With today’s fluctuations in the Stock Market, and knowing that the small investor is at the loosing end against big financial institutions, investing in debt instruments are more attractive than ever. Especially for investors approaching retirement age, this is a much safer area than stocks.
Investment earnings in general comes from debt instruments – like bonds, bills and notes which are basically loan types. Before deciding on what type of debt instrument you’ll use to develop your invested retirement income, you ought to know their characteristics.
U.S. Treasuries
U.S. Treasuries are the safest type of bonds since the Uncle Sam guarantees their interest and principal. Their safety, though, produces the lowest yields, since higher returns only come with higher risk. The interest income you earn from Treasuries is exempt from state and local taxes, but not from federal tax.
Treasury bills have the shortest maturities of 13 weeks, 26 weeks, and one year. They’re bought at a discount to their $10,000 face value and receive the full $10,000 at maturity, that is when the loan contract is up. The change reflects the interest you reap from them. Therefore, the bigger the discount, the higher is the interest rate you earn.
Treasury notes are in the mid range and mature in two to 10 years with a minimum investment of $1,000 or $5,000, depending on maturity. Interest is paid twice a year at a fixed rate.
Treasury bonds cover the longest maturities, which is 10 years, and are sold in units of $1,000. They also pay interest twice a year.
Zero-Coupon Bonds
Zero-coupon bonds are Treasury backed securities that are sold at a deep discount and redeemed at full face value when they mature in six months to 30 years. That change reflects your reaped interest. Although you’re not paid an interest annually, you’re still taxed on the implied interest that you pseudo-reap each year, unless you hold them in a tax-deferred account, such as an IRA. Otherwise, you need some cash to pay the annual tax on the attributed phantom interest.
Inflation-Indexed Treasuries
Inflation-indexed Treasuries follow the consumer price index, and pay a real rate of interest on their principal, which rises or falls with the consumer price index. You collect the inflation adjustment principal when the bond matures or you sell it. Like Zero-Coupon Bonds, you owe federal income tax on the phantom amount each year, in addition to the annual interest you receive. It’s also an advantage to hold them in tax-deferred accounts as well.
Municipal Bonds
Municipal bonds are issued by state and local governments, and their interest is exempt from federal taxes and state taxes of the state you live in. For example, if you live in California, bonds issued by Sacramento are exempt from state taxes, while bonds issued from Phoenix are not. Their yields are usually lower than taxable bonds of similar maturity and quality because of their tax exemptions. However, they may yield more for people that are above the 28 percent federal tax bracket.
Mortgage-Backed Bonds
Mortgage-backed bonds represent ownership in a group of mortgage loans issued or guaranteed by uncle sam agencies. They usually yield about 1 percent more than Treasuries of comparable maturities as they expose more risk.
Corporate Bonds
Corporate bonds pay taxable interest that is based on the creditworthiness of the business. Higher risk results in higher yields. Bonds of stable corporate companies are known as investment-grade bonds and are considered fairly safe, while companies with lower credit quality are called high-yield or junk bonds.
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