Bonds aid in adding diversity to your briefcase and check risk, but they are not easy to understand sometimes. We are interested in making bonds work for you. We can help you to understand the basics when it comes to bonds.
Table of Content
Buying and selling bonds
Bonds can be bought either at a discount or premium to its stated worth. A ‘discount bond’ is sold for less than its stated value, or equal, which would eventually be the price at which it is redeemed by the issuing company or governmental agency. While the selling price for a ‘premium bond’ exceeds its face value.
In the U.S. and all around the world, bonds are sold and bought in large quantities. There are some bonds that are harder to buy and sell than others. But this does not hinder investors from trading in all the different kinds of bonds available on every single trading day.
Buying and selling of bonds usually depend on the type of bond you are interested in.
- Treasury and savings bonds can be bought and sold at a brokerage firm using an account or by direct dealings with the U.S. government. Brokerage firms can sell to you new issues of Treasury bill, notes and bonds (plus tips). They can also be bought from the U.S Treasury Department’s direct website during auctions.
- Also, savings bonds can be gotten from the government using commission firms or brokerages, banks and various office payroll deduction programs.
- Municipal and corporate bonds like stock, may be bought through total-service, investment and commercial banks and also through discount or online brokers. Immediately new-issue bonds have been valued and sold, they start trading on the secondary market. Brokers handle buying and selling of bonds on the secondary market. To buy and sell corporate bonds through a brokerage firm, you are usually requested to pay a brokerage fee.
Buying bonds through a broker
Brokerage firms deal in the trading of virtually any kind of bond, though some firms may specialize in the buying and selling of a particular type of bond for example junk bonds or municipal bonds. But generally, you need a broker to buy anything except Treasury and savings bonds.
You should be aware that your brokerage firm is usually remunerated for carrying out these services for you. You may be charged a certain amount as commission by the firm that acts as agent for you. This means that the firm buys and sells bonds on your behalf. The firm is usually principal in most bond transactions i.e. it can sell to you bonds that it already owns. If a firm acts as principal when selling you a bond, it may raise or inflate the price that you pay more than the price the firm paid to acquire the bond. That raise in price is the firm’s remuneration. Likewise, if you are the seller of the bond, the firm, as the principal, may offer you a reduced price that will enable them to sell the bond to another buyer or dealer. Thus, you should be aware that you have most likely been charged by the firm for its transactional services.
However, if the firm is acting as the agent, the fee charged will be made known to you. The firm has to let you know the amount of commission you were charged during the confirmation of the transaction. But if the firm acts as principal, it is not so. As principal, the firm is not mandated to reveal to you during confirmation the total fee you paid to buy the bond. It is only mandated to show to you the price at which the bond is sold to you and its yield. Also, if the firm acts as principal when buying a security from you, the firm is also not required to tell you how much reduction is made in determining the price it will pay you. You can also buy and sell bonds through a discount or an online broker. Discount or online brokers often charge a flat rate to buy or sell bonds.
Bonds and Taxes
Similar to buying and selling stocks, there are tax charges associated with bond trading due to the gains or income you receive from your bond investments.
The entity issuing a bond determines whether or not you will be required to pay tax on the bond’s interest or the bond’s fund dividends.
- Corporate or Mortgaged-backed bonds– the interest gotten from this type of bond is usually subject to federal and state income tax.
- Treasuries and other Federal Government bonds-these type of bonds are backed by the ‘full faith and credit’ of the U.S. government and are subject to federal income tax but not state income tax. Bonds in which the U.S. government provides a guarantee such as GinnieMaes are excluded from this.
- Municipal bonds- These bonds are usually excluded from federal income tax. If the municipal bond was issued by the local or state government, then the interest from the bond is generally excluded from local and state taxes too. However, if you stay outside the state where the bond was issued, then the interest from the bond is subject to state income tax. Bonds issued by a U.S. territory like Puerto Rico or Guam, nevertheless, are excluded from all taxes in the 50 states.
A tax code which imposed a Net Investment Income Tax of 3.8 percent on stakeholders who meet certain income points and other criteria was implemented from January 1, 2013. To get more information about the tax and who it affects and how to calculate your net investment income, you can read the IRS’s Net Investment Income Tax FAQs or talk to your tax professional.
When you buy a single bond at stated value and hold it till it matures, there is no capital gain to tax on it. But if the bond is sold for profit before it matured, you are most likely to build up a taxable gain even if it is a tax-excluded bond. If the bond is owned for more than a year, then its gain is taxed at the long-term capital gain rate. If owned for a year or less, then the bond owner is taxed at the short-term rate.
You are not expected to sell at the same price you bought a bond fund. This means that you may get a capital loss or gain. Also, mutual fund managers trade in securities all through the year, generating capital gains or losses. If there are more gains than losses, investors usually receive a capital gain return at the end of the year.
Remember to always check with your tax advisor before investing in any single bond or bond funds as tax rules pertaining bonds are complicated.
Other things to consider
- Stay up to date with credit rating
The quality rating of a bond may be changed after it is issued may be due to a change in the issuer’s financial state. This has led many bonds to remain for a long time on the market. Therefore it is vital to always check current bond ratings.
- Be sure that there is an easy exit
Even if you buy a bond with the intention to hold it to maturity, it is not advisable to stick on just one investment. Stakeholders should limit themselves to simple-grade bonds that can be priced and sold easily to other stakeholders.
- Watch your maturities
You can select bonds that will mature exactly when you need a large amount of money for other important things like retirement, college expenses or for reinvestment in bonds currently with high yields to support your pension. Always remember that there is more risk involved with bonds that have further maturity dates.