As mentioned earlier, investments can be a very complicated subject. Earlier we discussed the two basic types of investments – equity and debt. We will now go a bit further into the discussion of one of these types – bonds, or debentures.
We have mentioned the fact that a municipal bond is a bond specific to a state or a municipality. Now we will discuss further details about these instruments, which are necessary in fully understanding how they function.
Municipal Bonds essentially give a tax break to investors who pay taxes in a specific state or municipality. Why do they do this? They do this to give investors a benefit for funding state or city projects. This gives the state or municipality a ready source of capital that is much cheaper than alternative sources of financing. The funds, which are generated through Municipal Bonds, are required to be used in projects that satisfy state and federal statutory requirements. Typically these projects must be public works projects such as roads or other types of assets of benefit to the general public such as low-income housing.
Obviously only states with a state tax will have municipal bonds and only investors who pay taxes in that particular state are eligible for the tax break for investing in these funds. The tax rate is “hidden” in the sense that what happens is that you receive the income from the funds but the state does not tax you for that amount of income. So it is the amount you avoided paying taxes on which is your benefit for investing in Municipal bonds.
One thing to be aware of is that it is only the income that is tax free in a municipal bond – NOT the capital appreciation received if you sell the bond early for a profit. There are other specific characteristics, which are dependent on an individuals tax situation that should be discussed with your financial advisor.
So far we have only mentioned Government Bonds in a general manner. Now we will discuss the various types as well as some of the other characteristics of such bonds.
Government Bonds are very similar in concept to municipal bonds. The main difference being that the tax break is at the federal level as opposed to the state. Government Bonds are generally comprised of either short-term United States Government Debentures or Long-Term Government Debentures.
The tax breaks for investing in Government Bonds are received in the same manner as the break received for Municipals. It is an income that you do not have to pay a federal tax on.
The only other feature of important to Government Bonds is the implied safety and security, which they have by being backed by the full faith and credit of the United States Government. This gives these debentures the highest possible safety in regards to the perception of the market.
Treasury Bills are the shortest term government debenture issued by the United States Government and they mature in periods ranging anywhere from 3 to 6 months. Because of their short maturity and the backing of the federal government they are considered one of the safest investment possible.
Treasury Notes are the next longest in terms of interest and as a result they pay a bit higher rate than T-Bills (slang for Treasury Bills). Treasury notes mature in periods ranging from 1 to 5 years.
Treasury Bonds are the longest maturing bonds issued by the Federal Government. Treasury Bonds have a maturity ranging anywhere from 5 to 30 years and pay the highest rates available for a Federal Government backed debenture.
Other than the maturity difference they are for the most part similar to the Treasury bills described above. The tax break for investing in Government Bond Funds are received in the same manner as the break received for Municipals. Only in this case, it is an income that is untaxed at the federal level.
Information is for educational purposes only and is not be interpreted as financial advice. This does not represent a recommendation to buy, sell, or hold any security. Consult your financial advisor.