authority to raise funds for general use or particular public works projects.
- Risk Considerations: Munis fall somewhere in the middle of the credit risk spectrum. The risk of default can vary depending on the creditworthiness of the issuer and the type of debt obligation.
- Tax Considerations: Perhaps the biggest advantage of most munis is their ability to offer income potential that may be income tax exempt. Gains on sale or redemption are taxable. Income from some municipal bonds may be subject to the alternative minimum tax.
|Know the Risks Associated With Bonds|
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