Understanding How Bonds Work

Bonds can satisfy a variety of investments needs, for instance, providing additional income and diversi-fication in your portfolio. But do you know what you are buying when you purchase a bond or a bond mutual fund?

Governments and corporations must raise money to expand or finance particular projects. These organizations sell bonds as a method of borrowing money. When you invest in a bond, you are lending money to its issuer. The bond is issued for a fixed period of time (maturity date) that can range from 13 weeks to 30 years. The issuer will make fixed-interest payments to you over the life of the bond and will pay you the face value of the bond when it matures.

There are several types of bonds on the market. The most common are as follows:

• U.S. Treasury bonds—The federal government sells bonds to finance its debt. They are backed by the “full faith and credit” of the U.S. government and are therefore regarded as the most conservative investments available. Interest received is tax-free at the state level but is subject to federal income tax.
• Municipal bonds—State and local governments might use the funds for the construction of schools, roads, and land conservation. The interest from municipal bonds is usually exempt from federal and state income tax. This tax-free status should be taken into consideration when comparing municipals to taxable investments.
• GSE—Government-sponsored enterprise securities are sold by government agencies like Fannie Mae, Freddie Mac, and Ginnie Mae. This money is used to fund loans for special borrowers such as farmers, homebuyers, and students.
• Corporate bonds—Companies often need money to build or improve facilities, pay off old debt, to acquire other firms, or for other expansion purposes. Interest from corporate bonds is taxable at the state and federal levels. Corporate bonds usually pay higher interest rates than government bonds because there is a chance that the company could default on the bond. High-yield bonds, also called junk bonds, are corporate bonds that are issued by companies with below-investment-grade credit ratings.

If low interest rates have your income down, bonds could help you increase your cash flow. If you would like to know which types of bonds would be best for your situation, please return the enclosed coupon for more information.