Last week, I talked about the safest, most liquid investments you can have: bank accounts and CDs. Bonds are slightly riskier but have better returns and sometimes allow you to fund very specific activities, which makes it easier to make moral investments. Bonds also encourage a long-term perspective since their value doesn’t fluctuate like stocks do. There are three major types of bonds, each with different benefitsa dn drawbacks: federal, municipal, and corporate.
A bond (or bill or note depending on how long they take to mature) is basically a loan to a company or government. You pay them a given amount and they pay you interest and then repay your loan at the end of the term. Some bonds roll the interest into the final payment while others give out occasional (usually quarterly or annual) interest payments. For example, you can put $25 into a savings bond and get $50 from the government in 15 years. Or, you can put it in a corporate bond and receive annual payments of $1 until you get your $25 back in 15 years (obviously, these numbers are totally made up).
US government bonds are some of the safest investments you can make. This lack of risk is reflected in their low returns, however. The current rate for most federal bonds range from 0.07% to 3.7% depending on the maturation date (1 month to 30 years out). Interest on government bonds is also exempt from state and local taxes (although not federal taxes), which increases the effective yield a little. Even though returns aren’t great, you know what you’re funding: the US government. Generally, the government takes a longer view than corporations but there are still some morally sticky areas, depending on your viewpoint. If you’re interested in federal bonds, you can buy them through TreasuryDirect.
Municipal bonds are similar, but sold by local governments. Usually, these bonds raise funds for a specific purpose like improving schools. Here in Bloomington, the city is considering floating a bond to buy a sports complex. To encourage people to invest, they’ve discussed how much money they’ll need to raise as well as how they plan to pay it back (savings from events they’d otherwise have to rent locations for and monthly access fees). This makes it easy to evaluate and decide whether or not it’s a sustainable purpose.
Even better, this money stays in the local economy. Interest rates are usually higher than those for federal bonds, about 1.7% to 6.8% (6 month to 30 year) right now. That’s because of slightly higher risk and difficulty finding buyers (it’s easier to sell to the entire US than to a small town). You also have to invest on the municipality’s schedule and not your own, since they don’t continuously float bonds. Many municipal bonds are tax free at all levels (federal, state, and local) but others offer no tax incentives at all.
Corporate bonds are floated by companies that need additional cash. Many large corporations use bonds to raise money for seasonal expenses or short-term capital expenses like building new factories. Like buying stock in a company, you’re funding all of the company’s activities, which can raise moral problems if the company isn’t one you believe in. Although corporate bonds are riskier than government bonds, they’re safer than stocks. If a company goes bankrupt, bond-holders are paid before stock-holders. Corporate rates range from 1.5% to 11% (2 year to 30 year) depending on the risk rating of the bond (A, AA, and AAA from reasonable risk to almost no risk).
If you buy a corporate or municipal bond, you’ll probably see numbers like the price, coupon, and maturity date. In general, all you really need to worry about is the yield-to-maturity (YTM). This incorporates all of those factors into a simple annual yield. For example, if the YTM is 3% then you know that buying a bond at $1000 will yield you $30 a year. If the bond costs $500, then you’ll only get $15 with the same YTM.
Federal bonds are a little simpler, since you pay a discount and receive face value on maturity. For example, a EE bond with a face value of $50 might cost you $25. In 30 years, you can redeem your EE bond for $50, an annual compound rate of 2.4%.
Bonds are great if you’re looking for tax exemption, low risk, regular payments, or specific projects to fund. They’re not so good if you want to invest money on a regular schedule or you want higher returns. I think that bonds are a great part of a sustainable portfolio, but since they take some work and aren’t always available, stocks have a place as well. I’ll talk more about that in my next article.