How To Choose The Right Bond For You

When it comes to investing, bonds are generally the best low-risk financial instruments available. Although they gain low interest amounts, the majority of bonds have the advantage of being government-backed. In times of market volatility, the allure of bonds gains momentum because of their dependability. Usually, investors look for security after experiencing a precipitous downturn in the stock market. As a result, more investors will park their funds in securities such as U.S. Treasuries, which gain conservative yet stable returns. (For background reading, check out our Bond Basics Tutorial.)

Government-backed bonds come in the form of Treasury bills (T-bills), notes and bonds. T-bills are short-term U.S. government securities with maturity of a year or less. They can be bought through a broker, a bank or directly from the government. At maturity, the buyer of the T-bill receives the full amount stated on the bond certificate. The difference between the face amount and the amount the bondholder paid for the certificate is considered the interest gained. This interest is exempt from state and local income taxes, but not from federal income taxes.

Treasury notes have a longer term; they are issued for two-, three-, five-, or 10-year periods, and their interest rates are fixed. Treasury note and bond owners receive interest payments every six months. That interest must be reported as interest income on federal tax returns. They also come in several types, including I bonds, Treasury inflation-protected securities (TIPS) and U.S. government savings bonds such as Series EE bonds. (Several factors affect the taxable interest that must be reported; learn more in Bond Taxation Rules.)

I bonds are savings bonds backed by the U.S. government. The difference between these bonds and the regular treasury bonds is in the interest gained. The rate earned on these bonds is actually a combination of two rates: a fixed interest rate set when the investor buys the bond and a semiannual variable rate tied to the current inflation rate. The maximum purchase for an I bond is $5,000 per calendar year, and the interest stops accruing 30 years after it is issued. Earnings from these bonds are exempt from state and local taxes, and federal taxes can be deferred until the bond is either redeemed or reaches the maturity date. One key benefit here is that if this bond is cashed to pay education expenses, it is completely tax exempt. However, if the bond is redeemed within the first five years, the holder will be penalized the previous three months' interest rate. (ILBs, such as TIPS and I-Bonds, allow investors to curb the corrosive effects of inflation and increase portfolio diversification; see Hedge Your Bets With Inflation-Linked Bonds.)

To protect yourself against inflation, you can also purchase the inflation indexed $1,000 bonds known as TIPS. These bonds guarantee to beat inflation because the principal is adjusted every six months according to the consumer price index, so if inflation occurs the principal amount increases. The interest rate on these bonds never changes and is set when the security is purchased. The terms of these bonds are from five to 30 years and interest is paid out to investors every six months until maturity.

Series EE savings bonds are different in that they are issued at a deep discount from face value and pay no annual interest because it accumulates within the bond itself, and the interest is paid out when the bond matures. The interest income is federally taxed but exempt from state and local taxes. If the bond is redeemed for the purpose of funding a college education, the interest is exempt from federal income tax. TreasuryDirect has the most current rates on all the bonds. (Learn more in The Lowdown On Savings Bonds and Bond Taxation Rules.)

Corporate bonds - long-term debt issued by a corporation - are also interest bearing. Companies issue these bonds as a way to increase company funds to finance major projects. These are long-term taxable bonds that pay the highest interest rate of all the bonds, due to increased risk of default. The advantage for the investor is that companies are required to pay bondholders first, before short-term creditors, in times of financial difficulty.

Moody's Bond Survey and Standard and Poor's can also help you make a decision on where to put your money. These rating services grade bonds based on the credit risk of the corporation or municipality issuing the bond. The quality and creditworthiness of the issuing company is displayed through these bond ratings. A high quality bond rating of AAA from Standard and Poor's, for example, means the bond is of the highest investment quality, suggesting the company will have the ability to pay both principal and interest at maturity. On the opposite end of the spectrum, a rating of DDD means the corporation selling the bond is in default. These are considered junk bonds, and the company will most likely not be able to pay back either the principal or interest at maturity to the bondholder. These types of low-rated bonds are the same as the high-yielding and speculative bonds, because they carry the highest risk and can bring the highest return on investment, if they are paid back at maturity.

Local governments also issue long-term bonds in the form of municipal bonds called "munis" - tax free and tax-exempt bonds. These are used by the local governments to finance public improvements projects such as roads, bridges and parks. Interest income from these bonds is not subject to federal income taxes, and if you live in the muni's issuing state, the bond's interest income is also exempt from state and local taxes. Capital gains on these bonds are taxable. Although these bonds offer a lower interest rate than corporate bonds, because of tax-exempt advantages, munis could bring in an after-tax return higher than a corporate bond. (Investing in these bonds may offer a tax-free income stream but they are not without risks; see The Basics Of Municipal Bonds.)

You can also find and trade a variety of bonds through the bond research web sites. When making a decision about which bond to buy, a good source of reference is Standard and Poor's. In addition to bond ratings, it lists filings of companies that issue bonds. Investors can use this information when searching for the most financially stable corporations.

Like stocks, investing in corporate bonds requires informed decisions. Finding out the ratings and reading the financial statements of companies will lead to a more confident choice. If you decide on Treasury securities, make sure you are comfortable with the return and term of your investment decision. Especially in times of high levels of stock market insecurity, it is wise to build a stronger and more stable portfolio with a variety of bonds. (Learn the basic terms to breakdown this seemingly complex investment area; read The ABCs Of The Bond Market.)