What Bond Types Should You Buy for Income?
by Shane Flait, ©2011

Investment income generally comes from debt (or loan) instruments – like bonds. Before deciding on what type of debt instrument you’ll use for your retirement income, you should know their characteristics. Here’s a quick overview (the table summaries key investment characteristics).

U.S. Treasuries are the safest bonds since the government guarantees their interest and principal. Their safety, though, produces the lowest yields, since higher returns only come with higher risk.  Its interest is exempt from state and local taxes, but not from federal tax.

Treasury bills, have the shortest maturities - 13 weeks, 26 weeks, and one year. You buy them at a discount to their $10,000 face value and receive the full $10,000 at maturity. The difference reflects the interest you earn. So the greater the discount, the higher is the interest rate they pay.

Treasury notes mature in two to 10 years with interest paid semi-annually at a fixed rate. The minimum investment is $1,000 or $5,000 depending on maturity.

Treasury bonds have the longest maturities at 10 years. They also pay interest semi-annually and are sold in units of $1,000.

Zero-coupon bonds are Treasury-based securities that are sold at a deep discount and redeemed at full face value when they mature in six months to 30 years. That difference reflects your earned interest. Although you’re not paid an interest annually, you’re taxed on the implied "phantom interest" that you earn each year! So you need some cash to pay the yearly tax on the attributed phantom interest. Hold them in a tax-deferred account to avoid paying the annual tax.

Inflation-indexed Treasuries pay a real rate of interest on a principal amount that rises or falls with the consumer price index. You don't collect the inflation adjustment principal until the bond matures or you sell it, but you still owe federal income tax on that phantom amount each year - in addition to tax on the interest you receive currently. It’s best to hold them in tax-deferred accounts too.

Mortgage-backed bonds represent ownership in a package of mortgage loans issued or guaranteed by government agencies. They generally yield up to 1 percent more than Treasurys of comparable maturities since they carry more risk.

Corporate bonds pay taxable interest. The creditworthiness of the company determines the bond risk. They carry higher risks and, therefore, higher yields than Treasurys. Top-quality corporates are known as "investment-grade" bonds. Corporates with lower credit quality are called "high-yield," or "junk," bonds. Junk bonds typically pay higher yields than other corporates.

Municipal bonds are issued by state and local governments and agencies. Their interest is exempt from federal taxes and if you live in the state issuing the bond, that state’s state and local taxes are exempt as well. Their yields are typically lower than taxable bonds of similar duration and quality because of their tax exemptions. However, for people in the 28 percent federal tax bracket or above, they may give a higher net return then taxable bonds.

Type bond	Minimum investment	Maturity (years)	Interest paid (typically)	Taxable	Comment
Treasury bills	$10,000	Up to 1	By discount (phantom)	Federal only	Very secure short term income
Treasury notes	$1,000 - $5,000	2 to 10	semiannually	Federal only	Very secure income
Treasury bonds	$1,000	10	Semiannually	Federal only	Very secure income
Treasury zeros	$1,000	½  to 30	By discount (phantom)	Federal only	No current income to use
Treasury inflation indexed	$1,000	30	Semiannually	Federal only	Little current income to use
Mortgage-backed bonds	$25,000	20	Monthly with partial return of principal	Federal and state	Fairly secure investment
Corporate bonds	$1,000	1 to 30	Quarterly	Federal and state	High to low risk Lower to high income
Municipal bonds	$5,000 and up	1 to 40	semiannually	Often fully exempt	Good for very high income tax payers

 

 

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