4 Types of Bonds to Choose from

1. Municipal bonds: Municipal bonds are state and local government bonds that pay interest that’s federally tax free and state tax-free to residents in the state of issue. For example, if you live in New York and buy a bond issued by a New York government agency, you don’t owe New York state or federal income tax on the interest.

The government organizations that issue municipal bonds know that the investors who buy municipals don’t have to pay most or any of the income tax that normally would be required on other bonds - which means that the issuing governments can get away with paying a lower rate of interest.

If you’re in a high tax bracket (31 percent or higher for federal tax) and you want to invest in bonds outside tax-sheltered retirement accounts, you should end up with a higher after-tax yield from a municipal bond (often called munis) than a bond that pays taxable interest. If you’re in the 28 percent federal bracket, it’s borderline whether you’ll come out ahead with munis. At less than 28 percent, don’t invest in munis.

Some people are concerned about the impact of the passage of a flat tax on their municipal bonds. Under some of the proposed versions of the flat tax, all interest earned on investments would not be taxed. Thus, muni bonds would lose their tax-free advantage versus other bonds. If such a flat tax were to pass, the price of municipal bonds, particularly longer-term ones, could fall significantly.

Corporate bonds: Corporate bonds are issued by companies such as McDonald’s, Macy’s, and IBM. Corporate bonds pay interest that’s fully taxable. Thus, they are appropriate for investing inside retirement accounts. Only lower tax bracket investors should consider buying such bonds outside a tax-sheltered retirement account.

Mortgage bonds: You remember that mortgage you took out when you purchased a home? Well, you can actually invest in that mortgage through purchasing a bond! Many banks actually sell their mortgages as bonds in the financial markets allowing other investors to invest in them. The repayment of principal on such bonds is usually guaranteed at the bond’s maturity by a government agency, such as the Government National Mortgage Association or the Federal National Mortgage Association.

Convertible bonds: Convertible bonds are hybrid securities - they’re bonds that you can convert into a preset number of shares of stock in the company that issued the bond. Although these bonds do pay interest, their yield is lower than nonconvertible bonds because convertibles offer you the upside potential of being able to make more money if the underlying stock rises.

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